[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2023 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          
          
          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.441 to 1.500)

                         Revised as of April 1, 2022

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2022
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as a 
                    Special Edition of the Federal Register

[[Page ii]]

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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     891
      Alphabetical List of Agencies Appearing in the CFR......     911
      Table of OMB Control Numbers............................     921
      List of CFR Sections Affected...........................     939

[[Page iv]]





                     ----------------------------

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.441-0 
                       refers to title 26, part 
                       1, section 441-0.

                     ----------------------------

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2022), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
dates and effective dates are usually not the same and care must be 
exercised by the user in determining the actual effective date. In 
instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
inserted following the text.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
amendments to existing regulations in the CFR. These OMB numbers are 
placed as close as possible to the applicable recordkeeping or reporting 
requirements.

PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 
the revision date stated on the cover of each volume are not carried. 
Code users may find the text of provisions in effect on any given date 
in the past by using the appropriate List of CFR Sections Affected 
(LSA). For the convenience of the reader, a ``List of CFR Sections 
Affected'' is published at the end of each CFR volume. For changes to 
the Code prior to the LSA listings at the end of the volume, consult 
previous annual editions of the LSA. For changes to the Code prior to 
2001, consult the List of CFR Sections Affected compilations, published 
for 1949-1963, 1964-1972, 1973-1985, and 1986-2000.

``[RESERVED]'' TERMINOLOGY

    The term ``[Reserved]'' is used as a place holder within the Code of 
Federal Regulations. An agency may add regulatory information at a 
``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used 
editorially to indicate that a portion of the CFR was left vacant and 
not dropped in error.

INCORPORATION BY REFERENCE

    What is incorporation by reference? Incorporation by reference was 
established by statute and allows Federal agencies to meet the 
requirement to publish regulations in the Federal Register by referring 
to materials already published elsewhere. For an incorporation to be 
valid, the Director of the Federal Register must approve it. The legal 
effect of incorporation by reference is that the material is treated as 
if it were published in full in the Federal Register (5 U.S.C. 552(a)). 
This material, like any other properly issued regulation, has the force 
of law.
    What is a proper incorporation by reference? The Director of the 
Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
approval is based are:
    (a) The incorporation will substantially reduce the volume of 
material published in the Federal Register.
    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
process.
    (c) The incorporating document is drafted and submitted for 
publication in accordance with 1 CFR part 51.
    What if the material incorporated by reference cannot be found? If 
you have any problem locating or obtaining a copy of material listed as 
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contacting the agency, you find the material is not available, please 
notify the Director of the Federal Register, National Archives and 
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or call 202-741-6010.

CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Authorities 
and Rules. A list of CFR titles, chapters, subchapters, and parts and an 
alphabetical list of agencies publishing in the CFR are also included in 
this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.

[[Page vii]]

    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

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in the Code of Federal Regulations.

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, 8601 Adelphi Road, College Park, MD 
20740-6001 or e-mail [email protected].

SALES

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ELECTRONIC SERVICES

    The full text of the Code of Federal Regulations, the LSA (List of 
CFR Sections Affected), The United States Government Manual, the Federal 
Register, Public Laws, Public Papers of the Presidents of the United 
States, Compilation of Presidential Documents and the Privacy Act 
Compilation are available in electronic format via www.govinfo.gov. For 
more information, contact the GPO Customer Contact Center, U.S. 
Government Publishing Office. Phone 202-512-1800, or 866-512-1800 (toll-
free). E-mail, [email protected].
    The Office of the Federal Register also offers a free service on the 
National Archives and Records Administration's (NARA) website for public 
law numbers, Federal Register finding aids, and related information. 
Connect to NARA's website at www.archives.gov/federal-register.
    The eCFR is a regularly updated, unofficial editorial compilation of 
CFR material and Federal Register amendments, produced by the Office of 
the Federal Register and the Government Publishing Office. It is 
available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register
    April 1, 2022







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations codified 
under this title by the Internal Revenue Service, Department of the 
Treasury, as of April 1, 2022. The first fifteen volumes comprise part 1 
(Subchapter A--Income Tax) and are arranged by sections as follows: 
Sec. Sec.  1.0-1.60; Sec. Sec.  1.61-1.139; Sec. Sec.  1.140-1.169; 
Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; Sec. Sec.  1.401-1.409; 
Sec. Sec.  1.410-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end of part 1. The sixteenth volume containing parts 2-29, includes the 
remainder of subchapter A and all of Subchapter B--Estate and Gift 
Taxes. The last six volumes contain parts 30-39 (Subchapter C--
Employment Taxes and Collection of Income Tax at Source); parts 40-49; 
parts 50-299 (Subchapter D--Miscellaneous Excise Taxes); parts 300-499 
(Subchapter F--Procedure and Administration); parts 500-599 (Subchapter 
G--Regulations under Tax Conventions); and part 600 to end (Subchapter 
H--Internal Revenue Practice).

    The OMB control numbers for title 26 appear in Sec.  602.101 of this 
chapter. For the convenience of the user, Sec.  602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

    For this volume, Michele Bugenhagen was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of John 
Hyrum Martinez, assisted by Stephen J. Frattini.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




         (This book contains part 1, Sec. Sec.  1.441 to 1.500)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




  --------------------------------------------------------------------

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes (Continued)....................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations, and Regulations Under Tax Conventions.

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)





PART 1_INCOME TAXES (CONTINUED)--Table of Contents



                  Normal Taxes and Surtaxes (Continued)

                 DEFERRED COMPENSATION, ETC. (CONTINUED)

              ACCOUNTING PERIODS AND METHODS OF ACCOUNTING

                           Accounting Periods

Sec.
1.441-0 Table of contents.
1.441-1 Period for computation of taxable income.
1.441-2 Election of taxable year consisting of 52-53 weeks.
1.441-3 Taxable year of a personal service corporation.
1.441-4 Effective date.
1.442-1 Change of annual accounting period.
1.443-1 Returns for periods of less than 12 months.
1.444-0T Table of contents (temporary).
1.444-1T Election to use a taxable year other than the required taxable 
          year (temporary).
1.444-2T Tiered structure (temporary).
1.444-3T Manner and time of making section 444 election (temporary).
1.444-4 Tiered structure.

                          Methods of Accounting

                    Methods of Accounting in General

1.446-1 General rule for methods of accounting.
1.446-2 Method of accounting for interest.
1.446-3 Notional principal contracts.
1.446-3T Notional principal contracts (temporary).
1.446-4 Hedging transactions.
1.446-5 Debt issuance costs.
1.446-6 REMIC inducement fees.
1.446-7 Net asset value method for certain money market fund shares.
1.448-1 Limitation on the use of the cash receipts and disbursements 
          method of accounting.
1.448-1T Limitation on the use of the cash receipts and disbursements 
          method of accounting (temporary).
1.448-2 Limitation on the use of the cash receipts and disbursements 
          method of accounting for taxable years beginning after 
          December 31, 2017.
1.448-3 Nonaccrual of certain amounts by service providers.

          Taxable Year for Which Items of Gross Income Included

1.451-1 General rule for taxable year of inclusion.
1.451-2 Constructive receipt of income.
1.451-3 Timing of income inclusion for taxpayers with an applicable 
          financial statement using an accrual method of accounting.
1.451-4 Accounting for redemption of trading stamps and coupons.
1.451-6 Election to include crop insurance proceeds in gross income in 
          the taxable year following the taxable year of destruction or 
          damage.
1.451-7 Election relating to livestock sold on account of drought.
1.451-8 Advance payments for goods, services, and certain other items.
1.453-1--1.453-2 [Reserved]
1.453-3 Purchaser evidences of indebtedness payable on demand or readily 
          tradable.
1.453-4-1.453.8 [Reserved]
1.453-9 Gain or loss on disposition of installment obligations.
1.453-10 [Reserved]
1.453-11 Installment obligations received from a liquidating 
          corporation.
1.453-12 Allocation of unrecaptured section 1250 gain reported on the 
          installment method.
1.453A-0 Table of contents.
1.453A-1 Installment method of reporting income by dealers on personal 
          property.
1.453A-2 [Reserved]
1.453A-3 Requirements for adoption of or change to installment method by 
          dealers in personal property.
1.454-1 Obligations issued at discount.
1.455-1 Treatment of prepaid subscription income.
1.455-2 Scope of election under section 455.
1.455-3 Method of allocation.
1.455-4 Cessation of taxpayer's liability.
1.455-5 Definitions and other rules.
1.455-6 Time and manner of making election.
1.456-1 Treatment of prepaid dues income.
1.456-2 Scope of election under section 456.
1.456-3 Method of allocation.
1.456-4 Cessation of liability or existence.
1.456-5 Definitions and other rules.
1.456-6 Time and manner of making election.
1.456-7 Transitional rule.
1.457-1 General overviews of section 457.
1.457-2 Definitions.
1.457-3 General introduction to eligible plans.
1.457-4 Annual deferrals, deferral limitations, and deferral agreements 
          under eligible plans.

[[Page 6]]

1.457-5 Individual limitation for combined annual deferrals under 
          multiple eligible plans.
1.457-6 Timing of distributions under eligible plans.
1.457-7 Taxation of Distribution Under Eligible Plans.
1.457-8 Funding rules for eligible plans.
1.457-9 Effect on eligible plans when not administered in accordance 
          with eligibility requirements.
1.457-10 Miscellaneous provisions.
1.457-11 Tax treatment of participants if plan is not an eligible plan.
1.457-12 Effective dates.
1.458-1 Exclusion for certain returned magazines, paperbacks, or 
          records.
1.458-2 Manner of and time for making election.
1.460-0 Outline of regulations under section 460.
1.460-1 Long-term contracts.
1.460-2 Long-term manufacturing contracts.
1.460-3 Long-term construction contracts.
1.460-4 Methods of accounting for long-term contracts.
1.460-5 Cost allocation rules.
1.460-6 Look-back method.

                 Taxable Year for Which Deductions Taken

1.461-0 Table of contents.
1.461-1 General rule for taxable year of deduction.
1.461-2 Contested liabilities.
1.461-3 Prepaid interest. [Reserved]
1.461-4 Economic performance.
1.461-5 Recurring item exception.
1.461-6 Economic performance when certain liabilities are assigned or 
          are extinguished by the establishment of a fund.
1.465-1T Aggregation of certain activities (temporary).
1.465-8 General rules; interest other than that of a creditor.
1.465-20 Treatment of amounts borrowed from certain persons and amounts 
          protected against loss.
1.465-27 Qualified nonrecourse financing.
1.466-1 Method of accounting for the redemption cost of qualified 
          discount coupons.
1.466-2 Special protective election for certain taxpayers.
1.466-3 Manner of and time for making election under section 466.
1.466-4 Manner of and time for making election under section 373(c) of 
          the Revenue Act of 1978.
1.467-0 Table of contents.
1.467-1 Treatment of lessors and lessees generally.
1.467-2 Rent accrual for section 467 rental agreements without adequate 
          interest.
1.467-3 Disqualified leasebacks and long-term agreements.
1.467-4 Section 467 loan.
1.467-5 Section 467 rental agreements with variable interest.
1.467-6 Section 467 rental agreements with contingent payments. 
          [Reserved]
1.467-7 Section 467 recapture and other rules relating to dispositions 
          and modifications.
1.467-8 Automatic consent to change to constant rental accrual for 
          certain rental agreements.
1.467-9 Effective/applicability dates and automatic method changes for 
          certain agreements.
1.468A-0 Nuclear decommissioning costs; table of contents.
1.468A-1 Nuclear decommissioning costs; general rules.
1.468A-2 Treatment of electing taxpayer.
1.468A-3 Ruling amount.
1.468A-4 Treatment of nuclear decommissioning fund.
1.468A-5 Nuclear decommissioning fund--miscellaneous provisions.
1.468A-6 Disposition of an interest in a nuclear power plant.
1.468A-7 Manner of and time for making election.
1.468A-8 Special transfers to qualified funds pursuant to section 
          468A(f).
1.468A-9 Applicability dates.
1.468B Designated settlement funds.
1.468B-0 Table of contents.
1.468B-1 Qualified settlement funds.
1.468B-2 Taxation of qualified settlement funds and related 
          administrative requirements.
1.468B-3 Rules applicable to the transferor.
1.468B-4 Taxability of distributions to claimants.
1.468B-5 Effective dates and transition rules applicable to qualified 
          settlement funds.
1.468B-6 Escrow accounts, trusts, and other funds used during deferred 
          exchanges of like-kind property under section 1031(a)(3).
1.468B-7 Pre-closing escrows.
1.468B-8 Contingent-at-closing escrows. [Reserved]
1.468B-9 Disputed ownership funds.
1.469-0 Table of contents.
1.469-1 General rules.
1.469-1T General rules (temporary).
1.469-2 Passive activity loss.
1.469-2T Passive activity loss (temporary).
1.469-3 Passive activity credit.
1.469-3T Passive activity credit (temporary).
1.469-4 Definition of activity.
1.469-4T Definition of activity (temporary).
1.469-5 Material participation.
1.469-5T Material participation (temporary).
1.469-6 Treatment of losses upon certain dispositions. [Reserved]
1.469-7 Treatment of self-charged items of interest income and 
          deduction.

[[Page 7]]

1.469-8 Application of section 469 to trust, estates, and their 
          beneficiaries. [Reserved]
1.469-9 Rules for certain rental real estate activities.
1.469-10 Application of section 469 to publicly traded partnerships.
1.469-11 Applicability date and transition rules.

                               Inventories

1.471-1 Need for inventories.
1.471-2 Valuation of inventories.
1.471-3 Inventories at cost.
1.471-4 Inventories at cost or market, whichever is lower.
1.471-5 Inventories by dealers in securities.
1.471-6 Inventories of livestock raisers and other farmers.
1.471-7 Inventories of miners and manufacturers.
1.471-8 Inventories of retail merchants.
1.471-9 Inventories of acquiring corporations.
1.471-10 Applicability of long-term contract methods.
1.471-11 Inventories of manufacturers.
1.472-1 Last-in, first-out inventories.
1.472-2 Requirements incident to adoption and use of LIFO inventory 
          method.
1.472-3 Time and manner of making election.
1.472-4 Adjustments to be made by taxpayer.
1.472-5 Revocation of election.
1.472-6 Change from LIFO inventory method.
1.472-7 Inventories of acquiring corporations.
1.472-8 Dollar-value method of pricing LIFO inventories.
1.475-0 Table of contents.
1.475(a)-1--1.475(a)-2 [Reserved]
1.475(a)-3 Acquisition by a dealer of a security with a substituted 
          basis.
1.475(a)-4 Valuation safe harbor.
1.475(b)-1 Scope of exemptions from mark-to-market requirement.
1.475(b)-2 Exemptions--identification requirements.
1.475(b)-3 [Reserved]
1.475(c)-1 Definitions--dealer in securities.
1.475(c)-2 Definitions--security.
1.475(d)-1 Character of gain or loss.
1.475(g)-1 Effective dates.

                               Adjustments

1.481-1 Adjustments in general.
1.481-2 Limitation on tax.
1.481-3 Adjustments attributable to pre-1954 years where change was not 
          initiated by taxpayer.
1.481-4 Adjustments taken into account with consent.
1.481-5 Eligible terminated S corporation.
1.481-6 Effective dates; applicability dates.
1.482-0 Outline of regulations under section 482.
1.482-1 Allocation of income and deductions among taxpayers.
1.482-1T Allocation of income and deductions among taxpayers 
          (temporary).
1.482-2 Determination of taxable income in specific situations.
1.482-3 Methods to determine taxable income in connection with a 
          transfer of tangible property.
1.482-4 Methods to determine taxable income in connection with a 
          transfer of intangible property.
1.482-5 Comparable profits method.
1.482-6 Profit split method.
1.482-7 Methods to determine taxable income in connection with a cost 
          sharing arrangement.
1.482-8 Examples of the best method rule.
1.482-9 Methods to determine taxable income in connection with a 
          controlled services transaction.
1.483-1 Interest on certain deferred payments.
1.483-2 Unstated interest.
1.483-3 Test rate of interest applicable to a contract.
1.483-4 Contingent payments.

 Regulations Applicable for Taxable Years Beginning on or Before April 
                                21, 1993

1.482-1A Allocation of income and deductions among taxpayers.
1.482-2A Determination of taxable income in specific situations.
1.482-7A Methods to determine taxable income in connection with a cost 
          sharing arrangement.
1.484-1.500 [Reserved]

    Authority: 26 U.S.C. 7805.
    Section 1.441-2T also issued under 26 U.S.C. 441(f).
    Section 1.441-3T also issued under 26 U.S.C. 441.
    Section 1.442-2T and 1.442-3T also issued under 26 U.S.C. 422, 706, 
and 1378.
    Section 1.444-0T through 1.444-3T and
    Section 1.444-4 is also issued under 26 U.S.C. 444(g).
    Section 1.446-1 also issued under 26 U.S.C. 446 and 461(h).
    Section 1.446-4 also issued under 26 U.S.C. 1502.
    Section 1.446-6 also issued under 26 U.S.C. 446 and 26 U.S.C. 860G.
    Section 1.446-7 also issued under 26 U.S.C. 446.
    Section 1.451-3 also issued under 26 U.S.C. 451(b)(1)(A)(ii), 
(b)(3)(C) and 461(h).
    Section 1.451-8 also issued under 26 U.S.C. 451(c)(2)(A), (3), 
(4)(A)(iii), (4)(b)(vii), and 461(h).
    Section 1.453-11 also issued under 26 U.S.C. 453(j)(1) and (k).

[[Page 8]]

    Section 1.453A-3 also issued under 26 U.S.C. 453A.
    Section 1.458-1 also issued under 26 U.S.C. 458.
    Section 1.460-1 also issued under 26 U.S.C. 460(h).
    Section 1.460-2 also issued under 26 U.S.C. 460(h).
    Section 1.460-3 also issued under 26 U.S.C. 460(h).
    Section 1.460-4 also issued under 26 U.S.C. 460(h) and 1502.
    Section 1.460-5 also issued under 26 U.S.C. 460(h).
    Section 1.460-6 also issued under 26 U.S.C. 460(h).
    Section 1.461-1 also issued under 26 U.S.C. 461(h).
    Section 1.461-2 also issued under 26 U.S.C. 461(h).
    Section 1.461-4 also issued under 26 U.S.C. 461(h).
    Section 1.461-4(d) also issued under 26 U.S.C. 460 and 26 U.S.C. 
461(h).
    Section 1.461-5 also issued under 26 U.S.C. 461(h).
    Section 1.461-6 also issued under 26 U.S.C. 461(h).
    Section 1.465-8 also issued under 26 U.S.C. 465.
    Section 1.465-20 also issued under 26 U.S.C. 465.
    Section 1.465-27 also issued under 26 U.S.C. 465(b)(6)(B)(iii).
    Section 1.466-1 through 1.466-4 also issued under 26 U.S.C. 466.
    Section 1.467-1 is also issued under 26 U.S.C. 467.
    Section 1.467-2 is also issued under 26 U.S.C. 467.
    Section 1.467-3 is also issued under 26 U.S.C. 467.
    Section 1.467-4 is also issued under 26 U.S.C. 467.
    Section 1.467-5 is also issued under 26 U.S.C. 467.
    Section 1.467-6 is also issued under 26 U.S.C. 467.
    Section 1.467-7 is also issued under 26 U.S.C. 467.
    Section 1.467-8 is also issued under 26 U.S.C. 467.
    Section 1.467-9 is also issued under 26 U.S.C. 467.
    Section 1.468A-5 also issued under 26 U.S.C. 468A(e)(5).
    Section 1.468A-5T also issued under 26 U.S.C. 468A(e)(5).
    Section 1.468B-1 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-2 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-3 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-4 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-5 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-7 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-9 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.469-1 also issued under 26 U.S.C. 469.
    Section 1.469-1T also issued under 26 U.S.C. 469.
    Section 1.469-2 also issued under 26 U.S.C. 469(l).
    Section 1.469-2T also issued under 26 U.S.C. 469(l).
    Section 1.469-3 also issued under 26 U.S.C. 469(l).
    Section 1.469-3T also issued under 26 U.S.C. 469(l).
    Section 1.469-4 also issued under 26 U.S.C. 469(l).
    Section 1.469-5 also issued under 26 U.S.C. 469(l).
    Section 1.469-5T also issued under 26 U.S.C. 469(l).
    Section 1.469-7 also issued under 26 U.S.C. 469(l).
    Section 1.469-9 also issued under 26 U.S.C. 469(c)(6), (h)(2), and 
(l)(1).
    Section 1.469-11 also issued under 26 U.S.C. 469(l).
    Section 1.471 also issued under 26 U.S.C. 471.
    Section 1.471-3 also issued under 26 U.S.C. 471(a).
    Section 1.471-4 also issued under 26 U.S.C. 263A.
    Section 1.471-5 also issued under 26 U.S.C. 263A.
    Section 1.471-6 also issued under 26 U.S.C. 471.
    Section 1.472-8 also issued under 26 U.S.C. 472.
    Section 1.475(a)-3 also issued under 26 U.S.C. 475(e).
    Section 1.475(a)-4 also issued under 26 U.S.C. 475(g).
    Section 1.475(b)-1 also issued under 26 U.S.C. 475(b)(4) and 26 
U.S.C. 475(e).
    Section 1.475(b)-2 also issued under 26 U.S.C. 475(b)(2) and 26 
U.S.C. 475(e).
    Section 1.475(b)-4 also issued under 26 U.S.C. 475(b)(2), 26 U.S.C. 
475(e), and 26 U.S.C. 6001.
    Section 1.475(c)-1 also issued under 26 U.S.C. 475(e).
    Section 1.475(c)-2 also issued under 26 U.S.C. 475(e) and 26 U.S.C. 
860G(e).
    Section 1.475(d)-1 also issued under 26 U.S.C. 475(e).
    Section 1.475(e)-1 also issued under 26 U.S.C. 475(e).
    Section 1.481-1 also issued under 26 U.S.C. 481.
    Section 1.481-2 also issued under 26 U.S.C. 481.
    Section 1.481-3 also issued under 26 U.S.C. 481.

[[Page 9]]

    Section 1.481-4 also issued under 26 U.S.C. 481.
    Section 1.481-5 also issued under 26 U.S.C. 481.
    Section 1.481-6 is also issued under 26 U.S.C. 481.
    Section 1.482-1 also issued under 26 U.S.C. 482 and 936.
    Sections 1.482-1 and 1.482-1T also issued under 26 U.S.C. 482.
    Section 1.482-2 also issued under 26 U.S.C. 482.
    Section 1.482-3 also issued under 26 U.S.C. 482.
    Section 1.482-4 also issued under 26 U.S.C. 482.
    Section 1.482-5 also issued under 26 U.S.C. 482.
    Section 1.482-7 is also issued under 26 U.S.C. 482.
    Section 1.482-9 also issued under 26 U.S.C. 482.
    Section 1.482-2A also issued under 26 U.S.C. 482.
    Section 1.482-7A also issued under 26 U.S.C. 482.
    Section 1.482-9 also issued under 26 U.S.C. 482.
    Section 1.483-1 through 1.483-3 also issued under 26 U.S.C. 483(f).
    Section 1.483-4 also issued under 26 U.S.C. 483(f).

                 DEFERRED COMPENSATION, ETC. (CONTINUED)

              ACCOUNTING PERIODS AND METHODS OF ACCOUNTING

                           Accounting Periods



Sec.  1.441-0  Table of contents.

    This section lists the captions contained in Sec. Sec.  1.441-1 
through 1.441-4 as follows:

         Sec.  1.441-1 Period for computation of taxable income.

    (a) Computation of taxable income.
    (1) In general.
    (2) Length of taxable year.
    (b) General rules and definitions.
    (1) Taxable year.
    (1) Required taxable year.
    (i) In general.
    (ii) Exceptions.
    (A) 52-53-week taxable years.
    (B) Partnerships, S corporations, and PSCs.
    (C) Specified foreign corporations.
    (3) Annual accounting period.
    (4) Calendar year.
    (5) Fiscal year.
    (i) Definition.
    (ii) Recognition.
    (6) Grandfathered fiscal year.
    (7) Books.
    (8) Taxpayer.
    (c) Adoption of taxable year.
    (1) In general.
    (2) Approval required.
    (i) Taxpayers with required taxable years.
    (ii) Taxpayers without books.
    (d) Retention of taxable year.
    (e) Change of taxable year.
    (f) Obtaining approval of the Commissioner or making a section 444 
election.

    Sec.  1.441-2 Election of taxable year consisting of 52-53 weeks

    (a) In general.
    (1) Election.
    (2) Effect.
    (3) Eligible taxpayer.
    (4) Example.
    (b) Procedures to elect a 52-53-week taxable year.
    (1) Adoption of a 52-53-week taxable year.
    (i) In general.
    (ii) Filing requirement.
    (2) Change to (or from) a 52-53-week taxable year.
    (i) In general.
    (ii) Special rules for short period required to effect the change.
    (3) Examples.
    (c) Application of effective dates.
    (1) In general.
    (2) Examples.
    (3) Changes in tax rates.
    (4) Examples.
    (d) Computation of taxable income.
    (e) Treatment of taxable years ending with reference to the same 
calendar month.
    (1) Pass-through entities.
    (2) Personal service corporations and employee-owners.
    (3) Definitions.
    (i) Pass-through entity.
    (ii) Owner of a pass-through entity.
    (4) Examples.
    (5) Transition rule.

      Sec.  1.441-3 Taxable year of a personal service corporation

    (a) Taxable year.
    (1) Required taxable year.
    (2) Exceptions.
    (b) Adoption, change, or retention of taxable year.
    (1) Adoption of taxable year.
    (2) Change in taxable year.
    (3) Retention of taxable year.
    (4) Procedures for obtaining approval or making a section 444 
election.
    (5) Examples.
    (c) Personal service corporation defined.
    (1) In general.
    (2) Testing period.
    (i) In general.
    (ii) New corporations.
    (3) Examples.

[[Page 10]]

    (d) Performance of personal services.
    (1) Activities described in section 448(d)(2)(A).
    (2) Activities not described in section 448(d)(2)(A).
    (e) Principal activity.
    (1) General rule.
    (2) Compensation cost.
    (i) Amounts included.
    (ii) Amounts excluded.
    (3) Attribution of compensation cost to personal service activity.
    (i) Employees involved only in the performance of personal services.
    (ii) Employees involved only in activities that are not treated as 
the performance of personal services.
    (iii) Other employees.
    (A) Compensation cost attributable to personal service activity.
    (B) Compensation cost not attributable to personal service activity.
    (f) Services substantially performed by employee-owners.
    (1) General rule.
    (2) Compensation cost attributable to personal services.
    (3) Examples.
    (g) Employee-owner defined.
    (1) General rule.
    (2) Special rule for independent contractors who are owners.
    (h) Special rules for affiliated groups filing consolidated returns.
    (1) In general.
    (2) Examples.

                      Sec.  1.441-4 Effective date

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec.  1.441-1  Period for computation of taxable income.

    (a) Computation of taxable income--(1) In general. Taxable income 
must be computed and a return must be made for a period known as the 
taxable year. For rules relating to methods of accounting, the taxable 
year for which items of gross income are included and deductions are 
taken, inventories, and adjustments, see parts II and III (section 446 
and following), subchapter E, chapter 1 of the Internal Revenue Code, 
and the regulations thereunder.
    (2) Length of taxable year. Except as otherwise provided in the 
Internal Revenue Code and the regulations thereunder (e.g., Sec.  1.441-
2 regarding 52-53-week taxable years), a taxable year may not cover a 
period of more than 12 calendar months.
    (b) General rules and definitions. The general rules and definitions 
in this paragraph (b) apply for purposes of sections 441 and 442 and the 
regulations thereunder.
    (1) Taxable year. Taxable year means--
    (i) The period for which a return is made, if a return is made for a 
period of less than 12 months (short period). See section 443 and the 
regulations thereunder;
    (ii) Except as provided in paragraph (b)(1)(i) of this section, the 
taxpayer's required taxable year (as defined in paragraph (b)(2) of this 
section), if applicable;
    (iii) Except as provided in paragraphs (b)(1)(i) and (ii) of this 
section, the taxpayer's annual accounting period (as defined in 
paragraph (b)(3) of this section), if it is a calendar year or a fiscal 
year; or
    (iv) Except as provided in paragraphs (b)(1)(i) and (ii) of this 
section, the calendar year, if the taxpayer keeps no books, does not 
have an annual accounting period, or has an annual accounting period 
that does not qualify as a fiscal year.
    (2) Required taxable year--(i) In general. Certain taxpayers must 
use the particular taxable year that is required under the Internal 
Revenue Code and the regulations thereunder (the required taxable year). 
For example, the required taxable year is--
    (A) [Reserved]
    (B) In the case of a personal service corporation (PSC), the taxable 
year determined under section 441(i) and Sec.  1.441-3;
    (C) In the case of a nuclear decommissioning fund, the taxable year 
determined under Sec.  1.468A-4(c)(1);
    (D) In the case of a designated settlement fund or a qualified 
settlement fund, the taxable year determined under Sec.  1.468B-2(j);
    (E) In the case of a common trust fund, the taxable year determined 
under section 584(i);
    (F) In the case of certain trusts, the taxable year determined under 
section 644;
    (G) In the case of a partnership, the taxable year determined under 
section 706 and Sec.  1.706-1;
    (H) In the case of an insurance company, the taxable year determined 
under section 843 and Sec.  1.1502-76(a)(2);

[[Page 11]]

    (I) In the case of a real estate investment trust, the taxable year 
determined under section 859;
    (J) In the case of a real estate mortgage investment conduit, the 
taxable year determined under section 860D(a)(5) and Sec.  1.860D-
1(b)(6);
    (K) In the case of a specified foreign corporation, the taxable year 
determined under section 898(c)(1)(A);
    (L) In the case of an S corporation, the taxable year determined 
under section 1378 and Sec.  1.1378-1; or
    (M) In the case of a member of an affiliated group that makes a 
consolidated return, the taxable year determined under Sec.  1.1502-76.
    (ii) Exceptions. Notwithstanding paragraph (b)(2)(i) of this 
section, the following taxpayers may have a taxable year other than 
their required taxable year:
    (A) 52-53-week taxable years. Certain taxpayers may elect to use a 
52-53-week taxable year that ends with reference to their required 
taxable year. See, for example, Sec. Sec.  1.441-3 (PSCs), 1.706-1 
(partnerships), 1.1378-1 (S corporations), and 1.1502-76(a)(1) (members 
of a consolidated group).
    (B) Partnerships, S corporations, and PSCs. A partnership, S 
corporation, or PSC may use a taxable year other than its required 
taxable year if the taxpayer elects to use a taxable year other than its 
required taxable year under section 444, elects a 52-53-week taxable 
year that ends with reference to its required taxable year as provided 
in paragraph (b)(2)(ii)(A) of this section or to a taxable year elected 
under section 444, or establishes a business purpose to the satisfaction 
of the Commissioner under section 442 (such as a grandfathered fiscal 
year).
    (C) Specified foreign corporations. A specified foreign corporation 
(as defined in section 898(b)) may use a taxable year other than its 
required taxable year if it elects a 52-53-week taxable year that ends 
with reference to its required taxable year as provided in paragraph 
(b)(2)(ii)(A) of this section or makes a one-month deferral election 
under section 898(c)(1)(B).
    (3) Annual accounting period. Annual accounting period means the 
annual period (calendar year or fiscal year) on the basis of which the 
taxpayer regularly computes its income in keeping its books.
    (4) Calendar year. Calendar year means a period of 12 consecutive 
months ending on December 31. A taxpayer who has not established a 
fiscal year must make its return on the basis of a calendar year.
    (5) Fiscal year--(i) Definition. Fiscal year means--
    (A) A period of 12 consecutive months ending on the last day of any 
month other than December; or
    (B) A 52-53-week taxable year, if such period has been elected by 
the taxpayer. See Sec.  1.441-2.
    (ii) Recognition. A fiscal year will be recognized only if the books 
of the taxpayer are kept in accordance with such fiscal year.
    (6) Grandfathered fiscal year. Grandfathered fiscal year means a 
fiscal year (other than a year that resulted in a three month or less 
deferral of income) that a partnership or an S corporation received 
permission to use on or after July 1, 1974, by a letter ruling (i.e., 
not by automatic approval).
    (7) Books. Books include the taxpayer's regular books of account and 
such other records and data as may be necessary to support the entries 
on the taxpayer's books and on the taxpayer's return, as for example, a 
reconciliation of any difference between such books and the taxpayer's 
return. Records that are sufficient to reflect income adequately and 
clearly on the basis of an annual accounting period will be regarded as 
the keeping of books. See section 6001 and the regulations thereunder 
for rules relating to the keeping of books and records.
    (8) Taxpayer. Taxpayer has the same meaning as the term person as 
defined in section 7701(a)(1) (e.g., an individual, trust, estate, 
partnership, association, or corporation) rather than the meaning of the 
term taxpayer as defined in section 7701(a)(14) (any person subject to 
tax).
    (c) Adoption of taxable year--(1) In general. Except as provided in 
paragraph (c)(2) of this section, a new taxpayer may adopt any taxable 
year that satisfies the requirements of section 441 and the regulations 
thereunder

[[Page 12]]

without the approval of the Commissioner. A taxable year of a new 
taxpayer is adopted by filing its first Federal income tax return using 
that taxable year. The filing of an application for automatic extension 
of time to file a Federal income tax return (e.g., Form 7004, 
``Application for Automatic Extension of Time to File Corporation Income 
Tax Return''), the filing of an application for an employer 
identification number (i.e., Form SS-4, ``Application for Employer 
Identification Number''), or the payment of estimated taxes, for a 
particular taxable year do not constitute an adoption of that taxable 
year.
    (2) Approval required--(i) Taxpayers with required taxable years. A 
newly-formed partnership, S corporation, or PSC that wants to adopt a 
taxable year other than its required taxable year, a taxable year 
elected under section 444, or a 52-53-week taxable year that ends with 
reference to its required taxable year or a taxable year elected under 
section 444 must establish a business purpose and obtain the approval of 
the Commissioner under section 442.
    (ii) Taxpayers without books. A taxpayer that must use a calendar 
year under section 441(g) and paragraph (f) of this section may not 
adopt a fiscal year without obtaining the approval of the Commissioner.
    (d) Retention of taxable year. In certain cases, a partnership, S 
corporation, electing S corporation, or PSC will be required to change 
its taxable year unless it obtains the approval of the Commissioner 
under section 442, or makes an election under section 444, to retain its 
current taxable year. For example, a corporation using a June 30 fiscal 
year that either becomes a PSC or elects to be an S corporation and, as 
a result, is required to use the calendar year under section 441(i) or 
1378, respectively, must obtain the approval of the Commissioner to 
retain its current fiscal year. Similarly, a partnership using a taxable 
year that corresponds to its required taxable year must obtain the 
approval of the Commissioner to retain such taxable year if its required 
taxable year changes as a result of a change in ownership. However, a 
partnership that previously established a business purpose to the 
satisfaction of the Commissioner to use a taxable year is not required 
to obtain the approval of the Commissioner if its required taxable year 
changes as a result of a change in ownership.
    (e) Change of taxable year. Once a taxpayer has adopted a taxable 
year, such taxable year must be used in computing taxable income and 
making returns for all subsequent years unless the taxpayer obtains 
approval from the Commissioner to make a change or the taxpayer is 
otherwise authorized to change without the approval of the Commissioner 
under the Internal Revenue Code (e.g., section 444 or 859) or the 
regulations thereunder.
    (f) Obtaining approval of the Commissioner or making a section 444 
election. See Sec.  1.442-1(b) for procedures for obtaining approval of 
the Commissioner (automatically or otherwise) to adopt, change, or 
retain an annual accounting period. See Sec. Sec.  1.444-1T and 1.444-2T 
for qualifications, and 1.444-3T for procedures, for making an election 
under section 444.

[T.D. 8996, 67 FR 35012, May 17, 2002, as amended at by T.D. 9849, 84 FR 
9234, Mar. 14, 2019]



Sec.  1.441-2  Election of taxable year consisting of 52-53 weeks.

    (a) In general--(1) Election. An eligible taxpayer may elect to 
compute its taxable income on the basis of a fiscal year that--
    (i) Varies from 52 to 53 weeks;
    (ii) Ends always on the same day of the week; and
    (iii) Ends always on--
    (A) Whatever date this same day of the week last occurs in a 
calendar month; or
    (B) Whatever date this same day of the week falls that is the 
nearest to the last day of the calendar month.
    (2) Effect. In the case of a taxable year described in paragraph 
(a)(1)(iii)(A) of this section, the year will always end within the 
month and may end on the last day of the month, or as many as six days 
before the end of the month. In the case of a taxable year described in 
paragraph (a)(1)(iii)(B) of this section, the year may end on the last 
day of the month, or as many as three days before or

[[Page 13]]

three days after the last day of the month.
    (3) Eligible taxpayer. A taxpayer is eligible to elect a 52-53-week 
taxable year if such fiscal year would otherwise satisfy the 
requirements of section 441 and the regulations thereunder. For example, 
a taxpayer that is required to use a calendar year under Sec.  1.441-
1(b)(2)(i)(D) is not an eligible taxpayer.
    (4) Example. The provisions of this paragraph (a) are illustrated by 
the following example:

    Example. If the taxpayer elects a taxable year ending always on the 
last Saturday in November, then for the year 2001, the taxable year 
would end on November 24, 2001. On the other hand, if the taxpayer had 
elected a taxable year ending always on the Saturday nearest to the end 
of November, then for the year 2001, the taxable year would end on 
December 1, 2001.

    (b) Procedures to elect a 52-53-week taxable year--(1) Adoption of a 
52-53-week taxable year--(i) In general. A new eligible taxpayer elects 
a 52-53-week taxable year by adopting such year in accordance with Sec.  
1.441-1(c). A newly-formed partnership, S corporation or personal 
service corporation (PSC) may adopt a 52-53-week taxable year without 
the approval of the Commissioner if such year ends with reference to 
either the taxpayer's required taxable year (as defined in Sec.  1.441-
1(b)(2)) or the taxable year elected under section 444. See Sec. Sec.  
1.441-3, 1.706-1, and 1.1378-1. Similarly, a newly-formed specified 
foreign corporation (as defined in section 898(b)) may adopt a 52-53-
week taxable year if such year ends with reference to the taxpayer's 
required taxable year, or, if the one-month deferral election under 
section 898(c)(1)(B) is made, with reference to the month immediately 
preceding the required taxable year. See Sec.  1.1502-76(a)(1) for 
special rules regarding subsidiaries adopting 52-53-week taxable years.
    (ii) Filing requirement. A taxpayer adopting a 52-53-week taxable 
year must file with its Federal income tax return for its first taxable 
year a statement containing the following information--
    (A) The calendar month with reference to which the 52-53-week 
taxable year ends;
    (B) The day of the week on which the 52-53-week taxable year always 
will end; and
    (C) Whether the 52-53-week taxable year will always end on the date 
on which that day of the week last occurs in the calendar month, or on 
the date on which that day of the week falls that is nearest to the last 
day of that calendar month.
    (2) Change to (or from) a 52-53-week taxable year--(i) In general. 
An election of a 52-53-week taxable year by an existing eligible 
taxpayer with an established taxable year is treated as a change in 
annual accounting period that requires the approval of the Commissioner 
in accordance with Sec.  1.442-1. Thus, a taxpayer must obtain approval 
to change from its current taxable year to a 52-53-week taxable year, 
even if such 52-53-week taxable year ends with reference to the same 
calendar month. Similarly, a taxpayer must obtain approval to change 
from a 52-53-week taxable year, or to change from one 52-53-week taxable 
year to another 52-53-week taxable year. However, a taxpayer may obtain 
approval for 52-53-week taxable year changes automatically to the extent 
provided in administrative procedures published by the Commissioner. See 
Sec.  1.442-1(b) for procedures for obtaining such approval.
    (ii) Special rules for the short period required to effect the 
change. If a change to or from a 52-53-week taxable year results in a 
short period (within the meaning of Sec.  1.443-1(a)) of 359 days or 
more, or six days or less, the tax computation under Sec.  1.443-1(b) 
does not apply. If the short period is 359 days or more, it is treated 
as a full taxable year. If the short period is six days or less, such 
short period is not a separate taxable year but instead is added to and 
deemed a part of the following taxable year. (In the case of a change to 
or from a 52-53-week taxable year not involving a change of the month 
with reference to which the taxable year ends, the tax computation under 
Sec.  1.443-1(b) does not apply because the short period will always be 
359 days or more, or six days or less.) In the case of a short period 
which is more than six days and less than 359 days, taxable income for 
the short period is placed on an annual

[[Page 14]]

basis for purposes of Sec.  1.443-1(b) by multiplying such income by 365 
and dividing the result by the number of days in the short period. In 
such case, the tax for the short period is the same part of the tax 
computed on such income placed on an annual basis as the number of days 
in the short period is of 365 days (unless Sec.  1.443-1(b)(2), relating 
to the alternative tax computation, applies). For an adjustment in 
deduction for personal exemption, see Sec.  1.443-1(b)(1)(v).
    (3) Examples. The following examples illustrate paragraph (b)(2)(ii) 
of this section:

    Example 1. A taxpayer having a fiscal year ending April 30, obtains 
approval to change to a 52-53-week taxable year ending the last Saturday 
in April for taxable years beginning after April 30, 2001. This change 
involves a short period of 362 days, from May 1, 2001, to April 27, 
2002, inclusive. Because the change results in a short period of 359 
days or more, it is not placed on an annual basis and is treated as a 
full taxable year.
    Example 2. Assume the same conditions as Example 1, except that the 
taxpayer changes for taxable years beginning after April 30, 2002, to a 
taxable year ending on the Thursday nearest to April 30. This change 
results in a short period of two days, May 1 to May 2, 2002. Because the 
short period is less than seven days, tax is not separately computed. 
This short period is added to and deemed part of the following 52-53-
week taxable year, which would otherwise begin on May 3, 2002, and end 
on May 1, 2003.

    (c) Application of effective dates--(1) In general. Except as 
provided in paragraph (c)(3) of this section, for purposes of 
determining the effective date (e.g., of legislative, regulatory, or 
administrative changes) or the applicability of any provision of the 
internal revenue laws that is expressed in terms of taxable years 
beginning, including, or ending with reference to the first or last day 
of a specified calendar month, a 52-53-week taxable year is deemed to 
begin on the first day of the calendar month nearest to the first day of 
the 52-53-week taxable year, and is deemed to end or close on the last 
day of the calendar month nearest to the last day of the 52-53-week 
taxable year, as the case may be. Examples of provisions of this title, 
the applicability of which is expressed in terms referred to in the 
preceding sentence, include the provisions relating to the time for 
filing returns and other documents, paying tax, or performing other 
acts, and the provisions of part II, subchapter B, chapter 6 (section 
1561 and following) relating to surtax exemptions of certain controlled 
corporations.
    (2) Examples. The provisions of paragraph (c)(1) of this section may 
be illustrated by the following examples:

    Example 1. Assume that an income tax provision is applicable to 
taxable years beginning on or after January 1, 2001. For that purpose, a 
52-53-week taxable year beginning on any day within the period December 
26, 2000, to January 4, 2001, inclusive, is treated as beginning on 
January 1, 2001.
    Example 2. Assume that an income tax provision requires that a 
return must be filed on or before the 15th day of the third month 
following the close of the taxable year. For that purpose, a 52-53-week 
taxable year ending on any day during the period May 25 to June 3, 
inclusive, is treated as ending on May 31, the last day of the month 
ending nearest to the last day of the taxable year, and the return, 
therefore, must be made on or before August 15.
    Example 3. Assume that a revenue procedure requires the performance 
of an act by the taxpayer within ``the first 90 days of the taxable 
year,'' by ``the 75th day of the taxable year,'' or, alternately, by 
``the last day of the taxable year.'' The taxpayer employs a 52-53-week 
taxable year that ends always on the Saturday closest to the last day of 
December. These requirements are not expressed in terms of taxable years 
beginning, including, or ending with reference to the first or last day 
of a specified calendar month, and are accordingly outside the scope of 
the rule stated in Sec.  1.441-2(c)(1). Accordingly, the taxpayer must 
perform the required act by the 90th, 75th, or last day, respectively, 
of its taxable year.
    Example 4. X, a corporation created on January 1, 2001, elects a 52-
53-week taxable year ending on the Friday nearest the end of December. 
Thus, X's first taxable year begins on Monday, January 1, 2001, and ends 
on Friday, December 28, 2001; its next taxable year begins on Saturday, 
December 29, 2001, and ends on Friday, January 3, 2003; and its next 
taxable year begins on Saturday, January 4, 2003, and ends on Friday, 
January 2, 2004. For purposes of applying the provisions of part II, 
subchapter B, chapter 6 of the Internal Revenue Code, X's first taxable 
year is deemed to end on December 31, 2001; its next taxable year is 
deemed to begin on January 1, 2002, and end on December 31, 2002, and 
its next taxable year is deemed to begin on January 1, 2003, and end on 
December 31, 2003. Accordingly, each such taxable year is treated as 
including one and only one December 31st.


[[Page 15]]


    (3) Changes in tax rates. If a change in the rate of tax is 
effective during a 52-53-week taxable year (other than on the first day 
of such year as determined under paragraph (c)(1) of this section), the 
tax for the 52-53-week taxable year must be computed in accordance with 
section 15, relating to effect of changes, and the regulations 
thereunder. For the purpose of the computation under section 15, the 
determination of the number of days in the period before the change, and 
in the period on and after the change, is to be made without regard to 
the provisions of paragraph (b)(1) of this paragraph.
    (4) Examples. The provisions of paragraph (c)(3) of this section may 
be illustrated by the following examples:

    Example 1. Assume a change in the rate of tax is effective for 
taxable years beginning after June 30, 2002. For a 52-53-week taxable 
year beginning on Friday, November 2, 2001, the tax must be computed on 
the basis of the old rates for the actual number of days from November 
2, 2001, to June 30, 2002, inclusive, and on the basis of the new rates 
for the actual number of days from July 1, 2002, to Thursday, October 
31, 2002, inclusive.
    Example 2. Assume a change in the rate of tax is effective for 
taxable years beginning after June 30, 2001. For this purpose, a 52-53-
week taxable year beginning on any of the days from June 25 to July 4, 
inclusive, is treated as beginning on July 1. Therefore, no computation 
under section 15 will be required for such year because of the change in 
rate.

    (d) Computation of taxable income. The principles of section 451, 
relating to the taxable year for inclusion of items of gross income, and 
section 461, relating to the taxable year for taking deductions, 
generally are applicable to 52-53-week taxable years. Thus, except as 
otherwise provided, all items of income and deduction must be determined 
on the basis of a 52-53-week taxable year. However, a taxpayer may 
determine particular items as though the 52-53-week taxable year were a 
taxable year consisting of 12 calendar months, provided that practice is 
consistently followed by the taxpayer and clearly reflects income. For 
example, an allowance for depreciation or amortization may be determined 
on the basis of a 52-53-week taxable year, or as though the 52-53-week 
taxable year is a taxable year consisting of 12 calendar months, 
provided the taxpayer consistently follows that practice with respect to 
all depreciable or amortizable items.
    (e) Treatment of taxable years ending with reference to the same 
calendar month--(1) Pass-through entities. If a pass-through entity (as 
defined in paragraph (e)(3)(i) of this section) or an owner of a pass-
through entity (as defined in paragraph (e)(3)(ii) of this section), or 
both, use a 52-53-week taxable year and the taxable year of the pass-
through entity and the owner end with reference to the same calendar 
month, then, for purposes of determining the taxable year in which items 
of income, gain, loss, deductions, or credits from the pass-through 
entity are taken into account by the owner of the pass-through, the 
owner's taxable year will be deemed to end on the last day of the pass-
through's taxable year. Thus, if the taxable year of a partnership and a 
partner end with reference to the same calendar month, then for purposes 
of determining the taxable year in which that partner takes into account 
items described in section 702 and items that are deductible by the 
partnership (including items described in section 707(c)) and includible 
in the income of that partner, that partner's taxable year will be 
deemed to end on the last day of the partnership's taxable year. 
Similarly, if the taxable year of an S corporation and a shareholder end 
with reference to the same calendar month, then for purposes of 
determining the taxable year in which that shareholder takes into 
account items described in section 1366(a) and items that are deductible 
by the S corporation and includible in the income of that shareholder, 
that shareholder's taxable year will be deemed to end on the last day of 
the S corporation's taxable year.
    (2) Personal service corporations and employee-owners. If the 
taxable year of a PSC (within the meaning of Sec.  1.441-3(c)) and an 
employee-owner (within the meaning of Sec.  1.441-3(g)) end with 
reference to the same calendar month, then for purposes of determining 
the taxable year in which an employee-owner takes into account items 
that are deductible by the PSC and includible in the income of the 
employee-owner, the employee-owner's taxable

[[Page 16]]

year will be deemed to end on the last day of the PSC's taxable year.
    (3) Definitions--(i) Pass-through entity. For purposes of this 
section, a pass-through entity means a partnership, S corporation, 
trust, estate, closely-held real estate investment trust (within the 
meaning of section 6655(e)(5)(B)), common trust fund (within the meaning 
of section 584(i)), controlled foreign corporation (within the meaning 
of section 957), foreign personal holding company (within the meaning of 
section 552), or passive foreign investment company that is a qualified 
electing fund (within the meaning of section 1295).
    (ii) Owner of a pass-through entity. For purposes of this section, 
an owner of a pass-through entity generally means a taxpayer that owns 
an interest in, or stock of, a pass-through entity. For example, an 
owner of a pass-through entity includes a partner in a partnership, a 
shareholder of an S corporation, a beneficiary of a trust or an estate, 
an owner of a closely-held real estate investment trust (within the 
meaning of section 6655(e)(5)(A)), a participant in a common trust fund, 
a U.S. shareholder (as defined in section 951(b)) of a controlled 
foreign corporation, a U.S. shareholder (as defined in section 551(a)) 
of a foreign personal holding company, or a U.S. person that holds stock 
in a passive foreign investment company that is a qualified electing 
fund with respect to that shareholder.
    (4) Examples. The provisions of paragraph (e)(2) of this section may 
be illustrated by the following examples:

    Example 1. ABC Partnership uses a 52-53-week taxable year that ends 
on the Wednesday nearest to December 31, and its partners, A, B, and C, 
are individual calendar year taxpayers. Assume that, for ABC's taxable 
year ending January 3, 2001, each partner's distributive share of ABC's 
taxable income is $10,000. Under section 706(a) and paragraph (e)(1) of 
this section, for the taxable year ending December 31, 2000, A, B, and C 
each must include $10,000 in income with respect to the ABC year ending 
January 3, 2001. Similarly, if ABC makes a guaranteed payment to A on 
January 2, 2001, A must include the payment in income for A's taxable 
year ending December 31, 2000.
    Example 2. X, a PSC, uses a 52-53-week taxable year that ends on the 
Wednesday nearest to December 31, and all of the employee-owners of X 
are individual calendar year taxpayers. Assume that, for its taxable 
year ending January 3, 2001, X pays a bonus of $10,000 to each employee-
owner on January 2, 2001. Under paragraph (e)(2) of this section, each 
employee-owner must include its bonus in income for the taxable year 
ending December 31, 2000.

    (5) Transition rule. In the case of an owner of a pass-through 
entity (other than the owner of a partnership or S corporation) that is 
required by this paragraph (e) to include in income for its first 
taxable year ending on or after May 17, 2002 amounts attributable to two 
taxable years of a pass-through entity, the amount that otherwise would 
be required to be included in income for such first taxable year by 
reason of this paragraph (e) should be included in income ratably over 
the four-taxable-year period beginning with such first taxable year 
under principles similar to Sec.  1.702-3T, unless the owner of the 
pass-through entity elects to include all such income in its first 
taxable year ending on or after May 17, 2002.

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec.  1.441-3  Taxable year of a personal service corporation.

    (a) Taxable year--(1) Required taxable year. Except as provided in 
paragraph (a)(2) of this section, the taxable year of a personal service 
corporation (PSC) (as defined in paragraph (c) of this section) must be 
the calendar year.
    (2) Exceptions. A PSC may have a taxable year other than its 
required taxable year (i.e., a fiscal year) if it makes an election 
under section 444, elects to use a 52-53-week taxable year that ends 
with reference to the calendar year or a taxable year elected under 
section 444, or establishes a business purpose for such fiscal year and 
obtains the approval of the Commissioner under section 442.
    (b) Adoption, change, or retention of taxable year--(1) Adoption of 
taxable year. A PSC may adopt, in accordance with Sec.  1.441-1(c), the 
calendar year, a taxable year elected under section 444, or a 52-53-week 
taxable year ending with reference to the calendar year or a taxable 
year elected under section 444 without the approval of the Commissioner. 
See Sec.  1.441-1. A PSC that wants to adopt any other taxable year must

[[Page 17]]

establish a business purpose and obtain the approval of the Commissioner 
under section 442.
    (2) Change in taxable year. A PSC that wants to change its taxable 
year must obtain the approval of the Commissioner under section 442 or 
make an election under section 444. However, a PSC may obtain automatic 
approval for certain changes, including a change to the calendar year or 
to a 52-53-week taxable year ending with reference to the calendar year, 
pursuant to administrative procedures published by the Commissioner.
    (3) Retention of taxable year. In certain cases, a PSC will be 
required to change its taxable year unless it obtains the approval of 
the Commissioner under section 442, or makes an election under section 
444, to retain its current taxable year. For example, a corporation 
using a June 30 fiscal year that becomes a PSC and, as a result, is 
required to use the calendar year must obtain the approval of the 
Commissioner to retain its current fiscal year.
    (4) Procedures for obtaining approval or making a section 444 
election. See Sec.  1.442-1(b) for procedures to obtain the approval of 
the Commissioner (automatically or otherwise) to adopt, change, or 
retain a taxable year. See Sec. Sec.  1.444-1T and 1.444-2T for 
qualifications, and 1.444-3T for procedures, for making an election 
under section 444.
    (5) Examples. The provisions of paragraph (b)(4) of this section may 
be illustrated by the following examples:

    Example 1. X, whose taxable year ends on January 31, 2001, becomes a 
PSC for its taxable year beginning February 1, 2001, and does not obtain 
the approval of the Commissioner for using a fiscal year. Thus, for 
taxable years ending before February 1, 2001, this section does not 
apply with respect to X. For its taxable year beginning on February 1, 
2001, however, X will be required to comply with paragraph (a) of this 
section. Thus, unless X obtains approval of the Commissioner to use a 
January 31 taxable year, or makes a section 444 election, X will be 
required to change its taxable year to the calendar year under paragraph 
(b) of this section by using a short taxable year that begins on 
February 1, 2001, and ends on December 31, 2001. Under paragraph (b)(1) 
of this section, X may obtain automatic approval to change its taxable 
year to a calendar year. See Sec.  1.442-1(b).
    Example 2. Assume the same facts as in Example 1, except that X 
desires to change to a 52-53-week taxable year ending with reference to 
the month of December. Under paragraph (b)(1) of this section X may 
obtain automatic approval to make the change. See Sec.  1.442-1(b).

    (c) Personal service corporation defined--(1) In general. For 
purposes of this section and section 442, a taxpayer is a PSC for a 
taxable year only if--
    (i) The taxpayer is a C corporation (as defined in section 
1361(a)(2)) for the taxable year;
    (ii) The principal activity of the taxpayer during the testing 
period is the performance of personal services;
    (iii) During the testing period, those services are substantially 
performed by employee-owners (as defined in paragraph (g) of this 
section); and
    (iv) Employee-owners own (as determined under the attribution rules 
of section 318, except that the language ``any'' applies instead of ``50 
percent'' in section 318(a)(2)(C)) more than 10 percent of the fair 
market value of the outstanding stock in the taxpayer on the last day of 
the testing period.
    (2) Testing period--(i) In general. Except as otherwise provided in 
paragraph (c)(2)(ii) of this section, the testing period for any taxable 
year is the immediately preceding taxable year.
    (ii) New corporations. The testing period for a taxpayer's first 
taxable year is the period beginning on the first day of that taxable 
year and ending on the earlier of--
    (A) The last day of that taxable year; or
    (B) The last day of the calendar year in which that taxable year 
begins.
    (3) Examples. The provisions of paragraph (c)(2)(ii) of this section 
may be illustrated by the following examples:

    Example 1. Corporation A's first taxable year begins on June 1, 
2001, and A desires to use a September 30 taxable year. However, if A is 
a personal service corporation, it must obtain the Commissioner's 
approval to use a September 30 taxable year. Pursuant to paragraph 
(c)(2)(ii) of this section, A's testing period for its first taxable 
year beginning June 1, 2001, is the period June 1, 2001 through 
September 30, 2001. Thus, if, based upon such testing period, A is a 
personal service corporation, A must obtain the Commissioner's 
permission to use a September 30 taxable year.
    Example 2. The facts are the same as in Example 1, except that A 
desires to use a March 31 taxable year. Pursuant to paragraph

[[Page 18]]

(c)(2)(ii) of this section, A's testing period for its first taxable 
year beginning June 1, 2001, is the period June 1, 2001, through 
December 31, 2001. Thus, if, based upon such testing period, A is a 
personal service corporation, A must obtain the Commissioner's 
permission to use a March 31 taxable year.

    (d) Performance of personal services--(1) Activities described in 
section 448(d)(2)(A). For purposes of this section, any activity of the 
taxpayer described in section 448(d)(2)(A) or the regulations thereunder 
will be treated as the performance of personal services. Therefore, any 
activity of the taxpayer that involves the performance of services in 
the fields of health, law, engineering, architecture, accounting, 
actuarial science, performing arts, or consulting (as such fields are 
defined in Sec.  1.448-1T) will be treated as the performance of 
personal services for purposes of this section.
    (2) Activities not described in section 448(d)(2)(A). For purposes 
of this section, any activity of the taxpayer not described in section 
448(d)(2)(A) or the regulations thereunder will not be treated as the 
performance of personal services.
    (e) Principal activity--(1) General rule. For purposes of this 
section, the principal activity of a corporation for any testing period 
will be the performance of personal services if the cost of the 
corporation's compensation (the compensation cost) for such testing 
period that is attributable to its activities that are treated as the 
performance of personal services within the meaning of paragraph (d) of 
this section (i.e., the total compensation for personal service 
activities) exceeds 50 percent of the corporation's total compensation 
cost for such testing period.
    (2) Compensation cost--(i) Amounts included. For purposes of this 
section, the compensation cost of a corporation for a taxable year is 
equal to the sum of the following amounts allowable as a deduction, 
allocated to a long-term contract, or otherwise chargeable to a capital 
account by the corporation during such taxable year--
    (A) Wages and salaries; and
    (B) Any other amounts, attributable to services performed for or on 
behalf of the corporation by a person who is an employee of the 
corporation (including an owner of the corporation who is treated as an 
employee under paragraph (g)(2) of this section) during the testing 
period. Such amounts include, but are not limited to, amounts 
attributable to deferred compensation, commissions, bonuses, 
compensation includible in income under section 83, compensation for 
services based on a percentage of profits, and the cost of providing 
fringe benefits that are includible in income.
    (ii) Amounts excluded. Notwithstanding paragraph (e)(2)(i) of this 
section, compensation cost does not include amounts attributable to a 
plan qualified under section 401(a) or 403(a), or to a simplified 
employee pension plan defined in section 408(k).
    (3) Attribution of compensation cost to personal service activity--
(i) Employees involved only in the performance of personal services. The 
compensation cost for employees involved only in the performance of 
activities that are treated as personal services under paragraph (d) of 
this section, or employees involved only in supporting the work of such 
employees, are considered to be attributable to the corporation's 
personal service activity.
    (ii) Employees involved only in activities that are not treated as 
the performance of personal services. The compensation cost for 
employees involved only in the performance of activities that are not 
treated as personal services under paragraph (d) of this section, or for 
employees involved only in supporting the work of such employees, are 
not considered to be attributable to the corporation's personal service 
activity.
    (iii) Other employees. The compensation cost for any employee who is 
not described in either paragraph (e)(3)(i) or (ii) of this section (a 
mixed-activity employee) is allocated as follows--
    (A) Compensation cost attributable to personal service activity. 
That portion of the compensation cost for a mixed activity employee that 
is attributable to the corporation's personal service activity equals 
the compensation cost for that employee multiplied by the percentage of 
the total time worked for the corporation by that employee during the 
year that is attributable to activities of the corporation that are 
treated as the performance of personal

[[Page 19]]

services under paragraph (d) of this section. That percentage is to be 
determined by the taxpayer in any reasonable and consistent manner. Time 
logs are not required unless maintained for other purposes;
    (B) Compensation cost not attributable to personal service activity. 
That portion of the compensation cost for a mixed activity employee that 
is not considered to be attributable to the corporation's personal 
service activity is the compensation cost for that employee less the 
amount determined in paragraph (e)(3)(iii)(A) of this section.
    (f) Services substantially performed by employee-owners--(1) General 
rule. Personal services are substantially performed during the testing 
period by employee-owners of the corporation if more than 20 percent of 
the corporation's compensation cost for that period attributable to its 
activities that are treated as the performance of personal services 
within the meaning of paragraph (d) of this section (i.e., the total 
compensation for personal service activities) is attributable to 
personal services performed by employee-owners.
    (2) Compensation cost attributable to personal services. For 
purposes of paragraph (f)(1) of this section--
    (i) The corporation's compensation cost attributable to its 
activities that are treated as the performance of personal services is 
determined under paragraph (e)(3) of this section; and
    (ii) The portion of the amount determined under paragraph (f)(2)(i) 
of this section that is attributable to personal services performed by 
employee-owners is to be determined by the taxpayer in any reasonable 
and consistent manner.
    (3) Examples. The provisions of this paragraph (f) may be 
illustrated by the following examples:

    Example 1. For its taxable year beginning February 1, 2001, Corp A's 
testing period is the taxable year ending January 31, 2000. During that 
testing period, A's only activity was the performance of personal 
services. The total compensation cost of A (including compensation cost 
attributable to employee-owners) for the testing period was $1,000,000. 
The total compensation cost attributable to employee-owners of A for the 
testing period was $210,000. Pursuant to paragraph (f)(1) of this 
section, the employee-owners of A substantially performed the personal 
services of A during the testing period because the compensation cost of 
A's employee-owners was more than 20 percent of the total compensation 
cost for all of A's employees (including employee-owners).
    Example 2. Corp B has the same facts as corporation A in Example 1, 
except that during the taxable year ending January 31, 2001, B also 
participated in an activity that would not be characterized as the 
performance of personal services under this section. The total 
compensation cost of B (including compensation cost attributable to 
employee-owners) for the testing period was $1,500,000 ($1,000,000 
attributable to B's personal service activity and $500,000 attributable 
to B's other activity). The total compensation cost attributable to 
employee-owners of B for the testing period was $250,000 ($210,000 
attributable to B's personal service activity and $40,000 attributable 
to B's other activity). Pursuant to paragraph (f)(1) of this section, 
the employee-owners of B substantially performed the personal services 
of B during the testing period because more than 20 percent of B's 
compensation cost during the testing period attributable to its personal 
service activities was attributable to personal services performed by 
employee-owners ($210,000).

    (g) Employee-owner defined--(1) General rule. For purposes of this 
section, a person is an employee-owner of a corporation for a testing 
period if--
    (i) The person is an employee of the corporation on any day of the 
testing period; and
    (ii) The person owns any outstanding stock of the corporation on any 
day of the testing period.
    (2) Special rule for independent contractors who are owners. Any 
person who is an owner of the corporation within the meaning of 
paragraph (g)(1)(ii) of this section and who performs personal services 
for, or on behalf of, the corporation is treated as an employee for 
purposes of this section, even if the legal form of that person's 
relationship to the corporation is such that the person would be 
considered an independent contractor for other purposes.
    (h) Special rules for affiliated groups filing consolidated 
returns--(1) In general. For purposes of applying this section to the 
members of an affiliated group of corporations filing a consolidated 
return for the taxable year--
    (i) The members of the affiliated group are treated as a single 
corporation;

[[Page 20]]

    (ii) The employees of the members of the affiliated group are 
treated as employees of such single corporation; and
    (iii) All of the stock of the members of the affiliated group that 
is not owned by any other member of the affiliated group is treated as 
the outstanding stock of that corporation.
    (2) Examples. The provisions of this paragraph (h) may be 
illustrated by the following examples:

    Example 1. The affiliated group AB, consisting of corporation A and 
its wholly owned subsidiary B, filed a consolidated Federal income tax 
return for the taxable year ending January 31, 2001, and AB is 
attempting to determine whether it is affected by this section for its 
taxable year beginning February 1, 2001. During the testing period 
(i.e., the taxable year ending January 31, 2001), A did not perform 
personal services. However, B's only activity was the performance of 
personal services. On the last day of the testing period, employees of A 
did not own any stock in A. However, some of B's employees own stock in 
A. In the aggregate, B's employees own 9 percent of A's stock on the 
last day of the testing period. Pursuant to paragraph (h)(1) of this 
section, this section is effectively applied on a consolidated basis to 
members of an affiliated group filing a consolidated Federal income tax 
return. Because the only employee-owners of AB are the employees of B, 
and because B's employees do not own more than 10 percent of AB on the 
last day of the testing period, AB is not a PSC subject to the 
provisions of this section. Thus, AB is not required to determine on a 
consolidated basis whether, during the testing period, its principal 
activity is the providing of personal services, or the personal services 
are substantially performed by employee-owners.
    Example 2. The facts are the same as in Example 1, except that on 
the last day of the testing period A owns only 80 percent of B. The 
remaining 20 percent of B is owned by employees of B. The fair market 
value of A, including its 80 percent interest in B, as of the last day 
of the testing period, is $1,000,000. In addition, the fair market value 
of the 20 percent interest in B owned by B's employees is $50,000 as of 
the last day of the testing period. Pursuant to paragraphs (c)(1)(iv) 
and (h)(1) of this section, AB must determine whether the employee-
owners of A and B (i.e., B's employees) own more than 10 percent of the 
fair market value of A and B as of the last day of the testing period. 
Because the $140,000 [($1,000,000 x .09) + $50,000] fair market value of 
the stock held by B's employees is greater than 10 percent of the 
aggregate fair market value of A and B as of the last day of the testing 
period, or $105,000 [$1,000,000 + $50,000 x .10], AB may be subject to 
this section if, on a consolidated basis during the testing period, the 
principal activity of AB is the performance of personal services and the 
personal services are substantially performed by employee-owners.

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec.  1.441-4  Effective date.

    Sections 1.441-0 through 1.441-3 are applicable for taxable years 
ending on or after May 17, 2002.

[T.D. 8996, 67 FR 35012, May 17, 2002]



Sec.  1.442-1  Change of annual accounting period.

    (a) Approval of the Commissioner. A taxpayer that has adopted an 
annual accounting period (as defined in Sec.  1.441-1(b)(3)) as its 
taxable year generally must continue to use that annual accounting 
period in computing its taxable income and for making its Federal income 
tax returns. If the taxpayer wants to change its annual accounting 
period and use a new taxable year, it must obtain the approval of the 
Commissioner, unless it is otherwise authorized to change without the 
approval of the Commissioner under either the Internal Revenue Code 
(e.g., section 444 and section 859) or the regulations thereunder (e.g., 
paragraph (c) of this section). In addition, as described in Sec.  
1.441-1(c) and (d), a partnership, S corporation, electing S 
corporation, or personal service corporation (PSC) generally is required 
to secure the approval of the Commissioner to adopt or retain an annual 
accounting period other than its required taxable year. The manner of 
obtaining approval from the Commissioner to adopt, change, or retain an 
annual accounting period is provided in paragraph (b) of this section. 
However, special rules for obtaining approval may be provided in other 
sections.
    (b) Obtaining approval--(1) Time and manner for requesting approval. 
In order to secure the approval of the Commissioner to adopt, change, or 
retain an annual accounting period, a taxpayer must file an application, 
generally on Form 1128, ``Application To Adopt, Change, or Retain a Tax 
Year,'' with the Commissioner within such time and in such manner as is 
provided in administrative procedures published by the Commissioner.

[[Page 21]]

    (2) General requirements for approval. An adoption, change, or 
retention in annual accounting period will be approved where the 
taxpayer establishes a business purpose for the requested annual 
accounting period and agrees to the Commissioner's prescribed terms, 
conditions, and adjustments for effecting the adoption, change, or 
retention. In determining whether a taxpayer has established a business 
purpose and which terms, conditions, and adjustments will be required, 
consideration will be given to all the facts and circumstances relating 
to the adoption, change, or retention, including the tax consequences 
resulting therefrom. Generally, the requirement of a business purpose 
will be satisfied, and adjustments to neutralize any tax consequences 
will not be required, if the requested annual accounting period 
coincides with the taxpayer's required taxable year (as defined in Sec.  
1.441-1(b)(2)), ownership taxable year, or natural business year. In the 
case of a partnership, S corporation, electing S corporation, or PSC, 
deferral of income to partners, shareholders, or employee-owners will 
not be treated as a business purpose.
    (3) Administrative procedures. The Commissioner will prescribe 
administrative procedures under which a taxpayer may be permitted to 
adopt, change, or retain an annual accounting period. These 
administrative procedures will describe the business purpose 
requirements (including an ownership taxable year and a natural business 
year) and the terms, conditions, and adjustments necessary to obtain 
approval. Such terms, conditions, and adjustments may include 
adjustments necessary to neutralize the tax effects of a substantial 
distortion of income that would otherwise result from the requested 
annual accounting period including: a deferral of a substantial portion 
of the taxpayer's income, or shifting of a substantial portion of 
deductions, from one taxable year to another; a similar deferral or 
shifting in the case of any other person, such as a beneficiary in an 
estate; the creation of a short period in which there is a substantial 
net operating loss, capital loss, or credit (including a general 
business credit); or the creation of a short period in which there is a 
substantial amount of income to offset an expiring net operating loss, 
capital loss, or credit. See, for example, Rev. Proc. 2002-39, 2002-22 
I.R.B., procedures for obtaining the Commissioner's prior approval of an 
adoption, change, or retention in annual accounting period through 
application to the national office; Rev. Proc. 2002-37, 2002-22 I.R.B., 
automatic approval procedures for certain corporations; Rev. Proc. 2002-
38, 2002-22 I.R.B., automatic approval procedures for partnerships, S 
corporations, electing S corporations, and PSCs; and Rev. Proc. 66-50, 
1966-2 C.B. 1260, automatic approval procedures for individuals. For 
availability of Revenue Procedures and Notices, see Sec.  601.601(d)(2) 
of this chapter.
    (4) Taxpayers to whom section 441(g) applies. If section 441(g) and 
Sec.  1.441-1(b)(1)(iv) apply to a taxpayer, the adoption of a fiscal 
year is treated as a change in the taxpayer's annual accounting period 
under section 442. Therefore, that fiscal year can become the taxpayer's 
taxable year only with the approval of the Commissioner. In addition to 
any other terms and conditions that may apply to such a change, the 
taxpayer must establish and maintain books that adequately and clearly 
reflect income for the short period involved in the change and for the 
fiscal year proposed.
    (c) Special rule for change of annual accounting period by 
subsidiary corporation. A subsidiary corporation that is required to 
change its annual accounting period under Sec.  1.1502-76, relating to 
the taxable year of members of an affiliated group that file a 
consolidated return, does not need to obtain the approval of the 
Commissioner or file an application on Form 1128 with respect to that 
change.
    (d) Special rule for newly married couples. (1) A newly married 
husband or wife may obtain automatic approval under this paragraph (d) 
to change his or her annual accounting period in order to use the annual 
accounting period of the other spouse so that a joint return may be 
filed for the first or second taxable year of that spouse ending after 
the date of marriage. Such automatic approval will be granted only if 
the newly married husband or wife

[[Page 22]]

adopting the annual accounting period of the other spouse files a 
Federal income tax return for the short period required by that change 
on or before the 15th day of the 4th month following the close of the 
short period. See section 443 and the regulations thereunder. If the due 
date for any such short-period return occurs before the date of 
marriage, the first taxable year of the other spouse ending after the 
date of marriage cannot be adopted under this paragraph (d). The short-
period return must contain a statement at the top of page one of the 
return that it is filed under the authority of this paragraph (d). The 
newly married husband or wife need not file Form 1128 with respect to a 
change described in this paragraph (d). For a change of annual 
accounting period by a husband or wife that does not qualify under this 
paragraph (d), see paragraph (b) of this section.
    (2) The provisions of this paragraph (d) may be illustrated by the 
following example:

    Example. H & W marry on September 25, 2001. H is on a fiscal year 
ending June 30, and W is on a calendar year. H wishes to change to a 
calendar year in order to file joint returns with W. W's first taxable 
year after marriage ends on December 31, 2001. H may not change to a 
calendar year for 2001 since, under this paragraph (d), he would have 
had to file a return for the short period from July 1 to December 31, 
2000, by April 16, 2001. Since the date of marriage occurred subsequent 
to this due date, the return could not be filed under this paragraph 
(d). Therefore, H cannot change to a calendar year for 2001. However, H 
may change to a calendar year for 2002 by filing a return under this 
paragraph (d) by April 15, 2002, for the short period from July 1 to 
December 31, 2001. If H files such a return, H and W may file a joint 
return for calendar year 2002 (which is W's second taxable year ending 
after the date of marriage).

    (e) Effective date. The rules of this section are applicable for 
taxable years ending on or after May 17, 2002.

[T.D. 8996, 67 FR 35019, May 17, 2002]



Sec.  1.443-1  Returns for periods of less than 12 months.

    (a) Returns for short period. A return for a short period, that is, 
for a taxable year consisting of a period of less than 12 months, shall 
be made under any of the following circumstances:
    (1) Change of annual accounting period. In the case of a change in 
the annual accounting period of a taxpayer, a separate return must be 
filed for the short period of less than 12 months beginning with the day 
following the close of the old taxable year and ending with the day 
preceding the first day of the new taxable year. However, such a return 
is not required for a short period of six days or less, or 359 days or 
more, resulting from a change from or to a 52-53-week taxable year. See 
section 441(f) and Sec.  1.441-2. The computation of the tax for a short 
period required to effect a change of annual accounting period is 
described in paragraph (b) of this section. In general, a return for a 
short period resulting from a change of annual accounting period shall 
be filed and the tax paid within the time prescribed for filing a return 
for a taxday of the short period. For rules applicable to a subsidiary 
corporation which becomes a member of an affiliated group which files a 
consolidated return, see Sec.  1.1502-76.
    (2) Taxpayer not in existence for entire taxable year. If a taxpayer 
is not in existence for the entire taxable year, a return is required 
for the short period during which the taxpayer was in existence. For 
example, a corporation organized on August 1 and adopting the calendar 
year as its annual accounting period is required to file a return for 
the short period from August 1 to December 31, and returns for each 
calendar year thereafter. Similarly, a dissolving corporation which 
files its returns for the calendar year is required to file a return for 
the short period from January 1 to the date it goes out of existence. 
Income for the short period is not required to be annualized if the 
taxpayer is not in existence for the entire taxable year, and, in the 
case of a taxpayer other than a corporation, the deduction under section 
151 for personal exemptions (or deductions in lieu thereof) need not be 
reduced under section 443(c). In general, the requirements with respect 
to the filing of returns and the payment of tax for a short period where 
the taxpayer has not been in existence for the entire taxable year are 
the same as for the filing of a return and the payment of tax for a 
taxable year of 12 months ending

[[Page 23]]

on the last day of the short period. Although the return of a decedent 
is a return for the short period beginning with the first day of his 
last taxable year and ending with the date of his death, the filing of a 
return and the payment of tax for a decedent may be made as though the 
decedent had lived throughout his last taxable year.
    (b) Computation of tax for short period on change of annual 
accounting period--(1) General rule. (i) If a return is made for a short 
period resulting from a change of annual accounting period, the taxable 
income for the short period shall be placed on an annual basis by 
multiplying such income by 12 and dividing the result by the number of 
months in the short period. Unless section 443(b)(2) and subparagraph 
(2) of this paragraph apply, the tax for the short period shall be the 
same part of the tax computed on the annual basis as the number of 
months in the short period is of 12 months.
    (ii) If a return is made for a short period of more than 6 days, but 
less than 359 days, resulting from a change from or to a 52-53-week 
taxable year, the taxable income for the short period shall be 
annualized and the tax computed on a daily basis, as provided in section 
441(f)(2)(B)(iii) and Sec.  1.441-2(b)(2)(ii).
    (iii) For method of computation of income for a short period in the 
case of a subsidiary corporation required to change its annual 
accounting period to conform to that of its parent, see Sec.  1.1502-
76(b).
    (iv) An individual taxpayer making a return for a short period 
resulting from a change of annual accounting period is not allowed to 
take the standard deduction provided in section 141 in computing his 
taxable income for the short period. See section 142(b)(3).
    (v) In computing the taxable income of a taxpayer other than a 
corporation for a short period (which income is to be annualized in 
order to determine the tax under section 443(b)(1)) the personal 
exemptions allowed individuals under section 151 (and any deductions 
allowed other taxpayers in lieu thereof, such as the deduction under 
section 642(b)) shall be reduced to an amount which bears the same ratio 
to the full amount of the exemptions as the number of months in the 
short period bears to 12. In the case of the taxable income for a short 
period resulting from a change from or to a 52-53-week taxable year to 
which section 441(f)(2)(B)(iii) applies, the computation required by the 
preceding sentence shall be made on a daily basis, that is, the 
deduction for personal exemptions (or any deduction in lieu thereof) 
shall be reduced to an amount which bears the same ratio to the full 
deduction as the number of days in the short period bears to 365.
    (vi) If the amount of a credit against the tax (for example, the 
credits allowable under section 34 (for dividends received on or before 
December 31, 1964), and 35 (for partially tax-exempt interest)) is 
dependent upon the amount of any item of income or deduction, such 
credit shall be computed upon the amount of the item annualized 
separately in accordance with the foregoing rules. The credit so 
computed shall be treated as a credit against the tax computed on the 
basis of the annualized taxable income. In any case in which a 
limitation on the amount of a credit is based upon taxable income, 
taxable income shall mean the taxable income computed on the annualized 
basis.
    (vii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. A taxpayer with one dependent who has been granted 
permission under section 442 to change his annual accounting period 
files a return for the short period of 10 months ending October 31, 
1956. He has income and deductions as follows:

                 Income
Interest income........................  ........  .........  $10,000.00
Partially tax-exempt interest with       ........  .........      500.00
 respect to which a credit is allowable
 under section 35......................
Dividends to which sections 34 and 116   ........  .........      750.00
 are applicable........................
                                                             -----------
                                         ........  .........   11,250.00
               Deductions
Real estate taxes......................  ........  .........      200.00
2 personal exemptions at $600 on an      ........  .........    1,200.00
 annual basis..........................
The tax for the 10-month period is
 computed as follows:
Total income as above..................  ........  .........   11,250.00
Less:
  Exclusion for dividends received.....  ........     $50.00
  2 personal exemptions ($1,200 x \10/   ........   1,000.00
   12\)................................

[[Page 24]]

 
  Real estate taxes....................  ........     200.00
                                         ........   --------    1,250.00
                                                             -----------
    Taxable income for 10-month period   ........  .........   10,000.00
     before annualizing................
Taxable income annualized (10,000 x \12/ ........  .........   12,000.00
 10\)..................................
Tax on $12,000 before credits..........  ........  .........    3,400.00
Deduct credits:
  Dividends received for 10-month         $750.00
   period..............................
  Less: Excluded portion...............     50.00
                                        ----------
  Included in gross income.............    700.00
  Dividend income annualized ($700 x       840.00
   \12/10\)............................
  Credit (4 percent of $840)...........  ........      33.60
  Partially tax-exempt interest            500.00
   included in gross income for 10-
   month period........................
  Partially tax-exempt interest            600.00
   (annualized) ($500 x \12/10\).......
  Credit (3 percent of $600)...........  ........      18.00
                                         ........   --------       51.60
                                                             -----------
    Tax on $12,000 (after credits).....  ........  .........    3,348.40
                                                             -----------
Tax for 10-month period ($3,348.40 x     ........  .........    2,790.33
 \10/12\)..............................
------------------------------------------------------------------------
 

    Example 2. The X Corporation makes a return for the one-month period 
ending September 30, 1956, because of a change in annual accounting 
period permitted under section 442. Income and expenses for the short 
period are as follows:

Gross operating income.......................................   $126,000
Business expenses............................................    130,000
                                                   ------------
Net loss from operations.....................................    (4,000)
Dividends received from taxable domestic corporations........     30,000
                                                   ------------
  Gross income for short period before annualizing...........     26,000
Dividends received deduction (85 percent of $30,000, but not      22,100
 in excess of 85 percent of $26,000).........................
                                                   ------------
  Taxable income for short period before annualizing.........      3,900
Taxable income annualized ($8,900 x 12)......................     46,800
                                                   ============
Tax on annual basis:
  $46,800 at 52 percent...........................    $24,336
  Less surtax exemption...........................      5,500
                                                     --------    $18,836
                                                              ==========
Tax for 1-month period ($18,836 x \1/12\)....................      1,570
 

    Example 3. The Y Corporation makes a re- turn for the six-month 
period ending June 30, 1957, because of a change in annual accounting 
period permitted under section 442. Income for the short period is as 
follows:

Taxable income exclusive of net long-term capital gain.......    $40,000
Net long-term capital gain...................................     10,000
                                                   ------------
  Taxable income for short period before annualizing.........     50,000
Taxable income annualized ($50,000 x \12/6\).................    100,000
                                                   ============
 
              Regular tax computation
 
Taxable income annualized....................................   100,000
Tax on annual basis:
  $100,000 at 52 percent..........................    $52,000
  Less surtax exemption...........................      5,500
                                                   ============
                                                      46,500
Tax for 6-month period ($46,500 x \6/12\)....................     23,250
                                                   ============
 
            Alternative tax computation
 
Taxable income annualized....................................    100,000
Less annualized capital gain ($10,000 x \12/6\)..............     20,000
                                                   ------------
  Annualized taxable income subject to partial tax...........     80,000
                                                   ============
            Partial tax on annual basis
 
$60,000 at 52 percent.............................    $41,600
Less surtax exemption.............................      5,500
                                                     --------    36,100
25 percent of annualized capital gain ($20,000)..............      5,000
                                                   ------------
  Alternative tax on annual basis............................     41,100
Alternative tax for 6-month period ($41,100 x \6/12\)........     20,550
 

    Since the alternative tax of $20,550 is less than the tax computed 
in the regular manner ($23,250), the corporation's tax for the 6-month 
short period is $20,550.

    (2) Exception: computation based on 12-month period. (i) A taxpayer 
whose tax would otherwise be computed under section 443(b)(1) (or 
section 441(f)(2)(B)(iii) in the case of certain changes from or to a 
52-53-week taxable year) for the short period resulting from a change of 
annual accounting period may apply to the district director to have his 
tax computed under the provisions of section 443(b)(2) and this 
subparagraph. If such application is made, as provided in subdivision 
(v) of this subparagraph, and if the taxpayer establishes the amount of 
his taxable income for the 12-month period described in subdivision (ii) 
of this subparagraph, then the tax for the short period shall be the 
greater of the following--
    (a) An amount which bears the same ratio to the tax computed on the 
taxable income which the taxpayer has established for the 12-month 
period as the taxable income computed on the basis of the short period 
bears to the taxable income for such 12-month period; or

[[Page 25]]

    (b) The tax computed on the taxable income for the short period 
without placing the taxable income on an annual basis.

However, if the tax computed under section 443(b)(2) and this 
subparagraph is not less than the tax for the short period computed 
under section 443(b)(1) (or section 441(f)(2)(B)(iii) in the case of 
certain changes from or to a 52-53-week taxable year), then section 
443(b)(2) and this subparagraph do not apply.
    (ii) The term ``12-month period'' referred to in subdivision (i) of 
this subparagraph means the 12-month period beginning on the first day 
of the short period. However, if the taxpayer is not in existence at the 
end of such 12-month period, or if the taxpayer is a corporation which 
has disposed of substantially all of its assets before the end of such 
12-month period, the term ``12-month period'' means the 12-month period 
ending at the close of the last day of the short period. For the 
purposes of the preceding sentence, a corporation which has ceased 
business and distributed so much of the assets used in its business that 
it cannot resume its customary operations with the remaining assets, 
will be considered to have disposed of substantially all of its assets. 
In the case of a change from a 52-53-week taxable year, the term ``12-
month period'' means the period of 52 or 53 weeks (depending on the 
taxpayer's 52-53-week taxable year) beginning on the first day of the 
short period.
    (iii)(a) The taxable income for the 12-month period is computed 
under the same provisions of law as are applicable to the short period 
and is computed as if the 12-month period were an actual annual 
accounting period of the taxpayer. All items which fall in such 12-month 
period must be included even if they are extraordinary in amount or of 
an unusual nature. If the taxpayer is a member of a partnership, his 
taxable income for the 12-month period shall include his distributive 
share of partnership income for any taxable year of the partnership 
ending within or with such 12-month period, but no amount shall be 
included with respect to a taxable year of the partnership ending before 
or after such 12-month period. If any other item partially applicable to 
such 12-month period can be determined only at the end of a taxable year 
which includes only part of the 12-month period, the taxpayer, subject 
to review by the Commissioner, shall apportion such item to the 12-month 
period in such manner as will most clearly reflect income for the 12-
month period.
    (b) In the case of a taxpayer permitted or required to use 
inventories, the cost of goods sold during a part of the 12-month period 
included in a taxable year shall be considered, unless a more exact 
determination is available, as such part of the cost of goods sold 
during the entire taxable year as the gross receipts from sales for such 
part of the 12-month period is of the gross receipts from sales for the 
entire taxable year. For example, the 12-month period of a corporation 
engaged in the sale of merchandise, which has a short period from 
January 1, 1956, to September 30, 1956, is the calendar year 1956. The 
three-month period, October 1, 1956, to December 31, 1956, is part of 
the taxpayer's taxable year ending September 30, 1957. The cost of goods 
sold during the three-month period, October 1, 1956, to December 31, 
1956, is such part of the cost of goods sold during the entire fiscal 
year ending September 30, 1957, as the gross receipts from sales for 
such three-month period are of the gross receipts from sales for the 
entire fiscal year.
    (c) The Commissioner may, in granting permission to a taxpayer to 
change his annual accounting period, require, as a condition to 
permitting the change, that the taxpayer must take a closing inventory 
upon the last day of the 12-month period if he wishes to obtain the 
benefits of section 443(b)(2). Such closing inventory will be used only 
for the purposes of section 443(b)(2), and the taxpayer will not be 
required to use such inventory in computing the taxable income for the 
taxable year in which such inventory is taken.
    (iv) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. The taxpayer in Example 1 under paragraph (b)(1)(vii) of 
this section establishes his taxable income for the 12-

[[Page 26]]

month period from January 1, 1956, to December 31, 1956. The taxpayer 
has a short period of 10 months, from January 1, 1956, to October 31, 
1956. The taxpayer files an application in accordance with subdivision 
(v) of this subparagraph to compute his tax under section 443(b)(2). The 
taxpayer's income and deductions for the 12-month period, as so 
established, follow:

                            Income
Interest income...............................................   $11,000
Partially tax-exempt interest with respect to which a credit         600
 is allowable under section 35................................
Dividends to which sections 34 and 116 are applicable.........       850
                                                       ---------
                                                                  12,450
 
                          Deductions
 
Real estate taxes.............................................       200
2 personal exemptions at $600.................................     1,200
 
Tax computation for short period under section 443(b)(2)(A)(i)
 
Total income as above.........................................  $12,450
Less:
Exclusion for dividends received......................     $50
Personal exemptions...................................   1,200
Deduction for taxes...................................     200
                                                       --------
                                                        ......     1,450
                                                               ---------
   Taxable income for 12-month period.........................    11,000
                                                       =========
Tax before credits............................................    3,020
Credit for partially tax-exempt interest (3 percent of      18
 $600)................................................
Credit for dividends received (4 percent of ($850-50))      32
                                                       --------
                                                        ......        50
                                                               ---------
Tax under section 443(b)(2)(A)(i) for 12-month period.........     2,970
Taxable income for 10-month short period from Example 1 of        10,000
 paragraph (b)(1)(vii) of this section before annualizing.....
Tax for short period under section 443(b)(2)(A)(i) ($2,970 x       2,700
 $10,000 (taxable income for short period)/$11,000 (taxable
 income for 12-month period)).................................
 
        Tax computation for short period under section
                       443(b)(2)(A)(ii)
 
Total income for 10-month short period........................   11,250
Less:
  Exclusion for dividends received....................      50
  2 personal exemptions...............................   1,200
  Real estate taxes...................................     200
                                                       --------
                                                        ......     1,450
                                                               ---------
  Taxable income for short period without annualizing and          9,800
   without proration of personal exemptions...................
Tax before credits............................................     2,572
Less credits:
  Partially tax-exempt interest (3 percent of $500)...      15
  Dividends received (4 percent of ($750-50)).........      28
                                                       --------
                                                        ......        43
                                                               ---------
   Tax for short period under section 443(b)(2)(A)(ii)........     2,529
 


The tax of $2,700 computed under section 443(b)(2)(A)(i) is greater than 
the tax of $2,529, computed under section 443(b)(2)(A)(ii), and is, 
therefore, the tax under section 443(b)(2). Since the tax of $2,700 
(computed under section 443(b)(2)) is less than the tax of $2,790.33 
(computed under section 443(b)(1)) on the annualized income of the short 
period (see Example 1 of paragraph (b)(1)(vii) of this section), the 
taxpayer's tax for the 10-month short period is $2,700.
    Example 2. Assume the same facts as in Example 1 of this 
subdivision, except that, during the month of November 1956, the 
taxpayer suffered a casualty loss of $5,000. The tax computation for the 
short period under section 443(b)(2) would be as follows:

Tax computation for short period under section 443(b)(2)(A)(i)
 
Taxable income for 12-month period from Example 1.............   $11,000
Less: Casualty loss...........................................     5,000
                                                     -----------
   Taxable income for 12-month period.........................     6,000
                                                     ===========
Tax before credits..................................    $1,360
Credits from Example 1..............................        50
                                                     ==========
Tax under section 443(b)(2)(A)(i) for 12-month           1,310
 period.............................................
                                                     ===========
Tax for short period ($1,310 x $10,000/$6,000) under     2,183
 section 443(b)(2)(A)(i)............................
 
   Tax computation for short period under section
                  443(b)(2)(A)(ii)
 
Total income for the short period...................    11,250
Less:
  Exclusion for dividends received..................        50
  2 personal exemptions.............................     1,200
  Real estate taxes.................................       200
                                                     ----------
                                                      ........     1,450
                                                               ---------
   Taxable income for short period without annualizing and         9,800
   without proration of personal exemptions...................
Tax before credits............................................    2,572
Less credits:
  Partially tax-exempt interest (3 percent of $500).        15
  Dividends received (4 percent of $750-50))........        28
                                                     -----------
                                                      ........        43
                                                               ---------
Tax for short period under section 443(b)(2)(A)(ii)...........     2,529
 


The tax of $2,529, computed under section 443(b)(2)(A)(ii) is greater 
than the tax of $2,183 computed under section 443(b)(2)- (A)(i) and is, 
therefore, the tax under section 443(b)(2). Since this tax is less than 
the tax of $2,790.33, computed under section 443(b)(1) (see Example 1 of 
paragraph (b)(1)(vii) of this section), the taxpayer's tax for the 10-
month short period is $2,529.

    (v)(a) A taxpayer who wishes to compute his tax for a short period 
resulting from a change of annual accounting period under section 
443(b)(2) must make

[[Page 27]]

an application therefor. Except as provided in (b) of this subdivision, 
the taxpayer shall first file his return for the short period and 
compute his tax under section 443(b)(1). The application for the 
benefits of section 443(b)(2) shall subsequently be made in the form of 
a claim for credit or refund. The claim shall set forth the computation 
of the taxable income and the tax thereon for the 12-month period and 
must be filed not later than the time (including extensions) prescribed 
for filing the return for the taxpayer's first taxable year which ends 
on or after the day which is 12 months after the beginning of the short 
period. For example, assume that a taxpayer changes his annual 
accounting period from the calendar year to a fiscal year ending 
September 30, and files a return for the short period from January 1, 
1956, to September 30, 1956. His application for the benefits of section 
443(b)(2) must be filed not later than the time prescribed for filing 
his return for his first taxable year which ends on or after the last 
day of December 1956, the twelfth month after the beginning of the short 
period. Thus, the taxpayer must file his application not later than the 
time prescribed for filing the return for his fiscal year ending 
September 30, 1957. If he obtains an extension of time for filing the 
return for such fiscal year, he may file his application during the 
period of such extension. If the district director determines that the 
taxpayer has established the amount of his taxable income for the 12-
month period, any excess of the tax paid for the short period over the 
tax computed under section 443(b)(2) will be credited or refunded to the 
taxpayer in the same manner as in the case of an overpayment.
    (b) If at the time the return for the short period is filed, the 
taxpayer is able to determine that the 12-month period ending with the 
close of the short period (see section 443(b)(2)- (B)(ii) and 
subparagraph (2)(ii) of this paragraph) will be used in the computations 
under section 443(b)(2), then the tax on the return for the short period 
may be determined under the provisions of section 443(b)(2). In such 
case, a return covering the 12-month period shall be attached to the 
return for the short period as a part thereof, and the return and 
attachment will then be considered as an application for the benefits of 
section 443(b)(2).
    (c) Adjustment in deduction for personal exemption. For adjustment 
in the deduction for personal exemptions in computing the tax for a 
short period resulting from a change of annual accounting period under 
section 443(b)(1) (or under section 441(f)(2)(B)(iii) in the case of 
certain changes from or to a 52-53-week taxable year), see paragraph 
(b)(1)(v) of this section.
    (d) Adjustments in exclusion of computing minimum tax for tax 
preferences. (1) If a return is made for a short period on account of 
any of the reasons specified in subsection (a) of section 443, the 
$30,000 amount specified in section 56 (relating to minimum tax for tax 
preferences), modified as provided by section 58 and the regulations 
thereunder, shall be reduced to the amount which bears the same ratio to 
such specified amount as the number of days in the short period bears to 
365.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. A taxpayer who is an unmarried individual has been granted 
permission under section 442 to change his annual accounting period 
files a return for the short period of 4 months ending April 30, 1970. 
The $30,000 amount specified in section 56 is reduced as follows:

    (120/365) x $30,000 = $9,835.89.

    (e) Cross references. For inapplicability of section 443(b) and 
paragraph (b) of this section in computing--
    (1) Accumulated earnings tax, see section 536 and the regulations 
thereunder;
    (2) Personal holding company tax, see section 546 and the 
regulations thereunder;
    (3) Undistributed foreign personal holding company income, see 
section 557 and the regulations thereunder;
    (4) The taxable income of a regulated investment company, see 
section 852(b)(2)(E) and the regulations thereunder; and
    (5) The taxable income of a real estate investment trust, see 
section

[[Page 28]]

857(b)(2)(C) and the regulations thereunder.

[T.D. 6500, 25 FR 11705, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4093, Apr. 28, 1962; T.D. 6777, 29 FR 17808, Dec. 16, 1964; T.D. 7244, 
37 FR 28897, Dec. 30, 1972, T.D. 7564, 43 FR 40494, Sept. 12, 1978; T.D. 
7575, 43 FR 58816, Dec. 18, 1978; T.D. 7767, 465 FR 11265, Feb. 6, 1981; 
T.D. 8996, 67 FR 35012, May 17, 2002]



Sec.  1.444-0T  Table of contents (temporary).

    This section lists the captions that appear in the temporary 
regulations under section 444.

 Sec.  1.444-1T Election to use a taxable year other than the required 
                        taxable year (temporary).

    (a) General rules.
    (1) Year other than required year.
    (2) Effect of section 444 election.
    (i) In general.
    (ii) Duration of section 444 election.
    (3) Section 444 election not required for certain years.
    (4) Required taxable year.
    (5) Termination of section 444 election.
    (i) In general.
    (ii) Effective date of termination.
    (iii) Example.
    (iv) Special rule for entity that liquidates or is sold prior to 
making a section 444 election, required return, or required payment.
    (6) Re-activating certain S elections.
    (i) Certain corporations electing S status that did not make a back-
up calendar year request.
    (ii) Certain corporations that revoked their S status.
    (iii) Procedures for re-activating an S election.
    (iv) Examples.
    (b) Limitation on taxable years that may be elected.
    (1) General rule.
    (2) Changes in taxable year.
    (i) In general.
    (ii) Special rule for certain existing corporations electing S 
status.
    (iii) Deferral period of the taxable year that is being changed.
    (iv) Examples.
    (3) Special rule for entities retaining 1986 taxable year.
    (4) Deferral period.
    (i) Retentions of taxable year.
    (ii) Adoptions of and changes in taxable year.
    (A) In general.
    (B) Special rule.
    (C) Examples.
    (5) Miscellaneous rules.
    (i) Special rule for determining the taxable year of a corporation 
electing S status.
    (ii) Special procedure for cases where an income tax return is 
superseded.
    (A) In general.
    (B) Procedure for superseding return.
    (iii) Anti-abuse rule.
    (iv) Special rules for partial months and 52-53-week taxable years.
    (c) Effective date.
    (d) Examples.
    (1) Changes in taxable year.
    (2) Special rule for entities retaining their 1986 taxable year.

              Sec.  1.444-2T Tiered structure (temporary).

    (a) General rule.
    (b) Definition of a member of a tiered structure.
    (1) In general.
    (2) Deferral entity.
    (i) In general.
    (ii) Grantor trusts.
    (3) Anti-abuse rule.
    (c) De minimis rules.
    (1) In general.
    (2) Downstream de minimis rule.
    (i) General rule.
    (ii) Definition of testing period.
    (iii) Definition of adjusted taxable income.
    (A) Partnership.
    (B) S corporation.
    (C) Personal service corporation.
    (iv) Special rules.
    (A) Pro-forma rule.
    (B) Reasonable estimates allowed.
    (C) Newly formed entities.
    (1) Newly formed deferral entities.
    (2) Newly formed partnership, S corporation, or personal service 
corporation desiring to make a section 444 election.
    (3) Upstream de minimis rule.
    (d) Date for determining the existence of a tiered structure.
    (1) General rule.
    (2) Special rule for taxable years beginning in 1987.
    (e) Same taxable year exception.
    (1) In general.
    (2) Definition of tiered structure.
    (i) General rule.
    (ii) Special flow-through rule for downstream controlled 
partnerships.
    (3) Determining the taxable year of a partnership or S corporation.
    (4) Special rule for 52-53-week taxable years.
    (5) Interaction with de minimis rules.
    (i) Downstream de minimis rule.
    (A) In general.
    (B) Special rule for members of a tiered structure directly owned by 
a downstream controlled partnership.
    (ii) Upstream de minimis rule.
    (f) Examples.
    (g) Effective date.

[[Page 29]]

     Sec.  1.444-3T Manner and time of making section 444 election 
                              (temporary).

    (a) In general.
    (b) Manner and time of making election.
    (1) General rule.
    (2) Special extension of time for making an election.
    (3) Corporation electing to be an S corporation.
    (i) In general.
    (ii) Examples.
    (4) Back-up section 444 election.
    (i) General rule.
    (ii) Procedures for making a back-up section 444 election.
    (iii) Procedures for activating a back-up section 444 election.
    (A) Partnership and S corporations.
    (1) In general.
    (2) Special rule if Form 720 used to satisfy return requirement.
    (B) Personal service corporations.
    (iv) Examples.
    (c) Administrative relief.
    (1) Extension of time to file income tax returns.
    (i) Automatic extension.
    (ii) Additional extensions.
    (iii) Examples.
    (2) No penalty for certain late payments.
    (i) In general.
    (ii) Example.
    (d) Effective date.

[T.D. 8205, 53 FR 19693, May 27, 1988]



Sec.  1.444-1T  Election to use a taxable year other than the required 
taxable year (temporary).

    (a) General rules--(1) Year other than required year. Except as 
otherwise provided in this section and Sec.  1.444-2T, a partnership, S 
corporation, or personal service corporation (as defined in Sec.  1.441-
3(c)) may make or continue an election (a ``section 444 election'') to 
have a taxable year other than its required taxable year. See paragraph 
(b) of this section for limitations on the taxable year that may be 
elected. See Sec.  1.444-2T for rules that generally prohibit a 
partnership, S corporation, or personal service corporation that is a 
member of a tiered structure from making or continuing a section 444 
election. See Sec.  1.444-3T for rules explaining how and when to make a 
section 444 election.
    (2) Effect of section 444 election--(i) In general. A partnership or 
S corporation that makes or continues a section 444 election shall file 
returns and make payments as required by Sec. Sec.  1.7519-1T and 
1.7519-2T. A personal service corporation that makes or continues a 
section 444 election is subject to the deduction limitation of Sec.  
1.280H-1T.
    (ii) Duration of section 444 election. A section 444 election shall 
remain in effect until the election is terminated pursuant to paragraph 
(a)(5) of this section.
    (3) Section 444 election not required for certain years. A 
partnership, S corporation, or personal service corporation is not 
required to make a section 444 election to use--
    (i) A taxable year for which such entity establishes a business 
purpose to the satisfaction of the Commissioner (i.e., approved under 
section 4 or 6 of Rev. Proc. 87-32, 1987-28 I.R.B. 14, or any successor 
revenue ruling or revenue procedure), or
    (ii) A taxable year that is a ``grandfathered fiscal year,'' within 
the meaning of section 5.01(2) of Rev. Proc. 87-32 or any successor 
revenue ruling or revenue procedure.

Although a partnership, S corporation or personal service corporation 
qualifies to use a taxable year described in paragraph (a)(3) (i) or 
(ii) of this section, such entity may, if otherwise qualified, make a 
section 444 election to use a different taxable year. Thus, for example, 
assume that a personal service corporation that historically used a 
January 31 taxable year established to the satisfaction of the 
Commissioner, under section 6 of Rev. Proc. 87-32, a business purpose to 
use a September 30 taxable year for its taxable year beginning February 
1, 1987. Pursuant to this paragraph (a)(3), such personal service 
corporation may use a September 30 taxable year without making a section 
444 election. However, the corporation may, if otherwise qualified, make 
a section 444 election to use a year ending other than September 30 for 
its taxable year beginning February 1, 1987.
    (4) Required taxable year. For purposes of this section, the term 
``required taxable year'' means the taxable year determined under 
section 706(b), 1378, or 441(i) without taking into account any taxable 
year which is allowable either--
    (i) By reason of business purpose (i.e., approved under section 4 or 
6 of Rev.

[[Page 30]]

Proc. 87-32 or any successor revenue ruling or procedure), or
    (ii) As a ``grandfathered fiscal year'' within the meaning of 
section 5.01(2) of Rev. Proc. 87-32, or any successor revenue ruling or 
procedure.
    (5) Termination of section 444 election--(i) In general. A section 
444 election is terminated when--
    (A) A partnership, S corporation, or personal service corporation 
changes to its required taxable year; or
    (B) A partnership, S corporation, or personal service corporation 
liquidates (including a deemed liquidation of a partnership under Sec.  
1.708-1 (b)(1)(iv)); or
    (C) A partnership, S corporation, or personal service corporation 
willfully fails to comply with the requirements of section 7519 or 280H, 
whichever is applicable; or
    (D) A partnership, S corporation, or personal service corporation 
becomes a member of a tiered structure (within the meaning of Sec.  
1.444-2T), unless it is a partnership or S corporation that meets the 
same taxable year exception under Sec.  1.444-2T (e); or
    (E) An S corporation's S election is terminated; or
    (F) A personal service corporation ceases to be a personal service 
corporation.

However, if a personal service corporation, that has a section 444 
election in effect, elects to be an S corporation, the S corporation may 
continue the section 444 election of the personal service corporation. 
Similarly, if an S corporation that has a section 444 election in effect 
terminates its S election and immediately becomes a personal service 
corporation, the personal service corporation may continue the section 
444 election of the S corporation. If a section 444 election is 
terminated under this paragraph (a)(5), the partnership, S corporation, 
or personal service corporation may not make another section 444 
election for any taxable year.
    (ii) Effective date of termination. A termination of a section 444 
election shall be effective--
    (A) In the case of a change to the required year, on the first day 
of the short year caused by the change;
    (B) In the case of a liquidating entity, on the date the liquidation 
is completed for tax purposes;
    (C) In the case of willful failure to comply, on the first day of 
the taxable year (determined as if a section 444 election had never been 
made) determined in the discretion of the District Director;
    (D) In the case of membership in a tiered structure, on the first 
day of the taxable year in which the entity is considered to be a member 
of a tiered structure, or such other taxable year determined in the 
discretion of the District Director;
    (E) In the case of termination of S status, on the first day of the 
taxable year for which S status no longer exists;
    (F) In the case of a personal service corporation that changes 
status, on the first day of the taxable year, for which the entity is no 
longer a personal service corporation.

In the case of a termination under this paragraph (a)(5) that results in 
a short taxable year, an income tax return is required for the short 
period. In order to allow the Service to process the affected income tax 
return in an efficient manner, a partnership, S corporation, or personal 
service corporation that files such a short period return should type or 
legibly print at the top of the first page of the income tax return for 
the short taxable year--``SECTION 444 ELECTION TERMINATED.'' In 
addition, a personal service corporation that changes its taxable year 
to the required taxable year is required to annualize its income for the 
short period.
    (iii) Example. The provisions of paragraph (a)(5)(ii) of this 
section may be illustrated by the following example.

    Example. Assume a partnership that is 100 percent owned, at all 
times, by calendar year individuals has historically used a June 30 
taxable year. Also assume the partnership makes a valid section 444 
election to retain a year ending June 30 for its taxable year beginning 
July 1, 1987. However, for its taxable year beginning July 1, 1988, the 
partnership changes to a calendar year, its required year. Based on 
these facts, the partnership's section 444 election is terminated on 
July 1, 1988, and the partnership must file a short period return for 
the period July 1, 1988-December 31, 1988. Furthermore, pursuant to

[[Page 31]]

Sec.  1.702-3T(a)(1), the partners in such partnership are not entitled 
to a 4-year spread with respect to partnership items of income and 
expense for the taxable year beginning July 1, 1988 and ending December 
31, 1988.

    (iv) Special rule for entity that liquidates or is sold prior to 
making a section 444 election, required return, or required payment. A 
partnership, S corporation, or personal service corporation that is 
liquidated or sold for tax purposes before a section 444 election, 
required return, or required payment is made for a particular year may, 
nevertheless, make or continue a section 444 election, if otherwise 
qualified. (See Sec. Sec.  1.7519-2T (a)(2) and 1.7519-1T (a)(3), 
respectively, for a description of the required return and a definition 
of the term ``required payment.'') However, the partnership, S 
corporation, or personal service corporation (or a trustee or agent 
thereof) must comply with the requirements for making or continuing a 
section 444 election. Thus, if applicable, required payments must be 
made and a subsequent claim for refund must be made in accordance with 
Sec.  1.7519-2T(a)(6). The following examples illustrate the application 
of this paragraph (a)(5)(iv).

    Example 1. Assume an existing S corporation historically used a June 
30 taxable year and desires to make a section 444 election for its 
taxable year beginning July 1, 1987. Assume further that the S 
corporation is liquidated for tax purposes on February 15, 1988. If 
otherwise qualified, the S corporation (or a trustee or agent thereof) 
may make a section 444 election to have a taxable year beginning July 1, 
1987, and ending February 15, 1988. However, if the S corporation makes 
a section 444 election, it must comply with the requirements for making 
a section 444 election, including making required payments.
    Example 2. The facts are the same as in Example 1, except that 
instead of liquidating on February 15, 1988, the shareholders of the S 
corporation sell their stock to a corporation on February 15, 1988. 
Thus, the corporation's S election is terminated on February 15, 1988. 
If otherwise qualified, the corporation may make a section 444 election 
to have a taxable year beginning July 1, 1987, and ending February 14, 
1988.
    Example 3. The facts are the same as in Example 2, except that the 
new shareholders are individuals. Furthermore, the corporation's S 
election is not terminated. Based on these facts, the S corporation, if 
otherwise qualified, may make a section 444 election to retain a year 
ending June 30 for its taxable year beginning July 1, 1987. Furthermore, 
the S corporation may, if otherwise qualified, continue its section 444 
election for subsequent taxable years.

    (6) Re-activating certain S elections--(i) Certain corporations 
electing S status that did not make a back-up calendar year request. If 
a corporation that timely filed Form 2553, Election by a Small Business 
Corporation, effective for its first taxable year beginning in 1987--
    (A) Requested a fiscal year based on business purpose,
    (B) Did not agree to use a calendar year in the event its business 
purpose request was denied, and
    (C) Such business purpose request is denied or withdrawn,

such corporation may retroactively re-activate its S election by making 
a valid section 444 election for its first taxable year beginning in 
1987 and complying with the procedures in paragraph (a)(6)(iii) of this 
section.
    (ii) Certain corporations that revoked their S status. If a 
corporation that used a fiscal year revoked its S election (pursuant to 
section 1362(d)(1)) for its first taxable year beginning in 1987, such 
corporation may retroactively re-activate its S election (i.e. rescind 
its revocation) by making a valid section 444 election for its first 
taxable year beginning in 1987 and complying with the procedures in 
paragraph (a)(6)(iii) of this section.
    (iii) Procedures for re-activating an S election. A corporation re-
activating its S election pursuant to paragraph (a)(6) (i) or (ii) of 
this section must--
    (A) Obtain the consents of all shareholders who have owned stock in 
the corporation since the first day of the first taxable year of the 
corporation beginning after December 31, 1986,
    (B) Include the following statement at the top of the first page of 
the corporation's Form 1120S for its first taxable year beginning in 
1987--``SECTION 444 ELECTION--RE-ACTIVATES S STATUS,'' and
    (C) Include the following statement with Form 1120S--``RE-ACTIVATION 
CONSENTED TO BY ALL SHAREHOLDERS WHO HAVE OWNED STOCK AT ANY TIME SINCE 
THE FIRST DAY OF THE FIRST TAXABLE YEAR OF THIS CORPORATION BEGINNING 
AFTER DECEMBER 31, 1986.''

[[Page 32]]

    (iv) Examples. The provisions of this paragraph (a)(6) may be 
illustrated by the following examples.

    Example 1. Assume a corporation historically used a June 30 taxable 
year and such corporation timely filed Form 2553, Election by a Small 
Business Corporation, to be effective for its taxable year beginning 
July 1, 1987. On its Form 2553, the corporation requested permission to 
retain its June 30 taxable year based on business purpose. However, the 
corporation did not agree to use a calendar year in the event its 
business purpose request was denied. On April 1, 1988, the Internal 
Revenue Service notified the corporation that its business purpose 
request was denied and therefore the corporation's S election was not 
effective. Pursuant to paragraph (a)(6)(i) of this section, the 
corporation may re-activate its S election by making a valid section 444 
election and complying with the procedures in paragraph (a)(6)(iii) of 
this section.
    Example 2. The facts are the same as in Example 1, except that as of 
July 26, 1988, the Internal Revenue Service has not yet determined 
whether the corporation has a valid business purpose to retain a June 30 
taxable year. Based on these facts, the corporation may, if otherwise 
qualified, make a back-up section 444 election as provided in Sec.  
1.444-3T(b)(4). If the corporation's business purpose request is 
subsequently denied, the corporation should follow the procedures in 
Sec.  1.444-3T(b)(4)(iii) for activating a back-up section 444 election 
rather than the procedures provided in this paragraph (a)(6 for re-
activating an S election.
    Example 3. Assume a corporation has historically been an S 
corporation with a March 31 taxable year. However, for its taxable year 
beginning April 1, 1987, the corporation revoked its S election pursuant 
to section 1362 (d)(1). Pursuant to paragraph (a)(6)(ii) of this 
section, such corporation may retroactively rescind its S election 
revocation by making a valid section 444 election for its taxable year 
beginning April 1, 1987, and complying with the procedures provided in 
paragraph (a)(6)(iii) of this section. If the corporation retroactively 
rescinds its S revocation, the corporation shall file a Form 1120S for 
its taxable year beginning April 1, 1987.

    (b) Limitation on taxable years that may be elected--(1) General 
rule. Except as provided in paragraphs (b)(2) and (3) of this section, a 
section 444 election may be made only if the deferral period (as defined 
in paragraph (b)(4) of this section) of the taxable year to be elected 
is not longer than three months.
    (2) Changes in taxable year--(i) In general. In the case of a 
partnership, S corporation, or personal service corporation changing its 
taxable year, such entity may make a section 444 election only if the 
deferral period of the taxable year to be elected is not longer than the 
shorter of--
    (A) Three months, or
    (B) The deferral period of the taxable year that is being changed, 
as defined in paragraph (b)(2)(iii) of this section.
    (ii) Special rule for certain existing corporations electing S 
status. If a corporation with a taxable year other than the calendar 
year--
    (A) Elected after September 18, 1986, and before January 1, 1988, 
under section 1362 of the Code to be an S corporation, and
    (B) Elected to have the calendar year as the taxable year of the S 
corporation,

then, for taxable years beginning before 1989, paragraph (b)(2)(i) of 
this section shall be applied by taking into account the deferral period 
of the last taxable year of the corporation prior to electing to be an S 
corporation, rather than the deferral period of the taxable year that is 
being changed. Thus, the provisions of the preceding sentence do not 
apply to a corporation that elected to be an S corporation for its first 
taxable year.
    (iii) Deferral period of the taxable year that is being changed. For 
purposes of paragraph (b)(2)(i)(B) of this section, the phrase 
``deferral period of the taxable year that is being changed'' means the 
deferral period of the taxable year immediately preceding the taxable 
year for which the taxpayer desires to make a section 444 election. 
Furthermore, the deferral period of such year will be determined by 
using the required taxable year of the taxable year for which the 
taxpayer desires to make a section 444 election. For example, assume P, 
a partnership that has historically used a March 31 taxable year, 
desires to change to a September 30 taxable year by making a section 444 
election for its taxable year beginning April 1, 1987. Furthermore, 
assume that pursuant to paragraph (a)(4) of this section, P's required 
taxable year for the taxable year beginning April 1, 1987 is a year 
ending December 31. Based on these facts the deferral period of the 
taxable year being changed is nine

[[Page 33]]

months (the period from March 31 to December 31).
    (iv) Examples. See paragraph (d)(1) of this section for examples 
that illustrate the provisions of this paragraph (b)(2).
    (3) Special rule for entities retaining 1986 taxable year. 
Notwithstanding paragraph (b)(2) of this section, a partnership, S 
corporation, or personal service corporation may, for its first taxable 
year beginning after December 31, 1986, if otherwise qualified, make a 
section 444 election to have a taxable year that is the same as the 
entity's last taxable year beginning in 1986. See paragraph (d)(2) of 
this section for examples that illustrate the provisions of this 
paragraph (b)(3).
    (4) Deferral period--(i) Retentions of taxable year. For a 
partnership, S corporation, or personal service corporation that desires 
to retain its taxable year by making a section 444 election, the term 
``deferral period'' means the months between the beginning of such year 
and the close of the first required taxable year (as defined in 
paragraph (a)(4) of this section). The following example illustrates the 
application of this paragraph (b)(4)(i).

    Example. AB partnership has historically used a taxable year ending 
July 31. AB desires to retain its July 31 taxable year by making a 
section 444 election for its taxable year beginning August 1, 1987. 
Calendar year individuals, A and B, each own 50 percent of the profits 
and capital of AB; thus, under paragraph (a)(4) of this section AB's 
required taxable year is the year ending December 31. Pursuant to this 
paragraph (b)(4)(i), if AB desires to retain its year ending July 31, 
the deferral period is five months (the months between July 31 and 
December 31).

    (ii) Adoptions of and changes in taxable year--(A) In general. For a 
partnership, S corporation, or personal service corporation that desires 
to adopt or change its taxable year by making a section 444 election, 
the term ``deferral period'' means the months that occur after the end 
of the taxable year desired under section 444 and before the close of 
the required taxable year.
    (B) Special rule. If a partnership, S corporation or personal 
service corporation is using the required taxable year as its taxable 
year, the deferral period is deemed to be zero.
    (C) Examples. The provisions of this paragraph (b)(4)(ii) may be 
illustrated by the following examples.

    Example 1. Assume that CD partnership has historically used the 
calendar year and that CD's required taxable year is the calendar year. 
Under the special rule provided in paragraph (b)(4)(ii)(B) of this 
section, CD's deferral period is zero. See paragraph (b)(2)(i) of this 
section for rules that preclude CD from making a section 444 election to 
change its taxable year.
    Example 2. E, a newly formed partnership, began operations on 
December 1, 1987, and is owned by calendar year individuals. E desires 
to make a section 444 election to adopt a September 30 taxable year. E's 
required taxable year is December 31. Pursuant to paragraph 
(b)(4)(ii)(A) of this section E's deferral period for the taxable year 
beginning December 1, 1987, is three months (the number of months 
between September 30 and December 31).
    Example 3. Assume that F, a personal service corporation, has 
historically used a June 30 taxable year. F desires to make a section 
444 election to change to an August 31 taxable year, effective for its 
taxable year beginning July 1, 1987. For purposes of determining the 
availability of a section 444 election for changing to the taxable year 
ending August 31, the deferral period of an August 31 taxable year is 
four months (the number of months between August 31 and December 31). 
The deferral period for F's existing June 30 taxable year is six months 
(the number of months between June 30 and December 31). Pursuant to 
Sec.  1.444-1T(b)(2)(i), F may not make a section 444 election to change 
to an August 31 taxable year.

    (5) Miscellaneous rules--(i) Special rule for determining the 
taxable year of a corporation electing S status. For purposes of this 
section, and only for purposes of this section, a corporation that 
elected to be an S corporation for a taxable year beginning in 1987 or 
1988 and which elected to be an S corporation prior to September 26, 
1988, will not be considered to have adopted or changed its taxable year 
by virtue of information included on Form 2553, Election by a Small 
Business Corporation. See Example 8 in paragraph (d) of this section.
    (ii) Special procedure for cases where an income tax return is 
superseded--(A) In general. In the case of a partnership, S corporation, 
or personal service corporation that filed an income tax return for its 
first taxable year beginning

[[Page 34]]

after December 31, 1986, but subsequently makes a section 444 election 
that would result in a different year end for such taxable year, the 
income tax return filed pursuant to the section 444 election will 
supersede the original return. However, any payments of income tax made 
with respect to such superseded return will be credited to the 
taxpayer's superseding return and the taxpayer may file a claim for 
refund for such payments. See examples (5) and (7) in paragraph (d)(2) 
of this section.
    (B) Procedure for superseding return. In order to allow the Service 
to process the affected income tax returns in an efficient manner, a 
partnership, S corporation, or personal service corporation that desires 
to supersede an income tax return in accordance with paragraph 
(b)(5)(ii)(A) of this section, should type or legibly print at the top 
of the first page of the income tax return for the taxable year 
elected--``SECTION 444 ELECTION--SUPERSEDES PRIOR RETURN.''
    (iii) Anti-abuse rule--If an existing partnership, S corporation or 
personal service corporation (``predecessor entities''), or the owners 
thereof, transfer assets to a related party and the principal purpose of 
such transfer is to--
    (A) Create a deferral period greater than the deferral period of the 
predecessor entity's taxable year, or
    (B) Make a section 444 election following the termination of the 
predecessor entity's section 444 election,

then such transfer will be disregarded for purposes of section 444 and 
this section, even if the deferral created by such change is effectively 
eliminated by a required payment (within the meaning of section 7519) or 
deferral of a deduction (to a personal service corporation under section 
280H). The following example illustrates the application of this 
paragraph (b)(5)(iii).

    Example. Assume that P1 is a partnership that historically used the 
calendar year and is owned by calendar year partners. Assume that P1 
desires to make a section 444 election to change to a September year for 
the taxable year beginning January 1, 1988. P1 may not make a section 
444 election to change taxable years under section 444(b)(2) because its 
current deferral period is zero. Assume further that P1 transfers a 
substantial portion of its assets to a newly-formed partnership (P2), 
which is owned by the partners of P1. Absent paragraph (b)(5)(iii) of 
this section, P2 could, if otherwise qualified, make a section 444 
election under paragraph (b)(1) of this section to use a taxable year 
with a three month or less deferral period (i.e., a September 30, 
October 31, or November 30 taxable year). However, if the principal 
purpose of the asset transfer was to create a one-, two-, or three-month 
deferral period by P2 making a section 444 election, the section 444 
election shall not be given effect, even if the deferral would be 
effectively eliminated by P2 making a required payment under section 
7519.

    (iv) Special rules for partial months and 52-53-week taxable years. 
Except as otherwise provided in Sec.  1.280H-1T(c)(2)(i)(A), for 
purposes of this section and Sec. Sec.  1.7519-1T, 1.7519-2T and 1.280H-
1T--
    (A) A month of less than 16 days is disregarded, and a month of more 
than 15 days is treated as a full month; and
    (B) A 52-53-week taxable year with reference to the end of a 
particular month will be considered to be the same as a taxable year 
ending with reference to the last day of such month.
    (c) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.
    (d) Examples--(1) Changes in taxable year. The following examples 
illustrate the provisions of paragraph (b)(2) of this section.

    Example 1. A is a personal service corporation that historically 
used a June 30 taxable year. A desires to make a section 444 election to 
change to an August 31 taxable year, effective with its taxable year 
beginning July 1, 1987. Under paragraph (b)(4)(ii) of this section, the 
deferred period of the taxable year to be elected is four months (the 
number of months between August 31 and December 31). Furthermore, the 
deferral period of the taxable year that is being changed is six months 
(the number of months between June 30 and December 31). Pursuant to 
paragraph (b)(2)(i) of this section, a taxpayer may, if otherwise 
qualified, make a section 444 election to change to a taxable year only 
if the deferral period of the taxable year to be elected is not longer 
than the shorter of three months or the deferred period of the taxable 
year being changed. Since the deferral period of the taxable year to be 
elected (August 31) is greater than three months, A may not make a 
section 444 election to change to the taxable year ending August 31, 
However, since the deferral period of the taxable year that is being 
changed is three months or more, A may, if otherwise qualified, make a 
section

[[Page 35]]

444 election to change to a year ending September 30, 1987 (three-month 
deferral period), a year ending October 31, 1987 (two-month deferral 
period), or a year ending November 30, 1987 (one-month deferral period). 
In addition, instead of making a section 444 election to change its 
taxable year, A could, if otherwise qualified, make a section 444 
election to retain its June end, pursuant to paragraph (b)(3) of this 
section.
    Example 2. B, a corporation that historically used an August 31 
taxable year, elected on November 1, 1986 to be an S corporation for its 
taxable year beginning September 1, 1986. As a condition to having the S 
election accepted, B agreed on Form 2553 to use calendar year. Pursuant 
to the general effective date provided in paragraph (c) of this section, 
B may not make a section 444 election for its taxable year beginning in 
1986. Thus, B must file a short period income tax return for the period 
September 1 to December 31, 1986.
    Example 3. The facts are the same as in Example 2, except that B 
desires to make a section 444 election for its taxable year beginning 
January 1, 1987. Absent paragraph (b)(2)(ii) of this section, B would 
not be allowed to change its taxable year because the deferral period of 
the taxable year being changed (i.e., the calendar year) is zero. 
However, pursuant to the special rule provided in paragraph (b)(2)(ii) 
of this section, B shall apply paragraph (b)(2)(i) of this section by 
taking into account the deferral period of the last taxable year of B 
prior to B's election to be an S corporation (four months), rather than 
the deferral period of B's taxable year that is being changed (zero 
months). Thus, if otherwise qualified, B may make a section 444 election 
to change to a taxable year ending September 30, October 31, or November 
30, for its taxable year beginning January 1, 1987.
    Example 4. The facts are the same as in Example 3, except that B 
files a calendar year income tax return for 1987 rather than making a 
section 444 election. However, for its taxable year beginning January 1, 
1988, B desires to change its taxable year by making a section 444 
election. Given that the special rule provided in paragraph (b)(2)(ii) 
of this section applies to section 444 elections made in taxable years 
beginning before 1989, B may, if otherwise qualified, make a section 444 
election to change to a taxable year ending September 30, October 31, or 
November 30 for its taxable year beginning January 1, 1988.
    Example 5. C, a corporation that historically used a June 30 taxable 
year, elected on December 15, 1986 to be an S corporation for its 
taxable year beginning July 1, 1987. As a condition to having the S 
election accepted, C agreed on Form 2553 to use a calendar year. 
Although pursuant to paragraph (b)(3) of this section, C would, if 
otherwise qualified, be allowed to retain its June 30 taxable year, C 
desires to change to a September 30 taxable year by making a section 444 
election. Pursuant to paragraph (b)(2) of this section, a taxpayer may, 
if otherwise qualified, make a section 444 election to change to a 
taxable year only if the deferral period of the taxable year to be 
elected is not longer than the shorter of three months or the deferral 
period of the taxable year being changed. Given these facts, the 
deferral period of the taxable year to be elected is 3 months (September 
30 to December 31) while the deferral period of the taxable year being 
changed is 6 months (June 30 to December 31). Thus, C may, if otherwise 
qualified, change to a September 30 taxable year for its taxable year 
beginning July 1, 1987, by making a section 444 election. The fact that 
C agreed on Form 2553 to use a calendar year is not relevant.
    Example 6. D, a corporation that historically used a March 31 
taxable year, elects on June 1, 1988 to be an S corporation for its 
taxable year beginning April 1, 1988. D desires to change to a June 30 
taxable year by making a section 444 election for its taxable year 
beginning April 1, 1988. Pursuant to paragraph (b)(2)(i) of this 
section, D may not change to a June 30 taxable year because such year 
would have a deferral period greater than 3 months. However, if 
otherwise qualified, D may make a section 444 election to change to a 
taxable year ending September 30, October 31, or November 30 for its 
taxable year beginning April 1, 1988.
    Example 7. E, a corporation that began operations on November 1, 
1986, elected to be an S corporation on December 15, 1986, for its 
taxable year beginning November 1, 1986. E filed a short period income 
tax return for the period November 1 to December 31, 1986. E desires to 
change to a September 30 taxable year by making a section 444 election 
for its taxable year beginning January 1, 1987. Although E elected to be 
an S corporation after September 18, 1986, and before January 1, 1988, 
paragraph (b)(2)(ii) of this section does not apply to E since E was not 
a C corporation prior to electing S status. Thus, E may not change its 
taxable year for the taxable year beginning January 1, 1987, by making a 
section 444 election.
    Example 8. The facts are the same as in Example 7, except that E 
began operations on April 15, 1987, and elected to be an S corporation 
on June 1, 1987, for its taxable year beginning April 15, 1987. As a 
condition to being an S corporation, E agreed on Form 2553 to use a 
calendar year. E desires to make a section 444 election to use a year 
ending September 30 for its taxable year beginning April 15, 1987. 
Pursuant to paragraph (b)(5)(i) of this section, E's agreement to use a 
calendar year on Form 2553 does not mean that E has adopted a calendar 
year. Thus, E's desire to make a section 444 election to use a

[[Page 36]]

September 30 taxable year will not be considered a change in taxable 
year and thus paragraph (b)(2) of this section will not apply. Instead, 
E will be subject to paragraph (b)(1) of this section. Since a September 
30 taxable year would result in only a three-month deferral period 
(September 30 to December 31), E may, if otherwise qualified, make a 
section 444 election to use a year ending September 30 for its taxable 
year beginning April 15, 1987.

    (2) Special rule for entities retaining their 1986 taxable year. The 
following examples illustrate the provisions of paragraph (b)(3) of this 
section.

    Example 1. F, an S corporation that elected to be an S corporation 
several years ago, has historically used a June 30 taxable year. F 
desires to retain its June 30 taxable year by making a section 444 
election for its taxable year beginning July 1, 1987. Pursuant to 
paragraph (b)(4)(i) of this section, the deferral period of the taxable 
year being retained is 6 months (June 30 to December 31, F's required 
taxable year). Absent the special rule provided in paragraph (b)(3) of 
this section, F would be subject to the general rule provided in 
paragraph (b)(1) of this section which limits the deferral period of the 
taxable year elected to three months or less. However, pursuant to 
paragraph (b)(3) of this section, F may, if otherwise qualified, make a 
section 444 election to retain its year ending June 30 for its taxable 
year beginning July 1, 1987.
    Example 2. The facts are the same as in Example 1, except that F 
received permission from the Commissioner to change its taxable year to 
the calendar year, and filed a short period income tax return for the 
period July 1 to December 31, 1986. F desires to make a section 444 
election to use a year ending June 30 for its taxable year beginning 
January 1, 1987. Given that F had a December 31 taxable year for its 
last taxable year beginning in 1986, the special rule provided in 
paragraph (b)(3) of this section does not allow F to use a June 30 
taxable year for its taxable year beginning January 1, 1987. 
Furthermore, pursuant to paragraph (b)(2)(i) of this section, F is not 
allowed to change its taxable year from December 31 to June 30 because 
the deferral period of the taxable year being changed is zero months.
    Example 3. G, a corporation that historically used an August 31 
taxable year, elected be an S corporation on November 15, 1986, for its 
taxable year beginning September 1, 1986. As a condition to obtaining S 
status, G agreed to use a calendar year. Thus, G filed its first S 
corporation return for the period September 1 to December 31, 1986. G 
desires to make a section 444 election to use a year ending August 31 
for its taxable year beginning January 1, 1987. Since G's last taxable 
year beginning in 1986 was a calendar year, G cannot use paragraph 
(b)(3) of this section, relating to retentions of taxable years, to 
elect an August 31 taxable year. Thus, G is subject to paragraph 
(b)(2)(i) of this section, relating to changes in taxable year. Although 
G, if otherwise qualified, may use the special rule provided in 
paragraph (b)(2)(ii) of this section, G may only change from its current 
taxable year (i.e., the calendar year) to a taxable year that has no 
more than a three-month deferral period (i.e., September 30, October 31, 
or November 30).
    Example 4. The facts are the same as in Example 3, except that G 
elected to be an S corporation for its taxable year beginning September 
1, 1987, rather than its taxable year beginning September 1, 1986. As a 
condition to making its S election, G agreed, on Form 2553, to use the 
calendar year. However, G has not yet filed a short period income tax 
return for the period September 1 to December 31, 1987. Given these 
facts, paragraph (b)(3) of this section would allow G, if otherwise 
qualified, to make a section 444 election to retain an August 31 taxable 
year for its taxable year beginning September 1, 1987.
    Example 5. The facts are the same as in Example 4, except that G has 
already filed a short period income tax return for the period September 
1 to December 31, 1987. Pursuant to paragraph (b)(5)(ii)(A) of this 
section, G may supersede the return it filed for the period September 1 
to December 31, 1987. Thus, pursuant to paragraph (b)(3) of this 
section, G may, if otherwise qualified, make a section 444 election to 
retain an August 31 taxable year for the taxable year beginning 
September 1, 1987. In addition, G should follow the special procedures 
set forth in paragraph (b)(5)(ii)(B) of this section.
    Example 6. H, a corporation that historically used a May 31 taxable 
year, elects to be an S corporation on June 15, 1988 for its taxable 
year beginning June 1, 1988. H desires to make a section 444 election to 
use a taxable year other than the calendar year. Since the taxable year 
in issue is not H's first taxable year beginning after December 31, 
1986, H may not use the special rule provided in paragraph (b)(3)(i) and 
thus may not retain its May 31 year. However, H may, if otherwise 
qualified, make a section 444 election under paragraph (b)(2)(i) of this 
section, to change to a taxable year that has no more than a three-month 
deferral period (i.e., September 30, October 31, or November 30) for its 
taxable year beginning June 1, 1988.
    Example 7. I is a partnership that has historically used a calendar 
year. Sixty percent of the profits and capital of I are owned by Q, a 
corporation (that is neither an S corporation nor a personal service 
corporation) that has a June 30 taxable year, and 40 percent of the 
profits and capital are owned by

[[Page 37]]

R, a calendar year individual. Since the partner that has more than a 
fifty percent interest in I has a June 30 taxable year, I's required 
taxable year is June 30. Accordingly, I filed an income tax return for 
the period January 1 to June 30, 1987. Based on these facts, I may, 
pursuant to paragraph (b)(5)(ii)(A) of this section, disregard the 
income tax return filed for the period January 1 to June 30, 1987. Thus, 
if otherwise qualified, I may make a section 444 election under 
paragraph (b)(2)(i) of this section to use a calendar year for its 
taxable year beginning January 1, 1987. If I makes such a section 444 
election, I should follow the special procedures set forth in paragraph 
(b)(5)(ii)(B) of this section.

[T.D. 8205, 53 FR 19694, May 27, 1988, as amended by T.D. 8996, 67 FR 
35012, May 17, 2002]



Sec.  1.444-2T  Tiered structure (temporary).

    (a) General rule. Except as provided in paragraph (e) of this 
section, no section 444 election shall be made or continued with respect 
to a partnership, S corporation, or personal service corporation that is 
a member of a tiered structure on the date specified in paragraph (d) of 
this section. For purposes of this section, the term ``personal service 
corporation'' means a personal service corporation as defined in Sec.  
1.441-3(c).
    (b) Definition of a member of a tiered structure--(1) In general. A 
partnership, S corporation, or personal service corporation is 
considered a member of a tiered structure if--
    (i) The partnership, S corporation, or personal service corporation 
directly owns any portion of a deferral entity, or
    (ii) A deferral entity directly owns any portion of the partnership, 
S corporation, or personal service corporation.

However, see paragraph (c) of this section for certain de minimis rules, 
and see paragraph (b)(3) of this section for an anti-abuse rule. In 
addition, for purposes of this section, a beneficiary of a trust shall 
be considered to own an interest in the trust.
    (2) Deferral entity--(i) In general. For purposes of this section, 
the term ``deferral entity'' means an entity that is a partnership, S 
corporation, personal service corporation, or trust. In the case of an 
affiliated group of corporations filing a consolidated income tax return 
that is treated as a personal service corporation pursuant to Sec.  
1.441-4T (i), such affiliated group is considered to be a single 
deferral entity.
    (ii) Grantor trusts. The term ``deferral entity'' does not include a 
trust (or a portion of a trust) which is treated as owned by the grantor 
or beneficiary under Subpart E, part I, subchapter J, chapter 1, of the 
Code (relating to grantor trusts), including a trust that is treated as 
a grantor trust pursuant to section 1361(d)(1)(A) of the Code (relating 
to qualified subchapter S trusts). Thus, any taxpayer treated under 
subpart E as owning a portion of a trust shall be treated as owning the 
assets of the trust attributable to that ownership. The following 
examples illustrate the provisions of this paragraph (b)(2)(ii).

    Example 1. A, an individual, is the sole beneficiary of T. T is a 
trust that owns 50 percent of the profits and capital of X, a 
partnership that desires to make a section 444 election. Furthermore, 
pursuant to Subpart E, Part I, subchapter J, chapter 1 of the Code, A is 
treated as an owner of X. Based upon these facts, T is not a deferral 
entity and 50 percent of X is considered to be directly owned by A.
    Example 2. The facts are the same as in Example 1, except that A is 
a personal service corporation rather than an individual. Given these 
facts, 50 percent of X is considered to be directly owned by A, a 
deferral entity. Thus, X is considered to be a member of a tiered 
structure.

    (3) Anti-abuse rule. Notwithstanding paragraph (b)(1) of this 
section, a partnership, S corporation, or personal service corporation 
is considered a member of a tiered structure if the partnership, S 
corporation, personal service corporation, or related taxpayers have 
organized or reorganized their ownership structure or operations for the 
principal purpose of obtaining a significant unintended tax benefit from 
making or continuing a section 444 election. For purposes of the 
preceding sentence, a significant unintended tax benefit results when a 
partnership, S corporation, or personal service corporation makes a 
section 444 election and, as a result, a taxpayer (not limited to the 
entity making the election) obtains a significant deferral of income

[[Page 38]]

substantially all of which is not eliminated by a required payment under 
section 7519. See examples (15) through (19) in paragraph (f) of this 
section.
    (c) De minimis rules--(1) In general. For rules relating to a de 
minimis exception to paragraph (b)(1)(i) of this section (the 
``downstream de minimis rule''), see paragraph (c)(2) of this section. 
For rules relating to a de minimis exception to paragraph (b)(1)(ii) of 
this section (the ``upstream de minimis rule''), see paragraph (c)(3) of 
this section. For rules relating to the interaction of the de minimis 
rules provided in this paragraph (c) and the ``same taxable year 
exception'' provided in paragraph (e) of this section, see paragraph 
(e)(5) of this section.
    (2) Downstream de minimis rule--(i) General rule. If a partnership, 
S corporation, or personal service corporation directly owns any portion 
of one or more deferral entities as of the date specified in paragraph 
(d) of this section, such ownership is disregarded for purposes of 
paragraph (b)(1)(i) of this section if, in the aggregate, all such 
deferral entities accounted for--
    (A) Not more than 5 percent of the partnership's, S corporation's, 
or personal service corporation's adjusted taxable income for the 
testing period (``5 percent adjusted taxable income test''), or
    (B) Not more than 2 percent of the partnership's, S corporation's, 
or personal service corporation's gross income for the testing period 
(``2 percent gross income test''). See section 702 (c) for rules 
relating to the determination of gross income of a partner in a 
partnership.

See examples (3) through (5) in paragraph (f) of this section.
    (ii) Definition of testing period. For purposes of this paragraph 
(c)(2), the term ``testing period'' means the taxable year that ends 
immediately prior to the taxable year for which the partnership, S 
corporation, or personal service corporation desires to make or continue 
a section 444 election. However, see the special rules provided in 
paragraph (c)(2)(iv) of this section for certain special cases (e.g., 
the partnership, S corporation, personal service corporation or deferral 
entity was not in existence during the entire testing period). The 
following example illustrates the application of this paragraph 
(c)(2)(ii).

    Example. A partnership desires to make a section 444 election for 
its taxable year beginning November 1, 1987. The testing period for 
purposes of determining whether deferral entities owned by such 
partnership are de minimis under paragraph (c)(2) of this section is the 
taxable year ending October 31, 1987. If either the partnership or the 
deferral entities were not in existence for the entire taxable year 
ending October 1, 1987, see the special rules provided in paragraph 
(c)(2)(iv) of this section.

    (iii) Definition of adjusted taxable income--(A) Partnership. In the 
case of a partnership, adjusted taxable income for purposes of paragraph 
(c)(2) of this section is an amount equal to the sum of the--
    (1) Aggregate amount of the partnership items described in section 
702(a) (other than credits and tax-exempt income),
    (2) Applicable payments defined in section 7519(d)(3) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(A)(1) of this section, and
    (3) Guaranteed payments defined in section 707(c) that are deducted 
in determining the amount described in paragraph (c)(2)(iii)(A)(1) of 
this section and are not otherwise included in paragraph 
(c)(2)(iii)(A)(2) of this section. For purposes of determining the 
aggregate amount of partnership items under paragraph (c)(2)(iii)(A)(1) 
of this section, deductions and losses are treated as negative income. 
Thus, for example, if under section 702(a) a partnership has $1,000 of 
ordinary taxable income, $500 of specially allocated deductions, and 
$300 of capital loss, the partnership's aggregate amount of partnership 
items under paragraph (c)(2)(iii)(A)(1) of this section is $200 ($1,000-
$500-$300).
    (B) S corporation. In the case of an S corporation, adjusted taxable 
income for purposes of paragraph (c)(2) of this section is an amount 
equal to the sum of the--
    (1) Aggregate amount of the S corporation items described in section 
1366(a) (other than credits and tax-exempt income), and
    (2) Applicable payments defined in section 7519(d)(3) that are 
deducted in

[[Page 39]]

determining the amount described in paragraph (c)(2)(iii)(B)(1) of this 
section.

For purposes of determining the aggregate amount of S corporation items 
under paragraph (c)(2)(iii)(B)(1) of this section, deductions and losses 
are treated as negative income. Thus, for example, if under section 
1366(a) an S corporation has $2,000 of ordinary taxable income, $1,000 
of deductions described in section 1366(a)(1)(A) of the Code, and $500 
of capital loss, the S corporation's aggregate amount of S corporation 
items under paragraph (c)(2)(iii)(B)(1) of this section is $500 ($2,000-
$1,000-$500).
    (C) Personal service corporation. In the case of a personal service 
corporation, adjusted taxable income for purposes of paragraph (c)(2) of 
this section is an amount equal to the sum of the--
    (1) Taxable income of the personal service corporation, and
    (2) Applicable amounts defined in section 280H(f)(1) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(C)(1) of this section.
    (iv) Special rules--(A) Pro-forma rule. Except as provided in 
paragraph (c)(iv)(C)(2) of this section, if a partnership, S 
corporation, or personal service corporation directly owns any interest 
in a deferral entity as of the date specified in paragraph (d) of this 
section and such ownership interest is different in amount from the 
partnership's, S corporation's, or personal service corporation's 
interest on any day during the testing period, the 5 percent adjusted 
taxable income test and the 2 percent gross income test must be applied 
on a pro-forma basis (i.e., adjusted taxable income and gross income 
must be calculated for the testing period assuming that the partnership, 
S corporation, or personal service corporation owned the same interest 
in the deferral entity that it owned as of the date specified in 
paragraph (d) of this section). The following example illustrates the 
application of this paragraph (c)(2)(iv)(A).

    Example. A personal service corporation desiring to make a section 
444 election for its taxable year beginning October 1, 1987, acquires a 
25 percent ownership interest in a partnership on or after October 1, 
1987. Furthermore, the partnership has been in existence for several 
years. The personal service corporation must modify its calculations of 
the 5 percent adjusted taxable income test and the 2 percent gross 
income test for the testing period ended September 30, 1987, by assuming 
that the personal service corporation owned 25 percent of the 
partnership during such testing period and the personal service 
corporation's adjusted taxable income and gross income were 
correspondingly adjusted.

    (B) Reasonable estimates allowed. If the information necessary to 
complete the pro-forma calculation described in paragraph (c)(2)(iv)(A) 
of this section is not readily available, the partnership, S 
corporation, or personal service corporation may make a reasonable 
estimate of such information.
    (C) Newly formed entities--(1) Newly formed deferral entities. If a 
partnership, S corporation, or personal service corporation owns any 
portion of a deferral entity on the date specified in paragraph (d) of 
this section and such deferral entity was not in existence during the 
entire testing period (hereinafter referred to as a ``newly formed 
deferral entity''), both the 5 percent adjusted taxable income test and 
the 2 percent gross income test are modified as follows. First, the 
partnership, S corporation, or personal service corporation shall 
calculate the percentage of its adjusted taxable income or gross income 
that is attributable to deferral entities, excluding newly formed 
deferral entities. Second, the partnership, S corporation, or personal 
service corporation shall calculate (on the date specified in paragraph 
(d) of this section) the percentage of the tax basis of its assets that 
are attributable to its tax basis with respect to its ownership 
interests in all newly formed deferral entities. If the sum of the two 
percentages is 5 percent or less, the deferral entities are considered 
de minimis and are disregarded for purposes of paragraph (b)(1)(i) of 
this section. If the sum of the two percentages is greater than 5 
percent, the deferral entities do not qualify for the de minimis rule 
provided in paragraph (c)(2) of this section and thus the partnership, S 
corporation, or personal service corporation is considered to be a 
member of a tiered structure for purposes of this section.
    (2) Newly formed partnership, S corporation, or personal service 
corporation

[[Page 40]]

desiring to make a section 444 election. If a partnership, S 
corporation, or personal service corporation desires to make a section 
444 election for the first taxable year of its existence, the 5 percent 
adjusted taxable income test and the 2 percent gross income test are 
replaced by a 5 percent of assets test. Thus, if on the date specified 
in paragraph (d) of this section, 5 percent or less of the assets 
(measured by reference to the tax basis of the assets) of the newly 
formed partnership, S corporation, or personal service corporation are 
attributable to the tax basis with respect to its ownership interests in 
the deferral entities, the deferral entities will be considered de 
minimis and will be disregarded for purposes of paragraph (b)(1)(i) of 
this section.
    (3) Upstream de minimis rule. If a partnership, S corporation, or 
personal service corporation is directly owned by one or more deferral 
entities as of the date specified in paragraph (d) of this section, such 
ownership is disregarded for purposes of paragraph (b)(1)(ii) of this 
section if on the date specified in paragraph (d) of this section the 
deferral entities directly own, in the aggregate, 5 percent or less of--
    (i) An interest in the current profits of the partnership, or
    (ii) The stock (measured by value) of the S corporation or personal 
service corporation.

See examples (6) and (7) in paragraph (f) of this section.
    (d) Date for determining the existence of a tiered structure--(1) 
General rule. For purposes of paragraph (a) of this section, a 
partnership, S corporation, or personal service corporation will be 
considered a member of a tiered structure for a particular taxable year 
if the partnership, S corporation, or personal service corporation is a 
member of a tiered structure on the last day of the required taxable 
year (as defined in section 444 (e) of the Code) ending within such 
year. If a particular taxable year does not include the last day of the 
required taxable year for such year, the partnership, S corporation, or 
personal service corporation will not be considered a member of a tiered 
structure for such year. The following examples illustrate the 
application of this paragraph (d)(1).

    Example 1. Assume that a newly formed partnership whose first 
taxable year begins November 1, 1988, desires to adopt a September 30 
taxable year by making a section 444 election. Furthermore, assume that 
for its taxable year beginning November 1, 1988, the partnership's 
required taxable year is December 31. If the partnership is a member of 
a tiered structure on December 31, 1988, it will not be eligible to make 
a section 444 election for a taxable year beginning November 1, 1988, 
and ending September 30, 1989.
    Example 2. Assume an S corporation that historically used a June 30 
taxable year desires to make a section 444 election to change to a year 
ending September 30 for its taxable year beginning July 1, 1987. If the 
S corporation can make the section 444 election, it will have a short 
taxable year beginning July 1, 1987, and ending September 30, 1987. 
Given these facts, the short taxable year beginning July 1, 1987, does 
not include the last day of the S corporation's required taxable year 
for such year (i.e., December 31, 1987). Thus, pursuant to paragraph 
(d)(1) of this section, the S corporation will not be considered a 
member of a tiered structure for its taxable year beginning July 1, 
1987, and ending September 30, 1987.

    (2) Special rule for taxable years beginning in 1987. For purposes 
of paragraph (a) of this section, a partnership, S corporation, or 
personal service corporation will not be considered a member of a tiered 
structure for a taxable year beginning in 1987 if the partnership, S 
corporation, or personal service corporation is not a member of a tiered 
structure on the day the partnership, S corporation, or personal service 
corporation timely files its section 444 election for such year. The 
following examples illustrate the application of this paragraph (d)(2).

    Example 1. Assume that a partnership desires to retain a June 30 
taxable year by making a section 444 election for its taxable year 
beginning July 1, 1987. Furthermore, assume that the partnership's 
required taxable year for such year is December 31 and that the 
partnership was a member of a tiered structure on such date. Also assume 
that the partnership was not a member of a tiered structure as of the 
date it timely filed its section 444 election for its taxable year 
beginning July 1, 1987. Based upon the special rule provided in this 
paragraph (d)(2), the partnership will not be considered a member of a 
tiered structure for its taxable year beginning July 1, 1987.
    Example 2. Assume the same facts as in Example 1, except that the 
partnership was a member of a tiered structure on the date it filed its 
section 444 election for its taxable

[[Page 41]]

year beginning July 1, 1987, but was not a member of a tiered structure 
on December 31, 1987. Paragraph (d)(1) of this section would still apply 
and thus the partnership would not be considered part of a tiered 
structure for its taxable year beginning July 1, 1987. However, the 
partnership would be considered a member of a tiered structure for its 
taxable year beginning July 1, 1988, if the partnership was a member of 
a tiered structure on December 31, 1988.

    (e) Same taxable year exception--(1) In general. Although a 
partnership or S corporation is a member of a tiered structure as of the 
date specified in paragraph (d) of this section, the partnership, S 
corporation may make or continue a section 444 election if the tiered 
structure (as defined in paragraph (e)(2) of this section) consists 
entirely of partnerships or S corporations (or both), all of which have 
the same taxable year as determined under paragraph (e)(3) of this 
section. However, see paragraph (e)(5) of this section for the 
interaction of the de minimis rules provided in paragraph (c) of this 
section with the same taxable year exception. For purposes of this 
paragraph (e), two or more entities are considered to have the same 
taxable year if their taxable years end on the same day, even though 
they begin on different days. See examples (8) through (14) in paragraph 
(f) of this section.
    (2) Definition of tiered structure--(i) General rule. For purposes 
of the same taxable year exception, the members of a tiered structure 
are defined to include the following entities--
    (A) The partnership or S corporation that desires to qualify for the 
same taxable year exception,
    (B) A deferral entity (or entities) directly owned (in whole or in 
part) by the partnership or S corporation that desires to qualify for 
the same taxable year exception,
    (C) A deferral entity (or entities) directly owning any portion of 
the partnership or S corporation that desires to qualify for the same 
taxable year exception, and
    (D) A deferral entity (or entities) directly owned (in whole or in 
part) by a ``downstream controlled partnership,'' as defined in 
paragraph (e)(2)(ii) of this section.
    (ii) Special flow-through rule for downstream controlled 
partnerships. If more than 50 percent of a partnership's profits and 
capital are owned by a partnership or S corporation that desires to 
qualify for the same taxable year exception, such owned partnership is 
considered a downstream controlled partnership for purposes of paragraph 
(e)(2)(i) of this section. Furthermore, if more than 50 percent of a 
partnership's profits and capital are owned by a downstream controlled 
partnership, such owned partnership is considered a downstream 
controlled partnership for purposes of paragraph (e)(2)(i) of this 
section.
    (3) Determining the taxable year of a partnership or S corporation. 
The taxable year of a partnership or S corporation to be taken into 
account for purposes of paragraph (e)(1) of this section is the taxable 
year ending with or prior to the date specified in paragraph (d) of this 
section. Furthermore, the determination of such taxable year will take 
into consideration any section 444 elections made by the partnership or 
S corporation. See examples (10) and (11) in paragraph (f) of this 
section.
    (4) Special rule for 52-53-week taxable years. For purposes of this 
paragraph (e), a 52-53-week taxable year with reference to the end of a 
particular month will be considered to be the same as a taxable year 
ending with reference to the last day of such month.
    (5) Interaction with de minimis rules--(i) Downstream de minimis 
rule--(A) In general. If a partnership or S corporation that desires to 
make or continue a section 444 election is a member of a tiered 
structure (as defined in paragraph (e)(2) of this section) and directly 
owns any member (or members) of the tiered structure with a taxable year 
different from the taxable year of the partnership or S corporation, 
such ownership is disregarded for purposes of the same taxable year 
exception of paragraph (e)(1) of this section provided that, in the 
aggregate, the de minimis rule of paragraph (c)(2) of this section is 
satisfied with respect to such owned member (or members). The following 
example illustrates the application of this paragraph (e)(5)(i)(A).

    Example. P, a partnership with a June 30 taxable year, owns 60 
percent of P1, another partnership with a June 30 taxable year. P also 
owns 1 percent of P2 and P3, calendar

[[Page 42]]

year partnerships. If, in the aggregate, P's ownership interests in P2 
and P3 are considered de minimis under paragraph (c)(2) of this section, 
P meets the same taxable year exception and may make a section 444 
election to retain its June 30 taxable year.

    (B) Special rule for members of a tiered structure directly owned by 
a downstream controlled partnership. For purposes of paragraph 
(e)(5)(i)(A) of this section, a partnership or S corporation desiring to 
make or continue a section 444 election is considered to directly own 
any member of the tiered structure (as defined in paragraph (e)(2) of 
this section) directly owned by a downstream controlled partnership (as 
defined in paragraph (e)(2)(ii) of this section). The adjusted taxable 
income or gross income of the partnership or S corporation that is 
attributable to a member of a tiered structure directly owned by a 
downstream controlled partnership equals the adjusted taxable income or 
gross income of such member multiplied by the partnership's or S 
corporation's indirect ownership percentage of such member. The 
following example illustrates the application of this paragraph 
(e)(5)(i)(B).

    Example. P, a partnership, desires to retain its June 30 taxable 
year by making a section 444 election. However, as of the date specified 
in paragraph (d) of this section, P owns 75 percent of P1, a June 30 
partnership, and P1 owns 40 percent of P2, a calendar year partnership. 
P also owns 25 percent of P3, a calendar year partnership. Pursuant to 
paragraphs (e)(5)(i) (A) and (B) of this section, P may only qualify to 
use the same taxable year exception if, in the aggregate, P2 and P3 are 
de minimis with respect to P. Pursuant to paragraph (e)(5)(i)(B) of this 
section, P's adjusted taxable income or gross income attributable to P2 
equals 30 percent (75 percent times 40 percent) of P2's adjusted taxable 
income or gross income.

    (ii) Upstream de minimis rule. If a partnership or S corporation 
that desires to make or continue a section 444 election is a member of a 
tiered structure (as defined in paragraph (e)(2) of this section) and is 
owned directly by a member (or members) of the tiered structure with 
taxable years different from the taxable year of the partnership or S 
corporation, such ownership is disregarded for purposes of the same 
taxable year exception of paragraph (e)(1) of this section provided 
that, in the aggregate, the de minimis rule of paragraph (c)(3) of this 
section is satisfied with respect to such owning member (or members). 
See Example 12 of paragraph (f) of this section.
    (f) Examples. The provisions of this section may be illustrated by 
the following examples.

    Example 1. A, a partnership, desires to make or continue a section 
444 election. However, on the date specified in paragraph (d) of this 
section, A is owned by a combination of individuals and S corporations. 
The S corporations are deferral entities, as defined in paragraph (b)(2) 
of this section. Thus, pursuant to paragraph (b)(1)(ii) of this section, 
A will be a member of a tiered structure unless under paragraph (c)(3) 
of this section, the S corporations, in the aggregate, own a de minimis 
portion of A. If the S corporations' ownership in A is not considered de 
minimis under paragraph (c)(3) of this section, A is a member of a 
tiered structure and will be allowed to make or continue a section 444 
election only if it meets the same taxable year exception provided in 
paragraph (e) of this section.
    Example 2. B, a partnership, desires to make or continue a section 
444 election. However, on the date specified in paragraph (d) of this 
section, B is a partner in two partnerships, B1 and B2. B1 and B2 are 
deferral entities, as defined in paragraph (b)(2) of this section. Thus, 
under paragraph (b)(1)(i) of this section, B will be a member of a 
tiered structure unless B's aggregate ownership interests in B1 and B2 
are considered de minimis under paragraph (c)(2) of this section. If B 
is a member of a tiered structure on the date specified in paragraph (d) 
of this section, B will be allowed to make or continue a section 444 
election only if it meets the same taxable year exception provided in 
paragraph (e) of this section.
    Example 3. C, a partnership with a September 30 taxable year, is 100 
percent owned by calendar year individuals. C desires to make a section 
444 election for its taxable year beginning October 1, 1987. However, on 
the date specified in paragraph (d) of this section, C owns a 1 percent 
interest in C1, a partnership. C does not own any other interest in a 
deferral entity. For the taxable year ended September 30, 1987, 10 
percent of C's adjusted taxable income (as defined in paragraph 
(c)(2)(iii) of this section) was attributable to C's partnership 
interest in C1. Furthermore, 4 percent of C's gross income for the 
taxable year ended September 30, 1987, was attributable to C's 
partnership interest in C1. Under paragraph (c)(2) of this section, C's 
partnership interest in C1 is not de minimis because during the testing 
period more than 5 percent of C's adjusted taxable income is 
attributable to C1 and more than 2 percent

[[Page 43]]

of C's gross income is attributable to C1. Thus, C is a member of a 
tiered structure for its taxable year beginning October 1, 1987.
    Example 4. The facts are the same as Example 3, except that for the 
taxable year ended September 30, 1987, only 2 percent of C's adjusted 
taxable income was attributable to C1. Under paragraph (c)(2) of this 
section, C's partnership interest in C1 is considered de minimis for 
purposes of determining whether C is a member of a tiered structure 
because not more than 5 percent of C's adjusted taxable income during 
the testing period is attributable to C1. Thus, C is not a member of a 
tiered structure for its taxable year beginning October 1, 1987.
    Example 5. The facts are the same as Example 4, except that in 
addition to owning C1, C also owns 15 percent of C2, another 
partnership. For the taxable year ended September 30, 1987, 2 percent of 
C's adjusted taxable income is attributable to C1 and an additional 4 
percent is attributable to C2. Furthermore, for the taxable year ended 
September 30, 1987, 4 percent of C's gross income is attributable to C1 
while 3 percent is attributable to C2. Under paragraph (c)(2) of this 
section, C1 and C2 must be aggregated for purposes of determining 
whether C meets either the 5 percent adjusted taxable income test or the 
2 percent gross income test. Since C's adjusted taxable income 
attributable to C1 and C2 is 6 percent (2 percent + 4 percent) and C's 
gross income attributable to C1 and C2 is 7 percent (4 percent + 3 
percent), C does not meet the downstream de minimis rule provided in 
paragraph (c)(2) of this section. Thus, C is a member of a tiered 
structure for its taxable year beginning October 1, 1987.
    Example 6. The facts are the same as Example 3, except that instead 
of determining whether C is part of a tiered structure, the issue is 
whether C1 is part of a tiered structure. In addition, assume that on 
the date specified in paragraph (d) of this section, the remaining 99 
percent of C1 is owned by calendar year individuals and C1 does not own 
an interest in any deferral entity. Although C in Example 3 was 
considered to be a part of a tiered structure by virtue of its ownership 
interest in C1, C1 must be tested separately to determine whether it is 
part of a tiered structure. Since C's interest in C1 is 5 percent or 
less, C's interest in C1 is de minimis with respect to C1. See paragraph 
(c)(3) of this section. Thus, based upon these facts, C1 is not part of 
a tiered structure.
    Example 7. The facts are the same as Example 6, except that the 
remaining 99 percent of C1 is owned 94 percent by calendar year 
individuals and 5 percent by C3, another partnership. Thus, deferral 
entities own 6 percent of C1 (1 percent owned by C and 5 percent owned 
by C3). Under paragraph (c)(3) of this section, deferral entities own 
more than a de minimis interest (i.e., 5 percent) of C1, and thus C1 is 
part of a tiered structure.
    Example 8. D, a partnership with a September 30 taxable year, 
desires to make a section 444 election for its taxable year beginning 
October 1, 1987. On December 31, 1987, and the date D plans to file its 
section 444 election, D is 10 percent owned by D1, a personal service 
corporation with a September 30 taxable year, and 90 percent owned by 
calendar year individuals. Furthermore, D1 will retain its September 30 
taxable year because it previously established a business purpose for 
such year. Since D is owned in part by D1, a personal service 
corporation, and the ownership interest is not de minimis under 
paragraph (c)(3) of this section, D is considered a member of a tiered 
structure for its taxable year beginning October 1, 1987. Furthermore, 
although D and D1 have the same taxable year, D does not qualify for the 
same taxable year exception provided in paragraph (e) of this section 
because D1 is a personal service corporation rather than a partnership 
or S corporation. Thus, pursuant to paragraph (a) of this section, D may 
not make a section 444 election for its taxable year beginning October 
1, 1987.
    Example 9. The facts are the same as Example 8, except that D1 is a 
partnership rather than a personal service corporation. Based upon these 
facts, D qualifies for the same taxable year exception provided in 
paragraph (e) of this section. Thus, D may make a section 444 election 
for its taxable year beginning October 1, 1987.
    Example 10. The facts are the same as Example 9, except that D1 has 
not established a business purpose for a September 30 taxable year. In 
addition, D1 does not desire to make a section 444 election and, under 
section 706(b), D1 will be required to change to a calendar year for its 
taxable year beginning October 1, 1987. Pursuant to paragraph (e)(3) of 
this section, D and D1 do not have the same taxable year for purposes of 
the same taxable year exception provided in paragraph (e) of this 
section. Thus, D may not make a section 444 election for its taxable 
year beginning October 1, 1987.
    Example 11. The facts are the same as Example 8, except that D1 is a 
partnership with a March 31 taxable year. Furthermore, for its taxable 
year beginning April 1, 1987, D1 will change to a September 30 taxable 
year by making a section 444 election. Pursuant to paragraph (e)(3) of 
this section, D1 is considered to have a September 30 taxable year for 
purposes of determining whether D qualifies for the same taxable year 
exception provided in paragraph (e) of this section. Since both D and D1 
will have the same taxable year as of the date specified in paragraph 
(d) of this section, D may make a section 444 election for its taxable 
year beginning October 1, 1987.
    Example 12. The facts are the same as Example 11, except that 
instead of the remaining 90 percent of D being owned by calendar

[[Page 44]]

year individuals, it is owned 86 percent by individuals and 4 percent by 
D2, a calendar year partnership. Thus, D, a September 30 partnership, is 
10 percent owned by D1, a September 30 partnership, 86 percent owned by 
calendar year individuals, and 4 percent owned by D2, a calendar year 
partnership. Under paragraph (e)(5)(ii) of this section, D2's ownership 
interest in D is considered de minimis for purposes of the same taxable 
year exception. Since D2's ownership interest in D is considered de 
minimis, it is disregarded for purposes of determining whether D 
qualifies for the same taxable year exception provided in paragraph (e) 
of this section. Thus, since both D and D1 will have the same taxable 
year as of the date specified in paragraph (d) of this section, D may 
make a section 444 election for its taxable year beginning October 1, 
1987.
    Example 13. E, a partnership with a June 30 taxable year, desires to 
make a section 444 election for its taxable year beginning July 1, 1987. 
On the date specified in paragraph (d) of this section, E is 100 percent 
owned by calendar year individuals; E owns 99 percent of the profits and 
capital of E1, a partnership with a June 30 taxable year; and E1 owns 30 
percent of the profits and capital of E2, a partnership with a September 
30 taxable year. E owns no other deferral entities. Pursuant to 
paragraph (b)(1)(i) of this section, E is considered to be a member of a 
tiered structure. Furthermore, pursuant to paragraph (e) of this 
section, E does not qualify for the same taxable year exception because 
E2 does not have the same taxable year as E and E1.
    Example 14. The facts are the same as Example 13, except that E owns 
only 49 percent (rather than 99 percent) of the profits and capital of 
E1. Pursuant to paragraph (e) of this section, E qualifies for the same 
taxable year exception because E and E1 have the same taxable year. 
Pursuant to paragraph (e) of this section, E1's ownership interest in E2 
is disregarded since E does not own more than 50 percent of E1's profits 
and capital.
    Example 15. Prior to consideration of the anti-abuse rule provided 
in paragraph (b)(3) of this section, H, a partnership that commenced 
operations on October 1, 1987, is eligible to make a section 444 
election for its taxable year beginning October 1, 1987. Although H may 
obtain a significant deferral of income substantially all of which is 
not eliminated by a required payment under section 7519 (since there 
will be no required payment for H's first taxable year), the anti-abuse 
rule of paragraph (b)(3) will not apply unless the principal purpose of 
organizing H was the attainment of a significant deferral of income that 
would result from making a section 444 election.
    Example 16. F, a partnership with a January 31 taxable year, desires 
to make a section 444 election to retain its January 31 taxable year for 
the taxable year beginning February 1, 1987. F is 100 percent owned by 
calendar year individuals. Prior to the date specified in paragraph (d) 
of this section, F contributes substantially all of its assets to F1, a 
partnership, in exchange for a 51 percent interest in F1. The remaining 
49 percent of F1 is owned by the calendar year individuals owning 100 
percent of F. If F is allowed to make a section 444 election to retain 
its January 31 taxable year, F1's required taxable year will be January 
31 since a majority of F1's partners use a January 31 taxable year (see 
Sec.  1.706-3T). F's principal purpose for creating F1 and contributing 
its assets to F1 is to obtain an 11-month deferral on 49 percent of the 
income previously earned by F and now earned by F1. Pursuant to 
paragraph (b)(3) of this section, F is not allowed to make a section 444 
election for its taxable year beginning February 1, 1987.
    Example 17. The facts are the same as in Example 16, except that F 
does not create F1 and contribute its assets to F1 until immediately 
after F makes its section 444 election for the taxable year beginning 
February 1, 1987. Thus, F is allowed to make a section 444 election for 
its taxable year beginning February 1, 1987. However, pursuant to 
paragraph (b)(3) of this section, F will have its section 444 election 
terminated for subsequent years unless the tax deferral inherent in the 
structure is eliminated (e.g., F1 is liquidated or the individual owners 
of F contribute their interests in F1 to F) prior to the date specified 
in paragraph (d) of this section for subsequent taxable years beginning 
on or after February 1, 1988.
    Example 18. The facts are the same as in Example 16, except that F1 
is 99 percent owned by F and none of the individual owners of F own any 
portion of F1. Furthermore, F obtained no tax benefit from creating and 
contributing assets to F1. Given these facts paragraph (b)(3) of this 
section does not apply and thus, F may make a section 444 election for 
its taxable year beginning February 1, 1987.
    Example 19. G, a partnership with an October 31 taxable year, 
desires to retain its October 31 taxable year for its taxable year 
beginning November 1, 1987. However, as of December 31, 1987, G owns a 
30 percent interest in G1, a calendar year partnership. G owns no other 
deferral entity, and G is 100 percent owned by calendar year 
individuals. Furthermore, G's interest in G1 does not meet the de 
minimis rule provided in paragraph (c)(3) of this section. Thus, in 
order to avoid being a tiered structure, G sells its interest in G1 to 
an unrelated third party prior to the date G timely makes it section 444 
election for its taxable year beginning November 1, 1987. Although the 
sale of G1 allows G to qualify to make a section 444 election, and 
therefore to obtain a significant tax benefit, such benefit is not 
unintended. Thus, paragraph (b)(3) of

[[Page 45]]

this section does not apply, and G may make a section 444 election for 
its taxable year beginning November 1, 1987.

    (g) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.

[T.D. 8205, 53 FR 19698, May 27, 1988, as amended by T.D. 8996, 67 FR 
35012, May 17, 2002]



Sec.  1.444-3T  Manner and time of making section 444 election (temporary).

    (a) In general. A section 444 election shall be made in the manner 
and at the time provided in this section.
    (b) Manner and time of making election--(1) General rule. A section 
444 election shall be made by filing a properly prepared Form 8716, 
``Election to Have a Tax Year Other Than a Required Tax Year,'' with the 
Service Center indicated by the instructions to Form 8716. Except as 
provided in paragraphs (b) (2) and (4) of this section, Form 8716 must 
be filed by the earlier of--
    (i) The 15th day of the fifth month following the month that 
includes the first day of the taxable year for which the election will 
first be effective, or
    (ii) The due date (without regard to extensions) of the income tax 
return resulting from the section 444 election.


In addition, a copy of Form 8716 must be attached to Form 1065 or Form 
1120 series form, whichever is applicable, for the first taxable year 
for which the section 444 election is made. Form 8716 shall be signed by 
any person who is authorized to sign Form 1065 or Form 1120 series form, 
whichever is applicable. (See sections 6062 and 6063, relating to the 
signing of returns.) The provisions of this paragraph (b)(1) may be 
illustrated by the following examples.

    Example 1. A, a partnership that began operations on September 10, 
1988, is qualified to make a section 444 election to use a September 30 
taxable year for its taxable year beginning September 10, 1988. Pursuant 
to paragraph (b)(1) of this section, A must file Form 8716 by the 
earlier of the 15th day of the fifth month following the month that 
includes the first day of the taxable year for which the election will 
first be effective (i.e., February 15, 1989) or the due date (without 
regard to extensions) of the partnership's tax return for the period 
September 10, 1988 to September 30, 1988 (i.e., January 15, 1989). Thus, 
A must file Form 8716 by January 15, 1989.
    Example 2. The facts are the same as in Example 1, except that A 
began operations on October 20, 1988. Based upon these facts, A must 
file Form 8716 by March 15, 1989, the 15th day of the fifth month 
following the month that includes the first day of the taxable year for 
which the election will first be effective.
    Example 3. B is a corporation that first becomes a personal service 
corporation for its taxable year beginning September 1, 1988. B 
qualifies to make a section 444 election to use a September 30 taxable 
year for its taxable year beginning September 1, 1988. Pursuant to this 
paragraph (b)(1), B must file Form 8716 by December 15, 1988, the due 
date of the income tax return for the short period September 1 to 
September 30, 1988.

    (2) Special extension of time for making an election. If, pursuant 
to paragraph (b)(1) of this section, the due date for filing Form 8716 
is prior to July 26, 1988, such date is extended to July 26, 1988. The 
provisions of this paragraph (b)(2) may be illustrated by the following 
examples.

    Example 1. B, a partnership that historically used a June 30 taxable 
year, is qualified to make a section 444 election to retain a June 30 
taxable year for its taxable year beginning July 1, 1987. Absent 
paragraph (b)(2) of this section, B would be required to file Form 8716 
by December 15, 1987. However, pursuant to paragraph (b)(2) of this 
section, B's due date for filing Form 8716 is extended to July 26, 1988.
    Example 2. C, a partnership that began operations on January 20, 
1988, is qualified to make a section 444 election to use a year ending 
September 30 for its taxable year beginning January 20, 1988. Absent 
paragraph (b)(2) of this section, C is required to file Form 8716 by 
June 15, 1988 (the 15th day of the fifth month following the month that 
includes the first day of the taxable year for which the election will 
first be effective). However, pursuant to paragraph (b)(2) of this 
section, the due date for filing Form 8716 is July 26, 1988.

    (3) Corporation electing to be an S corporation--(i) In general. A 
corporation electing to be an S corporation is subject to the same time 
and manner rules for filing Form 8716 as any other taxpayer making a 
section 444 election. Thus, a corporation electing to be an S 
corporation that desires to make a section 444 election is not required 
to file Form 8716 with its Form 2553, ``Election by a Small Business 
Corporation.'' However, a corporation electing to be an S corporation 
after September 26,

[[Page 46]]

1988, is required to state on Form 2553 its intention to--
    (A) Make a section 444 election, if qualified, or
    (B) Make a ``back-up section 444 election'' as described in 
paragraph (b)(4) of this section.


If a corporation electing to be an S corporation fails to state either 
of the above intentions, the District Director may, at his discretion, 
disregard any section 444 election for such taxpayer.
    (ii) Examples. The provisions of this paragraph (b)(3) may be 
illustrated by the following examples.

    Example 1. D is a corporation that commences operations on October 
1, 1988, and elects to be an S corporation for its taxable year 
beginning October 1, 1988. All of D's shareholders use the calendar year 
as their taxable year. D desires to adopt a September 30 taxable year. D 
does not believe it has a business purpose for a September 30 taxable 
year and thus it must make a section 444 election to use such year. 
Based on these facts, D must, pursuant to the instructions to Form 2553, 
state on Form 2553 that, if qualified, it will make a section 444 
election to adopt a year ending September 30 for its taxable year 
beginning October 1, 1988. If D is qualified (i.e., D is not a member of 
a tiered structure on December 31, 1988) to make a section 444 election 
for its taxable year beginning October 1, 1988, D must file Form 8716 by 
March 15, 1989. If D ultimately is not qualified to make a section 444 
election for its taxable year beginning October 1, 1988, D's election to 
be an S corporation will not be effective unless, pursuant to the 
instructions to Form 2553, D made a back-up calendar year election 
(i.e., an election to adopt the calendar year in the event D ultimately 
is not qualified to make a section 444 election for such year).
    Example 2. The facts are the same as in Example 1, except that D 
believes it can establish, to the satisfaction of the Commissioner, a 
business purpose for adopting a September 30 taxable year. However, D 
desires to make a ``back-up section 444 election'' (see paragraph (b)(4) 
of this section) in the event that the Commissioner does not grant 
permission to adopt a September 30 taxable year based upon business 
purpose. Based on these facts, D must, pursuant to the instructions to 
Form 2553, state on Form 2553 its intention, if qualified, to make a 
back-up section 444 election to adopt a September 30 taxable year. If, 
by March 15, 1989, D has not received permission to adopt a September 30 
taxable year and D is qualified to make a section 444 election, D must 
make a back-up election in accordance with paragraph (b)(4) of this 
section.

    (4) Back-up section 444 election--(i) General rule. A taxpayer that 
has requested (or is planning to request) permission to use a particular 
taxable year based upon business purpose, may, if otherwise qualified, 
file a section 444 election (referred to as a ``back-up section 444 
election''). If the Commissioner subsequently denies the business 
purpose request, the taxpayer will, if otherwise qualified, be required 
to activate the back-up section 444 election. See examples (1) and (2) 
in paragraph (b)(4)(iv) of this section.
    (ii) Procedures for making a back-up section 444 election. In 
addition to following the general rules provided in this section, a 
taxpayer making a back-up section 444 election should, in order to allow 
the Service to process the affected returns in an efficient manner, type 
or legibly print the words ``BACK-UP ELECTION'' at the top of Form 8716, 
``Election to Have a Tax Year Other Than a Required Tax Year.'' However, 
if such Form 8716 is filed on or after the date a Form 1128, Application 
for Change in Accounting Period, is filed with respect to a period that 
begins on the same date, the words ``FORM 1128 BACK-UP ELECTION'' should 
be typed or legibly printed at the top of Form 8716.
    (iii) Procedures for activating a back-up section 444 election--(A) 
Partnerships and S corporations--(1) In general. A back-up section 444 
election made by a partnership or S corporation is activated by filing 
the return required in Sec.  1.7519-2T (a)(2)(i) and making the payment 
required in Sec.  1.7519-1T. The due date for filing such return and 
payment will be the later of--
    (i) The due dates provided in Sec.  1.7519-2T, or
    (ii) 60 days from the date the Commissioner denies the business 
purpose request.


However, interest will be assessed (at the rate provided in section 6621 
(a)(2)) on any required payment made after the due date (without regard 
to any extension for a back-up election) provided in Sec.  1.7519-2T 
(a)(4)(i) or (a)(4)(ii), whichever is applicable, for such payment. 
Interest will be calculated from such due date to the date such amount 
is actually paid. Interest assessed under this paragraph will be 
separate

[[Page 47]]

from any required payments. Thus, interest will not be subject to refund 
under Sec.  1.7519-2T.
    (2) Special rule if Form 720 used to satisfy return requirement. If, 
pursuant to Sec.  1.7519-2T (a)(3), a partnership or S corporation must 
use Form 720, ``Quarterly Federal Excise Tax Return,'' to satisfy the 
return requirement of Sec.  1.7519-2T (a)(2), then in addition to 
following the general rules provided in Sec.  1.7519-2T, the partnership 
or S corporation must type or legibly print the words ``ACTIVATING BACK-
UP ELECTION'' on the top of Form 720. A partnership or S corporation 
that would otherwise file a Form 720 on or before the date specified in 
paragraph (b)(4)(iii)(A)(1) of this section may satisfy the return 
requirement by including the necessary information on such Form 720. 
Alternatively, such partnership or S corporation may file an additional 
Form 720 (i.e., a Form 720 separate from the Form 720 it would otherwise 
file). Thus, for example, if the due date for activating an S 
corporation's back-up election is November 15, 1988, and the S 
corporation must file a Form 720 by October 31, 1988, to report 
manufacturers excise tax for the third quarter of 1988, the S 
corporation may use that Form 720 to activate its back-up election. 
Alternatively, the S corporation may file its regular Form 720 that is 
due October 31, 1988, and file an additional Form 720 by November 15, 
1988, activating its back-up election.
    (B) Personal service corporations. A back-up section 444 election 
made by a personal service corporation is activated by filing Form 8716 
with the personal service corporation's original or amended income tax 
return for the taxable year in which the election is first effective, 
and typing or legibly printing the words--``ACTIVATING BACK-UP 
ELECTION'' on the top of such income tax return.
    (iv) Examples. The provisions of this paragraph (b)(4) may be 
illustrated by the following examples. Also see Example 2 in paragraph 
(b)(3) of this section.

    Example 1. E, a partnership that historically used a June 30 taxable 
year, requested (pursuant to section 6 of Rev. Proc. 87-32, 1987-28 
I.R.B. 14) permission from the Commissioner to retain a June 30 taxable 
year for its taxable year beginning July 1, 1987. Furthermore, E is 
qualified to make a section 444 election to retain a June 30 taxable 
year for its taxable year beginning July 1, 1987. However, as of the 
date specified in paragraph (b)(2) of this section, the Commissioner has 
not determined whether E has a valid business purpose for retaining its 
June 30 taxable year. Based on these facts, E may, by the date specified 
in paragraph (b)(2) of this section, make a back-up section 444 election 
to retain its June 30 taxable year.
    Example 2. The facts are the same as in Example 1. In addition, on 
August 12, 1988, the Internal Revenue Service notifies E that its 
business purpose request is denied. E asks for reconsideration of the 
Service's decision, and the Service sustains the original denial on 
September 30, 1988. Based on these facts, E must activate its back-up 
section 444 election within 60 days after September 30, 1988.
    Example 3. The facts are the same as in Example 1, except that E 
desires to make a section 444 election to use a year ending September 30 
for its taxable year beginning July 1, 1987. Although E qualifies to 
make a section 444 election to retain its June 30 taxable year, E may 
make a back-up section 444 election for a September 30 taxable year.

    (c) Administrative relief--(1) Extension of time to file income tax 
returns--(i) Automatic extension. If a partnership, S corporation, or 
personal service corporation makes a section 444 election (or does not 
make a section 444 election, either because it is ineligible or because 
it decides not to make the election, and therefore changes to its 
required taxable year) for its first taxable year beginning after 
December 31, 1986, the due date for filing its income tax return for 
such year shall be the later of--
    (A) The due date established under--
    (1) Section 6072, in the case of Form 1065,
    (2) Sec.  1.6037-1 (b), in the case of Form 1120S,
    (3) Section 6072 (b), in the case of other Form 1120 series form; or
    (B) August 15, 1988.


The words ``SECTION 444 RETURN'' should, in order to allow the Service 
to process the affected returns in an efficient manner, be typed or 
legibly printed at the top of the Form 1065 or Form 1120 series form, 
whichever is applicable, filed under this paragraph (c)(1)(i).
    (ii) Additional extensions. If the due date of the income tax return 
for the first taxable year beginning after December 31, 1986, extended 
as provided in paragraph (c)(1)(i)(B) of this section,

[[Page 48]]

occurs before the date that is 6 months after the date specified in 
paragraph (c)(1)(i)(A) of this section, the partnership, S corporation, 
or personal service corporation may request an additional extension or 
extensions of time (up to 6 months after the date specified in paragraph 
(c)(1)(i)(A) of this section) to file its income tax return for such 
first taxable year. The request must be made by the later of the date 
specified in paragraph (c)(1)(i)(A) or (c)(1)(i)(B) of this section and 
must be made on Form 7004, ``Application for Automatic Extension of Time 
To File Corporation Income Tax Return'', or Form 2758, ``Application for 
Extension of Time to File U.S. Partnership, Fiduciary, and Certain Other 
Returns,'' whichever is applicable, in accordance with the form and its 
instructions. In addition, the following words should be typed or 
legibly printed at the top of the form--``SECTION 444 REQUEST FOR 
ADDITIONAL EXTENSION.''
    (iii) Examples. The provisions of paragraph (c)(1) of this section 
may be illustrated by the following examples.

    Example 1. G, a partnership that historically used a January 31 
taxable year, makes a section 444 election to retain such year for its 
taxable year beginning February 1, 1987. Absent paragraph (c)(1)(i) of 
this section, G's Form 1065 for the taxable year ending January 31, 
1988, is due on or before May 15, 1988. However, if G types or legibly 
prints ``SECTION 444 RETURN'' at the top of Form 1065 for such year, 
paragraph (c)(1)(i) of this section automatically extends the due date 
of such return to August 15, 1988.
    Example 2. The facts are the same as in Example 1, except that G 
desires to extend the due date of its income tax return for the year 
ending January 31, 1988, to a date beyond August 15, 1988. Pursuant to 
paragraph (c)(1)(ii) of this section, G may extend such return to 
November 15, 1988 (i.e., the date that is up to 6 months after May 15, 
1988, the normal due date of the return). However, in order to obtain 
this additional extension, G must file Form 2758 pursuant to paragraph 
(c)(1)(i) of this section on or before August 15, 1988.
    Example 3. H, a partnership that historically used a May 31 taxable 
year, makes a section 444 election to use a year ending September 30 for 
its taxable year beginning on June 1, 1987. Absent paragraph (c)(1)(i) 
of this section, H's Form 1065 for the taxable year beginning June 1, 
1987, and ending September 30, 1987, is due on or before January 15, 
1988. However, if H types or legibly prints ``SECTION 444 RETURN'' at 
the top of Form 1065 for such year, paragraph (c)(1)(i) of this section 
automatically extends the due date of such return to August 15, 1988.
    Example 4. The facts are the same as in Example 3, except H desires 
to further extend (i.e., extend beyond August 15, 1988) the due date of 
its income tax return for its taxable year beginning June 1, 1987, and 
ending September 30, 1987. Since August 15, 1988, is 6 months or more 
after the due date (without extensions) of such return, paragraph 
(c)(1)(ii) of this section prevents H from further extending the time 
for filing such return.
    Example 5. I, a partnership that historically used a June 30 taxable 
year, considered making a section 44 election to retain such taxable 
year, but eventually decided to change to a December 31, taxable year 
(I's required taxable year). Absent paragraph (c)(1)(i) of this section, 
I's Form 1065 for the taxable year beginning July 1, 1987, and ending 
December 31, 1987, is due on or before April 15, 1988. Pursuant to 
paragraph (c)(1)(i) of this section, if I types or legibly prints 
``SECTION 444 RETURN'' at the top of Form 1065 for such year, paragraph 
(c)(1)(i) of this section automatically extends the due date of such 
return to August 15, 1988. In addition, I may further extend such return 
pursuant to paragraph (c)(1)(ii) of this section.

    (2) No penalty for certain late payments--(i) In general. In the 
case of a personal service corporation or S corporation described in 
paragraph (c)(1)(i) of this section, no penalty under section 6651 
(a)(2) will be imposed for failure to pay income tax (if any) for the 
first taxable year beginning after December 31, 1986, but only for the 
period beginning with the last date for payment and ending with the 
later of the date specified in paragraph (c)(1)(i) or paragraph 
(c)(1)(ii) of this section.
    (ii) Example. The provisions of paragraph (c)(2)(i) of this section 
may be illustrated by the following example.

    Example. J, a personal service corporation that historically used a 
January 31 taxable year, makes a section 444 election to retain such 
year for its taxable year beginning February 1, 1987. The last date 
(without extension) for payment of J's income tax (if any) for its 
taxable year beginning February 1, 1987, is April 15, 1988. However, 
under paragraph (c)(2)(i) of this section, no penalty under section 
6651(a)(2) will be imposed on any underpayment of income tax for the 
period beginning April 15, 1988 and ending August 15, 1988.


[[Page 49]]


    (d) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.

[T.D. 8205, 53 FR 19703, May 27, 1988]



Sec.  1.444-4  Tiered structure.

    (a) Electing small business trusts. For purposes of Sec.  1.444-2T, 
solely with respect to an S corporation shareholder, the term deferral 
entity does not include a trust that is treated as an electing small 
business trust under section 1361(e). An S corporation with an electing 
small business trust as a shareholder may make an election under section 
444. This paragraph is applicable to taxable years beginning on and 
after December 29, 2000; however, taxpayers may voluntarily apply it to 
taxable years of S corporations beginning after December 31, 1996.
    (b) Certain tax-exempt trusts. For purposes of Sec.  1.444-2T, 
solely with respect to an S corporation shareholder, the term deferral 
entity does not include a trust that is described in section 401(a) or 
501(c)(3), and is exempt from taxation under section 501(a). An S 
corporation with a trust as a shareholder that is described in section 
401(a) or section 501(c)(3), and is exempt from taxation under section 
501(a) may make an election under section 444. This paragraph is 
applicable to taxable years beginning on and after December 29, 2000; 
however taxpayers may voluntarily apply it to taxable years of S 
corporations beginning after December 31, 1997.
    (c) Certain terminations disregarded--(1) In general. An S 
corporation that is described in this paragraph (c)(1) may request that 
a termination of its election under section 444 be disregarded, and that 
the S corporation be permitted to resume use of the year it previously 
elected under section 444, by following the procedures of paragraph 
(c)(2) of this section. An S corporation is described in this paragraph 
if the S corporation is otherwise qualified to make a section 444 
election, and its previous election was terminated under Sec.  1.444-
2T(a) solely because--
    (i) In the case of a taxable year beginning after December 31, 1996, 
a trust that is treated as an electing small business trust became a 
shareholder of such S corporation; or
    (ii) In the case of a taxable year beginning after December 31, 
1997, a trust that is described in section 401(a) or 501(c)(3), and is 
exempt from taxation under section 501(a) became a shareholder of such S 
corporation.
    (2) Procedure--(i) In general. An S corporation described in 
paragraph (c)(1) of this section that wishes to make the request 
described in paragraph (c)(1) of this section must do so by filing Form 
8716, ``Election To Have a Tax Year Other Than a Required Tax Year,'' 
and typing or printing legibly at the top of such form--``CONTINUATION 
OF SECTION 444 ELECTION UNDER Sec.  1.444-4.'' In order to assist the 
Internal Revenue Service in updating the S corporation's account, on 
Line 5 the Box ``Changing to'' should be checked. Additionally, the 
election month indicated must be the last month of the S corporation's 
previously elected section 444 election year, and the effective year 
indicated must end in 2002.
    (ii) Time and place for filing Form 8716. Such form must be filed on 
or before October 15, 2002, with the service center where the S 
corporation's returns of tax (Forms 1120S) are filed. In addition, a 
copy of the Form 8716 should be attached to the S corporation's short 
period Federal income tax return for the first election year beginning 
on or after January 1, 2002.
    (3) Effect of request--(i) Taxable years beginning on or after 
January 1, 2002. An S corporation described in paragraph (c)(1) of this 
section that requests, in accordance with this paragraph, that a 
termination of its election under section 444 be disregarded will be 
permitted to resume use of the year it previously elected under section 
444, commencing with its first taxable year beginning on or after 
January 1, 2002. Such S corporation will be required to file a return 
under Sec.  1.7519-2T for each taxable year beginning on or after 
January 1, 2002. No payment under section 7519 will be due with respect 
to the first taxable year beginning on or after January 1, 2002. 
However, a required payment will be due on or before May 15, 2003, with 
respect to such S corporation's second continued section 444 election 
year that begins in calendar year 2002.

[[Page 50]]

    (ii) Taxable years beginning prior to January 1, 2002. An S 
corporation described in paragraph (c)(1) of this section that requests, 
in accordance with this paragraph, that a termination of its election 
under section 444 be disregarded will not be required to amend any prior 
Federal income tax returns, make any required payments under section 
7519, or file any returns under Sec.  1.7519-2T, with respect to taxable 
years beginning on or after the date the termination of its section 444 
election was effective and prior to January 1, 2002.
    (iii) Section 7519: required payments and returns. The Internal 
Revenue Service waives any requirement for an S corporation described in 
paragraph (c)(1) of this section to file the federal tax returns and 
make any required payments under section 7519 for years prior to the 
taxable year of continuation as described in paragraph (c)(3)(i) of this 
section, if for such years the S corporation filed its federal income 
tax returns on the basis of its required taxable year.

[T.D. 8994, 67 FR 34394, May 14, 2002]

                          Methods of Accounting

                    methods of accounting in general



Sec.  1.446-1  General rule for methods of accounting.

    (a) General rule. (1) Section 446(a) provides that taxable income 
shall be computed under the method of accounting on the basis of which a 
taxpayer regularly computes his income in keeping his books. The term 
``method of accounting'' includes not only the overall method of 
accounting of the taxpayer but also the accounting treatment of any 
item. Examples of such over-all methods are the cash receipts and 
disbursements method, an accrual method, combinations of such methods, 
and combinations of the foregoing with various methods provided for the 
accounting treatment of special items. These methods of accounting for 
special items include the accounting treatment prescribed for research 
and experimental expenditures, soil and water conservation expenditures, 
depreciation, net operating losses, etc. Except for deviations permitted 
or required by such special accounting treatment, taxable income shall 
be computed under the method of accounting on the basis of which the 
taxpayer regularly computes his income in keeping his books. For 
requirement respecting the adoption or change of accounting method, see 
section 446(e) and paragraph (e) of this section.
    (2) It is recognized that no uniform method of accounting can be 
prescribed for all taxpayers. Each taxpayer shall adopt such forms and 
systems as are, in his judgment, best suited to his needs. However, no 
method of accounting is acceptable unless, in the opinion of the 
Commissioner, it clearly reflects income. A method of accounting which 
reflects the consistent application of generally accepted accounting 
principles in a particular trade or business in accordance with accepted 
conditions or practices in that trade or business will ordinarily be 
regarded as clearly reflecting income, provided all items of gross 
income and expense are treated consistently from year to year.
    (3) Items of gross income and expenditures which are elements in the 
computation of taxable income need not be in the form of cash. It is 
sufficient that such items can be valued in terms of money. For general 
rules relating to the taxable year for inclusion of income and for 
taking deductions, see sections 451 and 461, and the regulations 
thereunder.
    (4) Each taxpayer is required to make a return of his taxable income 
for each taxable year and must maintain such accounting records as will 
enable him to file a correct return. See section 6001 and the 
regulations thereunder. Accounting records include the taxpayer's 
regular books of account and such other records and data as may be 
necessary to support the entries on his books of account and on his 
return, as for example, a reconciliation of any differences between such 
books and his return. The following are among the essential features 
that must be considered in maintaining such records:
    (i) Except in the case of a taxpayer qualifying as a small business 
taxpayer for the taxable year under section 471(c), in all cases in 
which the production, purchase or sale of merchandise

[[Page 51]]

of any kind is an income-producing factor, merchandise on hand 
(including finished goods, work in progress, raw materials, and 
supplies) at the beginning and end of the year shall be taken into 
account in computing the taxable income of the year. (For rules relating 
to computation of inventories, see section 263A, 471, and 472 and the 
regulations thereunder.)
    (ii) Expenditures made during the year shall be properly classified 
as between capital and expense. For example, expenditures for such items 
as plant and equipment, which have a useful life extending substantially 
beyond the taxable year, shall be charged to a capital account and not 
to an expense account.
    (iii) In any case in which there is allowable with respect to an 
asset a deduction for depreciation, amortization, or depletion, any 
expenditures (other than ordinary repairs) made to restore the asset or 
prolong its useful life shall be added to the asset account or charged 
against the appropriate reserve.
    (b) Exceptions. (1) If the taxpayer does not regularly employ a 
method of accounting which clearly reflects his income, the computation 
of taxable income shall be made in a manner which, in the opinion of the 
Commissioner, does clearly reflect income.
    (2) A taxpayer whose sole source of income is wages need not keep 
formal books in order to have an accounting method. Tax returns, copies 
thereof, or other records may be sufficient to establish the use of the 
method of accounting used in the preparation of the taxpayer's income 
tax returns.
    (c) Permissible methods--(1) In general. Subject to the provisions 
of paragraphs (a) and (b) of this section, a taxpayer may compute his 
taxable income under any of the following methods of accounting:
    (i) Cash receipts and disbursements method. Generally, under the 
cash receipts and disbursements method in the computation of taxable 
income, all items which constitute gross income (whether in the form of 
cash, property, or services) are to be included for the taxable year in 
which actually or constructively received. Expenditures are to be 
deducted for the taxable year in which actually made. For rules relating 
to constructive receipt, see Sec.  1.451-2. For treatment of an 
expenditure attributable to more than one taxable year, see section 
461(a) and paragraph (a)(1) of Sec.  1.461-1.
    (ii) Accrual method. (A) Generally, under an accrual method, income 
is to be included for the taxable year when all the events have occurred 
that fix the right to receive the income and the amount of the income 
can be determined with reasonable accuracy. (See Sec.  1.451-1 for rules 
relating to the taxable year of inclusion.) Under such a method, a 
liability is incurred, and generally is taken into account for Federal 
income tax purposes, in the taxable year in which all the events have 
occurred that establish the fact of the liability, the amount of the 
liability can be determined with reasonable accuracy, and economic 
performance has occurred with respect to the liability. (See paragraph 
(a)(2)(iii)(A) of Sec.  1.461-1 for examples of liabilities that may not 
be taken into account until after the taxable year incurred, and see 
Sec. Sec.  1.461-4 through 1.461-6 for rules relating to economic 
performance.) Applicable provisions of the Code, the Income Tax 
Regulations, and other guidance published by the Secretary prescribe the 
manner in which a liability that has been incurred is taken into 
account. For example, section 162 provides that a deductible liability 
generally is taken into account in the taxable year incurred through a 
deduction from gross income. As a further example, under section 263 or 
263A, a liability that relates to the creation of an asset having a 
useful life extending substantially beyond the close of the taxable year 
is taken into account in the taxable year incurred through 
capitalization (within the meaning of Sec.  1.263A-1(c)(3)) and may 
later affect the computation of taxable income through depreciation or 
otherwise over a period including subsequent taxable years, in 
accordance with applicable Internal Revenue Code sections and related 
guidance.
    (B) The term ``liability'' includes any item allowable as a 
deduction, cost, or expense for Federal income tax purposes. In addition 
to allowable deductions, the term includes any amount

[[Page 52]]

otherwise allowable as a capitalized cost, as a cost taken into account 
in computing cost of goods sold, as a cost allocable to a long-term 
contract, or as any other cost or expense. Thus, for example, an amount 
that a taxpayer expends or will expend for capital improvements to 
property must be incurred before the taxpayer may take the amount into 
account in computing its basis in the property. The term ``liability'' 
is not limited to items for which a legal obligation to pay exists at 
the time of payment. Thus, for example, amounts prepaid for goods or 
services and amounts paid without a legal obligation to do so may not be 
taken into account by an accrual basis taxpayer any earlier than the 
taxable year in which those amounts are incurred.
    (C) No method of accounting is acceptable unless, in the opinion of 
the Commissioner, it clearly reflects income. The method used by the 
taxpayer in determining when income is to be accounted for will 
generally be acceptable if it accords with generally accepted accounting 
principles, is consistently used by the taxpayer from year to year, and 
is consistent with the Income Tax Regulations. For example, a taxpayer 
engaged in a manufacturing business may account for sales of the 
taxpayer's product when the goods are shipped, when the product is 
delivered or accepted, or when title to the goods passes to the 
customers, whether or not billed, depending on the method regularly 
employed in keeping the taxpayer's books.
    (iii) Other permissible methods. Special methods of accounting are 
described elsewhere in chapter 1 of the Code and the regulations 
thereunder. For example, see the following sections and the regulations 
thereunder: Sections 61 and 162, relating to the crop method of 
accounting; section 453, relating to the installment method; section 
460, relating to the long-term contract methods. In addition, special 
methods of accounting for particular items of income and expense are 
provided under other sections of chapter 1. For example, see section 
174, relating to research and experimental expenditures, and section 
175, relating to soil and water conservation expenditures.
    (iv) Combinations of the foregoing methods. (a) In accordance with 
the following rules, any combination of the foregoing methods of 
accounting will be permitted in connection with a trade or business if 
such combination clearly reflects income and is consistently used. Where 
a combination of methods of accounting includes any special methods, 
such as those referred to in subdivision (iii) of this subparagraph, the 
taxpayer must comply with the requirements relating to such special 
methods. A taxpayer using an accrual method of accounting with respect 
to purchases and sales may use the cash method in computing all other 
items of income and expense. However, a taxpayer who uses the cash 
method of accounting in computing gross income from his trade or 
business shall use the cash method in computing expenses of such trade 
or business. Similarly, a taxpayer who uses an accrual method of 
accounting in computing business expenses shall use an accrual method in 
computing items affecting gross income from his trade or business.
    (b) A taxpayer using one method of accounting in computing items of 
income and deductions of his trade or business may compute other items 
of income and deductions not connected with his trade or business under 
a different method of accounting.
    (2) Special rules. (i) In any case in which it is necessary to use 
an inventory, the accrual method of accounting must be used with regard 
to purchases and sales unless:
    (A) The taxpayer qualifies as a small business taxpayer for the 
taxable year under section 471(c), or
    (B) Otherwise authorized under paragraph (c)(2)(ii) of this section.
    (ii) No method of accounting will be regarded as clearly reflecting 
income unless all items of gross profit and deductions are treated with 
consistency from year to year. The Commissioner may authorize a taxpayer 
to adopt or change to a method of accounting permitted by this chapter 
although the method is not specifically described in the regulations in 
this part if, in the opinion of the Commissioner, income is clearly 
reflected by the use of such method. Further, the Commissioner

[[Page 53]]

may authorize a taxpayer to continue the use of a method of accounting 
consistently used by the taxpayer, even though not specifically 
authorized by the regulations in this part, if, in the opinion of the 
Commissioner, income is clearly reflected by the use of such method. See 
section 446(a) and paragraph (a) of this section, which require that 
taxable income shall be computed under the method of accounting on the 
basis of which the taxpayer regularly computes his income in keeping his 
books, and section 446(e) and paragraph (e) of this section, which 
require the prior approval of the Commissioner in the case of changes in 
accounting method.
    (iii) The timing rules of Sec.  1.1502-13 are a method of accounting 
for intercompany transactions (as defined in Sec.  1.1502-13(b)(1)(i)), 
to be applied by each member of a consolidated group in addition to the 
member's other methods of accounting. See Sec.  1.1502-13(a)(3)(i). This 
paragraph (c)(2)(iii) is applicable to consolidated return years 
beginning on or after November 7, 2001.
    (3) Applicability date. The first sentence of paragraph (a)(4)(i) of 
this section and paragraph (c)(2)(i) of this section apply to taxable 
years beginning on or after January 5, 2021. However, for a taxable year 
beginning after December 31, 2017, and before January 5, 2021, a 
taxpayer may apply the rules provided in the first sentence of this 
paragraph (c)(3), provided that the taxpayer follows all the applicable 
rules contained in the regulations under section 446 for such taxable 
year and all subsequent taxable years.
    (d) Taxpayer engaged in more than one business. (1) Where a taxpayer 
has two or more separate and distinct trades or businesses, a different 
method of accounting may be used for each trade or business, provided 
the method used for each trade or business clearly reflects the income 
of that particular trade or business. For example, a taxpayer may 
account for the operations of a personal service business on the cash 
receipts and disbursements method and of a manufacturing business on an 
accrual method, provided such businesses are separate and distinct and 
the methods used for each clearly reflect income. The method first used 
in accounting for business income and deductions in connection with each 
trade or business, as evidenced in the taxpayer's income tax return in 
which such income or deductions are first reported, must be consistently 
followed thereafter.
    (2) No trade or business will be considered separate and distinct 
for purposes of this paragraph unless a complete and separable set of 
books and records is kept for such trade or business.
    (3) If, by reason of maintaining different methods of accounting, 
there is a creation or shifting of profits or losses between the trades 
or businesses of the taxpayer (for example, through inventory 
adjustments, sales, purchases, or expenses) so that income of the 
taxpayer is not clearly reflected, the trades or businesses of the 
taxpayer will not be considered to be separate and distinct.
    (e) Requirement respecting the adoption or change of accounting 
method. (1) A taxpayer filing his first return may adopt any permissible 
method of accounting in computing taxable income for the taxable year 
covered by such return. See section 446(c) and paragraph (c) of this 
section for permissible methods. Moreover, a taxpayer may adopt any 
permissible method of accounting in connection with each separate and 
distinct trade or business, the income from which is reported for the 
first time. See section 446(d) and paragraph (d) of this section. See 
also section 446(a) and paragraph (a) of this section.
    (2)(i) Except as otherwise expressly provided in chapter 1 of the 
Code and the regulations thereunder, a taxpayer who changes the method 
of accounting employed in keeping his books shall, before computing his 
income upon such new method for purposes of taxation, secure the consent 
of the Commissioner. Consent must be secured whether or not such method 
is proper or is permitted under the Internal Revenue Code or the 
regulations thereunder.
    (ii) (a) A change in the method of accounting includes a change in 
the overall plan of accounting for gross income or deductions or a 
change in the treatment of any material item used in such

[[Page 54]]

overall plan. Although a method of accounting may exist under this 
definition without the necessity of a pattern of consistent treatment of 
an item, in most instances a method of accounting is not established for 
an item without such consistent treatment. A material item is any item 
that involves the proper time for the inclusion of the item in income or 
the taking of a deduction. Changes in method of accounting include a 
change from the cash receipts and disbursement method to an accrual 
method, or vice versa, a change involving the method or basis used in 
the valuation of inventories (see sections 471 and 472 and the 
regulations under sections 471 and 472), a change from the cash or 
accrual method to a long-term contract method, or vice versa (see Sec.  
1.460-4), certain changes in computing depreciation or amortization (see 
paragraph (e)(2)(ii)(d) of this section), a change involving the 
adoption, use or discontinuance of any other specialized method of 
computing taxable income, such as the crop method, and a change where 
the Internal Revenue Code and regulations under the Internal Revenue 
Code specifically require that the consent of the Commissioner must be 
obtained before adopting such a change.
    (b) A change in method of accounting does not include correction of 
mathematical or posting errors, or errors in the computation of tax 
liability (such as errors in computation of the foreign tax credit, net 
operating loss, percentage depletion, or investment credit). Also, a 
change in method of accounting does not include adjustment of any item 
of income or deduction that does not involve the proper time for the 
inclusion of the item of income or the taking of a deduction. For 
example, corrections of items that are deducted as interest or salary, 
but that are in fact payments of dividends, and of items that are 
deducted as business expenses, but that are in fact personal expenses, 
are not changes in method of accounting. In addition, a change in the 
method of accounting does not include an adjustment with respect to the 
addition to a reserve for bad debts. Although such adjustment may 
involve the question of the proper time for the taking of a deduction, 
such items are traditionally corrected by adjustment in the current and 
future years. For the treatment of the adjustment of the addition to a 
bad debt reserve (for example, for banks under section 585 of the 
Internal Revenue Code), see the regulations under section 166 of the 
Internal Revenue Code. A change in the method of accounting also does 
not include a change in treatment resulting from a change in underlying 
facts. For further guidance on changes involving depreciable or 
amortizable assets, see paragraph (e)(2)(ii)(d) of this section and 
Sec.  1.1016-3(h).
    (c) A change in an overall plan or system of identifying or valuing 
items in inventory is a change in method of accounting. Also a change in 
the treatment of any material item used in the overall plan for 
identifying or valuing items in inventory is a change in method of 
accounting.
    (d) Changes involving depreciable or amortizable assets--(1) Scope. 
This paragraph (e)(2)(ii)(d) applies to property subject to section 167, 
168, 197, 1400I, 1400L(c), to section 168 prior to its amendment by the 
Tax Reform Act of 1986 (100 Stat. 2121) (former section 168), or to an 
additional first year depreciation deduction provision of the Internal 
Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)).
    (2) Changes in depreciation or amortization that are a change in 
method of accounting. Except as provided in paragraph (e)(2)(ii)(d)(3) 
of this section, a change in the treatment of an asset from 
nondepreciable or nonamortizable to depreciable or amortizable, or vice 
versa, is a change in method of accounting. Additionally, a correction 
to require depreciation or amortization in lieu of a deduction for the 
cost of depreciable or amortizable assets that had been consistently 
treated as an expense in the year of purchase, or vice versa, is a 
change in method of accounting. Further, except as provided in paragraph 
(e)(2)(ii)(d)(3) of this section, the following changes in computing 
depreciation or amortization are a change in method of accounting:
    (i) A change in the depreciation or amortization method, period of 
recovery, or convention of a depreciable or amortizable asset.

[[Page 55]]

    (ii) A change from not claiming to claiming the additional first 
year depreciation deduction provided by, for example, section 168(k), 
1400L(b), or 1400N(d), for, and the resulting change to the amount 
otherwise allowable as a depreciation deduction for the remaining 
adjusted depreciable basis (or similar basis) of, depreciable property 
that qualifies for the additional first year depreciation deduction (for 
example, qualified property, 50-percent bonus depreciation property, 
qualified New York Liberty Zone property, or qualified Gulf Opportunity 
Zone property), provided the taxpayer did not make the election out of 
the additional first year depreciation deduction (or did not make a 
deemed election out of the additional first year depreciation deduction; 
for further guidance, for example, see Rev. Proc. 2002-33 (2002-1 C.B. 
963), Rev. Proc. 2003-50 (2003-2 C.B. 119), Notice 2006-77 (2006-40 
I.R.B. 590), and Sec.  601.601(d)(2)(ii)(b) of this chapter) for the 
class of property in which the depreciable property that qualifies for 
the additional first year depreciation deduction (for example, qualified 
property, 50-percent bonus depreciation property, qualified New York 
Liberty Zone property, or qualified Gulf Opportunity Zone property) is 
included.
    (iii) A change from claiming the 30-percent additional first year 
depreciation deduction to claiming the 50-percent additional first year 
depreciation deduction for depreciable property that qualifies for the 
50-percent additional first year depreciation deduction, provided the 
property is not included in any class of property for which the taxpayer 
elected the 30-percent, instead of the 50-percent, additional first year 
depreciation deduction (for example, 50-percent bonus depreciation 
property or qualified Gulf Opportunity Zone property), or a change from 
claiming the 50-percent additional first year depreciation deduction to 
claiming the 30-percent additional first year depreciation deduction for 
depreciable property that qualifies for the 30-percent additional first 
year depreciation deduction, including property that is included in a 
class of property for which the taxpayer elected the 30-percent, instead 
of the 50-percent, additional first year depreciation deduction (for 
example, qualified property or qualified New York Liberty Zone 
property), and the resulting change to the amount otherwise allowable as 
a depreciation deduction for the property's remaining adjusted 
depreciable basis (or similar basis). This paragraph 
(e)(2)(ii)(d)(2)(iii) does not apply if a taxpayer is making a late 
election or revoking a timely valid election under the applicable 
additional first year depreciation deduction provision of the Internal 
Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)) (see 
paragraph (e)(2)(ii)(d)(3)(iii) of this section).
    (iv) A change from claiming to not claiming the additional first 
year depreciation deduction for an asset that does not qualify for the 
additional first year depreciation deduction, including an asset that is 
included in a class of property for which the taxpayer elected not to 
claim any additional first year depreciation deduction (for example, an 
asset that is not qualified property, 50-percent bonus depreciation 
property, qualified New York Liberty Zone property, or qualified Gulf 
Opportunity Zone property), and the resulting change to the amount 
otherwise allowable as a depreciation deduction for the property's 
depreciable basis.
    (v) A change in salvage value to zero for a depreciable or 
amortizable asset for which the salvage value is expressly treated as 
zero by the Internal Revenue Code (for example, section 168(b)(4)), the 
regulations under the Internal Revenue Code (for example, Sec.  1.197-
2(f)(1)(ii)), or other guidance published in the Internal Revenue 
Bulletin.
    (vi) A change in the accounting for depreciable or amortizable 
assets from a single asset account to a multiple asset account 
(pooling), or vice versa, or from one type of multiple asset account 
(pooling) to a different type of multiple asset account (pooling).
    (vii) For depreciable or amortizable assets that are mass assets 
accounted for in multiple asset accounts or pools, a change in the 
method of identifying which assets have been disposed. For purposes of 
this paragraph (e)(2)(ii)(d)(2)(vii), the term mass assets means a mass 
or group of individual items of depreciable or amortizable assets that 
are not necessarily homogeneous, each of which is minor in

[[Page 56]]

value relative to the total value of the mass or group, numerous in 
quantity, usually accounted for only on a total dollar or quantity 
basis, with respect to which separate identification is impracticable, 
and placed in service in the same taxable year.
    (viii) Any other change in depreciation or amortization as the 
Secretary may designate by publication in the Federal Register or in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter).
    (3) Changes in depreciation or amortization that are not a change in 
method of accounting. Section 1.446-1(e)(2)(ii)(b) applies to determine 
whether a change in depreciation or amortization is not a change in 
method of accounting. Further, the following changes in depreciation or 
amortization are not a change in method of accounting:
    (i) Useful life. An adjustment in the useful life of a depreciable 
or amortizable asset for which depreciation is determined under section 
167 (other than under section 168, section 1400I, section 1400L(c), 
former section 168, or an additional first year depreciation deduction 
provision of the Internal Revenue Code (for example, section 168(k), 
1400L(b), or 1400N(d))) is not a change in method of accounting. This 
paragraph (e)(2)(ii)(d)(3)(i) does not apply if a taxpayer is changing 
to or from a useful life (or recovery period or amortization period) 
that is specifically assigned by the Internal Revenue Code (for example, 
section 167(f)(1), section 168(c), section 168(g)(2) or (3), section 
197), the regulations under the Internal Revenue Code, or other guidance 
published in the Internal Revenue Bulletin and, therefore, such change 
is a change in method of accounting (unless paragraph 
(e)(2)(ii)(d)(3)(v) of this section applies). See paragraph 
(e)(2)(ii)(d)(5)(iv) of this section for determining the taxable year in 
which to correct an adjustment in useful life that is not a change in 
method of accounting.
    (ii) Change in use. A change in computing depreciation or 
amortization allowances in the taxable year in which the use of an asset 
changes in the hands of the same taxpayer is not a change in method of 
accounting.
    (iii) Elections. Generally, the making of a late depreciation or 
amortization election or the revocation of a timely valid depreciation 
or amortization election is not a change in method of accounting, except 
as otherwise expressly provided by the Internal Revenue Code, the 
regulations under the Internal Revenue Code, or other guidance published 
in the Internal Revenue Bulletin. This paragraph (e)(2)(ii)(d)(3)(iii) 
also applies to making a late election or revoking a timely valid 
election made under section 13261(g)(2) or (3) of the Revenue 
Reconciliation Act of 1993 (107 Stat. 312, 540) (relating to amortizable 
section 197 intangibles). A taxpayer may request consent to make a late 
election or revoke a timely valid election by submitting a request for a 
private letter ruling. For making or revoking an election under section 
179 of the Internal Revenue Code, see section 179(c) and Sec.  1.179-5.
    (iv) Salvage value. Except as provided under paragraph 
(e)(2)(ii)(d)(2)(v) of this section, a change in salvage value of a 
depreciable or amortizable asset is not treated as a change in method of 
accounting.
    (v) Placed-in-service date. Except as otherwise expressly provided 
by the Internal Revenue Code, the regulations under the Internal Revenue 
Code, or other guidance published in the Internal Revenue Bulletin, any 
change in the placed-in-service date of a depreciable or amortizable 
asset is not treated as a change in method of accounting. For example, 
if a taxpayer changes the placed-in-service date of a depreciable or 
amortizable asset because the taxpayer incorrectly determined the date 
on which the asset was placed in service, such a change is a change in 
the placed-in-service date of the asset and, therefore, is not a change 
in method of accounting. However, if a taxpayer incorrectly determines 
that a depreciable or amortizable asset is nondepreciable property and 
later changes the treatment of the asset to depreciable property, such a 
change is not a change in the placed-in-service date of the asset and, 
therefore, is a change in method of accounting under paragraph 
(e)(2)(ii)(d)(2) of this section. Further, a

[[Page 57]]

change in the convention of a depreciable or amortizable asset is not a 
change in the placed-in-service date of the asset and, therefore, is a 
change in method of accounting under paragraph (e)(2)(ii)(d)(2)(i) of 
this section. See paragraph (e)(2)(ii)(d)(5)(v) of this section for 
determining the taxable year in which to make a change in the placed-in-
service date of a depreciable or amortizable asset that is not a change 
in method of accounting.
    (vi) Any other change in depreciation or amortization as the 
Secretary may designate by publication in the Federal Register or in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter).
    (4) Item being changed. For purposes of a change in depreciation or 
amortization to which this paragraph (e)(2)(ii)(d) applies, the item 
being changed generally is the depreciation treatment of each individual 
depreciable or amortizable asset. However, the item is the depreciation 
treatment of each vintage account with respect to a depreciable asset 
for which depreciation is determined under Sec.  1.167(a)-11 (class life 
asset depreciation range (CLADR) property). Similarly, the item is the 
depreciable treatment of each general asset account with respect to a 
depreciable asset for which general asset account treatment has been 
elected under section 168(i)(4) or the item is the depreciation 
treatment of each mass asset account with respect to a depreciable asset 
for which mass asset account treatment has been elected under former 
section 168(d)(2)(A). Further, a change in computing depreciation or 
amortization under section 167 (other than under section 168, section 
1400I, section 1400L(c), former section 168, or an additional first year 
depreciation deduction provision of the Internal Revenue Code (for 
example, section 168(k), 1400L(b), or 1400N(d))) is permitted only with 
respect to all assets in a particular account (as defined in Sec.  
1.167(a)-7) or vintage account.
    (5) Special rules. For purposes of a change in depreciation or 
amortization to which this paragraph (e)(2)(ii)(d) applies--
    (i) Declining balance method to the straight line method for MACRS 
property. For tangible, depreciable property subject to section 168 
(MACRS property) that is depreciated using the 200-percent or 150-
percent declining balance method of depreciation under section 168(b)(1) 
or (2), a taxpayer may change without the consent of the Commissioner 
from the declining balance method of depreciation to the straight line 
method of depreciation in the first taxable year in which the use of the 
straight line method with respect to the adjusted depreciable basis of 
the MACRS property as of the beginning of that year will yield a 
depreciation allowance that is greater than the depreciation allowance 
yielded by the use of the declining balance method. When the change is 
made, the adjusted depreciable basis of the MACRS property as of the 
beginning of the taxable year is recovered through annual depreciation 
allowances over the remaining recovery period (for further guidance, see 
section 6.06 of Rev. Proc. 87-57 (1987-2 C.B. 687) and Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (ii) Depreciation method changes for section 167 property. For a 
depreciable or amortizable asset for which depreciation is determined 
under section 167 (other than under section 168, section 1400I, section 
1400L(c), former section 168, or an additional first year depreciation 
deduction provision of the Internal Revenue Code (for example, section 
168(k), 1400L(b), or 1400N(d))), see Sec.  1.167(e)-1(b), (c), and (d) 
for the changes in depreciation method that are permitted to be made 
without the consent of the Commissioner. For CLADR property, see Sec.  
1.167(a)-11(c)(1)(iii) for the changes in depreciation method for CLADR 
property that are permitted to be made without the consent of the 
Commissioner. Further, see Sec.  1.167(a)-11(b)(4)(iii)(c) for how to 
correct an incorrect classification or characterization of CLADR 
property.
    (iii) Section 481 adjustment. Except as otherwise expressly provided 
by the Internal Revenue Code, the regulations under the Internal Revenue 
Code, or other guidance published in the Internal Revenue Bulletin, no 
section 481 adjustment is required or permitted for a change from one 
permissible method of computing depreciation or amortization to another 
permissible method of

[[Page 58]]

computing depreciation or amortization for an asset because this change 
is implemented by either a cut-off method (for further guidance, for 
example, see section 2.06 of Rev. Proc. 97-27 (1997-1 C.B. 680), section 
2.06 of Rev. Proc. 2002-9 (2002-1 C.B. 327), and Sec.  
601.601(d)(2)(ii)(b) of this chapter) or a modified cut-off method 
(under which the adjusted depreciable basis of the asset as of the 
beginning of the year of change is recovered using the new permissible 
method of accounting), as appropriate. However, a change from an 
impermissible method of computing depreciation or amortization to a 
permissible method of computing depreciation or amortization for an 
asset results in a section 481 adjustment. Similarly, a change in the 
treatment of an asset from nondepreciable or nonamortizable to 
depreciable or amortizable (or vice versa) or a change in the treatment 
of an asset from expensing to depreciating (or vice versa) results in a 
section 481 adjustment.
    (iv) Change in useful life. This paragraph (e)(2)(ii)(d)(5)(iv) 
applies to an adjustment in the useful life of a depreciable or 
amortizable asset for which depreciation is determined under section 167 
(other than under section 168, section 1400I, section 1400L(c), former 
section 168, or an additional first year depreciation deduction 
provision of the Internal Revenue Code (for example, section 168(k), 
1400L(b), or 1400N(d))) and that is not a change in method of accounting 
under paragraph (e)(2)(ii)(d) of this section. For this adjustment in 
useful life, no section 481 adjustment is required or permitted. The 
adjustment in useful life, whether initiated by the Internal Revenue 
Service (IRS) or a taxpayer, is corrected by adjustments in the taxable 
year in which the conditions known to exist at the end of that taxable 
year changed thereby resulting in a redetermination of the useful life 
under Sec.  1.167(a)-1(b) (or if the period of limitation for assessment 
under section 6501(a) has expired for that taxable year, in the first 
succeeding taxable year open under the period of limitation for 
assessment), and in subsequent taxable years. In other situations (for 
example, the useful life is incorrectly determined in the placed-in-
service year), the adjustment in the useful life, whether initiated by 
the IRS or a taxpayer, may be corrected by adjustments in the earliest 
taxable year open under the period of limitation for assessment under 
section 6501(a) or the earliest taxable year under examination by the 
IRS but in no event earlier than the placed-in-service year of the 
asset, and in subsequent taxable years. However, if a taxpayer initiates 
the correction in useful life, in lieu of filing amended Federal tax 
returns (for example, because the conditions known to exist at the end 
of a prior taxable year changed thereby resulting in a redetermination 
of the useful life under Sec.  1.167(a)-1(b)), the taxpayer may correct 
the adjustment in useful life by adjustments in the current and 
subsequent taxable years.
    (v) Change in placed-in-service date. This paragraph 
(e)(2)(ii)(d)(5)(v) applies to a change in the placed-in-service date of 
a depreciable or amortizable asset that is not a change in method of 
accounting under paragraph (e)(2)(ii)(d) of this section. For this 
change in placed-in-service date, no section 481 adjustment is required 
or permitted. The change in placed-in-service date, whether initiated by 
the IRS or a taxpayer, may be corrected by adjustments in the earliest 
taxable year open under the period of limitation for assessment under 
section 6501(a) or the earliest taxable year under examination by the 
IRS but in no event earlier than the placed-in-service year of the 
asset, and in subsequent taxable years. However, if a taxpayer initiates 
the change in placed-in-service date, in lieu of filing amended Federal 
tax returns, the taxpayer may correct the placed-in-service date by 
adjustments in the current and subsequent taxable years.
    (iii) Examples. The rules of this paragraph (e) are illustrated by 
the following examples:

    Example 1. Although the sale of merchandise is an income producing 
factor, and therefore inventories are required, a taxpayer in the retail 
jewelry business reports his income on the cash receipts and 
disbursements method of accounting. A change from the cash receipts and 
disbursements method of accounting to the accrual method of accounting 
is a change in the overall plan of accounting and thus is a change in 
method of accounting.

[[Page 59]]

    Example 2. A taxpayer in the wholesale dry goods business computes 
its income and expenses on the accrual method of accounting and files 
its Federal income tax returns on such basis except for real estate 
taxes which have been reported on the cash receipts and disbursements 
method of accounting. A change in the treatment of real estate taxes 
from the cash receipts and disbursements method to the accrual method is 
a change in method of accounting because such change is a change in the 
treatment of a material item within his overall accounting practice.
    Example 3. A taxpayer in the wholesale dry goods business computes 
its income and expenses on the accrual method of accounting and files 
its Federal income tax returns on such basis. Vacation pay has been 
deducted in the year in which paid because the taxpayer did not have a 
completely vested vacation pay plan, and, therefore, the liability for 
payment did not accrue until that year. Subsequently, the taxpayer 
adopts a completely vested vacation pay plan that changes its year for 
accruing the deduction from the year in which payment is made to the 
year in which the liability to make the payment now arises. The change 
for the year of deduction of the vacation pay plan is not a change in 
method of accounting but results, instead, because the underlying facts 
(that is, the type of vacation pay plan) have changed.
    Example 4. From 1968 through 1970, a taxpayer has fairly allocated 
indirect overhead costs to the value of inventories on a fixed 
percentage of direct costs. If the ratio of indirect overhead costs to 
direct costs increases in 1971, a change in the underlying facts has 
occurred. Accordingly, an increase in the percentage in 1971 to fairly 
reflect the increase in the relative level of indirect overhead costs is 
not a change in method of accounting but is a change in treatment 
resulting from a change in the underlying facts.
    Example 5. A taxpayer values inventories at cost. A change in the 
basis for valuation of inventories from cost to the lower of cost or 
market is a change in an overall practice of valuing items in inventory. 
The change, therefore, is a change in method of accounting for 
inventories.
    Example 6. A taxpayer in the manufacturing business has for many 
taxable years valued its inventories at cost. However, cost has been 
improperly computed since no overhead costs have been included in 
valuing the inventories at cost. The failure to allocate an appropriate 
portion of overhead to the value of inventories is contrary to the 
requirement of the Internal Revenue Code and the regulations under the 
Internal Revenue Code. A change requiring appropriate allocation of 
overhead is a change in method of accounting because it involves a 
change in the treatment of a material item used in the overall practice 
of identifying or valuing items in inventory.
    Example 7. A taxpayer has for many taxable years valued certain 
inventories by a method which provides for deducting 20 percent of the 
cost of the inventory items in determining the final inventory 
valuation. The 20 percent adjustment is taken as a ``reserve for price 
changes.'' Although this method is not a proper method of valuing 
inventories under the Internal Revenue Code or the regulations under the 
Internal Revenue Code, it involves the treatment of a material item used 
in the overall practice of valuing inventory. A change in such practice 
or procedure is a change of method of accounting for inventories.
    Example 8. A taxpayer has always used a base stock system of 
accounting for inventories. Under this system a constant price is 
applied to an assumed constant normal quantity of goods in stock. The 
base stock system is an overall plan of accounting for inventories which 
is not recognized as a proper method of accounting for inventories under 
the regulations. A change in this practice is, nevertheless, a change of 
method of accounting for inventories.
    Example 9. In 2003, A1, a calendar year taxpayer engaged in the 
trade or business of manufacturing knitted goods, purchased and placed 
in service a building and its components at a total cost of $10,000,000 
for use in its manufacturing operations. A1 classified the $10,000,000 
as nonresidential real property under section 168(e). A1 elected not to 
deduct the additional first year depreciation provided by section 168(k) 
on its 2003 Federal tax return. As a result, on its 2003, 2004, and 2005 
Federal tax returns, A1 depreciated the $10,000,000 under the general 
depreciation system of section 168(a), using the straight line method of 
depreciation, a 39-year recovery period, and the mid-month convention. 
In 2006, A1 completes a cost segregation study on the building and its 
components and identifies items that cost a total of $1,500,000 as 
section 1245 property. As a result, the $1,500,000 should have been 
classified in 2003 as 5-year property under section 168(e) and 
depreciated on A1's 2003, 2004, and 2005 Federal tax returns under the 
general depreciation system, using the 200-percent declining balance 
method of depreciation, a 5-year recovery period, and the half-year 
convention. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this section, 
A1's change to this depreciation method, recovery period, and convention 
is a change in method of accounting. This method change results in a 
section 481 adjustment. The useful life exception under paragraph 
(e)(2)(ii)(d)(3)(i) of this section does not apply because the assets 
are depreciated under section 168.
    Example 10. In 2003, B, a calendar year taxpayer, purchased and 
placed in service new equipment at a total cost of $1,000,000 for use

[[Page 60]]

in its plant located outside the United States. The equipment is 15-year 
property under section 168(e) with a class life of 20 years. The 
equipment is required to be depreciated under the alternative 
depreciation system of section 168(g). However, B incorrectly 
depreciated the equipment under the general depreciation system of 
section 168(a), using the 150-percent declining balance method, a 15-
year recovery period, and the half-year convention. In 2010, the IRS 
examines B's 2007 Federal income tax return and changes the depreciation 
of the equipment to the alternative depreciation system, using the 
straight line method of depreciation, a 20-year recovery period, and the 
half-year convention. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this 
section, this change in depreciation method and recovery period made by 
the IRS is a change in method of accounting. This method change results 
in a section 481 adjustment. The useful life exception under paragraph 
(e)(2)(ii)(d)(3)(i) of this section does not apply because the assets 
are depreciated under section 168.
    Example 11. In May 2003, C, a calendar year taxpayer, purchased and 
placed in service equipment for use in its trade or business. C never 
held this equipment for sale. However, C incorrectly treated the 
equipment as inventory on its 2003 and 2004 Federal tax returns. In 
2005, C realizes that the equipment should have been treated as a 
depreciable asset. Pursuant to paragraph (e)(2)(ii)(d)(2) of this 
section, C's change in the treatment of the equipment from inventory to 
a depreciable asset is a change in method of accounting. This method 
change results in a section 481 adjustment.
    Example 12. Since 2003, D, a calendar year taxpayer, has used the 
distribution fee period method to amortize distributor commissions and, 
under that method, established pools to account for the distributor 
commissions (for further guidance, see Rev. Proc. 2000-38 (2000-2 C.B. 
310) and Sec.  601.601(d)(2)(ii)(b) of this chapter). A change in the 
accounting of distributor commissions under the distribution fee period 
method from pooling to single asset accounting is a change in method of 
accounting pursuant to paragraph (e)(2)(ii)(d)(2)(vi) of this section. 
This method change results in no section 481 adjustment because the 
change is from one permissible method to another permissible method.
    Example 13. Since 2003, E, a calendar year taxpayer, has accounted 
for items of MACRS property that are mass assets in pools. Each pool 
includes only the mass assets that are placed in service by E in the 
same taxable year. E is able to identify the cost basis of each asset in 
each pool. None of the pools are general asset accounts under section 
168(i)(4) and the regulations under section 168(i)(4). E identified any 
dispositions of these mass assets by specific identification. Because of 
changes in E's recordkeeping in 2006, it is impracticable for E to 
continue to identify disposed mass assets using specific identification. 
As a result, E wants to change to a first-in, first-out method under 
which the mass assets disposed of in a taxable year are deemed to be 
from the pool with the earliest placed-in-service year in existence as 
of the beginning of the taxable year of each disposition. Pursuant to 
paragraph (e)(2)(ii)(d)(2)(vii) of this section, this change is a change 
in method of accounting. This method change results in no section 481 
adjustment because the change is from one permissible method to another 
permissible method.
    Example 14. In August 2003, F, a calendar year taxpayer, purchased 
and placed in service a copier for use in its trade or business. F 
incorrectly classified the copier as 7-year property under section 
168(e). F elected not to deduct the additional first year depreciation 
provided by section 168(k) on its 2003 Federal tax return. As a result, 
on its 2003 and 2004 Federal tax returns, F depreciated the copier under 
the general depreciation system of section 168(a), using the 200-percent 
declining balance method of depreciation, a 7-year recovery period, and 
the half-year convention. In 2005, F realizes that the copier is 5-year 
property and should have been depreciated on its 2003 and 2004 Federal 
tax returns under the general depreciation system using a 5-year 
recovery period rather than a 7-year recovery period. Pursuant to 
paragraph (e)(2)(ii)(d)(2)(i) of this section, F's change in recovery 
period from 7 to 5 years is a change in method of accounting. This 
method change results in a section 481 adjustment. The useful life 
exception under paragraph (e)(2)(ii)(d)(3)(i) of this section does not 
apply because the copier is depreciated under section 168.
    Example 15. In 2004, G, a calendar year taxpayer, purchased and 
placed in service an intangible asset that is not an amortizable section 
197 intangible and that is not described in section 167(f). G amortized 
the cost of the intangible asset under section 167(a) using the straight 
line method of depreciation and a determinable useful life of 13 years. 
The safe harbor useful life of 15 or 25 years under Sec.  1.167(a)-3(b) 
does not apply to the intangible asset. In 2008, because of changing 
conditions, G changes the remaining useful life of the intangible asset 
to 2 years. Pursuant to paragraph (e)(2)(ii)(d)(3)(i) of this section, 
G's change in useful life is not a change in method of accounting 
because the intangible asset is depreciated under section 167 and G is 
not changing to or from a useful life that is specifically assigned by 
the Internal Revenue Code, the regulations under the Internal Revenue 
Code, or other guidance published in the Internal Revenue Bulletin.
    Example 16. In July 2003, H, a calendar year taxpayer, purchased and 
placed in service

[[Page 61]]

``off-the-shelf'' computer software and a new computer. The cost of the 
new computer and computer software are separately stated. H incorrectly 
included the cost of this software as part of the cost of the computer, 
which is 5-year property under section 168(e). On its 2003 Federal tax 
return, H elected to depreciate its 5-year property placed in service in 
2003 under the alternative depreciation system of section 168(g) and H 
elected not to deduct the additional first year depreciation provided by 
section 168(k). The class life for a computer is 5 years. As a result, 
because H included the cost of the computer software as part of the cost 
of the computer hardware, H depreciated the cost of the software under 
the alternative depreciation system, using the straight line method of 
depreciation, a 5-year recovery period, and the half-year convention. In 
2005, H realizes that the cost of the software should have been 
amortized under section 167(f)(1), using the straight line method of 
depreciation, a 36-month useful life, and a monthly convention. H's 
change from 5-years to 36-months is a change in method of accounting 
because H is changing to a useful life that is specifically assigned by 
section 167(f)(1). The change in convention from the half-year to the 
monthly convention also is a change in method of accounting. Both 
changes result in a section 481 adjustment.
    Example 17. On May 1, 2003, I2, a calendar year taxpayer, purchased 
and placed in service new equipment at a total cost of $500,000 for use 
in its business. The equipment is 5-year property under section 168(e) 
with a class life of 9 years and is qualified property under section 
168(k)(2). I2 did not place in service any other depreciable property in 
2003. Section 168(g)(1)(A) through (D) do not apply to the equipment. I2 
intended to elect the alternative depreciation system under section 
168(g) for 5-year property placed in service in 2003. However, I2 did 
not make the election. Instead, I2 deducted on its 2003 Federal tax 
return the 30-percent additional first year depreciation attributable to 
the equipment and, on its 2003 and 2004 Federal tax returns, depreciated 
the remaining adjusted depreciable basis of the equipment under the 
general depreciation system under 168(a), using the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention. In 2005, I2 realizes its failure to make the alternative 
depreciation system election in 2003 and files a Form 3115, 
``Application for Change in Accounting Method,'' to change its method of 
depreciating the remaining adjusted depreciable basis of the 2003 
equipment to the alternative depreciation system. Because this equipment 
is not required to be depreciated under the alternative depreciation 
system, I2 is attempting to make an election under section 168(g)(7). 
However, this election must be made in the taxable year in which the 
equipment is placed in service (2003) and, consequently, I2 is 
attempting to make a late election under section 168(g)(7). Accordingly, 
I2's change to the alternative depreciation system is not a change in 
accounting method pursuant to paragraph (e)(2)(ii)(d)(3)(iii) of this 
section. Instead, I2 must submit a request for a private letter ruling 
under Sec.  301.9100-3 of this chapter, requesting an extension of time 
to make the alternative depreciation system election on its 2003 Federal 
tax return.
    Example 18. On December 1, 2004, J, a calendar year taxpayer, 
purchased and placed in service 20 previously-owned adding machines. For 
the 2004 taxable year, J incorrectly classified the adding machines as 
items in its ``suspense'' account for financial and tax accounting 
purposes. Assets in this suspense account are not depreciated until 
reclassified to a depreciable fixed asset account. In January 2006, J 
realizes that the cost of the adding machines is still in the suspense 
account and reclassifies such cost to the appropriate depreciable fixed 
asset account. As a result, on its 2004 and 2005 Federal tax returns, J 
did not depreciate the cost of the adding machines. Pursuant to 
paragraph (e)(2)(ii)(d)(2) of this section, J's change in the treatment 
of the adding machines from nondepreciable assets to depreciable assets 
is a change in method of accounting. The placed-in-service date 
exception under paragraph (e)(2)(ii)(d)(3)(v) of this section does not 
apply because the adding machines were incorrectly classified in a 
nondepreciable suspense account. This method change results in a section 
481 adjustment.
    Example 19. In December 2003, K, a calendar year taxpayer, purchased 
and placed in service equipment for use in its trade or business. 
However, K did not receive the invoice for this equipment until January 
2004. As a result, K classified the equipment on its fixed asset records 
as being placed in service in January 2004. On its 2004 and 2005 Federal 
tax returns, K depreciated the cost of the equipment. In 2006, K 
realizes that the equipment was actually placed in service during the 
2003 taxable year and, therefore, depreciation should have began in the 
2003 taxable year instead of the 2004 taxable year. Pursuant to 
paragraph (e)(2)(ii)(d)(3)(v) of this section, K's change in the placed-
in-service date of the equipment is not a change in method of 
accounting.
    (3)(i) Except as otherwise provided under the authority of paragraph 
(e)(3)(ii) of this section, to secure the Commissioner's consent to a 
taxpayer's change in method of accounting the taxpayer generally must 
file an application on Form 3115, ``Application for Change in Accounting 
Method,'' with the Commissioner during the taxable

[[Page 62]]

year in which the taxpayer desires to make the change in method of 
accounting. See Sec. Sec.  1.381(c)(4)-1(d)(2) and 1.381(c)(5)-1(d)(2) 
for rules allowing additional time, in some circumstances, for the 
filing of an application on Form 3115 with respect to a transaction to 
which section 381(a) applies. To the extent applicable, the taxpayer 
must furnish all information requested on the Form 3115. This 
information includes all classes of items that will be treated 
differently under the new method of accounting, any amounts that will be 
duplicated or omitted as a result of the proposed change, and the 
taxpayer's computation of any adjustments necessary to prevent such 
duplications or omissions. The Commissioner may require such other 
information as may be necessary to determine whether the proposed change 
will be permitted. Permission to change a taxpayer's method of 
accounting will not be granted unless the taxpayer agrees to the 
Commissioner's prescribed terms and conditions for effecting the change, 
including the taxable year or years in which any adjustment necessary to 
prevent amounts from being duplicated or omitted is to be taken into 
account. See section 481 and the regulations thereunder, relating to 
certain adjustments resulting from accounting method changes, and 
section 472 and the regulations thereunder, relating to adjustments for 
changes to and from the last-in, first-out inventory method. For any 
Form 3115 filed on or after May 15, 1997, see Sec.  1.446-
1T(e)(3)(i)(B).
    (ii) Notwithstanding the provisions of paragraph (e)(3)(i) of this 
section, the Commissioner may prescribe administrative procedures under 
which taxpayers will be permitted to change their method of accounting. 
The administrative procedures shall prescribe those terms and conditions 
necessary to obtain the Commissioner's consent to effect the change and 
to prevent amounts from being duplicated or omitted. The terms and 
conditions that may be prescribed by the Commissioner may include terms 
and conditions that require the change in method of accounting to be 
effected on a cut-off basis or by an adjustment under section 481(a) to 
be taken into account in the taxable year or years prescribed by the 
Commissioner.
    (iii) This paragraph (e)(3) applies to Forms 3115 filed on or after 
December 31, 1997. For other Forms 3115, see Sec.  1.446-1(e)(3) in 
effect prior to December 31, 1997 (Sec.  1.446-1(e)(3) as contained in 
the 26 CFR part 1 edition revised as of April 1, 1997).
    (4) Effective date--(i) In general. Except as provided in paragraphs 
(e)(3)(iii), (e)(4)(ii), and (e)(4)(iii) of this section, paragraph (e) 
of this section applies on or after December 30, 2003. For the 
applicability of regulations before December 30, 2003, see Sec.  1.446-
1(e) in effect prior to December 30, 2003 (Sec.  1.446-1(e) as contained 
in 26 CFR part 1 edition revised as of April 1, 2003).
    (ii) Changes involving depreciable or amortizable assets. With 
respect to paragraph (e)(2)(ii)(d) of this section, paragraph 
(e)(2)(iii) Examples 9 through 19 of this section, and the language 
``certain changes in computing depreciation or amortization (see 
paragraph (e)(2)(ii)(d) of this section)'' in the last sentence of 
paragraph (e)(2)(ii)(a) of this section--
    (A) For any change in depreciation or amortization that is a change 
in method of accounting, this section applies to such a change in method 
of accounting made by a taxpayer for a depreciable or amortizable asset 
placed in service by the taxpayer in a taxable year ending on or after 
December 30, 2003; and
    (B) For any change in depreciation or amortization that is not a 
change in method of accounting, this section applies to such a change 
made by a taxpayer for a depreciable or amortizable asset placed in 
service by the taxpayer in a taxable year ending on or after December 
30, 2003.
    (iii) Effective/applicability date for paragraph (e)(3)(i). The 
rules of paragraph (e)(3)(i) of this section apply to corporate 
reorganizations and tax-free liquidations described in section 381(a) 
that occur on or after August 31, 2011.

[T.D. 6500, 25 FR 11708, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting Sec.  
1.446-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.

[[Page 63]]



Sec.  1.446-2  Method of accounting for interest.

    (a) Applicability--(1) In general. This section provides rules for 
determining the amount of interest that accrues during an accrual period 
(other than interest described in paragraph (a)(2) of this section) and 
for determining the portion of a payment that consists of accrued 
interest. For purposes of this section, interest includes original issue 
discount and amounts treated as interest (whether stated or unstated) in 
any lending or deferred payment transaction. Accrued interest determined 
under this section is taken into account by a taxpayer under the 
taxpayer's regular method of accounting (e.g., an accrual method or the 
cash receipts and disbursements method). Application of an exception 
described in paragraph (a)(2) of this section to one party to a 
transaction does not affect the application of this section to any other 
party to the transaction.
    (2) Exceptions--(i) Interest included or deducted under certain 
other provisions. This section does not apply to interest that is taken 
into account under--
    (A) Sections 1272(a), 1275, and 163(e) (income and deductions 
relating to original issue discount);
    (B) Section 467(a)(2) (certain payments for the use of property or 
services);
    (C) Sections 1276 through 1278 (market discount);
    (D) Sections 1281 through 1283 (discount on certain short-term 
obligations);
    (E) Section 7872(a) (certain loans with below-market interest 
rates);
    (F) Section 1.1272-3 (an election by a holder to treat all interest 
on a debt instrument as original issue discount); or
    (G) Section 1.451-3(j) (special ordering rule for specified fees).
    (ii) De minimis original issue discount. This section does not apply 
to de minimis original issue discount (other than de minimis original 
issue discount treated as qualified stated interest) as determined under 
Sec.  1.1273-1(d). See Sec.  1.163-7 for the treatment of de minimis 
original issue discount by the issuer and Sec. Sec.  1.1273-1(d) and 
1.1272-3 for the treatment of de minimis original issue discount by the 
holder.
    (b) Accrual of qualified stated interest. Qualified stated interest 
(as defined in Sec.  1.1273-1(c)) accrues ratably over the accrual 
period (or periods) to which it is attributable and accrues at the 
stated rate for the period (or periods).
    (c) Accrual of interest other than qualified stated interest. 
Subject to the modifications in paragraph (d) of this section, the 
amount of interest (other than qualified stated interest) that accrues 
for any accrual period is determined under rules similar to those in the 
regulations under sections 1272 and 1275 for the accrual of original 
issue discount. The preceding sentence applies regardless of any 
contrary formula agreed to by the parties.
    (d) Modifications--(1) Issue price. The issue price of the loan or 
contract is equal to--
    (i) In the case of a contract for the sale or exchange of property 
to which section 483 applies, the amount described in Sec.  1.483-
2(a)(1)(i) or (ii), whichever is applicable;
    (ii) In the case of a contract for the sale or exchange of property 
to which section 483 does not apply, the stated principal amount; or
    (iii) In any other case, the amount loaned.
    (2) Principal payments that are not deferred payments. In the case 
of a contract to which section 483 applies, principal payments that are 
not deferred payments are ignored for purposes of determining yield and 
adjusted issue price.
    (e) Allocation of interest to payments--(1) In general. Except as 
provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each 
payment under a loan (other than payments of additional interest or 
similar charges provided with respect to amounts that are not paid when 
due) is treated as a payment of interest to the extent of the accrued 
and unpaid interest determined under paragraphs (b) and (c) of this 
section as of the date the payment becomes due.
    (2) Special rule for points deductible under section 461(g)(2). If a 
payment of points is deductible by the borrower under section 461(g)(2), 
the payment is treated by the borrower as a payment of interest.

[[Page 64]]

    (3) Allocation respected in certain small transactions. [Reserved]
    (4) Pro rata prepayments. Accrued but unpaid interest is allocated 
to a pro rata prepayment under rules similar to those for allocating 
accrued but unpaid original issue discount to a pro rata prepayment 
under Sec.  1.1275-2(f). For purposes of the preceding sentence, a pro 
rata prepayment is a payment that is made prior to maturity that--
    (i) Is not made pursuant to the contract's payment schedule; and
    (ii) Results in a substantially pro rata reduction of each payment 
remaining to be paid on the contract.
    (f) Aggregation rule. For purposes of this section, all contracts 
calling for deferred payments arising from the same transaction (or a 
series of related transactions) are treated as a single contract. This 
rule, however, generally only applies to contracts involving a single 
borrower and a single lender.
    (g) Debt instruments denominated in a currency other than the U.S. 
dollar. This section applies to a debt instrument that provides for all 
payments denominated in, or determined by reference to, the functional 
currency of the taxpayer or qualified business unit of the taxpayer 
(even if that currency is other than the U.S. dollar). See Sec.  1.988-
2(b) to determine interest income or expense for debt instruments that 
provide for payments denominated in, or determined by reference to, a 
nonfunctional currency.
    (h) Example. The following example illustrates the rules of this 
section.

    Example. Allocation of unstated interest to deferred payments. (i) 
Facts. On July 1, 1996, A sells his personal residence to B for a stated 
purchase price of $1,297,143.66. The property is not personal use 
property (within the meaning of section 1275(b)(3)) in the hands of B. 
Under the loan agreement, B is required to make two installment payments 
of $648,571.83 each, the first due on June 30, 1998, and the second due 
on June 30, 2000. Both A and B use the cash receipts and disbursements 
method of accounting and use a calendar year for their taxable year.
    (ii) Amount of unstated interest. Under section 483, the agreement 
does not provide for adequate stated interest. Thus, the loan's yield is 
the test rate of interest determined under Sec.  1.483-3. Assume that 
both A and B use annual accrual periods and that the test rate of 
interest is 9.2 percent, compounded annually. Under Sec.  1.483-2, the 
present value of the deferred payments is $1,000,000. Thus, the 
agreement has unstated interest of $297,143.66.
    (iii) First two accrual periods. Under paragraph (d)(1) of this 
section, the issue price at the beginning of the first accrual period is 
$1,000,000 (the amount described in Sec.  1.483-2(a)(1)(i)). Under 
paragraph (c) of this section, the amount of interest that accrues for 
the first accrual period is $92,000 ($1,000,000 x .092) and the amount 
of interest that accrues for the second accrual period is $100,464 
($1,092,000 x .092). Thus, $192,464 of interest has accrued as of the 
end of the second accrual period. Under paragraph (e)(1) of this 
section, the $648,571.83 payment made on June 30, 1998, is treated first 
as a payment of interest to the extent of $192,464. The remainder of the 
payment ($456,107.83) is treated as a payment of principal. Both A and B 
take the payment of interest ($192,464) into account in 1998.
    (iv) Second two accrual periods. The adjusted issue price at the 
beginning of the third accrual period is $543,892.17 ($1,092,000 + 
$100,464-$648,571.83). The amount of interest that accrues for the third 
accrual period is $50,038.08 ($543,892.17 x .092) and the amount of 
interest that accrues for the final accrual period is $54,641.58, the 
excess of the amount payable at maturity ($648,571.83), over the 
adjusted issue price at the beginning of the accrual period 
($593,930.25). As of the date the second payment becomes due, 
$104,679.66 of interest has accrued. Thus, of the $648,571.83 payment 
made on June 30, 2000, $104,679.66 is treated as interest and 
$543,892.17 is treated as principal. Both A and B take the payment of 
interest ($104,679.66) into account in 2000.

    (i) [Reserved]
    (j) Effective date. This section applies to debt instruments issued 
on or after April 4, 1994, and to lending transactions, sales, and 
exchanges that occur on or after April 4, 1994. Taxpayers, however, may 
rely on this section for debt instruments issued after December 21, 
1992, and before April 4, 1994, and for lending transactions, sales, and 
exchanges that occur after December 21, 1992, and before April 4, 1994.

[T.D. 8517, 59 FR 4804, Feb. 2, 1994, T.D. 9941, 86 FR 836, Jan. 6, 
2021; 86 FR 1256, Jan. 8, 2021]



Sec.  1.446-3  Notional principal contracts.

    (a) Table of contents. This paragraph (a) lists captioned paragraphs 
contained in Sec.  1.446-3.

               Sec.  1.446-3 Notional principal contracts.

    (a) Table of contents.
    (b) Purpose.

[[Page 65]]

    (c) Definitions and scope.
    (1) Notional principal contract.
    (i) In general.
    (ii) Excluded contracts.
    (iii) Transactions within section 475.
    (iv) Transactions within section 988.
    (2) Specified index.
    (3) Notional principal amount.
    (4) Special definitions.
    (i) Related person and party to the contract.
    (ii) Objective financial information.
    (iii) Dealer in notional principal contracts.
    (d) Taxable year of inclusion and deduction.
    (e) Periodic payments.
    (1) Definition.
    (2) Recognition rules.
    (i) In general.
    (ii) Rate set in arrears.
    (iii) Notional principal amount set in arrears.
    (3) Examples.
    (f) Nonperiodic payments.
    (1) Definition.
    (2) Recognition rules.
    (i) In general.
    (ii) General rule for swaps.
    (iii) Alternative methods for swaps.
    (A) Prepaid swaps.
    (B) Other nonperiodic swap payments.
    (iv) General rule for caps and floors.
    (v) Alternative methods for caps and floors that hedge debt 
instruments.
    (A) Prepaid caps and floors.
    (B) Other caps and floors.
    (C) Special method for collars.
    (vi) Additional methods.
    (3) Term of extendible or terminable contracts.
    (4) Examples.
    (g) Special rules.
    (1) Disguised notional principal contracts.
    (2) Hedged notional principal contracts.
    (3) Options and forwards to enter into notional principal contracts.
    (4) Swaps with significant nonperiodic payments.
    (5) Caps and floors that are significantly in-the-money. [Reserved]
    (6) Examples.
    (h) Termination payments.
    (1) Definition.
    (2) Taxable year of inclusion and deduction by original parties.
    (3) Taxable year of inclusion and deduction by assignees.
    (4) Special rules.
    (i) Assignment of one leg of a contract.
    (ii) Substance over form.
    (5) Examples.
    (i) Anti-abuse rule.
    (j) Effective date.

    (b) Purpose. The purpose of this section is to enable the clear 
reflection of the income and deductions from notional principal 
contracts by prescribing accounting methods that reflect the economic 
substance of such contracts.
    (c) Definitions and scope--(1) Notional principal contract--(i) In 
general. A notional principal contract is a financial instrument that 
provides for the payment of amounts by one party to another at specified 
intervals calculated by reference to a specified index upon a notional 
principal amount in exchange for specified consideration or a promise to 
pay similar amounts. An agreement between a taxpayer and a qualified 
business unit (as defined in section 989(a)) of the taxpayer, or among 
qualified business units of the same taxpayer, is not a notional 
principal contract because a taxpayer cannot enter into a contract with 
itself. Notional principal contracts governed by this section include 
interest rate swaps, currency swaps, basis swaps, interest rate caps, 
interest rate floors, commodity swaps, equity swaps, equity index swaps, 
and similar agreements. A collar is not itself a notional principal 
contract, but certain caps and floors that comprise a collar may be 
treated as a single notional principal contract under paragraph 
(f)(2)(v)(C) of this section. A contract may be a notional principal 
contract governed by this section even though the term of the contract 
is subject to termination or extension. Each confirmation under a master 
agreement to enter into agreements governed by this section is treated 
as a separate notional principal contract.
    (ii) Excluded contracts. A contract described in section 1256(b), a 
futures contract, a forward contract, and an option are not notional 
principal contracts. An instrument or contract that constitutes 
indebtedness under general principles of Federal income tax law is not a 
notional principal contract. An option or forward contract that entitles 
or obligates a person to enter into a notional principal contract is not 
a notional principal contract, but payments made under such an option or 
forward contract may be governed by paragraph (g)(3) of this section.
    (iii) Transactions within section 475. To the extent that the rules 
provided in paragraphs (e) and (f) of this section

[[Page 66]]

are inconsistent with the rules that apply to any notional principal 
contract that is governed by section 475 and regulations thereunder, the 
rules of section 475 and the regulations thereunder govern.
    (iv) Transactions within section 988. To the extent that the rules 
provided in this section are inconsistent with the rules that apply to 
any notional principal contract that is also a section 988 transaction 
or that is integrated with other property or debt pursuant to section 
988(d), the rules of section 988 and the regulations thereunder govern.
    (2) Specified index. A specified index is--
    (i) A fixed rate, price, or amount;
    (ii) A fixed rate, price, or amount applicable in one or more 
specified periods followed by one or more different fixed rates, prices, 
or amounts applicable in other periods;
    (iii) An index that is based on objective financial information (as 
defined in paragraph (c)(4)(ii) of this section); and
    (iv) An interest rate index that is regularly used in normal lending 
transactions between a party to the contract and unrelated persons.
    (3) Notional principal amount. For purposes of this section, a 
notional principal amount is any specified amount of money or property 
that, when multiplied by a specified index, measures a party's rights 
and obligations under the contract, but is not borrowed or loaned 
between the parties as part of the contract. The notional principal 
amount may vary over the term of the contract, provided that it is set 
in advance or varies based on objective financial information (as 
defined in paragraph (c)(4)(ii) of this section).
    (4) Special definitions--(i) Related person and party to the 
contract. A related person is a person related (within the meaning of 
section 267(b) or 707(b)(1)) to one of the parties to the notional 
principal contract or a member of the same consolidated group (as 
defined in Sec.  1.1502-1(h)) as one of the parties to the contract. For 
purposes of this paragraph (c), a related person is considered to be a 
party to the contract.
    (ii) Objective financial information. For purposes of this paragraph 
(c), objective financial information is any current, objectively 
determinable financial or economic information that is not within the 
control of any of the parties to the contract and is not unique to one 
of the parties' circumstances (such as one party's dividends, profits, 
or the value of its stock). Thus, for example, a notional principal 
amount may be based on a broadly-based equity index or the outstanding 
balance of a pool of mortgages, but not on the value of a party's stock.
    (iii) Dealer in notional principal contracts. A dealer in notional 
principal contracts is a person who regularly offers to enter into, 
assume, offset, assign, or otherwise terminate positions in notional 
principal contracts with customers in the ordinary course of a trade or 
business.
    (d) Taxable year of inclusion and deduction. For all purposes of the 
Code, the net income or net deduction from a notional principal contract 
for a taxable year is included in or deducted from gross income for that 
taxable year. The net income or net deduction from a notional principal 
contract for a taxable year equals the total of all of the periodic 
payments that are recognized from that contract for the taxable year 
under paragraph (e) of this section and all of the nonperiodic payments 
that are recognized from that contract for the taxable year under 
paragraph (f) of this section.
    (e) Periodic payments--(1) Definition. Periodic payments are 
payments made or received pursuant to a notional principal contract that 
are payable at intervals of one year or less during the entire term of 
the contract (including any extension periods provided for in the 
contract), that are based on a specified index described in paragraph 
(c)(2)(i), (iii), or (iv) of this section (appropriately adjusted for 
the length of the interval), and that are based on either a single 
notional principal amount or a notional principal amount that varies 
over the term of the contract in the same proportion as the notional 
principal amount that measures the other party's payments. Payments to 
purchase or sell a cap or a floor, however, are not periodic payments.

[[Page 67]]

    (2) Recognition rules--(i) In general. All taxpayers, regardless of 
their method of accounting, must recognize the ratable daily portion of 
a periodic payment for the taxable year to which that portion relates.
    (ii) Rate set in arrears. If the amount of a periodic payment is not 
determinable at the end of a taxable year because the value of the 
specified index is not fixed until a date that occurs after the end of 
the taxable year, the ratable daily portion of a periodic payment that 
relates to that taxable year is generally based on the specified index 
that would have applied if the specified index were fixed as of the last 
day of the taxable year. If a taxpayer determines that the value of the 
specified index as of the last day of the taxable year does not provide 
a reasonable estimate of the specified index that will apply when the 
payment is fixed, the taxpayer may use a reasonable estimate of the 
specified index each year, provided that the taxpayer (and any related 
person that is a party to the contract) uses the same method to make the 
estimate consistently from year to year and uses the same estimate for 
purposes of all financial reports to equity holders and creditors. The 
taxpayer's treatment of notional principal contracts with substantially 
similar specified indices will be considered in determining whether the 
taxpayer's estimate of the specified index is reasonable. Any difference 
between the amount that is recognized under this paragraph (e)(2)(ii) 
and the corresponding portion of the actual payment that becomes fixed 
under the contract is taken into account as an adjustment to the net 
income or net deduction from the notional principal contract for the 
taxable year during which the payment becomes fixed.
    (iii) Notional principal amount set in arrears. Rules similar to the 
rules of paragraph (e)(2)(ii) of this section apply if the amount of a 
periodic payment is not determinable at the end of a taxable year 
because the notional principal amount is not fixed until a date that 
occurs after the end of the taxable year.
    (3) Examples. The following examples illustrate the application of 
paragraph (e) of this section.

    Example 1. Accrual of periodic swap payments. (a) On April 1, 1995, 
A enters into a contract with unrelated counterparty B under which, for 
a term of five years, A is obligated to make a payment to B each April 
1, beginning April 1, 1996, in an amount equal to the London Interbank 
Offered Rate (LIBOR), as determined on the immediately preceding April 
1, multiplied by a notional principal amount of $100 million. Under the 
contract, B is obligated to make a payment to A each April 1, beginning 
April 1, 1996, in an amount equal to 8% multiplied by the same notional 
principal amount. A and B are calendar year taxpayers that use the 
accrual method of accounting. On April 1, 1995, LIBOR is 7.80%.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and both LIBOR and a fixed interest 
rate of 8% are specified indices under paragraph (c)(2) of this section. 
All of the payments to be made by A and B are periodic payments under 
paragraph (e)(1) of this section because each party's payments are based 
on a specified index described in paragraphs (c)(2)(iii) and (c)(2)(i) 
of this section, respectively, are payable at periodic intervals of one 
year or less throughout the term of the contract, and are based on a 
single notional principal amount.
    (c) Under the terms of the swap agreement, on April 1, 1996, B is 
obligated to make a payment to A of $8,000,000 (8% x $100,000,000) and A 
is obligated to make a payment to B of $7,800,000 (7.80% x 
$100,000,000). Under paragraph (e)(2)(i) of this section, the ratable 
daily portions for 1995 are the amounts of these periodic payments that 
are attributable to A's and B's taxable year ending December 31, 1995. 
The ratable daily portion of the 8% fixed leg is $6,010,929 (275 days/
366 days x $8,000,000), and the ratable daily portion of the floating 
leg is $5,860,656 (275 days/366 days x $7,800,000). The net amount for 
the taxable year is the difference between the ratable daily portions of 
the two periodic payments, or $150,273 ($6,010,929--$5,860,656). 
Accordingly, A has net income of $150,273 from this swap for 1995, and B 
has a corresponding net deduction of $150,273.
    (d) The $49,727 unrecognized balance of the $200,000 net periodic 
payment that is made on April 1, 1996, is included in A's and B's net 
income or net deduction from the contract for 1996.
    (e) If the parties had entered into the contract on February 1, 
1995, the result would not change because no portion of either party's 
obligation to make a payment under the swap relates to the period prior 
to April 1, 1995. Consequently, under paragraph (e)(2) of this section, 
neither party would accrue any income or deduction from the swap for the 
period from February 1, 1995, through March 31, 1995.

[[Page 68]]

    Example 2. Accrual of periodic swap payments by cash method 
taxpayer. (a) On April 1, 1995, C enters into a contract with unrelated 
counterparty D under which, for a period of five years, C is obligated 
to make a fixed payment to D each April 1, beginning April 1, 1996, in 
an amount equal to 8% multiplied by a notional principal amount of $100 
million. D is obligated to make semi-annual payments to C each April 1 
and October 1, beginning October 1, 1995, in an amount equal to one-half 
of the LIBOR amount as of the first day of the preceding 6-month period 
multiplied by the notional principal amount. The payments are to be 
calculated using a 30/360 day convention. C is a calendar year taxpayer 
that uses the accrual method of accounting. D is a calendar year 
taxpayer that uses the cash receipts and disbursements method of 
accounting. LIBOR is 7.80% on April 1, 1995, and 7.46% on October 1, 
1995.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and LIBOR and the fixed interest rate 
of 8% are each specified indices under paragraph (c)(2) of this section. 
All of the payments to be made by C and D are periodic payments under 
paragraph (e)(1) of this section because they are each based on 
appropriate specified indices, are payable at periodic intervals of one 
year or less throughout the term of the contract, and are based on a 
single notional principal amount.
    (c) Under the terms of the swap agreement, D pays C $3,900,000 (0.5 
x 7.8% x $100,000,000) on October 1, 1995. In addition, D is obligated 
to pay C $3,730,000 (0.5 x 7.46% x $100,000,000) on April 1, 1996. C is 
obligated to pay D $8,000,000 on April 1, 1996. Under paragraph 
(e)(2)(i) of this section, C's and D's ratable daily portions for 1995 
are the amounts of the periodic payments that are attributable to their 
taxable year ending December 31, 1995. The ratable daily portion of the 
8% fixed leg is $6,000,000 (270 days/360 days x $8,000,000), and the 
ratable daily portion of the floating leg is $5,765,000 ($3,900,000 + 
(90 days/180 days x $3,730,000)). Thus, C's net deduction from the 
contract for 1995 is $235,000 ($6,000,000--$5,765,000) and D reports 
$235,000 of net income from the contract for 1995.
    (d) The net unrecognized balance of $135,000 ($2,000,000 balance of 
the fixed leg--$1,865,000 balance of the floating leg) is included in 
C's and D's net income or net deduction from the contract for 1996.
    Example 3. Accrual of swap payments on index set in arrears. (a) The 
facts are the same as in Example 1, except that A's obligation to make 
payments based upon LIBOR is determined by reference to LIBOR on the day 
each payment is due. LIBOR is 8.25% on December 31, 1995, and 8.16% on 
April 1, 1996.
    (b) On December 31, 1995, the amount that A is obligated to pay B is 
not known because it will not become fixed until April 1, 1996. Under 
paragraph (e)(2)(ii) of this section, the ratable daily portion of the 
periodic payment from A to B for 1995 is based on the value of LIBOR on 
December 31, 1995 (unless A or B determines that the value of LIBOR on 
that day does not reasonably estimate the value of the specified index). 
Thus, the ratable daily portion of the floating leg is $6,198,770 (275 
days/366 days x 8.25% x $100,000,000), while the ratable daily portion 
of the fixed leg is $6,010,929 (275 days/366 days x $8,000,000). The net 
amount for 1995 on this swap is $187,841 ($6,198,770--$6,010,929). 
Accordingly, B has $187,841 of net income from the swap in 1995, and A 
has a net deduction of $187,841.
    (c) On April 1, 1996, A makes a net payment to B of $160,000 
($8,160,000 payment on the floating leg--$8,000,000 payment on the fixed 
leg). For purposes of determining their net income or net deduction from 
this contract for the year ended December 31, 1996, B and A must adjust 
the net income and net deduction they recognized in 1995 by $67,623 (275 
days/366 days x ($8,250,000 presumed payment on the floating leg--
$8,160,000 actual payment on the floating leg)).

    (f) Nonperiodic payments--(1) Definition. A nonperiodic payment is 
any payment made or received with respect to a notional principal 
contract that is not a periodic payment (as defined in paragraph (e)(1) 
of this section) or a termination payment (as defined in paragraph (h) 
of this section). Examples of nonperiodic payments are the premium for a 
cap or floor agreement (even if it is paid in installments), the payment 
for an off-market swap agreement, the prepayment of part or all of one 
leg of a swap, and the premium for an option to enter into a swap if and 
when the option is exercised.
    (2) Recognition rules--(i) In general. All taxpayers, regardless of 
their method of accounting, must recognize the ratable daily portion of 
a nonperiodic payment for the taxable year to which that portion 
relates. Generally, a nonperiodic payment must be recognized over the 
term of a notional principal contract in a manner that reflects the 
economic substance of the contract.
    (ii) General rule for swaps. A nonperiodic payment that relates to a 
swap must be recognized over the term of the contract by allocating it 
in accordance with the forward rates (or, in the case of a commodity, 
the forward prices) of a series of cash-settled forward contracts that 
reflect the specified index and the notional principal

[[Page 69]]

amount. For purposes of this allocation, the forward rates or prices 
used to determine the amount of the nonperiodic payment will be 
respected, if reasonable. See paragraph (f)(4) Example 7 of this 
section.
    (iii) Alternative methods for swaps. Solely for purposes of 
determining the timing of income and deductions, a nonperiodic payment 
made or received with respect to a swap may be allocated to each period 
of the swap contract using one of the methods described in this 
paragraph (f)(2)(iii). The alternative methods may not be used by a 
dealer in notional principal contracts (as defined in paragraph 
(c)(4)(iii) of this section) for swaps entered into or acquired in its 
capacity as a dealer.
    (A) Prepaid swaps. An upfront payment on a swap may be amortized by 
assuming that the nonperiodic payment represents the present value of a 
series of equal payments made throughout the term of the swap contract 
(the level payment method), adjusted as appropriate to take account of 
increases or decreases in the notional principal amount. The discount 
rate used in this calculation must be the rate (or rates) used by the 
parties to determine the amount of the nonperiodic payment. If that rate 
is not readily ascertainable, the discount rate used must be a rate that 
is reasonable under the circumstances. Under this method, an upfront 
payment is allocated by dividing each equal payment into its principal 
recovery and time value components. The principal recovery components of 
the equal payments are treated as periodic payments that are deemed to 
be made on each of the dates that the swap contract provides for 
periodic payments by the payor of the nonperiodic payment or, if none, 
on each of the dates that the swap contract provides for periodic 
payments by the recipient of the nonperiodic payment. The time value 
component is needed to compute the amortization of the nonperiodic 
payment, but is otherwise disregarded. See paragraph (f)(4) Example 5 of 
this section.
    (B) Other nonperiodic swap payments. Nonperiodic payments on a swap 
other than an upfront payment may be amortized by treating the contract 
as if it provided for a single upfront payment (equal to the present 
value of the nonperiodic payments) and a loan between the parties. The 
discount rate (or rates) used in determining the deemed upfront payment 
and the time value component of the deemed loan is the same as the rate 
(or rates) used in the level payment method. The single upfront payment 
is then amortized under the level payment method described in paragraph 
(f)(2)(iii)(A) of this section. The time value component of the loan is 
not treated as interest, but, together with the amortized amount of the 
deemed upfront payment, is recognized as a periodic payment. See 
paragraph (f)(4) Example 6 of this section. If both parties make 
nonperiodic payments, this calculation is done separately for the 
nonperiodic payments made by each party.
    (iv) General rule for caps and floors. A payment to purchase or sell 
a cap or floor must be recognized over the term of the agreement by 
allocating it in accordance with the prices of a series of cash-settled 
option contracts that reflect the specified index and the notional 
principal amount. For purposes of this allocation, the option pricing 
used by the parties to determine the total amount paid for the cap or 
floor will be respected, if reasonable. Only the portion of the purchase 
price that is allocable to the option contract or contracts that expire 
during a particular period is recognized for that period. Thus, under 
this paragraph (f)(2)(iv), straight-line or accelerated amortization of 
a cap premium is generally not permitted. See paragraph (f)(4) Examples 
1 and 2 of this section.
    (v) Alternative methods for caps and floors that hedge debt 
instruments. Solely for purposes of determining the timing of income and 
deductions, if a cap or floor is entered into primarily to reduce risk 
with respect to a specific debt instrument or group of debt instruments 
held or issued by the taxpayer, the taxpayer may amortize a payment to 
purchase or sell the cap or floor using the methods described in this 
paragraph (f)(2)(v), adjusted as appropriate to take account of 
increases or decreases in the notional principal amount. The alternative 
methods may not be used by a dealer in notional

[[Page 70]]

principal contracts (as defined in paragraph (c)(4)(iii) of this 
section) for caps or floors entered into or acquired in its capacity as 
a dealer.
    (A) Prepaid caps and floors. A premium paid upfront for a cap or a 
floor may be amortized using the ``level payment method'' described in 
paragraph (f)(2)(iii)(A) of this section. See paragraph (f)(4) Example 3 
of this section.
    (B) Other caps and floors. Nonperiodic payments on a cap or floor 
other than an upfront payment are amortized by treating the contract as 
if it provided for a single upfront payment (equal to the present value 
of the nonperiodic payments) and a loan between the parties as described 
in paragraph (f)(2)(iii)(B) of this section. Under the level payment 
method, a cap or floor premium paid in level annual installments over 
the term of the contract is effectively included or deducted from income 
ratably, in accordance with the level payments. See paragraph (f)(4) 
Example 4 of this section.
    (C) Special method for collars. A taxpayer may also treat a cap and 
a floor that comprise a collar as a single notional principal contract 
and may amortize the net nonperiodic payment to enter into the cap and 
floor over the term of the collar in accordance with the methods 
prescribed in this paragraph (f)(2)(v).
    (vi) Additional methods. The Commissioner may, by a revenue ruling 
or a revenue procedure published in the Internal Revenue Bulletin, 
provide alternative methods for allocating nonperiodic payments that 
relate to a notional principal contract to each year of the contract. 
See Sec.  601.601(d)(2)(ii)(b) of this chapter.
    (3) Term of extendible or terminable contracts. For purposes of this 
paragraph (f), the term of a notional principal contract that is subject 
to extension or termination is the reasonably expected term of the 
contract.
    (4) Examples. The following examples illustrate the application of 
paragraph (f) of this section.

    Example 1.Cap premium amortized using general rule. (a) On January 
1, 1995, when LIBOR is 8%, F pays unrelated party E $600,000 for a 
contract that obligates E to make a payment to F each quarter equal to 
one-quarter of the excess, if any, of three-month LIBOR over 9% with 
respect to a notional principal amount of $25 million. Both E and F are 
calendar year taxpayers. E provides F with a schedule of allocable 
premium amounts indicating that the cap was priced according to a 
reasonable variation of the Black-Scholes option pricing formula and 
that the total premium is allocable to the following periods:

------------------------------------------------------------------------
                                                              Pricing
                                                            allocation
------------------------------------------------------------------------
1995....................................................         $55,000
1996....................................................         225,000
1997....................................................         320,000
                                                         ---------------
                                                                $600,000
------------------------------------------------------------------------

    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and LIBOR is a specified index under 
paragraph (c)(2)(iii) of this section. Any payments made by E to F are 
periodic payments under paragraph (e)(1) of this section because they 
are payable at periodic intervals of one year or less throughout the 
term of the contract, are based on an appropriate specified index, and 
are based on a single notional principal amount. The $600,000 cap 
premium paid by F to E is a nonperiodic payment as defined in paragraph 
(f)(1) of this section.
    (c) The Black-Scholes model is recognized in the financial industry 
as a standard technique for pricing interest rate cap agreements. 
Therefore, because E has used a reasonable option pricing model, the 
schedule generated by E is consistent with the economic substance of the 
cap, and may be used by both E and F for calculating their ratable daily 
portions of the cap premium. Under paragraph (f)(2)(iv) of this section, 
E recognizes the ratable daily portion of the cap premium as income, and 
F recognizes the ratable daily portion of the cap premium as a deduction 
based on the pricing schedule. Thus, E and F account for the contract as 
follows:

------------------------------------------------------------------------
                                                           Ratable daily
                                                              portion
------------------------------------------------------------------------
1995....................................................         $55,000
1996....................................................         225,000
1997....................................................         320,000
                                                         ---------------
                                                                $600,000
------------------------------------------------------------------------

    (d) Any periodic payments under the cap agreement (that is, payments 
that E makes to F because LIBOR exceeds 9%) are included in the parties' 
net income or net deduction from the contract in accordance with 
paragraph (e)(2) of this section.
    Example 2. Cap premium allocated to proper period. (a) The facts are 
the same as in Example 1, except that the cap is purchased by F on 
November 1, 1994. The first determination

[[Page 71]]

date under the cap agreement is January 31, 1995 (the last day of the 
first quarter to which the contract relates). LIBOR is 9.1% on December 
31, 1994, and is 9.15% on January 31, 1995.
    (b) E and F recognize $9,192 (61 days/365 days x $55,000) as the 
ratable daily portion of the nonperiodic payment for 1994, and include 
that amount in their net income or net deduction from the contract for 
1994. If E's pricing model allocated the cap premium to each quarter 
covered by the contract, the ratable daily portion would be 61 days/92 
days times the premium allocated to the first quarter.
    (c) Under paragraph (e)(2)(ii) of this section, E and F calculate 
the payments using LIBOR as of December 31, 1994. F recognizes as income 
the ratable daily portion of the presumed payment, or $4,144 (61 days/92 
days x .25 x .001 x $25,000,000). Thus, E reports $5,048 of net income 
from the contract for 1994 ($9,192-$4,144), and F reports a net 
deduction from the contract of $5,048.
    (d) On January 31, 1995, E pays F $9,375 (.25 x .0015 x $25,000,000) 
under the terms of the cap agreement. For purposes of determining their 
net income or net deduction from this contract for the year ended 
December 31, 1995, E and F must adjust their respective net income and 
net deduction from the cap by $2,072 (61 days/92 days x ($9,375 actual 
payment under the cap on January 31, 1995--$6,250 presumed payment under 
the cap on December 31, 1994)).
    Example 3. Cap premium amortized using alternative method. (a) The 
facts are the same as in Example 1, except that the cap provides for 
annual payments by E and is entered into by F primarily to reduce risk 
with respect to a debt instrument issued by F. F elects to amortize the 
cap premium using the alternative level payment method provided under 
paragraph (f)(2)(v)(A) of this section. Under that method, F amortizes 
the cap premium by assuming that the $600,000 is repaid in 3 equal 
annual payments of $241,269, assuming a discount rate of 10%. Each 
payment is divided into a time value component and a principal 
component, which are set out below.

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                           Level payment        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................           $241,269            $60,000           $181,269
1996...................................................            241,269             41,873            199,396
1997...................................................            241,269             21,934            219,335
                                                        --------------------------------------------------------
                                                                  $723,807           $123,807           $600,000
----------------------------------------------------------------------------------------------------------------

    (b) The net of the ratable daily portions of the principal component 
and the payments, if any, received from E comprise F's annual net income 
or net deduction from the cap. The time value components are needed only 
to compute the ratable daily portions of the cap premium, and are 
otherwise disregarded.
    Example 4. Cap premium paid in level installments and amortized 
using alternative method. (a) The facts are the same as in Example 3, 
except that F agrees to pay for the cap in three level installments of 
$241,269 (a total of $723,807) on December 31, 1995, 1996, and 1997. The 
present value of three payments of $241,269, discounted at 10%, is 
$600,000. For purposes of amortizing the cap premium under the 
alternative method provided in paragraph (f)(2)(v)(B) of this section, F 
is treated as paying $600,000 for the cap on January 1, 1995, and 
borrowing $600,000 from E that will be repaid in three annual 
installments of $241,269. The time value component of the loan is 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                            Loan balance        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................           $600,000            $60,000           $181,269
1996...................................................            418,731             41,873            199,396
1997...................................................            219,335             21,934            219,335
                                                                           -------------------------------------
                                                         .................           $123,807           $600,000
----------------------------------------------------------------------------------------------------------------

    (b) F is treated as making periodic payments equal to the amortized 
principal components from a $600,000 cap paid in advance (as described 
in Example 3), increased by the time value components of the $600,000 
loan, which totals $241,269 each year. The time value components of the 
$600,000 loan are included in the periodic payments made by F, but are 
not characterized as interest income or expense. The effect of the 
alternative method in this situation is to allow F to amortize the cap 
premium in level installments, the same way it is paid. The net of the 
ratable daily portions of F's deemed periodic payments and the payments, 
if any, received

[[Page 72]]

from E comprise F's annual net income or net deduction from the cap.
    Example 5. Upfront interest rate swap payment amortized using 
alternative method. (a) On January 1, 1995, G enters into an interest 
rate swap agreement with unrelated counterparty H under which, for a 
term of five years, G is obligated to make annual payments at 11% and H 
is obligated to make annual payments at LIBOR on a notional principal 
amount of $100 million. At the time G and H enter into this swap 
agreement, the rate for similar on-market swaps is LIBOR to 10%. To 
compensate for this difference, on January 1, 1995, H pays G a yield 
adjustment fee of $3,790,786. G provides H with information that 
indicates that the amount of the yield adjustment fee was determined as 
the present value, at 10% compounded annually, of five annual payments 
of $1,000,000 (1% x $100,000,000). G and H are calendar year taxpayers.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section. The yield adjustment fee is a 
nonperiodic payment as defined in paragraph (f)(1) of this section.
    (c) Under the alternative method described in paragraph 
(f)(2)(iii)(A) of this section, the yield adjustment fee is recognized 
over the life of the agreement by assuming that the $3,790,786 is repaid 
in five level payments. Assuming a constant yield to maturity and annual 
compounding at 10%, the ratable daily portions are computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                           Level payment        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................         $1,000,000           $379,079           $620,921
1996...................................................          1,000,000            316,987            683,013
1997...................................................          1,000,000            248,685            751,315
1998...................................................          1,000,000            173,554            826,446
1999...................................................          1,000,000             90,909            909,091
                                                        --------------------------------------------------------
                                                                $5,000,000         $1,209,214         $3,790,786
----------------------------------------------------------------------------------------------------------------

    (d) G also makes swap payments to H at 11%, while H makes swap 
payments to G based on LIBOR. The net of the ratable daily portions of 
the 11% payments by G, the LIBOR payments by H, and the principal 
component of the yield adjustment fee paid by H determines the annual 
net income or net deduction from the contract for both G and H. The time 
value components are needed only to compute the ratable daily portions 
of the yield adjustment fee paid by H, and are otherwise disregarded.
    Example 6. Backloaded interest rate swap payment amortized using 
alternative method. (a) The facts are the same as in Example 5, but H 
agrees to pay G a yield adjustment fee of $6,105,100 on December 31, 
1999. Under the alternative method in paragraph (f)(2)(iii)(B) of this 
section, H is treated as paying a yield adjustment fee of $3,790,786 
(the present value of $6,105,100, discounted at a 10% rate with annual 
compounding) on January 1, 1995. Solely for timing purposes, H is 
treated as borrowing $3,790,786 from G. Assuming annual compounding at 
10%, the time value component is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                Time value         Principal
                                                            Loan balance        component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................         $3,790,786           $379,079                  0
1996...................................................          4,169,865            416,987                  0
1997...................................................          4,586,852            458,685                  0
1998...................................................          5,045,537            504,554                  0
1999...................................................          5,550,091            555,009          6,105,100
----------------------------------------------------------------------------------------------------------------

    (b) The amortization of H's yield adjustment fee is equal to the 
amortization of a yield adjustment fee of $3,790,786 paid in advance (as 
described in Example 5), increased by the time value component of the 
$3,790,786 deemed loan from G to H. Thus, the amount of H's yield 
adjustment fee that is allocated to 1995 is $1,000,000 ($620,921 + 
$379,079). The time value components of the $3,790,786 loan are included 
in the periodic payments paid by H, but are not characterized as 
interest income or expense. The net of the ratable daily portions of the 
11% swap payments by G, and the LIBOR payments by H, added to the 
principal components from Example 5 and the time value components from 
this Example 6, determines the annual net income or net deduction from 
the contract for both G and H.
    Example 7. Nonperiodic payment on a commodity swap amortized under 
general rule. (a) On January 1, 1995, I enters into a commodity swap 
agreement with unrelated counterparty J under which, for a term of

[[Page 73]]

three years, I is obligated to make annual payments based on a fixed 
price of $2.35 per bushel times a notional amount of 100,000 bushels of 
corn and J is obligated to make annual payments equal to the spot price 
times the same notional amount. Assume that on January 1, 1995, the 
price of a one year forward for corn is $2.40 per bushel, of a two year 
forward $2.55 per bushel, and of a 3 year forward $2.75 per bushel. To 
compensate for the below-market fixed price provided in the swap 
agreement, I pays J $53,530 for entering into the swap. I and J are 
calendar year taxpayers.
    (b) This contract is a notional principal contract as defined by 
paragraph (c)(1) of this section, and $2.35 and the spot price of corn 
are specified indices under paragraphs (c)(2)(i) and (iii) of this 
section, respectively. The $53,530 payment is a nonperiodic payment as 
defined by paragraph (f)(1) of this section.
    (c) Assuming that I does not use the alternative methods provided 
under paragraph (f)(2)(iii) of this section, paragraph (f)(2)(ii) of 
this section requires that I recognize the nonperiodic payment over the 
term of the agreement by allocating the payment to each forward contract 
in accordance with the forward price of corn. Solely for timing 
purposes, I treats the $53,530 nonperiodic payment as a loan that J will 
repay in three installments of $5,000, $20,000, and $40,000, the 
expected payouts on the in-the-money forward contracts. With annual 
compounding at 8%, the ratable daily portions are computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                          Expected forward      Time value         Principal
                                                              payment           component          component
----------------------------------------------------------------------------------------------------------------
1995...................................................             $5,000             $4,282               $718
1996...................................................             20,000              4,225             15,775
1997...................................................             40,000              2,963             37,037
                                                        --------------------------------------------------------
                                                                   $65,000            $11,470            $53,530
----------------------------------------------------------------------------------------------------------------

    (d) The ratable daily portion of the principal component is added to 
I's periodic payments in computing its net income or net deduction from 
the notional principal contract for each taxable year. The time value 
components are needed only to compute the principal components, and are 
otherwise disregarded.

    (g) Special rules--(1) Disguised notional principal contracts. The 
Commissioner may recharacterize all or part of a transaction (or series 
of transactions) if the effect of the transaction (or series of 
transactions) is to avoid the application of this section.
    (2) Hedged notional principal contracts. If a taxpayer, either 
directly or through a related person (as defined in paragraph (c)(4)(i) 
of this section), reduces risk with respect to a notional principal 
contract by purchasing, selling, or otherwise entering into other 
notional principal contracts, futures, forwards, options, or other 
financial contracts (other than debt instruments), the taxpayer may not 
use the alternative methods provided in paragraphs (f)(2)(iii) and (v) 
of this section. Moreover, where such positions are entered into to 
avoid the appropriate timing or character of income from the contracts 
taken together, the Commissioner may require that amounts paid to or 
received by the taxpayer under the notional principal contract be 
treated in a manner that is consistent with the economic substance of 
the transaction as a whole.
    (3) Options and forwards to enter into notional principal contracts. 
An option or forward contract that entitles or obligates a person to 
enter into a notional principal contract is subject to the general rules 
of taxation for options or forward contracts. Any payment with respect 
to the option or forward contract is treated as a nonperiodic payment 
for the underlying notional principal contract under the rules of 
paragraphs (f) and (g)(4) or (g)(5) of this section if and when the 
underlying notional principal contract is entered into.
    (4) Swaps with significant nonperiodic payments--(i) General rule. 
Except as provided in paragraph (g)(4)(ii) of this section, a swap with 
significant nonperiodic payments is treated as two separate transactions 
consisting of an on-market, level payment swap and a loan. The loan must 
be accounted for by the parties to the contract independently of the 
swap. The time value component associated with the loan, determined in 
accordance with paragraph (f)(2)(iii)(A) of this section, is

[[Page 74]]

recognized as interest expense to the payor and interest income to the 
recipient.
    (ii) Exception for cleared swaps and non-cleared swaps subject to 
margin or collateral requirements. Paragraph (g)(4)(i) of this section 
does not apply to a swap if the contract is described in paragraph 
(g)(4)(ii)(A) or (B) of this section.
    (A) The swap is cleared by a derivatives clearing organization, as 
such term is defined in section 1a of the Commodity Exchange Act (7 
U.S.C. 1a), or by a clearing agency, as such term is defined in section 
3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c), that is 
registered as a derivatives clearing organization under the Commodity 
Exchange Act or as a clearing agency under the Securities Exchange Act 
of 1934, respectively, and the derivatives clearing organization or 
clearing agency requires the parties to the swap to post and collect 
margin or collateral.
    (B) The swap is a non-cleared swap that requires the parties to meet 
the margin or collateral requirements of a federal regulator or that 
provides for margin or collateral requirements that are substantially 
similar to a cleared swap or a non-cleared swap subject to the margin or 
collateral requirements of a federal regulator. For purposes of this 
paragraph (g)(4)(ii)(B), the term federal regulator means the Securities 
and Exchange Commission (SEC), the Commodity Futures Trading Commission 
(CFTC), or a prudential regulator, as defined in section 1a(39) of the 
Commodity Exchange Act (7 U.S.C. 1a), as amended by section 721 of the 
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 
Public Law 111-203, 124 Stat. 1376, Title VII.
    (iii) Coordination with section 163(j). For the treatment of swaps 
with significant nonperiodic payments under section 163(j), see Sec.  
1.163(j)-1(b)(22)(ii).
    (5) Caps and floors that are significantly in-the-money. [Reserved]
    (6) Examples. The following examples illustrate the application of 
paragraph (g) of this section.

    Example 1. Cap hedged with options. (a) On January 1, 1995, K sells 
to unrelated counterparty L three cash settlement European-style put 
options on Eurodollar time deposits with a strike rate of 9%. The 
options have exercise dates of January 1, 1996, January 1, 1997, and 
January 1, 1998, respectively. If LIBOR exceeds 9% on any of the 
exercise dates, L will be entitled, by exercising the relevant option, 
to receive from K an amount that corresponds to the excess of LIBOR over 
9% times $25 million. L pays K $650,000 for the three options. 
Furthermore, K is related to F, the cap purchaser in paragraph (f)(4) 
Example 1 of this section.
    (b) K's option agreements with L reduce risk with respect to F's cap 
agreement with E. Accordingly, under paragraph (g)(2) of this section, F 
cannot use the alternative methods provided in paragraph (f)(2)(v) of 
this section to amortize the premium paid under the cap agreement. F 
must amortize the cap premium it paid in accordance with paragraph 
(f)(2)(iv) of this section.
    (c) The method that E may use to account for its agreement with F is 
not affected by the application of paragraph (g)(2) of this section to 
F.
    Example 2. [Reserved]. For further guidance, see Sec.  1.446-
3T(g)(6), Example 2.
    Example 3. [Reserved]. For further guidance, see Sec.  1.446-
3T(g)(6), Example 3.
    Example 4. [Reserved]. For further guidance, see Sec.  1.446-
3T(g)(6), Example 4.

    (h) Termination payments--(1) Definition. A payment made or received 
to extinguish or assign all or a proportionate part of the remaining 
rights and obligations of any party under a notional principal contract 
is a termination payment to the party making the termination payment and 
the party receiving the payment. A termination payment includes a 
payment made between the original parties to the contract (an 
extinguishment), a payment made between one party to the contract and a 
third party (an assignment), and any gain or loss realized on the 
exchange of one notional principal contract for another. Where one party 
assigns its remaining rights and obligations to a third party, the 
original nonassigning counterparty realizes gain or loss if the 
assignment results in a deemed exchange of contracts and a realization 
event under section 1001.
    (2) Taxable year of inclusion and deduction by original parties. 
Except as otherwise provided (for example, in section 453, section 1092, 
or Sec.  1.446-4), a party to a notional principal contract recognizes a 
termination payment in the year the contract is extinguished, assigned, 
or exchanged. When the termination payment is recognized, the

[[Page 75]]

party also recognizes any other payments that have been made or received 
pursuant to the notional principal contract, but that have not been 
recognized under paragraph (d) of this section. If only a proportionate 
part of a party's rights and obligations is extinguished, assigned, or 
exchanged, then only that proportion of the unrecognized payments is 
recognized under the previous sentence.
    (3) Taxable year of inclusion and deduction by assignees. A 
termination payment made or received by an assignee pursuant to an 
assignment of a notional principal contract is recognized by the 
assignee under the rules of paragraphs (f) and (g)(4) or (g)(5) of this 
section as a nonperiodic payment for the notional principal contract 
that is in effect after the assignment.
    (4) Special rules--(i) Assignment of one leg of a contract. A 
payment is not a termination payment if it is made or received by a 
party in exchange for assigning all or a portion of one leg of a 
notional principal contract at a time when a substantially proportionate 
amount of the other leg remains unperformed and unassigned. The payment 
is either an amount loaned, an amount borrowed, or a nonperiodic 
payment, depending on the economic substance of the transaction to each 
party. This paragraph (h)(4)(i) applies whether or not the original 
notional principal contract is terminated as a result of the assignment.
    (ii) Substance over form. Any economic benefit that is given or 
received by a taxpayer in lieu of a termination payment is a termination 
payment.
    (5) Examples. The following examples illustrate the application of 
this paragraph (h). The contracts in the examples are not hedging 
transactions as defined in Sec.  1.1221-2(b), and all of the examples 
assume that no loss-deferral rules apply.

    Example 1. Termination by extinguishment. (a) On January 1, 1995, P 
enters into an interest rate swap agreement with unrelated counterparty 
Q under which, for a term of seven years, P is obligated to make annual 
payments based on 10% and Q is obligated to make semi-annual payments 
based on LIBOR and a notional principal amount of $100 million. P and Q 
are both calendar year taxpayers. On January 1, 1997, when the fixed 
rate on a comparable LIBOR swap has fallen to 9.5%, P pays Q $1,895,393 
to terminate the swap.
    (b) The payment from P to Q extinguishes the swap contract and is a 
termination payment, as defined in paragraph (h)(1) of this section, for 
both parties. Accordingly, under paragraph (h)(2) of this section, P 
recognizes a loss of $1,895,393 in 1997 and Q recognizes $1,895,393 of 
gain in 1997.
    Example 2. Termination by assignment. (a) The facts are the same as 
in Example 1, except that on January 1, 1997, P pays unrelated party R 
$1,895,393 to assume all of P's rights and obligations under the swap 
with Q. In return for this payment, R agrees to pay 10% of $100 million 
annually to Q and to receive LIBOR payments from Q for the remaining 
five years of the swap.
    (b) The payment from P to R terminates P's interest in the swap 
contract with Q and is a termination payment, as defined in paragraph 
(h)(1) of this section, for P. Under paragraph (h)(2) of this section, P 
recognizes a loss of $1,895,393 in 1997. Whether Q also has a 
termination payment with respect to the payment from P to R is 
determined under section 1001.
    (c) Under paragraph (h)(3) of this section, the assignment payment 
that R receives from P is a nonperiodic payment for an interest rate 
swap. Because the assignment payment is not a significant nonperiodic 
payment within the meaning of paragraph (g)(1) of this section, R 
amortizes the $1,895,393 over the five year term of the swap agreement 
under paragraph (f)(2) of this section.
    Example 3. Assignment of swap with yield adjustment fee. (a) The 
facts are the same as in Example 2, except that on January 1, 1995, Q 
paid P a yield adjustment fee to enter into the seven year interest rate 
swap. In accordance with paragraph (f)(2) of this section, P and Q 
included the ratable daily portions of that nonperiodic payment in their 
net income or net deduction from the contract for 1995 and 1996. On 
January 1, 1997, $300,000 of the nonperiodic payment has not yet been 
recognized by P and Q.
    (b) Under paragraph (h)(2) of this section, P recognizes a loss of 
$1,595,393 ($1,895,393-$300,000) in 1997. R accounts for the termination 
payment in the same way it did in Example 2; the existence of an 
unamortized payment with respect to the original swap has no effect on 
R.
    Example 4. Assignment of one leg of a swap. (a) On January 1, 1995, 
S enters into an interest rate swap agreement with unrelated 
counterparty T under which, for a term of five years, S will make annual 
payments at 10% and T will make annual payments at LIBOR on a notional 
principal amount of $50 million. On January 1, 1996, unrelated party U 
pays T $15,849,327 for the right to receive the four remaining 
$5,000,000 payments from S. Under the terms of the agreement between

[[Page 76]]

S and T, S is notified of this assignment, and S is contractually bound 
thereafter to make its payments to U on the appropriate payment dates. 
S's obligation to pay U is conditioned on T making its LIBOR payment to 
S on the appropriate payment dates.
    (b) Because T has assigned to U its rights to the fixed rate 
payments, but not its floating rate obligations under the notional 
principal contract, U's payment to T is not a termination payment as 
defined in paragraph (h)(1) of this section, but is covered by paragraph 
(h)(4)(i) of this section. The economic substance of the transaction 
between T and U is a loan that does not affect the way that S and T 
account for the notional principal contract under this section.

    (i) Anti-abuse rule. If a taxpayer enters into a transaction with a 
principal purpose of applying the rules of this section to produce a 
material distortion of income, the Commissioner may depart from the 
rules of this section as necessary to reflect the appropriate timing of 
income and deductions from the transaction.
    (j)(1) Effective/applicability date. These regulations are effective 
for notional principal contracts entered into on or after December 13, 
1993.
    (2) The rules provided in paragraph (g)(4) of this section apply to 
notional principal contracts entered into on or after September 14, 
2021. Taxpayers may choose to apply the rules provided in paragraph 
(g)(4) of this section to notional principal contracts entered into 
before September 14, 2021.

[T.D. 8491, 58 FR 53128, Oct. 14, 1993; 59 FR 9411, Feb. 28, 1994, as 
amended by T.D. 8554, 59 FR 36358, July 18, 1994; T.D. 9719, 80 FR 
26440, May 8, 2015; 80 FR 34051, June 15, 2015; T.D. 9905, 85 FR 56839, 
Sept. 14, 2020]



Sec.  1.446-3T  Notional principal contracts (temporary).

    (a) through (g)(3) [Reserved]. For further guidance, see Sec.  
1.446-3(a) through (g)(3).
    (4) Notional principal contracts with nonperiodic payments--(i) 
General rule. Except as provided in paragraph (g)(4)(ii) of this 
section, a notional principal contract with one or more nonperiodic 
payments is treated as two separate transactions consisting of an on-
market, level payment swap and one or more loans. The loan(s) must be 
accounted for by the parties to the contract independently of the swap. 
The time value component associated with the loan(s) is not included in 
the net income or net deduction from the swap under Sec.  1.446-3(d), 
but it is recognized as interest for all purposes of the Internal 
Revenue Code. See paragraph (g)(6) Example 2 of this section.
    (ii) Exceptions--(A) Notional principal contract with a term of one 
year or less--(1) General rule. Except for purposes of sections 514 and 
956, paragraph (g)(4)(i) of this section does not apply to a notional 
principal contract if the term of the contract is one year or less. For 
purposes of this paragraph (g)(4)(ii)(A), the term of a notional 
principal contract is the stated term of the contract, inclusive of any 
extensions (optional or otherwise) provided for in the terms of the 
contract, without regard to whether any extension is unilateral, is 
subject to approval by one or both parties to the contract, or is based 
on the occurrence or non-occurrence of a specified event.
    (2) Anti-abuse rule. For purposes of determining the term of a 
contract under paragraph (g)(4)(ii)(A)(1) of this section, the 
Commissioner may treat two or more contracts as a single contract if a 
principal purpose of entering into separate contracts is to qualify for 
the exception set forth in paragraph (g)(4)(ii)(A)(1) of this section. A 
purpose may be a principal purpose even though it is outweighed by other 
purposes (taken together or separately).
    (B) Notional principal contract subject to margin or collateral 
requirements. Subject to the requirements in paragraph (g)(4)(ii)(C) of 
this section, paragraph (g)(4)(i) of this section does not apply to a 
notional principal contract if the contract is described in paragraph 
(g)(4)(ii)(B)(1) or (2) of this section. See Sec.  1.956-2T(b)(1)(xi) 
for a related exception under section 956.
    (1) The contract is cleared by a derivatives clearing organization 
(as such term is defined in section 1a of the Commodity Exchange Act (7 
U.S.C. 1a)) or by a clearing agency (as such term in defined in section 
3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)) that is 
registered as a derivatives clearing organization under the Commodity 
Exchange Act or as a clearing agency under the Securities Exchange Act 
of 1934, respectively, and the derivatives clearing organization or

[[Page 77]]

clearing agency requires the parties to the contract to post and collect 
margin or collateral to fully collateralize the mark-to-market exposure 
on the contract (including the exposure on the nonperiodic payment) on a 
daily basis for the entire term of the contract. The mark-to-market 
exposure on a contract will be fully collateralized only if the contract 
is subject to both initial variation margin in an amount equal to the 
nonperiodic payment (except for variances permitted by intraday price 
changes) and daily variation margin in an amount equal to the daily 
change in the fair market value of the contract. See paragraph (g)(6) 
Example 3 of this section.
    (2) The parties to the contract are required, pursuant to the terms 
of the contract or the requirements of a federal regulator, to post and 
collect margin or collateral to fully collateralize the mark-to-market 
exposure on the contract (including the exposure on the nonperiodic 
payment) on a daily basis for the entire term of the contract. The mark-
to-market exposure on a contract will be fully collateralized only if 
the contract is subject to both initial variation margin or collateral 
in an amount equal to the nonperiodic payment (except for variances 
permitted by intraday price changes) and daily variation margin or 
collateral in an amount equal to the daily change in the fair market 
value of the contract. For purposes of this paragraph (g)(4)(ii)(B)(2), 
the term ``federal regulator'' means the Securities and Exchange 
Commission (SEC), Commodity Futures Trading Commission (CFTC), or a 
prudential regulator, as defined in section 1a(39) of the Commodity 
Exchange Act (7 U.S.C. 1a), as amended by section 721 of the Dodd-Frank 
Act. See paragraph (g)(6) Example 4 of this section.
    (C) Limitations and special rules--(1) Cash requirement. A notional 
principal contract is described in paragraph (g)(4)(ii)(B) of this 
section only to the extent the parties post and collect margin or 
collateral to fully collateralize the mark-to-market exposure on the 
contract (including the exposure on the nonperiodic payment) by paying 
and receiving the required margin or collateral in cash. The term 
``cash'' includes U.S. dollars or cash in any currency in which payment 
obligations under the notional principal contract are denominated.
    (2) Excess margin or collateral. For purposes of paragraph 
(g)(4)(ii)(B)(2) of this section, if the amount of cash margin or 
collateral posted and collected is in excess of the amount necessary to 
fully collateralize the mark-to-market exposure on the contract 
(including the exposure on the nonperiodic payment) on a daily basis for 
the entire term of the contract, any excess is subject to the rule in 
paragraph (g)(4)(i) of this section.
    (3) Margin or collateral paid and received in cash and other 
property. If the parties to the contract post and collect both cash and 
other property to satisfy margin or collateral requirements to 
collateralize the mark-to-market exposure on the contract (including the 
exposure on the nonperiodic payment), any excess of the nonperiodic 
payment over the cash margin or collateral posted and collected is 
subject to the rule in paragraph (g)(4)(i) of this section.
    (5) [Reserved]. For further guidance, see Sec.  1.446-3(g)(5).
    (6) Examples through Example 1. [Reserved]. For further guidance, 
see Sec.  1.446-3(g)(6), Examples through Example 1.

    Example 2. Nonperiodic payment. (i) On January 1, 2016, unrelated 
parties M and N enter into an interest rate swap contract. Under the 
terms of the contract, N agrees to make five annual payments to M equal 
to LIBOR times a notional principal amount of $100 million. In return, M 
agrees to pay N 6% of $100 million annually, plus an upfront payment of 
$15,163,147 on January 1, 2016. At the time M and N enter into the 
contract, the rate for similar on-market swaps is LIBOR to 10%, and N 
provides M with information that the amount of the upfront payment was 
determined as the present value, at 10% compounded annually, of five 
annual payments from M to N of $4,000,000 (4% of $100,000,000). The 
contract does not require the parties to post and collect margin or 
collateral to collateralize the mark-to-market exposure on the contract 
on a daily basis for the entire term of the contract.
    (ii) The exceptions in paragraphs (g)(4)(ii)(A) and (B) of this 
section do not apply. Under paragraph (g)(4)(i) of this section, the 
transaction is recharacterized as consisting of both a $15,163,147 loan 
from M to N that N repays in installments over the

[[Page 78]]

term of the contract and an interest rate swap between M and N in which 
M immediately pays the installment payments on the loan back to N as 
part of its fixed payments on the swap in exchange for the LIBOR 
payments by N.
    (iii) The upfront payment is recognized over the life of the 
contract by treating the $15,163,147 as a loan that will be repaid with 
level payments over five years. Assuming a constant yield to maturity 
and annual compounding at 10%, M and N account for the principal and 
interest on the loan as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                 Interest          Principal
                                                           Level payment        component          component
----------------------------------------------------------------------------------------------------------------
2016...................................................         $4,000,000         $1,516,315         $2,483,685
2017...................................................          4,000,000          1,267,946          2,732,054
2018...................................................          4,000,000            994,741          3,005,259
2019...................................................          4,000,000            694,215          3,305,785
2020...................................................          4,000,000            363,636          3,636,364
                                                        --------------------------------------------------------
                                                                20,000,000          4,836,853         15,163,147
----------------------------------------------------------------------------------------------------------------

    (iv) M recognizes interest income, and N claims an interest 
deduction, each taxable year equal to the interest component of the 
deemed installment payments on the loan. These interest amounts are not 
included in the parties' net income or net deduction from the swap 
contract under Sec.  1.446-3(d). The principal components are needed 
only to compute the interest component of the level payment for the 
following period and do not otherwise affect the parties' net income or 
net deduction from this contract.
    (v) N also makes swap payments to M based on LIBOR and receives swap 
payments from M at a fixed rate that is equal to the sum of the stated 
fixed rate and the rate calculated by dividing the deemed level annual 
payments on the loan by the notional principal amount. Thus, the fixed 
rate on this swap is 10%, which is the sum of the stated rate of 6% and 
the rate calculated by dividing the annual loan payment of $4,000,000 by 
the notional principal amount of $100,000,000, or 4%. Using the methods 
provided in Sec.  1.446-3(e)(2), the fixed swap payments from M to N of 
$10,000,000 (10% of $100,000,000) and the LIBOR swap payments from N to 
M are included in the parties' net income or net deduction from the 
contract for each taxable year.
    Example 3. Full margin--cleared contract. (i) A, a domestic 
corporation enters into an interest rate swap contract with unrelated 
counterparty B. The contract is required to be cleared and is accepted 
for clearing by a U.S.-registered derivatives clearing organization 
(DCO). The standardized terms of the contract provide that A, for a term 
of X years, will pay B a fixed coupon of 1% per year and receive a 
floating coupon on a notional principal amount of $Y. When A and B enter 
into the interest rate swap, the market coupon for similar interest rate 
swaps is 2% per year. The DCO requires A to make an upfront payment to 
compensate B for the below-market annual coupon payments that B will 
receive, and A makes the upfront payment in cash. The DCO also requires 
B to post initial variation margin in an amount equal to the upfront 
payment and requires each party to post and collect daily variation 
margin in an amount equal to the change in the fair market value of the 
contract on a daily basis for the entire term of the contract. B posts 
the initial variation margin in U.S. dollars, and the parties post and 
collect daily variation margin in U.S. dollars.
    (ii) Because the contract is subject to initial variation margin in 
an amount equal to the upfront payment and daily variation margin in an 
amount equal to the change in the fair market value of the contract on a 
daily basis for the entire term of the contract, the contract is 
described in paragraph (g)(4)(ii)(B)(1) of this section and paragraph 
(g)(4)(i) of this section does not apply to the contract.
    Example 4. Full margin--uncleared contract. (i) On June 1, 2016, P, 
a domestic corporation, enters into an interest rate swap contract with 
an unrelated domestic counterparty, CP. Under the terms of the contract, 
CP agrees to make five annual payments to P equal to a specified 
contract rate of 3% times the notional amount of $10,000,000 plus an 
upfront payment of $1,878,030. In exchange, P agrees to make five annual 
payments to CP equal to the same notional amount times LIBOR. At the 
time the parties enter into the contract, the fixed rate for an on-
market swap is 7.52%. The contract is not required to be cleared and is 
not accepted for clearing by a U.S.-registered derivatives clearing 
organization. However, pursuant to the terms of the contract, P is 
obligated to post $1,878,030 as collateral with CP, and P and CP are 
obligated to post and collect collateral each business day in an amount 
equal to the daily change in the fair market value of the contract for 
the entire term of the contract. All

[[Page 79]]

collateral on the contract is required to be in U.S. dollars.
    (ii) Because the contract is required to be collateralized in an 
amount equal to the upfront payment and changes in the fair market value 
of the contract on a daily basis for the entire term of the contract, 
the contract is described in paragraph (g)(4)(ii)(B)(2) of this section 
and paragraph (g)(4)(i) of this section does not apply to the contract.

    (h) through (j)(1) [Reserved]. For further guidance, see Sec.  
1.446-3(h) through (j)(1).
    (2) Application of Sec.  1.446-3T(g)(4). Paragraph (g)(4)(i) of this 
section and paragraph (g)(6) Example 2 of this section apply to notional 
principal contracts entered into on or after the later of January 1, 
2017, or 180 days after the date of publication of the Treasury decision 
adopting these rules as final regulations in the Federal Register. 
Paragraph (g)(4)(ii) of this section applies to notional principal 
contracts entered into on or after May 8, 2015. However, before the 
later of January 1, 2017, or 180 days after the date of publication of 
the Treasury decision adopting paragraph (g)(4)(i) of this section as 
final regulations in the Federal Register, taxpayers may rely on the 
provision in Sec.  1.446-3(g)(4), as contained in 26 CFR part 1, revised 
April 1, 2015, which (except for purposes of section 956) limits the 
application of the embedded loan rule to nonperiodic payments that are 
significant, even if the requirements for the exceptions in paragraph 
(g)(4)(ii) of this section are not met. Taxpayers may apply paragraph 
(g)(4)(i) of this section, paragraph (g)(4)(ii) of this section, or both 
to notional principal contracts entered into before the dates set forth 
in this paragraph (j)(2).
    (k) Expiration date. The applicability of paragraph (g)(4) of this 
section and paragraph (g)(6) Examples 2, 3 and 4 of this section expires 
May 7, 2018.

[T.D. 9719, 80 FR 26440, May 8, 2015, as amended by 80 FR 61308, Oct. 
13, 2015]



Sec.  1.446-4  Hedging transactions.

    (a) In general. Except as provided in this paragraph (a), a hedging 
transaction as defined in Sec.  1.1221-2(b) (whether or not the 
character of gain or loss from the transaction is determined under Sec.  
1.1221-2) must be accounted for under the rules of this section. To the 
extent that provisions of any other regulations governing the timing of 
income, deductions, gain, or loss are inconsistent with the rules of 
this section, the rules of this section control.
    (1) Trades or businesses excepted. A taxpayer is not required to 
account for hedging transactions under the rules of this section for any 
trade or business in which the cash receipts and disbursements method of 
accounting is used or in which Sec.  1.471-6 is used for inventory 
valuations if, for all prior taxable years ending on or after September 
30, 1993, the taxpayer met the $5,000,000 gross receipts test of section 
448(c) (or would have met that test if the taxpayer were a corporation 
or partnership). A taxpayer not required to use the rules of this 
section may nonetheless use a method of accounting that is consistent 
with these rules.
    (2) Coordination with other sections. This section does not apply 
to--
    (i) Any position to which section 475(a) applies;
    (ii) An integrated transaction subject to Sec.  1.1275-6;
    (iii) Any section 988 hedging transaction if the transaction is 
integrated under Sec.  1.988-5 or if other regulations issued under 
section 988(d) (or an advance ruling described in 1.988-5(e)) govern 
when gain or loss from the transaction is taken into account; or
    (iv) The determination of the issuer's yield on an issue of tax-
exempt bonds for purposes of the arbitrage restrictions to which Sec.  
1.148-4(h) applies.
    (b) Clear reflection of income. The method of accounting used by a 
taxpayer for a hedging transaction must clearly reflect income. To 
clearly reflect income, the method used must reasonably match the timing 
of income, deduction, gain, or loss from the hedging transaction with 
the timing of income, deduction, gain, or loss from the item or items 
being hedged. Taking gains and losses into account in the period in 
which they are realized may clearly reflect income in the case of 
certain hedging transactions. For example, where a hedge and the item 
being hedged are disposed of in the same taxable year, taking realized 
gain or loss into account on both items in that taxable year may clearly 
reflect

[[Page 80]]

income. In the case of many hedging transactions, however, taking gains 
and losses into account as they are realized does not result in the 
matching required by this section.
    (c) Choice of method and consistency. For any given type of hedging 
transaction, there may be more than one method of accounting that 
satisfies the clear reflection requirement of paragraph (b) of this 
section. A taxpayer is generally permitted to adopt a method of 
accounting for a particular type of hedging transaction that clearly 
reflects the taxpayer's income from that type of transaction. See 
paragraph (e) of this section for requirements and limitations on the 
taxpayer's choice of method. Different methods of accounting may be used 
for different types of hedging transactions and for transactions that 
hedge different types of items. Once a taxpayer adopts a method of 
accounting, however, that method must be applied consistently and can 
only be changed with the consent of the Commissioner, as provided by 
section 446(e) and the regulations and procedures thereunder.
    (d) Recordkeeping requirements--(1) In general. The books and 
records maintained by a taxpayer must contain a description of the 
accounting method used for each type of hedging transaction. The 
description of the method or methods used must be sufficient to show how 
the clear reflection requirement of paragraph (b) of this section is 
satisfied.
    (2) Additional identification. In addition to the identification 
required by Sec.  1.1221-2(f), the books and records maintained by a 
taxpayer must contain whatever more specific identification with respect 
to a transaction is necessary to verify the application of the method of 
accounting used by the taxpayer for the transaction. This additional 
identification may relate to the hedging transaction or to the item, 
items, or aggregate risk being hedged. The additional identification 
must be made at the time specified in Sec.  1.1221-2(f)(2) and must be 
made on, and retained as part of, the taxpayer's books and records.
    (3) Transactions in which character of gain or loss is not 
determined under Sec.  1.1221-2. A section 988 transaction, as defined 
in section 988(c)(1), or a qualified fund, as defined in section 
988(c)(1)(E)(iii), is subject to the identification and recordkeeping 
requirements of Sec.  1.1221-2(f). See Sec.  1.1221-2(a)(4).
    (e) Requirements and limitations with respect to hedges of certain 
assets and liabilities. In the case of certain hedging transactions, 
this paragraph (e) provides guidance in determining whether a taxpayer's 
method of accounting satisfies the clear reflection requirement of 
paragraph (b) of this section. Even if these rules are satisfied, 
however, the taxpayer's method, as actually applied to the taxpayer's 
hedging transactions, must clearly reflect income by meeting the 
matching requirement of paragraph (b) of this section.
    (1) Hedges of aggregate risk--(i) In general. The method of 
accounting used for hedges of aggregate risk must comply with the 
matching requirements of paragraph (b) of this section. Even though a 
taxpayer may not be able to associate the hedging transaction with any 
particular item being hedged, the timing of income, deduction, gain, or 
loss from the hedging transaction must be matched with the timing of the 
aggregate income, deduction, gain, or loss from the items being hedged. 
For example, if a notional principal contract hedges a taxpayer's 
aggregate risk, taking into account income, deduction, gain, or loss 
under the provisions of Sec.  1.446-3 may clearly reflect income. See 
paragraph (e)(5) of this section.
    (ii) Mark-and-spread method. The following method may be appropriate 
for taking into account income, deduction, gain, or loss from hedges of 
aggregate risk:
    (A) The hedging transactions are marked to market at regular 
intervals for which the taxpayer has the necessary data, but no less 
frequently than quarterly; and
    (B) The income, deduction, gain, or loss attributable to the 
realization or periodic marking to market of hedging transactions is 
taken into account over the period for which the hedging transactions 
are intended to reduce risk. Although the period over which the hedging 
transactions are intended to reduce risk may change, the period must be

[[Page 81]]

reasonable and consistent with the taxpayer's hedging policies and 
strategies.
    (2) Hedges of items marked to market. In the case of a transaction 
that hedges an item that is marked to market under the taxpayer's method 
of accounting, marking the hedge to market clearly reflects income.
    (3) Hedges of inventory--(i) In general. If a hedging transaction 
hedges purchases of inventory, gain or loss on the hedging transaction 
may be taken into account in the same period that it would be taken into 
account if the gain or loss were treated as an element of the cost of 
inventory. Similarly, if a hedging transaction hedges sales of 
inventory, gain or loss on the hedging transaction may be taken into 
account in the same period that it would be taken into account if the 
gain or loss were treated as an element of sales proceeds. If a hedge is 
associated with a particular purchase or sales transaction, the gain or 
loss on the hedge may be taken into account when it would be taken into 
account if it were an element of cost incurred in, or sales proceeds 
from, that transaction. As with hedges of aggregate risk, however, a 
taxpayer may not be able to associate hedges of inventory purchases or 
sales with particular purchase or sales transactions. In order to match 
the timing of income, deduction, gain, or loss from the hedge with the 
timing of aggregate income, deduction, gain, or loss from the hedged 
purchases or sales, it may be appropriate for a taxpayer to account for 
its hedging transactions in the manner described in paragraph (e)(1)(ii) 
of this section, except that the gain or loss that is spread to each 
period is taken into account when it would be if it were an element of 
cost incurred (purchase hedges), or an element of proceeds from sales 
made (sales hedges), during that period.
    (ii) Alternative methods for certain inventory hedges. In lieu of 
the method described in paragraph (e)(3)(i) of this section, other 
simpler, less precise methods may be used in appropriate cases where the 
clear reflection requirement of paragraph (b) of this section is 
satisfied. For example:
    (A) Taking into account realized gains and losses on both hedges of 
inventory purchases and hedges of inventory sales when they would be 
taken into account if the gains and losses were elements of inventory 
cost in the period realized may clearly reflect income in some 
situations, but does not clearly reflect income for a taxpayer that uses 
the last-in, first-out method of accounting for the inventory; and
    (B) Marking hedging transactions to market with resulting gain or 
loss taken into account immediately may clearly reflect income even 
though the inventory that is being hedged is not marked to market, but 
only if the inventory is not accounted for under either the last-in, 
first-out method or the lower-of-cost-or-market method and only if items 
are held in inventory for short periods of time.
    (4) Hedges of debt instruments. Gain or loss from a transaction that 
hedges a debt instrument issued or to be issued by a taxpayer, or a debt 
instrument held or to be held by a taxpayer, must be accounted for by 
reference to the terms of the debt instrument and the period or periods 
to which the hedge relates. A hedge of an instrument that provides for 
interest to be paid at a fixed rate or a qualified floating rate, for 
example, generally is accounted for using constant yield principles. 
Thus, assuming that a fixed rate or qualified floating rate instrument 
remains outstanding, hedging gain or loss is taken into account in the 
same periods in which it would be taken into account if it adjusted the 
yield of the instrument over the term to which the hedge relates. For 
example, gain or loss realized on a transaction that hedged an 
anticipated fixed rate borrowing for its entire term is accounted for, 
solely for purposes of this section, as if it decreased or increased the 
issue price of the debt instrument. Similarly, gain or loss realized on 
a transaction that hedges a contingent payment on a debt instrument 
subject to Sec.  1.1275-4(c) (a contingent payment debt instrument 
issued for nonpublicly traded property) is taken into account when the 
contingent payment is taken into account under Sec.  1.1275-4(c).
    (5) Notional principal contracts. The rules of Sec.  1.446-3 govern 
the timing of income and deductions with respect to a notional principal 
contract unless, because the notional principal contract

[[Page 82]]

is part of a hedging transaction, the application of those rules would 
not result in the matching that is needed to satisfy the clear 
reflection requirement of paragraph (b) and, as applicable, (e)(4) of 
this section. For example, if a notional principal contract hedges a 
debt instrument, the method of accounting for periodic payments 
described in Sec.  1.446-3(e) and the methods of accounting for 
nonperiodic payments described in Sec.  1.446-3(f)(2)(iii) and (v) 
generally clearly reflect the taxpayer's income. The methods described 
in Sec.  1.446-3(f)(2)(ii) and (iv), however, generally do not clearly 
reflect the taxpayer's income in that situation.
    (6) Disposition of hedged asset or liability. If a taxpayer hedges 
an item and disposes of, or terminates its interest in, the item but 
does not dispose of or terminate the hedging transaction, the taxpayer 
must appropriately match the built-in gain or loss on the hedging 
transaction to the gain or loss on the disposed item. To meet this 
requirement, the taxpayer may mark the hedge to market on the date it 
disposes of the hedged item. If the taxpayer intends to dispose of the 
hedging transaction within a reasonable period, however, it may be 
appropriate to match the realized gain or loss on the hedging 
transaction with the gain or loss on the disposed item. If the taxpayer 
intends to dispose of the hedging transaction within a reasonable period 
and the hedging transaction is not actually disposed of within that 
period, the taxpayer must match the gain or loss on the hedge at the end 
of the reasonable period with the gain or loss on the disposed item. For 
purposes of this paragraph (e)(6), a reasonable period is generally 7 
days.
    (7) Recycled hedges. If a taxpayer enters into a hedging transaction 
by recycling a hedge of a particular hedged item to serve as a hedge of 
a different item, as described in Sec.  1.1221-2(d)(4), the taxpayer 
must match the built-in gain or loss at the time of the recycling to the 
gain or loss on the original hedged item, items, or aggregate risk. 
Income, deduction, gain, or loss attributable to the period after the 
recycling must be matched to the new hedged item, items, or aggregate 
risk under the principles of paragraph (b) of this section.
    (8) Unfulfilled anticipatory transactions--(i) In general. If a 
taxpayer enters into a hedging transaction to reduce risk with respect 
to an anticipated asset acquisition, debt issuance, or obligation, and 
the anticipated transaction is not consummated, any income, deduction, 
gain, or loss from the hedging transaction is taken into account when 
realized.
    (ii) Consummation of anticipated transaction. A taxpayer consummates 
a transaction for purposes of paragraph (e)(8)(i) of this section upon 
the occurrence (within a reasonable interval around the expected time of 
the anticipated transaction) of either the anticipated transaction or a 
different but similar transaction for which the hedge serves to 
reasonably reduce risk.
    (9) Hedging by members of a consolidated group--(i) General rule: 
single-entity approach. In general, a member of a consolidated group 
must account for its hedging transactions as if all of the members were 
separate divisions of a single corporation. Thus, the timing of the 
income, deduction, gain, or loss on a hedging transaction must match the 
timing of income, deduction, gain, or loss from the item or items being 
hedged. Because all of the members are treated as if they were divisions 
of a single corporation, intercompany transactions are neither hedging 
transactions nor hedged items for these purposes.
    (ii) Separate-entity election. If a consolidated group makes an 
election under Sec.  1.1221-2(e)(2), then paragraph (e)(9)(i) of this 
section does not apply. Thus, in that case, each member of the 
consolidated group must account for its hedging transactions in a manner 
that meets the requirements of paragraph (b) of this section. For 
example, the income, deduction, gain, or loss from intercompany hedging 
transactions (as defined in Sec.  1.1221-2(e)(2)(ii)) is taken into 
account under the timing rules of Sec.  1.446-4 rather than under the 
timing rules of Sec.  1.1502-13.
    (iii) Definitions. For definitions of consolidated group, divisions 
of a single corporation, intercompany transaction, and member, see 
section 1502 and the regulations thereunder.

[[Page 83]]

    (iv) Effective date. This paragraph (e)(9) applies to transactions 
entered into on or after March 8, 1996.
    (f) Type or character of income and deduction. The rules of this 
section govern the timing of income, deduction, gain, or loss on hedging 
transactions but do not affect the type or character of income, 
deduction, gain, or loss produced by the transaction. Thus, for example, 
the rules of paragraph (e)(3) of this section do not affect the 
computation of cost of goods sold or sales proceeds for a taxpayer that 
hedges inventory purchases or sales. Similarly, the rules of paragraph 
(e)(4) of this section do not increase or decrease the interest income 
or expense of a taxpayer that hedges a debt instrument or a liability.
    (g) Effective date. This section applies to hedging transactions 
entered into on or after October 1, 1994.
    (h) Consent to change methods of accounting. The Commissioner grants 
consent for a taxpayer to change its methods of accounting for 
transactions that are entered into on or after October 1, 1994, and that 
are described in paragraph (a) of this section. This consent is granted 
only for changes for the taxable year containing October 1, 1994. The 
taxpayer must describe its new methods of accounting in a statement that 
is included in its Federal income tax return for that taxable year.

[T.D. 8554, 59 FR 36358, July 18, 1994, as amended by T.D. 8653, 61 FR 
519, Jan. 8, 1996; T.D. 8674, 61 FR 30138, June 14, 1996; T.D. 8985, 67 
FR 12865, Mar. 20, 2002; 67 FR 31955, May 13, 2002]



Sec.  1.446-5  Debt issuance costs.

    (a) In general. This section provides rules for allocating debt 
issuance costs over the term of the debt. For purposes of this section, 
the term debt issuance costs means those transaction costs incurred by 
an issuer of debt (that is, a borrower) that are required to be 
capitalized under Sec.  1.263(a)-5. If these costs are otherwise 
deductible, they are deductible by the issuer over the term of the debt 
as determined under paragraph (b) of this section.
    (b) Method of allocating debt issuance costs--(1) In general. Solely 
for purposes of determining the amount of debt issuance costs that may 
be deducted in any period, these costs are treated as if they adjusted 
the yield on the debt. To effect this, the issuer treats the costs as if 
they decreased the issue price of the debt. See Sec.  1.1273-2 to 
determine issue price. Thus, debt issuance costs increase or create 
original issue discount and decrease or eliminate bond issuance premium.
    (2) Original issue discount. Any resulting original issue discount 
is taken into account by the issuer under the rules in Sec.  1.163-7, 
which generally require the use of a constant yield method (as described 
in Sec.  1.1272-1) to compute how much original issue discount is 
deductible for a period. However, see Sec.  1.163-7(b) for special rules 
that apply if the total original issue discount on the debt is de 
minimis.
    (3) Bond issuance premium. Any remaining bond issuance premium is 
taken into account by the issuer under the rules of Sec.  1.163-13, 
which generally require the use of a constant yield method for purposes 
of allocating bond issuance premium to accrual periods.
    (c) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (i) On January 1, 2004, X borrows $10,000,000. The 
principal amount of the loan ($10,000,000) is repayable on December 31, 
2008, and payments of interest in the amount of $500,000 are due on 
December 31 of each year the loan is outstanding. X incurs debt issuance 
costs of $130,000 to facilitate the borrowing.
    (ii) Under Sec.  1.1273-2, the issue price of the loan is 
$10,000,000. However, under paragraph (b) of this section, X reduces the 
issue price of the loan by the debt issuance costs of $130,000, 
resulting in an issue price of $9,870,000. As a result, X treats the 
loan as having original issue discount in the amount of $130,000 (stated 
redemption price at maturity of $10,000,000 minus the issue price of 
$9,870,000). Because this amount of original issue discount is more than 
the de minimis amount of original issue discount for the loan determined 
under Sec.  1.1273-1(d) ($125,000 ($10,000,000 x .0025 x 5)), X must 
allocate the original issue discount to each year based on the constant 
yield method described in Sec.  1.1272-1(b). See Sec.  1.163-7(a). Based 
on this method and a yield of 5.30%, compounded annually, the original 
issue discount is allocable to each year as follows: $23,385 for 2004, 
$24,625 for 2005, $25,931 for 2006, $27,306 for 2007, and $28,753 for 
2008.
    Example 2. (i) Assume the same facts as in Example 1, except that X 
incurs debt issuance costs of $120,000 rather than $130,000.
    (ii) Under Sec.  1.1273-2, the issue price of the loan is 
$10,000,000. However, under paragraph

[[Page 84]]

(b) of this section, X reduces the issue price of the loan by the debt 
issuance costs of $120,000, resulting in an issue price of $9,880,000. 
As a result, X treats the loan as having original issue discount in the 
amount of $120,000 (stated redemption price at maturity of $10,000,000 
minus the issue price of $9,880,000). Because this amount of original 
issue discount is less than the de minimis amount of original issue 
discount for the loan determined under Sec.  1.1273-1(d) ($125,000), X 
does not have to use the constant yield method described in Sec.  
1.1272-1(b) to allocate the original issue discount to each year. 
Instead, under Sec.  1.163-7(b)(2), X can choose to allocate the 
original issue discount to each year on a straight-line basis over the 
term of the loan or in proportion to the stated interest payments 
($24,000 each year). X also could choose to deduct the original issue 
discount at maturity of the loan. X makes its choice by reporting the 
original issue discount in a manner consistent with the method chosen on 
X's timely filed federal income tax return for 2004. If X wanted to use 
the constant yield method, based on a yield of 5.279%, compounded 
annually, the original issue discount is allocable to each year as 
follows: $21,596 for 2004, $22,736 for 2005, $23,937 for 2006, $25,200 
for 2007, and $26,531 for 2008.

    (d) Effective date. This section applies to debt issuance costs paid 
or incurred for debt instruments issued on or after December 31, 2003.
    (e) Accounting method changes--(1) Consent to change. An issuer 
required to change its method of accounting for debt issuance costs to 
comply with this section must secure the consent of the Commissioner in 
accordance with the requirements of Sec.  1.446-1(e). Paragraph (e)(2) 
of this section provides the Commissioner's automatic consent for 
certain changes.
    (2) Automatic consent. The Commissioner grants consent for an issuer 
to change its method of accounting for debt issuance costs incurred for 
debt instruments issued on or after December 31, 2003. Because this 
change is made on a cut-off basis, no items of income or deduction are 
omitted or duplicated and, therefore, no adjustment under section 481 is 
allowed. The consent granted by this paragraph (e)(2) applies provided--
    (i) The change is made to comply with this section;
    (ii) The change is made for the first taxable year for which the 
issuer must account for debt issuance costs under this section; and
    (iii) The issuer attaches to its federal income tax return for the 
taxable year containing the change a statement that it has changed its 
method of accounting under this section.

[T.D. 9107, 69 FR 464, Jan. 5, 2004]



Sec.  1.446-6  REMIC inducement fees.

    (a) Purpose. This section provides specific timing rules for the 
clear reflection of income from an inducement fee received in connection 
with becoming the holder of a noneconomic REMIC residual interest. An 
inducement fee must be included in income over a period reasonably 
related to the period during which the applicable REMIC is expected to 
generate taxable income or net loss allocable to the holder of the 
noneconomic residual interest.
    (b) Definitions. For purposes of this section:
    (1) Applicable REMIC. The applicable REMIC is the REMIC that issued 
the noneconomic residual interest with respect to which the inducement 
fee is paid.
    (2) Inducement fee. An inducement fee is the amount paid to induce a 
person to become the holder of a noneconomic residual interest in an 
applicable REMIC.
    (3) Noneconomic residual interest. A REMIC residual interest is a 
noneconomic residual interest if it is a noneconomic residual interest 
within the meaning of Sec.  1.860E-1(c)(2).
    (4) Remaining anticipated weighted average life. The remaining 
anticipated weighted average life is the anticipated weighted average 
life determined using the methodology set forth in Sec.  1.860E-
1(a)(3)(iv) applied as of the date of acquisition of the noneconomic 
residual interest.
    (5) REMIC. The term REMIC has the same meaning in this section as 
given in Sec.  1.860D-1.
    (c) General rule. All taxpayers, regardless of their overall method 
of accounting, must recognize an inducement fee over the remaining 
expected life of the applicable REMIC in a manner that reasonably 
reflects, without regard to this paragraph, the after-tax costs and 
benefits of holding that noneconomic residual interest.

[[Page 85]]

    (d) Special rule on disposition of a residual interest. If any 
portion of an inducement fee received with respect to becoming the 
holder of a noneconomic residual interest in an applicable REMIC has not 
been recognized in full by the holder as of the time the holder 
transfers, or otherwise ceases to be the holder for Federal tax purposes 
of, that residual interest in the applicable REMIC, then the holder must 
include the unrecognized portion of the inducement fee in income at that 
time. This rule does not apply to a transaction to which section 
381(c)(4) applies.
    (e) Safe harbors. If inducement fees are recognized in accordance 
with a method described in this paragraph (e), that method complies with 
the requirements of paragraph (c) of this section.
    (1) The book method. Under the book method, an inducement fee is 
recognized in accordance with the method of accounting, and over the 
same period, used by the taxpayer for financial reporting purposes 
(including consolidated financial statements to shareholders, partners, 
beneficiaries, and other proprietors and for credit purposes), provided 
that the inducement fee is included in income for financial reporting 
purposes over a period that is not shorter than the period during which 
the applicable REMIC is expected to generate taxable income.
    (2) The modified REMIC regulatory method. Under the modified REMIC 
regulatory method, the inducement fee is recognized ratably over the 
remaining anticipated weighted average life of the applicable REMIC as 
if the inducement fee were unrecognized gain being included in gross 
income under Sec.  1.860F-2(b)(4)(iii).
    (3) Additional safe harbor methods. The Commissioner, by revenue 
ruling or revenue procedure (see Sec.  1.601(d)(2) of this chapter), may 
provide additional safe harbor methods for recognizing inducement fees 
relating to noneconomic REMIC residual interests.
    (f) Method of accounting. The treatment of inducement fees is a 
method of accounting to which the provisions of sections 446 and 481 and 
the regulations thereunder apply. A taxpayer is generally permitted to 
adopt a method of accounting for inducement fees that satisfies the 
requirements of paragraph (c) of this section. Once a taxpayer adopts a 
method of accounting for inducement fees, that method must be applied 
consistently to all inducement fees received in connection with 
noneconomic REMIC residual interests and may be changed only with the 
consent of the Commissioner, as provided by section 446(e) and the 
regulations and procedures thereunder.
    (g) Effective date. This section is applicable for taxable years 
ending on or after May 11, 2004.

[T.D. 9128, 69 FR 26041, May 11, 2004]



Sec.  1.446-7  Net asset value method for certain money market fund shares.

    (a) In general. This section provides a permissible method of 
accounting (the net asset value method, or NAV method) for gain or loss 
on shares in a money market fund (or MMF).
    (b) Definitions. For purposes of this section--
    (1) Computation period. Computation periods are the periods (of 
either equal or varying length) that a taxpayer selects for computing 
gain and loss under the NAV method for shares in an MMF. Computation 
periods must possess all of the following attributes:
    (i) Every day during the taxable year falls within one, and only 
one, computation period;
    (ii) Each computation period contains days from only one taxable 
year; and
    (iii) If the taxpayer is a regulated investment company (RIC) that 
is not described in section 4982(f)--
    (A) The same computation periods are used for purposes of both 
income tax accounting under chapter 1 and excise tax computations under 
section 4982; and
    (B) The requirements in paragraphs (b)(1)(i) and (ii) of this 
section are also satisfied if applied by substituting the RIC's section 
4982 period for the RIC's taxable year.
    (2) Ending value. The ending value of a taxpayer's shares in an MMF 
for a computation period is the aggregate fair market value of the 
taxpayer's shares at the end of that computation period.
    (3) Fair market value. The fair market value of a share in an MMF is 
determined as follows:

[[Page 86]]

    (i) Presumption based on applicable published redemption amount. For 
purposes of this section, the fair market value of a share in an MMF is 
presumed to be the applicable published redemption amount for the share.
    (ii) Published redemption amount. The published redemption amount 
for a share in an MMF is the published amount for which the MMF would 
redeem the share (usually, the net asset value per share (NAV)), taking 
into account any corrections and not taking into account any liquidity 
fee described in Rule 2a-7(c)(2) under the Investment Company Act of 
1940 (17 CFR 270.2a-7(c)(2)).
    (iii) Applicable published redemption amount. The applicable 
published redemption amount is--
    (A) For purposes of determining the ending value of a taxpayer's 
shares in an MMF for a computation period under paragraph (b)(2) of this 
section, the last published redemption amount on the last day of that 
computation period;
    (B) For purposes of determining the value of MMF shares received in 
a redemption or exchange described in paragraph (b)(5)(ii)(A) of this 
section, the published redemption amount for such MMF shares used to 
determine the consideration received in the redemption or exchange, or 
if the consideration received is not based on a published redemption 
amount, the first published redemption amount for such MMF shares after 
the redemption or exchange;
    (C) For purposes of determining the amount received in a redemption 
or exchange described in paragraph (b)(5)(ii)(B) of this section in 
which the consideration received is based on a published redemption 
amount for the redeemed shares, that published redemption amount; and
    (D) For purposes of determining the amount received in an exchange 
described in paragraph (b)(5)(ii)(B) of this section that is not 
described in paragraph (b)(3)(iii)(C) of this section, or the amount of 
any adjustment resulting from a disposition transaction described in 
paragraph (b)(5)(iii) of this section, the first published redemption 
amount for the exchanged or disposed of MMF shares after the exchange or 
other transaction.
    (iv) Facts and circumstances determination. If there is no 
applicable published redemption amount or if circumstances indicate that 
the amount does not represent the fair market value of a share in the 
MMF, the fair market value is determined on the basis of all of the 
facts and circumstances.
    (4) Money market fund (or MMF). An MMF is a regulated investment 
company that is permitted to hold itself out to investors as a money 
market fund under Rule 2a-7 under the Investment Company Act of 1940 (17 
CFR 270.2a-7). See paragraph (c)(5) of this section for the treatment of 
shares in a single MMF held in more than one account.
    (5) Net investment--(i) In general. The net investment in an MMF for 
a computation period may be a positive amount, a negative amount, or 
zero. Except as provided in paragraph (b)(5)(iii) of this section, the 
net investment is equal to--
    (A) The aggregate cost of shares in the MMF purchased during the 
computation period (including purchases through reinvestment of 
dividends); minus
    (B) The aggregate amount received during the computation period in 
redemption of (or otherwise in exchange for) shares in the MMF in 
transactions in which gain or loss would be recognized if the taxpayer 
did not apply the NAV method to the shares.
    (ii) Aggregate amount received. For purposes of paragraph 
(b)(5)(i)(B) of this section, the amount received in a redemption or 
exchange of an MMF share is--
    (A) If no property other than cash and shares in one or more other 
MMFs is received, the amount of any cash plus the fair market value of 
any MMF shares received; or
    (B) If any property other than cash or shares in one or more other 
MMFs is received, the fair market value of the redeemed MMF share.
    (iii) Adjustments--(A) Dispositions in which gain or loss is not 
recognized. If, during the computation period, any shares in an MMF are 
disposed of in transactions in which gain or loss would not be 
recognized if the taxpayer

[[Page 87]]

did not apply the NAV method to the shares, the net investment in the 
MMF for the computation period is decreased by the fair market value of 
each such share at the time of its disposition.
    (B) Acquisitions other than by purchase. If, during the computation 
period, any shares in an MMF are acquired other than by purchase, the 
net investment in the MMF for the computation period is increased by the 
adjusted basis (for purposes of determining loss) of each such share 
immediately after its acquisition. If the adjusted basis of an acquired 
share would be determined by reference to the basis of a share or shares 
in an MMF that are being disposed of by the taxpayer in a transaction 
that is governed by paragraph (b)(5)(iii)(A) of this section, then the 
adjusted basis of each such disposed share is treated for purposes of 
this section as being the fair market value of that share at the time of 
its disposition. If the adjusted basis of an acquired share would be 
determined by reference to the basis of that share in the hands of the 
person from whom the share is acquired and that person was applying the 
NAV method to the share at the time of the transaction, then the 
adjusted basis of the share in the hands of the person from whom the 
share is acquired is treated for purposes of this section as being the 
fair market value of that share at the time of the transaction.
    (6) Section 4982 period. If a taxpayer using the NAV method is a RIC 
to which section 4982 applies, the section 4982 period is the one-year 
period with respect to which gain or loss is determined for purposes of 
section 4982(e)(2) and (e)(6). The preceding sentence is applied taking 
into account the application of section 4982(e)(4). See paragraph (c)(8) 
of this section regarding the application of section 4982(e)(6).
    (7) Starting basis. The starting basis of a taxpayer's shares in an 
MMF for a computation period is--
    (i) Except as provided in paragraph (b)(7)(ii) of this section, the 
ending value of the taxpayer's shares in the MMF for the immediately 
preceding computation period; or
    (ii) For the first computation period in a taxable year, if the 
taxpayer did not use the NAV method for shares in the MMF for the 
immediately preceding taxable year, the aggregate adjusted basis of the 
taxpayer's shares in the MMF at the end of the immediately preceding 
taxable year.
    (c) NAV method--(1) Scope. A taxpayer may use the NAV method 
described in this section to determine the gain or loss for a taxable 
year on the taxpayer's shares in an MMF. A taxpayer may have different 
methods of accounting, different computation periods, and gains or 
losses of differing character, for its shares in different MMFs. See 
paragraph (c)(5) of this section for the treatment of shares in a single 
MMF held in more than one account. See paragraph (c)(6) of this section 
for rules applicable to RICs to which section 4982 applies. See 
paragraph (c)(8) of this section for rules applicable to accounting 
method changes.
    (2) Net gain or loss for a taxable year--(i) Determination for each 
computation period. Subject to any adjustment under paragraph (c)(2)(ii) 
of this section, the net gain or loss for each computation period with 
respect to the shares in an MMF to which the NAV method applies equals 
the ending value, minus the starting basis, minus the net investment in 
the MMF for the computation period. If the computation produces a result 
that is greater than zero, the taxpayer has a gain for the computation 
period with respect to the shares in the MMF; if the computation 
produces a result that is less than zero, the taxpayer has a loss for 
the computation period with respect to the shares in the MMF; and if the 
computation produces a result that is equal to zero, the taxpayer has no 
gain or loss for the computation period with respect to the shares in 
the MMF.
    (ii) Adjustment of gain or loss to reflect any basis adjustments. 
If, during a computation period, there is any downward (or upward) 
adjustment to the taxpayer's basis in the shares in the MMF under any 
provision of internal revenue law, then the net gain or loss for the 
computation period on shares in the MMF determined under paragraph 
(c)(2)(i) of this section is increased (or decreased) by the amount of 
the adjustment.
    (iii) Timing of gains and losses. Gain or loss determined under the 
NAV method

[[Page 88]]

with respect to a taxpayer's shares in an MMF during a computation 
period is treated as arising on the last day of the computation period.
    (iv) Determination of net gain or loss for each taxable year. The 
taxpayer's net gain or loss for a taxable year on shares in an MMF is 
the sum of the net gains or losses on shares in the MMF for the 
computation period (or computation periods) that comprise the taxable 
year.
    (3) Character--(i) In the case of a taxpayer that applies the NAV 
method to shares in an MMF, the gain or loss with respect to those 
shares for a computation period is treated as gain or loss from a sale 
or exchange of a capital asset provided the sale or exchange of one or 
more of those shares during the computation period would give rise to 
capital gain or loss if the taxpayer did not apply the NAV method to the 
shares.
    (ii) In the case of a taxpayer that applies the NAV method to shares 
in an MMF, the gain or loss with respect to those shares for a 
computation period is treated as ordinary gain or loss provided the sale 
or exchange of every one of those shares during the computation period 
would give rise to ordinary gain or loss if the taxpayer did not apply 
the NAV method to the shares.
    (iii) See paragraph (c)(5) of this section for the treatment of 
shares in a single MMF held in more than one account.
    (4) Holding period. Capital gains and losses determined under the 
NAV method are treated as short-term capital gains and losses.
    (5) More than one account. If a taxpayer holds shares in an MMF 
through more than one account, the taxpayer must treat its holdings in 
each account as a separate MMF for purposes of this section. A taxpayer 
therefore may have different methods of accounting, different 
computation periods, and gains or losses of differing character, for its 
shares of a single MMF held in different accounts.
    (6) Consistency requirement for MMF shareholders that are RICs. If 
the taxpayer is a RIC that is not described in section 4982(f) (and 
therefore is subject to the section 4982 excise tax), then, for each 
MMF, the taxpayer must use the NAV method for both income tax and excise 
tax computations or for neither computation. See paragraph (c)(5) of 
this section for the treatment of shares in a single MMF held in more 
than one account. See paragraph (c)(8)(ii) of this section for changes 
to or from the NAV method by a RIC.
    (7) Treatment of ordinary gains and losses under section 4982(e)(6). 
Under section 4982(e)(6)(B), this section is a specified mark to market 
provision, and therefore any ordinary gains and losses determined under 
the NAV method are governed by section 4982(e)(6)(A).
    (8) Accounting method changes--(i) In general. A change to or from 
the NAV method is a change in method of accounting to which the 
provisions of section 446 and the accompanying regulations apply. A 
taxpayer seeking to change to or from the NAV method must secure the 
consent of the Commissioner in accordance with Sec.  1.446-1(e) and 
follow the administrative procedures issued under Sec.  1.446-
1(e)(3)(ii) for obtaining the Commissioner's consent to change the 
taxpayer's accounting method. Any such change will be made on a cut-off 
basis. Because there will be no duplication or omission of amounts as a 
result of such a change to or from the NAV method, no adjustment under 
section 481(a) will be required or permitted.
    (ii) RICs--(A) In general. A RIC that is subject to the excise tax 
under section 4982 and that changes to or from the NAV method for its 
shares in an MMF for income tax purposes must apply the new method for 
excise tax purposes starting with the first day of the RIC's income tax 
year of change. If that first day is not the first day of the RIC's 
section 4982 period that ends in or with the RIC's income tax year, then 
solely for purposes of applying the NAV method to compute the RIC's 
required distribution for the calendar year that ends with or within the 
RIC's income tax year of change, the section 4982 period is bifurcated 
into two portions, each of which is treated as a separate taxable year. 
The first portion begins on the first day of the section 4982 period and 
ends on the last day of the RIC's income tax year that precedes the year 
of change. The second portion begins on the first day of the

[[Page 89]]

income tax year of change and ends on the last day of the section 4982 
period.
    (B) Example. If a RIC that holds MMF shares as capital assets 
changes from a realization method to the NAV method for its income tax 
year ending January 31, 2019, the section 4982 period is bifurcated into 
two portions that are treated as separate taxable years solely for 
purposes of applying this section. For the portion starting on November 
1, 2017, and ending on January 31, 2018, the RIC applies its realization 
method for excise tax purposes. For the portion starting on February 1, 
2018, and ending on October 31, 2018, the RIC applies the NAV method for 
excise tax purposes, treating February 1, 2018, as the first day of the 
RIC's tax year for purposes of paragraphs (b)(1) and (6) of this 
section. The RIC's net gain or loss for this later portion is determined 
under paragraph (c)(2)(iii) of this section. This net gain or loss and 
any gains and losses for the earlier portion determined under the 
realization method are taken into account in determining the RIC's 
capital gain net income for the full one-year period described in 
section 4982(b)(1)(B).
    (d) Example. The provisions of this section may be illustrated by 
the following example:

    Example. (i) Fund is an MMF. Shareholder is a person whose taxable 
year is the calendar year. On January 1 of Year 1, Shareholder owns 
5,000,000 shares in Fund with an adjusted basis of $5,000,000.00. The 
price of Fund shares has not varied from $1.00 from the date Shareholder 
acquired the shares through January 1 of Year 1. During that period, 
Shareholder has engaged in multiple purchases and redemptions of Fund 
shares, but Shareholder has reported no gains or losses with respect to 
the shares because Shareholder realized an amount in each redemption 
equal to Shareholder's basis in the redeemed shares. During Year 1, the 
price of Fund shares begins to float. During Year 1, Shareholder 
receives $32,158.23 in taxable dividends from Fund and makes 120 
purchases of additional shares in Fund (including purchases through the 
reinvestment of those dividends) totaling $1,253,256.37 and 28 
redemptions totaling $1,124,591.71. The fair market value of 
Shareholder's shares in Fund at the end of Year 1 is $5,129,750.00. All 
of Shareholder's shares in Fund are held in a single account and as 
capital assets. There is no adjustment to the basis in Shareholder's 
shares in Fund under any provision of internal revenue law during Year 
1.
    (ii) Prior to Year 1, Shareholder has had no gains or losses to 
report with respect to the Fund shares under a realization method and no 
changes in fair market value that would have been reported under the NAV 
method. Therefore, Shareholder may use the NAV method for the shares in 
Fund for Year 1. Shareholder uses the NAV method for the shares with its 
taxable year as the computation period. Shareholder's net investment in 
Fund for Year 1 equals $128,664.66 (the $1,253,256.37 in purchases, 
minus the $1,124,591.71 in redemptions). Shareholder's Year 1 gain 
therefore is $1,085.34, which is the ending value of Shareholder's 
shares ($5,129,750.00), minus the starting basis of Shareholder's shares 
($5,000,000.00), minus Shareholder's net investment in the fund for the 
taxable year ($128,664.66). The gain of $1,085.34 is treated as short-
term capital gain. Shareholder's starting basis for Year 2 is 
$5,129,750.00. Shareholder also must include the $32,158.23 in dividends 
in its income for Year 1 in the same manner as if Shareholder did not 
use the NAV method.
    (iii) If Shareholder had instead adopted the calendar month as its 
computation period, it would have used the NAV method for every month of 
Year 1, even though prices of Fund shares may have been fixed for some 
months.

    (e) Effective/applicability date. Except as provided in the 
following sentence, this section applies to taxable years ending on or 
after July 8, 2016. For taxable years ending on or after July 28, 2014, 
and beginning before July 8, 2016, however, shareholders of MMFs may 
rely either on this section or on Sec.  1.446-7 of the 2014 proposed 
regulations REG-107012-14 (79 FR 43694).

[T.D. 9774, 81 FR 44512, July 8, 2016]



Sec.  1.448-1  Limitation on the use of the cash receipts 
and disbursements method of accounting.

    (a)-(f) [Reserved]
    (g) Treatment of accounting method change and timing rules for 
section 481(a) adjustment--(1) Treatment of change in accounting method. 
The rules provided in paragraph (g) of this section apply to taxable 
years beginning before January 1, 2018. See Sec.  1.448-2 for rules 
relating to taxable years beginning after December 31, 2017. 
Notwithstanding any other procedure published prior to January 7, 1991, 
concerning changes from the cash method, any taxpayer to whom section 
448 applies must change its method of accounting in accordance with the 
provisions of this paragraph (g) and paragraph (h) of this section. In

[[Page 90]]

the case of any taxpayer required by this section to change its method 
of accounting for any taxable year, the change shall be treated as a 
change initiated by the taxpayer. The adjustments required under section 
481(a) with respect to the change in method of accounting of such a 
taxpayer shall not be reduced by amounts attributable to taxable years 
preceding the Internal Revenue Code of 1954. Paragraph (h)(2) of this 
section provides procedures under which a taxpayer may change to an 
overall accrual method of accounting for the first taxable year the 
taxpayer is subject to this section (``first section 448 year''). If the 
taxpayer complies with the provisions of paragraph (h)(2) of this 
section for its first section 448 year, the change shall be treated as 
made with the consent of the Commissioner. Paragraph (h)(3) of this 
section provides procedures under which a taxpayer may change to other 
than an overall accrual method of accounting for its first section 448 
year. Unless the taxpayer complies with the provisions of paragraph 
(h)(2) or (h)(3) of this section for its first section 448 year, the 
taxpayer must comply with the provisions of paragraph (h)(4) of this 
section. See paragraph (h) of this section for rules to effect a change 
in method of accounting.
    (2) Timing rules for section 481(a) adjustment--(i) In general. 
Except as otherwise provided in paragraphs (g)(2)(ii) and (g)(3) of this 
section, a taxpayer required by this section to change from the cash 
method must take the net section 481(a) adjustment into account over the 
section 481(a) adjustment period as determined under the applicable 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to a change in accounting method 
(for example, see Rev. Proc. 2002-9 (2002-1 C.B. 327) and Rev. Proc. 97-
27 (1997-1 C.B. 680) (also see Sec.  601.601(d)(2) of this chapter)), 
provided the taxpayer complies with the provisions of paragraph (h)(2) 
or (3) of this section for its first section 448 year.
    (ii) Hospital timing rules--(A) In general. In the case of a 
hospital that is required by this section to change from the cash 
method, the section 481(a) adjustment shall be taken into account 
ratably (beginning with the year of change) over 10 years, provided the 
taxpayer complies with the provisions of paragraph (h)(2) or (h)(3) of 
this section for its first section 448 year.
    (B) Definition of hospital. For purposes of paragraph (g) of this 
section, a hospital is an institution--
    (1) Accredited by the Joint Commission on Accreditation of 
Healthcare Organizations or its predecessor (the JCAHO) (or accredited 
or approved by a program of the qualified governmental unit in which 
such institution is located if the Secretary of Health and Human 
Services has found that the accreditation or comparable approval 
standards of such qualified governmental unit are essentially equivalent 
to those of the JCAHO);
    (2) Used primarily to provide, by or under the supervision of 
physicians, to inpatients diagnostic services and therapeutic services 
for medical diagnosis, treatment, and care of injured, disabled, or sick 
persons;
    (3) Requiring every patient to be under the care and supervision of 
a physician; and
    (4) Providing 24-hour nursing services rendered or supervised by a 
registered professional nurse and having a licensed practical nurse or 
registered nurse on duty at all times.

For purposes of this section, an entity need not be owned by or on 
behalf of a governmental unit or by a section 501(c)(3) organization, or 
operated by a section 501(c)(3) organization, in order to be considered 
a hospital. In addition, for purposes of this section, a hospital does 
not include a rest or nursing home, continuing care facility, daycare 
center, medical school facility, research laboratory, or ambulatory care 
facility.
    (C) Dual function facilities. With respect to any taxpayer whose 
operations consist both of a hospital, and other facilities not 
qualifying as a hospital, the portion of the adjustment required by 
section 481(a) that is attributable to the hospital shall be taken into 
account in accordance with the rules of paragraph (g)(2) of this section 
relating to hospitals. The portion of the adjustment required by section 
481(a) that is not attributable to the hospital shall

[[Page 91]]

be taken into account in accordance with the rules of paragraph (g)(2) 
of this section not relating to hospitals.
    (iii) Untimely change in method of accounting to comply with this 
section. Unless a taxpayer (including a hospital and a cooperative) 
required by this section to change from the cash method complies with 
the provisions of paragraph (h)(2) or (h)(3) of this section for its 
first section 448 year within the time prescribed by those paragraphs, 
the taxpayer must take the section 481 (a) adjustment into account under 
the provisions of any applicable administrative procedure that is 
prescribed by the Commissioner after January 7, 1991, specifically for 
purposes of complying with this section. Absent such an administrative 
procedure, a taxpayer must request a change under Sec.  1.446-1(e)(3) 
and shall be subject to any terms and conditions (including the year of 
change) as may be imposed by the Commissioner.
    (3) Special timing rules for section 481(a) adjustment--(i)Cessation 
of trade or business. If the taxpayer ceases to engage in the trade or 
business to which the section 481(a) adjustment relates, or if the 
taxpayer operating the trade or business terminates existence, and such 
cessation or termination occurs prior to the expiration of the 
adjustment period described in paragraph (g)(2)(i) or (ii) of this 
section, the taxpayer must take into account, in the taxable year of 
such cessation or termination, the balance of the adjustment not 
previously taken into account in computing taxable income. For purposes 
of this paragraph (g)(3)(i), the determination as to whether a taxpayer 
has ceased to engage in the trade or business to which the section 
481(a) adjustment relates, or has terminated its existence, is to be 
made under the principles of Sec.  1.446-1(e)(3)(ii) and its underlying 
administrative procedures.
    (ii) De minimis rule for a taxpayer other than a cooperative. 
Notwithstanding paragraph (g)(2)(i) and (ii) of this section, a taxpayer 
other than a cooperative (within the meaning of section 1381(a)) that is 
required to change from the cash method by this section may elect to 
use, in lieu of the adjustment period described in paragraph (g)(2)(i) 
and (ii) of this section, the adjustment period for de minimis section 
481(a) adjustments provided in the applicable administrative procedure 
issued under Sec.  1.446-1(e)(3)(ii) for obtaining the Commissioner's 
consent to a change in accounting method. A taxpayer may make an 
election under this paragraph (g)(3)(ii) only if--
    (A) The taxpayer's entire net section 481(a) adjustment (whether 
positive or negative) is a de minimis amount as determined under the 
applicable administrative procedure issued under Sec.  1.446-1(e)(3)(ii) 
for obtaining the Commissioner's consent to a change in accounting 
method,
    (B) The taxpayer complies with the provisions of paragraph (h)(2) or 
(3) of this section for its first section 448 year,
    (C) The return for such year is due (determined with regard to 
extensions) after December 27, 1993, and
    (D) The taxpayer complies with any applicable instructions to Form 
3115 that specify the manner of electing the adjustment period for de 
minimis section 481(a) adjustments.
    (4) Additional rules relating to section 481(a) adjustment. In 
addition to the rules set forth in paragraph (g) (2) and (3) of this 
section, the following rules shall apply in taking the section 481(a) 
adjustment into account--
    (i) Any net operating loss and tax credit carryforwards will be 
allowed to offset any positive section 481(a) adjustment,
    (ii) Any net operating loss arising in the year of change or in any 
subsequent year that is attributable to a negative section 481(a) 
adjustment may be carried back to earlier taxable years in accordance 
with section 172, and
    (iii) For purposes of determining estimated income tax payments 
under sections 6654 and 6655, the section 481(a) adjustment will be 
recognized in taxable income ratably throughout a taxable year.
    (5) Outstanding section 481(a) adjustment from previous change in 
method of accounting. If a taxpayer changed its method of accounting to 
the cash method for a taxable year prior to the year the taxpayer was 
required by this section to change from the cash method (the section 448 
year), any section 481(a) adjustment from such prior

[[Page 92]]

change in method of accounting that is outstanding as of the section 448 
year shall be taken into account in accordance with the provisions of 
this paragraph (g)(5). A taxpayer shall account for any remaining 
portion of the prior section 481(a) adjustment outstanding as of the 
section 448 year by continuing to take such remaining portion into 
account under the provisions and conditions of the prior change in 
method of accounting, or, at the taxpayer's option, combining or netting 
the remaining portion of the prior section 481(a) adjustment with the 
section 481(a) adjustment required under this section, and taking into 
account under the provisions of this section the resulting net amount of 
the adjustment. Any taxpayer choosing to combine or net the section 
481(a) adjustments as described in the preceding sentence shall indicate 
such choice on the Form 3115 required to be filed by such taxpayer under 
the provisions of paragraph (h) of this section.
    (h) Procedures for change in method of accounting--(1) 
Applicability. The rules provided in paragraph (h) of this section apply 
to taxable years beginning before January 1, 2018. See Sec.  1.448-2 for 
rules relating to taxable years beginning after December 31, 2017. 
Paragraph (h) of this section applies to taxpayers who change from the 
cash method as required by this section. Paragraph (h) of this section 
does not apply to a change in accounting method required by any Code 
section (or regulations thereunder) other than this section.
    (2) Automatic rule for changes to an overall accrual method--(i) 
Timely changes in method of accounting. Notwithstanding any other 
available procedures to change to the accrual method of accounting, a 
taxpayer to whom paragraph (h) of this section applies who desires to 
make a change to an overall accrual method for its first section 448 
year must make that change under the provisions of this paragraph 
(h)(2). A taxpayer changing to an overall accrual method under this 
paragraph (h)(2) must file a current Form 3115 by the time prescribed in 
paragraph (h)(2)(ii). In addition, the taxpayer must set forth on a 
statement accompanying the Form 3115 the period over which the section 
481(a) adjustment will be taken into account and the basis for such 
conclusion. Moreover, the taxpayer must type or legibly print the 
following statement at the top of page 1 of the Form 3115: ``Automatic 
Change to Accrual Method--Section 448.'' The consent of the Commissioner 
to the change in method of accounting is granted to taxpayers who change 
to an overall accrual method under this paragraph (h)(2). See paragraph 
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is 
applicable, for rules to account for the section 481(a) adjustment.
    (ii) Time and manner for filing Form 3115--(A) In general. Except as 
provided in paragraph (h)(2)(ii)(B) of this section, the Form 3115 
required by paragraph (h)(2)(i) must be filed no later than the due date 
(determined with regard to extensions) of the taxpayer's federal income 
tax return for the first section 448 year and must be attached to that 
return.
    (B) Extension of filing deadline. Notwithstanding paragraph 
(h)(2)(ii)(A) of this section, the filing of the Form 3115 required by 
paragraph (h)(2)(i) shall not be considered late if such Form 3115 is 
attached to a timely filed amended income tax return for the first 
section 448 year, provided that--
    (1) The taxpayer's first section 448 year is a taxable year that 
begins (or, pursuant to Sec.  1.441-2(c), is deemed to begin) in 1987, 
1988, 1989, or 1990,
    (2) The taxpayer has not been contacted for examination, is not 
before appeals, and is not before a federal court with respect to an 
income tax issue (each as defined in applicable administrative 
pronouncements), unless the taxpayer also complies with any requirements 
for approval in those applicable administrative pronouncements, and
    (3) Any amended return required by this paragraph (h)(2)(ii)(B) is 
filed on or before July 8, 1991.

Filing an amended return under this paragraph (h)(2)(ii)(B) does not 
extend the time for making any other election. Thus, for example, 
taxpayers that comply with this section by filing an amended return 
pursuant to this paragraph (h)(2)(ii)(B) may not elect out of section 
448 pursuant to paragraph (i)(2) of this section.

[[Page 93]]

    (3) Changes to a method other than overall accrual method--(i) In 
general. A taxpayer to whom paragraph (h) of this section applies who 
desires to change to a special method of accounting must make that 
change under the provisions of this paragraph (h)(3), except to the 
extent other special procedures have been promulgated regarding the 
special method of accounting. Such a taxpayer includes taxpayers who 
change to both an accrual method of accounting and a special method of 
accounting such as a long-term contract method. In order to change an 
accounting method under this paragraph (h)(3), a taxpayer must submit an 
application for change in accounting method under the applicable 
administrative procedures in effect at the time of change, including the 
applicable procedures regarding the time and place of filing the 
application for change in method. Moreover, a taxpayer who changes an 
accounting method under this paragraph (h)(3) must type or legibly print 
the following statement on the top of page 1 of Form 3115: ``Change to a 
Special Method of Accounting--Section 448.'' The filing of a Form 3115 
by any taxpayer requesting a change of method of accounting under this 
paragraph (h)(3) for its taxable year beginning in 1987 will not be 
considered late if the form is filed with the appropriate office of the 
Internal Revenue Service on or before the later of: the date that is the 
180th day of the taxable year of change; or September 14, 1987. If the 
Commissioner approves the taxpayer's application for change in method of 
accounting, the timing of the adjustment required under section 481 (a), 
if applicable, will be determined under the provisions of paragraph 
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is 
applicable. If the Commissioner denies the taxpayer's application for 
change in accounting method, or if the taxpayer's application is 
untimely, the taxpayer must change to an overall accrual method of 
accounting under the provisions of either paragraph (h)(2) or (h)(4) of 
this section, whichever is applicable.
    (ii) Extension of filing deadline. Notwithstanding paragraph 
(h)(3)(i) of this section, if the events or circumstances which under 
section 448 disqualify a taxpayer from using the cash method occur after 
the time prescribed under applicable procedures for filing the Form 
3115, the filing of such form shall not be considered late if such form 
is filed on or before 30 days after the close of the taxable year.
    (4) Untimely change in method of accounting to comply with this 
section. Unless a taxpayer to whom paragraph (h) of this section applies 
complies with the provisions of paragraph (h)(2) or (h)(3) of this 
section for its first section 448 year, the taxpayer must comply with 
the requirements of Sec.  1.446-1 (e)(3) (including any applicable 
administrative procedure that is prescribed thereunder after January 7, 
1991 specifically for purposes of complying with this section) in order 
to secure the consent of the Commissioner to change to a method of 
accounting that is in compliance with the provisions of this section. 
The taxpayer shall be subject to any terms and conditions (including the 
year of change) as may be imposed by the Commissioner.
    (i) Effective date--(1) In general. Except as provided in paragraph 
(i)(2), (3), (4), and (5) of this section, this section applies to any 
taxable year beginning after December 31, 1986.
    (2) Election out of section 448--(i) In general. A taxpayer may 
elect not to have this section apply to any (A) transaction with a 
related party (within the meaning of section 267(b) of the Internal 
Revenue Code of 1954, as in effect on October 21, 1986), (B) loan, or 
(C) lease, if such transaction, loan, or lease was entered into on or 
before September 25, 1985. Any such election described in the preceding 
sentence may be made separately with respect to each transaction, loan, 
or lease. For rules relating to the making of such election, see Sec.  
301.9100-7T (temporary regulations relating to elections under the Tax 
Reform Act of 1986). Notwithstanding the provisions of this paragraph 
(i)(2), the gross receipts attributable to a transaction, loan, or lease 
described in this paragraph (i)(2) shall be taken into account for 
purposes of the $5,000,000 gross receipts test described in paragraph 
(f) of this section.

[[Page 94]]

    (ii) Special rules for loans. If the taxpayer makes an election 
under paragraph (i)(2)(i) of this section with respect to a loan entered 
into on or before September 25, 1985, the election shall apply only with 
respect to amounts that are attributable to the loan balance outstanding 
on September 25, 1985. The election shall not apply to any amounts 
advanced or lent after September 25, 1985, regardless of whether the 
loan agreement was entered into on or before such date. Moreover, any 
payments made on outstanding loan balances after September 25, 1985, 
shall be deemed to first extinguish loan balances outstanding on 
September 25, 1985, regardless of any contrary treatment of such loan 
payments by the borrower and lender.
    (3) Certain contracts entered into before September 25, 1985. This 
section does not apply to a contract for the acquisition or transfer of 
real property or a contract for services related to the acquisition or 
development of real property if--
    (i) The contract was entered into before September 25, 1985; and
    (ii) The sole element of the contract which was not performed as of 
September 25, 1985, was payment for such property or services.
    (4) Transitional rule for paragraphs (g) and (h) of this section. To 
the extent the provisions of paragraphs (g) and (h) of this section were 
not reflected in paragraphs (g) and (h) of Sec.  1.448-1T (as set forth 
in 26 CFR part 1 as revised on April 1, 1993), paragraphs (g) and (h) of 
this section will not be adversely applied to a taxpayer with respect to 
transactions entered into before December 27, 1993.
    (5) Effective date of paragraph (g)(2)(i). Paragraph (g)(2)(i) of 
this section applies to taxable years ending on or after June 16, 2004.

[T.D. 8514, 58 FR 68299, Dec. 27, 1993, as amended by T.D. 8996, 67 FR 
35012, May 17, 2002; T.D. 9131, 69 FR 33572, June 16, 2004; T.D. 9942, 
86 FR 268, Jan. 5, 2021]



Sec.  1.448-1T  Limitation on the use of the cash receipts 
and disbursements method of accounting (temporary).

    (a) Limitation on accounting method--(1) In general. This section 
prescribes regulations under section 448 relating to the limitation on 
the use of the cash receipts and disbursements method of accounting (the 
cash method) by certain taxpayers.
    (2) Limitation rule. Except as otherwise provided in this section, 
the computation of taxable income using the cash method is prohibited in 
the case of a--
    (i) C corporation,
    (ii) Partnership with a C corporation as a partner, or
    (iii) Tax shelter.

A partnership is described in paragraph (a)(2)(ii) of this section, if 
the partnership has a C corporation as a partner at any time during the 
partnership's taxable year beginning after December 31, 1986.
    (3) Meaning of C corporation. For purposes of this section, the term 
``C corporation'' includes any corporation that is not an S corporation. 
For example, a regulated investment company (as defined in section 851) 
or a real estate investment trust (as defined in section 856) is a C 
corporation for purposes of this section. In addition, a trust subject 
to tax under section 511 (b) shall be treated, for purposes of this 
section, as a C corporation, but only with respect to the portion of its 
activities that constitute an unrelated trade or business. Similarly, 
for purposes of this section, a corporation that is exempt from federal 
income taxes under section 501 (a) shall be treated as a C corporation 
only with respect to the portion of its activities that constitute an 
unrelated trade or business. Moreover, for purposes of determining 
whether a partnership has a C corporation as a partner, any partnership 
described in paragraph (a)(2)(ii) of this section is treated as a C 
corporation. Thus, if partnership ABC has a partner that is a 
partnership with a C corporation, then, for purposes of this section, 
partnership ABC is treated as a partnership with a C corporation 
partner.
    (4) Treatment of a combination of methods. For purposes of this 
section, the use of a method of accounting that records some, but not 
all, items on the cash method shall be considered the use of the cash 
method. Thus, a C corporation that uses a combination of accounting 
methods including the use of

[[Page 95]]

the cash method is subject to this section.
    (b) Tax shelter defined--(1) In general. For purposes of this 
section, the term ``tax shelter'' means any--
    (i) Enterprise (other than a C corporation) if at any time 
(including taxable years beginning before January 1, 1987) interests in 
such enterprise have been offered for sale in any offering required to 
be registered with any federal or state agency having the authority to 
regulate the offering of securities for sale,
    (ii) Syndicate (within the meaning of paragraph (b)(3) of this 
section), or
    (iii) Tax shelter within the meaning of section 6662(d)(2)(C).
    (2) Requirement of registration. For purposes of paragraph (b)(1)(i) 
of this section, an offering is required to be registered with a federal 
or state agency if, under the applicable federal or state law, failure 
to register the offering would result in a violation of the applicable 
federal or state law (regardless of whether the offering is in fact 
registered). In addition, an offering is required to be registered with 
a federal or state agency if, under the applicable federal or state law, 
failure to file a notice of exemption from registration would result in 
a violation of the applicable federal or state law (regardless of 
whether the notice is in fact filed).
    (3) Meaning of syndicate. For purposes of paragraph (b)(1)(ii) of 
this section, the term ``syndicate'' means a partnership or other entity 
(other than a C corporation) if more than 35 percent of the losses of 
such entity during the taxable year (for taxable years beginning after 
December 31, 1986) are allocated to limited partners or limited 
entrepreneurs. For purposes of this paragraph (b)(3), the term ``limited 
entrepreneur'' has the same meaning given such term in section 464 
(e)(2). In addition, in determining whether an interest in a partnership 
is held by a limited partner, or an interest in an entity or enterprise 
is held by a limited entrepreneur, section 464 (c)(2) shall apply in the 
case of the trade or business of farming (as defined in paragraph (d)(2) 
of this section), and section 1256 (e)(3)(C) shall apply in any other 
case. Moreover, for purposes of this paragraph (b)(3), the losses of a 
partnership, entity, or enterprise (the enterprise) means the excess of 
the deductions allowable to the enterprise over the amount of income 
recognized by such enterprise under the enterprise's method of 
accounting used for federal income tax purposes (determined without 
regard to this section). For this purpose, gains or losses from the sale 
of capital assets or section 1221 (2) assets are not taken into account.
    (4) Presumed tax avoidance. For purposes of paragraph (b)(1)(iii) of 
this section, marketed arrangements in which persons carrying on farming 
activities using the services of a common managerial or administrative 
service will be presumed to have the principal purpose of tax avoidance 
if such persons use borrowed funds to prepay a substantial portion of 
their farming expenses (e.g., payment for farm supplies that will not be 
used or consumed until a taxable year subsequent to the taxable year of 
payment).
    (5) Taxable year tax shelter must change accounting method. A 
partnership, entity, or enterprise that is a tax shelter must change 
from the cash method for the later of (i) the first taxable year 
beginning after December 31, 1986, or (ii) the taxable year that such 
partnership, entity, or enterprise becomes a tax shelter.
    (c) Effect of section 448 on other provisions. Nothing in section 
448 shall have any effect on the application of any other provision of 
law that would otherwise limit the use of the cash method, and no 
inference shall be drawn from section 448 with respect to the 
application of any such provision. For example, nothing in section 448 
affects the requirement of section 447 that certain corporations must 
use an accrual method of accounting in computing taxable income from 
farming, or the requirement of Sec.  1.446-1(c)(2) that an accrual 
method be used with regard to purchases and sales of inventory. 
Similarly, nothing in section 448 affects the authority of the 
Commissioner under section 446(b) to require the use of an accounting 
method that clearly reflects income, or the requirement under section 
446(e) that a taxpayer secure the consent of the Commissioner before 
changing its method of accounting. For example, a taxpayer using the

[[Page 96]]

cash method may be required to change to an accrual method of accounting 
under section 446(b) because such method clearly reflects that 
taxpayer's income, even though the taxpayer is not prohibited by section 
448 from using the cash method. Similarly, a taxpayer using an accrual 
method of accounting that is not prohibited by section 448 from using 
the cash method may not change to the cash method unless the taxpayer 
secures the consent of the Commissioner under section 446(e), and, in 
the opinion of the Commissioner, the use of the cash method clearly 
reflects that taxpayer's income under section 446(b).
    (d) Exception for farming business--(1) In general. Except in the 
case of a tax shelter, this section shall not apply to any farming 
business. A taxpayer engaged in a farming business and a separate 
nonfarming business is not prohibited by this section from using the 
cash method with respect to the farming business, even though the 
taxpayer may be prohibited by this section from using the cash method 
with respect to the nonfarming business.
    (2) Meaning of farming business. For purposes of paragraph (d) of 
this section, the term ``farming business'' means--
    (i) The trade or business of farming as defined in section 
263A(e)(4) (including the operation of a nursery or sod farm, or the 
raising or harvesting of trees bearing fruit, nuts, or other crops, or 
ornamental trees), or
    (ii) The raising, harvesting , or growing of trees described in 
section 263A(c)(5) (relating to trees raised, harvested, or grown by the 
taxpayer other than trees described in paragraph (d)(2)(i) of this 
section).

Thus, for purposes of this section, the term ``farming business'' 
includes the raising of timber. For purposes of this section, the term 
``farming business'' does not include the processing of commodities or 
products beyond those activities normally incident to the growing, 
raising or harvesting of such products. For example, assume that a C 
corporation taxpayer is in the business of growing and harvesting wheat 
and other grains. The taxpayer processes the harvested grains to produce 
breads, cereals, and similar food products which it sells to customers 
in the course of its business. Although the taxpayer is in the farming 
business with respect to the growing and harvesting of grain, the 
taxpayer is not in the farming business with respect to the processing 
of such grains to produce food products which the taxpayer sells to 
customers. Similarly, assume that a taxpayer is in the business of 
raising poultry or other livestock. The taxpayer uses the livestock in a 
meat processing operation in which the livestock are slaughtered, 
processed, and packaged or canned for sale to customers. Although the 
taxpayer is in the farming business with respect to the raising of 
livestock, the taxpayer is not in the farming business with respect to 
the meat processing operation. However, under this section the term 
``farming business'' does include processing activities which are 
normally incident to the growing, raising or harvesting of agricultural 
products. For example, assume a taxpayer is in the business of growing 
fruits and vegetables. When the fruits and vegetables are ready to be 
harvested, the taxpayer picks, washes, inspects, and packages the fruits 
and vegetables for sale. Such activities are normally incident to the 
raising of these crops by farmers. The taxpayer will be considered to be 
in the business of farming with respect to the growing of fruits and 
vegetables, and the processing activities incident to the harvest.
    (e) Exception for qualified personal service corporation--(1) In 
general. Except in the case of a tax shelter, this section does not 
apply to a qualified personal service corporation.
    (2) Certain treatment for qualified personal service corporation. 
For purposes of paragraph (a)(2)(ii) of this section (relating to 
whether a partnership has a C corporation as a partner), a qualified 
personal service corporation shall be treated as an individual.
    (3) Meaning of qualified personal service corporation. For purposes 
of this section, the term ``qualified personal service corporation'' 
means any corporation that meets--
    (i) The function test paragraph (e)(4) of this section, and
    (ii) The ownership test of paragraph (e)(5) of this section.

[[Page 97]]

    (4) Function test--(i) In general. A corporation meets the function 
test if substantially all the corporation's activities for a taxable 
year involve the performance of services in one or more of the following 
fields--
    (A) Health,
    (B) Law,
    (C) Engineering (including surveying and mapping),
    (D) Architecture,
    (E) Accounting,
    (F) Actuarial science,
    (G) Performing arts, or
    (H) Consulting.


Substantially all of the activities of a corporation are involved in the 
performance of services in any field described in the preceding sentence 
(a qualifying field), only if 95 percent or more of the time spent by 
employees of the corporation, serving in their capacity as such, is 
devoted to the performance of services in a qualifying field. For 
purposes of determining whether this 95 percent test is satisfied, the 
performance of any activity incident to the actual performance of 
services in a qualifying field is considered the performance of services 
in that field. Activities incident to the performance of services in a 
qualifying field include the supervision of employees engaged in 
directly providing services to clients, and the performance of 
administrative and support services incident to such activities.
    (ii) Meaning of services performed in the field of health. For 
purposes of paragraph (e)(4)(i)(A) of this section, the performance of 
services in the field of health means the provision of medical services 
by physicians, nurses, dentists, and other similar healthcare 
professionals. The performance of services in the field of health does 
not include the provision of services not directly related to a medical 
field, even though the services may purportedly relate to the health of 
the service recipient. For example, the performance of services in the 
field of health does not include the operation of health clubs or health 
spas that provide physical exercise or conditioning to their customers.
    (iii) Meaning of services performed in the field of performing arts. 
For purposes of paragraph (e)(4)(i)(G) of this section, the performance 
of services in the field of the performing arts means the provision of 
services by actors, actresses, singers, musicians, entertainers, and 
similar artists in their capacity as such. The performance of services 
in the field of the performing arts does not include the provision of 
services by persons who themselves are not performing artists (e.g., 
persons who may manage or promote such artists, and other persons in a 
trade or business that relates to the performing arts). Similarly, the 
performance of services in the field of the performing arts does not 
include the provision of services by persons who broadcast or otherwise 
disseminate the performances of such artists to members of the public 
(e.g., employees of a radio station that broadcasts the performances of 
musicians and singers). Finally, the performance of services in the 
field of the performing arts does not include the provision of services 
by athletes.
    (iv) Meaning of services performed in the field of consulting--(A) 
In general. For purposes of paragraph (e)(4)(i)(H) of this section, the 
performance of services in the field of consulting means the provision 
of advice and counsel. The performance of services in the field of 
consulting does not include the performance of services other than 
advice and counsel, such as sales or brokerage services, or economically 
similar services. For purposes of the preceding sentence, the 
determination of whether a person's services are sales or brokerage 
services, or economically similar services, shall be based on all the 
facts and circumstances of that person's business. Such facts and 
circumstances include, for example, the manner in which the taxpayer is 
compensated for the services provided (e.g., whether the compensation 
for the services is contingent upon the consummation of the transaction 
that the services were intended to effect).
    (B) Examples. The following examples illustrate the provisions of 
paragraph (e)(4)(iv)(A) of this section. The examples do not address all 
types of services that may or may not qualify as consulting. The 
determination of whether activities not specifically addressed in the 
examples qualify as consulting shall be made by comparing the service 
activities in question to the types of

[[Page 98]]

service activities discussed in the examples. With respect to a 
corporation which performs services which qualify as consulting under 
this section, and other services which do not qualify as consulting, see 
paragraph (e)(4)(i) of this section which requires that substantially 
all of the corporation's activities involve the performance of services 
in a qualifying field.

    Example 1. A taxpayer is in the business of providing economic 
analyses and forecasts of business prospects for its clients. Based on 
these analyses and forecasts, the taxpayer advises its clients on their 
business activities. For example, the taxpayer may analyze the economic 
conditions and outlook for a particular industry which a client is 
considering entering. The taxpayer will then make recommendations and 
advise the client on the prospects of entering the industry, as well as 
on other matters regarding the client's activities in such industry. The 
taxpayer provides similar services to other clients, involving, for 
example, economic analyses and evaluations of business prospects in 
different areas of the United States or in other countries, or economic 
analyses of overall economic trends and the provision of advice based on 
these analyses and evaluations. The taxpayer is considered to be engaged 
in the performance of services in the field of consulting.
    Example 2. A taxpayer is in the business of providing services that 
consist of determining a client's electronic data processing needs. The 
taxpayer will study and examine the client's business, focusing on the 
types of data and information relevant to the client and the needs of 
the client's employees for access to this information. The taxpayer will 
then make recommendations regarding the design and implementation of 
data processing systems intended to meet the needs of the client. The 
taxpayer does not, however, provide the client with additional computer 
programming services distinct from the recommendations made by the 
taxpayer with respect to the design and implementation of the client's 
data processing systems. The taxpayer is considered to be engaged in the 
performance of services in the field of consulting.
    Example 3. A taxpayer is in the business of providing services that 
consist of determining a client's management and business structure 
needs. The taxpayer will study the client's organization, including, for 
example, the departments assigned to perform specific functions, lines 
of authority in the managerial hierarchy, personnel hiring, job 
responsibility, and personnel evaluations and compensation. Based on the 
study, the taxpayer will then advise the client on changes in the 
client's management and business structure, including, for example, the 
restructuring of the client's departmental systems or its lines of 
managerial authority. The taxpayer is considered to be engaged in the 
performance of services in the field of consulting.
    Example 4. A taxpayer is in the business of providing financial 
planning services. The taxpayer will study a particular client's 
financial situation, including, for example, the client's present 
income, savings and investments, and anticipated future economic and 
financial needs. Based on this study, the taxpayer will then assist the 
client in making decisions and plans regarding the client's financial 
activities. Such financial planning includes the design of a personal 
budget to assist the client in monitoring the client's financial 
situation, the adoption of investment strategies tailored to the 
client's needs, and other similar services. The taxpayer is considered 
to be engaged in the performance of services in the field of consulting.
    Example 5. A taxpayer is in the business of executing transactions 
for customers involving various types of securities or commodities 
generally traded through organized exchanges or other similar networks. 
The taxpayer provides its clients with economic analyses and forecasts 
of conditions in various industries and businesses. Based on these 
analyses, the taxpayer makes recommendations regarding transactions in 
securities and commodities. Clients place orders with the taxpayer to 
trade securities or commodities based on the taxpayer's recommendations. 
The taxpayer's compensation for its services is typically based on the 
trade orders. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in brokerage services. Relevant to this determination is the 
fact that the compensation of the taxpayer for its services is 
contingent upon the consummation of the transaction the services were 
intended to effect (i.e., the execution of trade orders for its 
clients).
    Example 6. A taxpayer is in the business of studying a client's 
needs regarding its data processing facilities and making 
recommendations to the client regarding the design and implementation of 
data processing systems. The client will then order computers and other 
data processing equipment through the taxpayer based on the taxpayer's 
recommendations. The taxpayer's compensation for its services is 
typically based on the equipment orders made by the clients. The 
taxpayer is not considered to be engaged in the performance of services 
in the field of consulting. The taxpayer is engaged in the performance 
of sales services. Relevant to this determination is the fact that the 
compensation of the taxpayer for its

[[Page 99]]

services it contingent upon the consummation of the transaction the 
services were intended to effect (i.e., the execution of equipment 
orders for its clients).
    Example 7. A taxpayer is in the business of assisting businesses in 
meeting their personnel requirements by referring job applicants to 
employers with hiring needs in a particular area. The taxpayer may be 
informed by potential employers of their need for job applicants, or, 
alternatively, the taxpayer may become aware of the client's personnel 
requirements after the taxpayer studies and examines the client's 
management and business structure. The taxpayer's compensation for its 
services is typically based on the job applicants, referred by the 
taxpayer to the clients, who accept employment positions with the 
clients. The taxpayer is not considered to be engaged in the performance 
of services in the field of consulting. The taxpayer is involved in the 
performance of services economically similar to brokerage services. 
Relevant to this determination is the fact that the compensation of the 
taxpayer for its services is contingent upon the consummation of the 
transaction the services were intended to effect (i.e., the hiring of a 
job applicant by the client).
    Example 8. The facts are the same as in Example 7, except that the 
taxpayer's clients are individuals who use the services of the taxpayer 
to obtain employment positions. The taxpayer is typically compensated by 
its clients who obtain employment as a result of the taxpayer's 
services. For the reasons set forth in Example 7, the taxpayer is not 
considered to be engaged in the performance of services in the field of 
consulting.
    Example 9. A taxpayer is in the business of assisting clients in 
placing advertisements for their goods and services. The taxpayer 
analyzes the conditions and trends in the client's particular industry, 
and then makes recommendations to the client regarding the types of 
advertisements which should be placed by the client and the various 
types of advertising media (e.g., radio, television, magazines, etc.) 
which should be used by the client. The client will then purchase, 
through the taxpayer, advertisements in various media based on the 
taxpayer's recommendations. The taxpayer's compensation for its services 
is typically based on the particular orders for advertisements which the 
client makes. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in the performance of services economically similar to brokerage 
services. Relevant to this determination is the fact that the 
compensation of the taxpayer for its services is contingent upon the 
consummation of the transaction the services were intended to effect 
(i.e., the placing of advertisements by clients).
    Example 10. A taxpayer is in the business of selling insurance 
(including life and casualty insurance), annuities, and other similar 
insurance products to various individual and business clients. The 
taxpayer will study the particular client's financial situation, 
including, for example, the client's present income, savings and 
investments, business and personal insurance risks, and anticipated 
future economic and financial needs. Based on this study, the taxpayer 
will then make recommendations to the client regarding the desirability 
of various insurance products. The client will then purchase these 
various insurance products through the taxpayer. The taxpayer's 
compensation for its services is typically based on the purchases made 
by the clients. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in the performance of brokerage or sales services. Relevant to 
this determination is the fact that the compensation of the taxpayer for 
its services is contingent upon the consummation of the transaction the 
services were intended to effect (i.e., the purchase of insurance 
products by its clients).

    (5) Ownership test--(i) In general. A corporation meets the 
ownership test, if at all times during the taxable year, substantially 
all the corporation's stock, by value, is held, directly or indirectly, 
by--
    (A) Employees performing services for such corporation in connection 
with activities involving a field referred to in paragraph (e)(4) of 
this section,
    (B) Retired employees who had performed such services for such 
corporation,
    (C) The estate of any individual described in paragraph (e)(5)(i) 
(A) or (B) of this section, or
    (D) Any other person who acquired such stock by reason of the death 
of an individual described in paragraph (e)(5)(i) (A) or (B) of this 
section, but only for the 2-year period beginning on the date of the 
death of such individual.

For purposes of this paragraph (e)(5) of this section, the term 
``substantially all'' means an amount equal to or greater than 95 
percent.
    (ii) Definition of employee. For purposes of the ownership test of 
this paragraph (e)(5) of this section, a person shall not be considered 
an employee of a corporation unless the services performed by that 
person for such

[[Page 100]]

corporation, based on the facts and circumstances, are more than de 
minimis. In addition, a person who is an employee of a corporation shall 
not be treated as an employee of another corporation merely by reason of 
the employer corporation and the other corporation being members of the 
same affiliated group or otherwise related.
    (iii) Attribution rules. For purposes of this paragraph (e)(5) of 
this section, a corporation's stock is considered held indirectly by a 
person if, and to the extent, such person owns a proportionate interest 
in a partnership, S corporation, or qualified personal service 
corporation that owns such stock. No other arrangement or type of 
ownership shall constitute indirect ownership of a corporation's stock 
for purposes of this paragraph (e)(5) of this section. Moreover, stock 
of a corporation held by a trust is considered held by a person if, and 
to the extent, such person is treated under subpart E, part I, 
subchapter J, chapter 1 of the Code as the owner of the portion of the 
trust that consists of such stock.
    (iv) Disregard of community property laws. For purposes of this 
paragraph (e)(5) of this section, community property laws shall be 
disregarded. Thus, in determining the stock ownership of a corporation, 
stock owned by a spouse solely by reason of community property laws 
shall be treated as owned by the other spouse.
    (v) Treatment of certain stock plans. For purposes of this paragraph 
(e)(5) of this section, stock held by a plan described in section 401 
(a) that is exempt from tax under section 501 (a) shall be treated as 
held by an employee described in paragraph (e)(5)(i)(A) of this section.
    (vi) Special election for certain affiliated groups. For purposes of 
determining whether the stock ownership test of this paragraph (e)(5) of 
this section has been met, at the election of the common parent of an 
affiliated group (within the meaning of section 1504 (a)), all members 
of such group shall be treated as one taxpayer if substantially all 
(within the meaning of paragraph (e)(4)(i) of this section) the 
activities of all such members (in the aggregate) are in the same field 
described in paragraph (e)(4)(i)(A)-(H) of this section. For rules 
relating to the making of the election, see 26 CFR 5h.5 (temporary 
regulations relating to elections under the Tax Reform Act of 1986).
    (vii) Examples. The following examples illustrate the provisions of 
paragraph (e) of this section:

    Example 1. (i) X, a Corporation, is engaged in the business of 
providing accounting services to its clients. These services consist of 
the preparation of audit and financial statements and the preparation of 
tax returns. For purposes of section 448, such services consist of the 
performance of services in the field of accounting. In addition, for 
purposes of section 448, the supervision of employees directly preparing 
the statements and returns, and the performance of all administrative 
and support services incident to such activities (including secretarial, 
janitorial, purchasing, personnel, security, and payroll services) are 
the performance of services in the field of accounting.
    (ii) In addition, X owns and leases a portion of an office building. 
For purposes of this section, the following types of activities 
undertaken by the employees of X shall be considered as the performance 
of services in a field other than the field of accounting: (A) services 
directly relating to the leasing activities, e.g., time spent in leasing 
and maintaining the leased portion of the building; (B) supervision of 
employees engaged in directly providing services in the leasing 
activity; and (C) all administrative and support services incurred 
incident to services described in (A) and (B). The leasing activities of 
X are considered the performance of services in a field other than the 
field of accounting, regardless of whether such leasing activities 
constitute a trade or business under the Code. If the employees of X 
spend 95% or more of their time in the performance of services in the 
field of accounting, X satisfies the function test of paragraph (e)(4) 
of this section.
    Example 2. Assume that Y, a C corporation, meets the function test 
of paragraph (e)(4) of this section. Assume further that all the 
employees of Y are performing services for Y in a qualifying field as 
defined in paragraph (e)(4) of this section. P, a partnership, owns 40%, 
by value, of the stock of Y. The remaining 60% of the stock of Y is 
owned directly by employees of Y. Employees of Y have an aggregate 
interest of 90% in the capital and profits of P. This, 96% of the stock 
of Y is held directly, or indirectly, by employees of Y performing 
services in a qualifying field. Accordingly, Y meets the ownership test 
of paragraph (e)(5) of this section and is a qualified personal service 
corporation.
    Example 3. The facts are the same as in Example 2, except that 40% 
of the stock of Y is

[[Page 101]]

owned by Z, a C corporation. The remaining 60% of the stock is owned 
directly by the employees of Y. Employees of Y own 90% of the stock, by 
value, of Z. Assume that Z independently qualifies as a personal service 
corporation. The result is the same as in Example 2, i.e., 96% of the 
stock of Y is held, directly or indirectly, by employees of Y performing 
services in a qualifying field. Thus, Y is a qualified personal service 
corporation.
    Example 4. The facts are the same as in Example 3, except that Z 
does not independently qualify as a personal service corporation. 
Because Z is not a qualified personal service corporation, the Y stock 
owned by Z is not treated as being held indirectly by the Z 
shareholders. Consequently, only 60% of the stock of Y is held, directly 
or indirectly, by employees of Y. Thus, Y does not meet the ownership 
test of paragraph (e)(5) of this section, and is not a qualified 
personal service corporation.
    Example 5. Assume that W, a C corporation, meets the function test 
of paragraph (e)(4) of this section. In addition, assume that all the 
employees of W are performing services for W in a qualifying field. 
Nominal legal title to 100% of the stock of W is held by employees of W. 
However, due solely to the operation of community property laws, 20% of 
the stock of W is held by spouses of such employees who themselves are 
not employees of W. In determining the ownership of the stock, community 
property laws are disregarded. Thus, Y meets the ownership test of 
paragraph (e)(5) of this section, and is a qualified personal service 
corporation.
    Example 6. Assume that 90% of the stock of T, a C corporation, is 
directly owned by the employees of T. Spouses of T's employees directly 
own 5% of the stock of T. The spouses are not employees of T, and their 
ownership does not occur solely by operation of community property laws. 
In addition, 5% of the stock of T is held by trusts (other than a trust 
described in section 401(a) that is exempt from tax under section 
501(a)), the sole beneficiaries of which are employees of T. The 
employees are not treated as owners of the trusts under subpart E, part 
I, subchapter J, chapter 1 of the Code. Since a person is not treated as 
owning the stock of a corporation owned by that person's spouse, or by 
any portion of a trust that is not treated as owned by such person under 
subpart E, only 90% of the stock of T is treated as held, directly or 
indirectly, by employees of T. Thus, T does not meet the ownership test 
of paragraph (e)(5) of this section, and is not a qualified personal 
service corporation.
    Example 7. Assume that Y, a C corporation, directly owns all the 
stock of three subsidiaries, F, G, and H. Y is a common parent of an 
affiliated group within the meaning of section 1504(a) consisting of Y, 
F, G, and H. Y is not engaged in the performance of services in a 
qualifying field. Instead, Y is a holding company whose activities 
consist of its ownership and investment in its operating subsidiaries. 
Substantially all the activities of F involve the performance of 
services in the field of engineering. In addition, a majority of (but 
not substantially all) the activities of G involve the performance of 
services in the field of engineering; the remainder of G's services 
involve the performance of services in a nonqualifying field. Moreover, 
a majority of (but not substantially all) the activities of H involve 
the performance of services in the field of engineering; the remainder 
of H's activities involve the performance of services in the field of 
architecture. Nevertheless, substantially all the activities of the 
group consisting of Y, F, G, and H, in the aggregate, involve the 
performance of services in the field of engineering. Accordingly, Y 
elects under paragraph (e)(5)(vi) of this section to be treated as one 
taxpayer for determining the ownership test of paragraph (e)(5) of this 
section. Assume that substantially all the stock of Y (by value) is held 
by employees of F, G, or H who perform services in connection with a 
qualifying field (engineering or architecture). Thus, for purposes of 
determining whether any member corporation is a qualified personal 
service corporation, the ownership test of paragraph (e)(5) of this 
section has been satisfied. Since F and H satisfy the function test of 
paragraph (e)(4) of this section, F and H are qualified personal service 
corporations. However, since Y and G each fail the function test of 
paragraph (e)(4) of this section, neither corporation is a qualified 
personal service corporation.
    Example 8. The facts are the same as in Example 7, except that less 
than substantially all the activities of the group consisting of Y, F, 
G, and H, in the aggregate, are performed in the field of engineering. 
Substantially all the activities of the group consisting of Y, F, G, and 
H, are, in the aggregate, performed in two fields, the fields of 
engineering and architecture. Y may not elect to have the affiliated 
group treated as one taxpayer for purposes of determining whether group 
members meet the ownership test of paragraph (e)(5) of this section. The 
election is available only if substantially all the activities of the 
group, in the aggregate, involve the performance of services in only one 
qualifying field. Moreover, none of the group members are qualified 
personal service corporations. Y fails the function test of paragraph 
(e)(4) of this section because less than substantially all the 
activities of Y are performed in a qualifying field. In addition, F, G, 
and H fail the ownershp test of paragraph (e)(5) of this section because 
substantially all their stock is owned by Y and not by their employees. 
The owners of Y are not deemed to indirectly own the stock owned by Y 
because Y is not a qualified personal service corporation.

[[Page 102]]

    Example 9. (i) The facts are the same as in Example 8, except Y 
itself satisfies the function tests of paragraph (e)(4) of this section 
because substantially all the activities of Y involve the performance of 
services in the field of engineering. In addition, assume that all 
employees of Y are involved in the performance of services in the field 
of engineering, and that all such employees own 100% of Y's stock. 
Moreover, assume that one-third of all the employees of Y are separately 
employed by F. Similarly, another one-third of the employees of Y are 
separately employed by G and H, respectively. None of the employees of Y 
are employed by more than one of Y's subsidiaries. Also, no other 
persons except the employees of Y are employed by any of the 
subsidiaries.
    (ii) Y is a personal service corporation under section 448 because Y 
satisfies both the function and the ownership test of paragraphs (e) (4) 
and (5) of this section. As in Example 8, Y is unable to make the 
election to have the affiliated group treated as one taxpayer for 
purposes of determining whether group members meet the ownership test of 
paragraph (e)(5) of this section because less than substantially all the 
activities, in the aggregate, of the group members are performed in one 
of the qualifying fields. However, because Y is a personal service 
corporation, the stock owned by Y is treated as indirectly owned, 
proportionately, by the owners of Y. Thus, the employees of F are 
collectively treated as owning one-third of the stock of F, G, and H. 
The employees of G and H are similarly treated as owning one-third of 
each subsidiary's stock.
    (iii) F, G, and H each fail the ownership test of paragraph (e)(5) 
of this section because less than substantially all of each 
corporation's stock is owned by the employees of the respective 
corporation. Only one-third of each corporation's stock is owned by 
employees of that corporation. Thus, F, G, and H are not qualified 
personal service corporations.
    Example 10. (i) Assume that Y, a C corporation, directly owns all 
the stock of three subsidiaries, F, G, and Z. Y is a common parent of an 
affiliated group within the meaning of section 1504(a) consisting of Y, 
F, and G. Z is a foreign corporation and is excluded from the affiliated 
group under section 1504. Assume that Y is a holding company whose 
activities consist of its ownership and investment in its operating 
subsidiaries. Substantially all the activities of F, G, and Z involve 
the performance of services in the field of engineering. Assume that 
employees of Z own one-third of the stock of Y and that none of these 
employees are also employees of Y, F, or G. In addition, assume that Y 
elects to be treated as one taxpayer for determining whether group 
members meet the ownership tests of paragraph (e)(5) of this section. 
Thus, Y, F, and G are treated as one taxpayer for purposes of the 
ownership test.
    (ii) None of the members of the group are qualified personal service 
corporations. Y, F, and G fail the ownership test of paragraph (e)(5) of 
this section because less than substantially all the stock of Y is owned 
by employees of either Y, F, or G. Moreover, Z fails the ownership test 
of paragraph (e)(5) of this section because substantially all its stock 
is owned by Y and not by its employees.

    (6) Application of function and ownership tests. A corporation that 
fails the function test of paragraph (e)(4) of this section for any 
taxable year, or that fails the ownership test of paragraph (e)(5) of 
this section at any time during any taxable year, shall change from the 
cash method effective for the year in which the corporation fails to 
meet the function test or the ownership test. For example, if a personal 
service corporation fails the function test for taxable year 1987, such 
corporation must change from the cash method effective for taxable year 
1987. A corporation that fails the function or ownership test for a 
taxable year shall not be treated as a qualified personal service 
corporation for any part of that taxable year.
    (f) Exception for entities with gross receipts of not more than $5 
million--(1) In general. Except in the case of a tax shelter, this 
section shall not apply to any C corporation or partnership with a C 
corporation as a partner for any taxable year if, for all prior taxable 
years beginning after December 31, 1985, such corporation or partnership 
(or any predecessor thereof) meets the $5,000,000 gross receipts test of 
paragraph (f)(2) of this section.
    (2) The $5,000,000 gross receipts test--(i) In general. A 
corporation meets the $5,000,000 gross receipts test of this paragraph 
(f)(2) for any prior taxable year if the average annual gross receipts 
of such corporation for the 3 taxable years (or, if shorter, the taxable 
years during which such corporation was in existence) ending with such 
prior taxable year does not exceed $5,000,000. In the case of a C 
corporation exempt from federal income taxes under section 501(a), or a 
trust subject to tax under section 511(b) that is treated as a C 
corporation under paragraph (a)(3) of this section, only gross

[[Page 103]]

receipts from the activities of such corporation or trust that 
constitute unrelated trades or businesses are taken into account in 
determining whether the $5,000,000 gross receipts test is satisfied. A 
partnership with a C corporation as a partner meets the $5,000,000 gross 
receipts test of this paragraph (f)(2) for any prior taxable year if the 
average annual gross receipts of such partnership for the 3 taxable 
years (or, if shorter, the taxable years during which such partnership 
was in existence) ending with such prior year does not exceed 
$5,000,000. The gross receipts of the corporate partner are not taken 
into account in determining whether the partnership meets the $5,000,000 
gross receipts test.
    (ii) Aggregation of gross receipts. For purposes of determining 
whether the $5,000,000 gross receipts test has been satisfied, all 
persons treated as a single employer under section 52 (a) or (b), or 
section 414 (m) or (o) (or who would be treated as a single employer 
under such sections if they had employees) shall be treated as one 
person. Gross receipts attributable to transactions between persons who 
are treated as a common employer under this paragraph shall not be taken 
into account in determining whether the $5,000,000 gross receipts test 
is satisified.
    (iii) Treatment of short taxable year. In the case of any taxable 
year of less than 12 months (a short taxable year), the gross receipts 
shall be annualized by (A) multiplying the gross receipts for the short 
period by 12 and (B) dividing the result by the number of months in the 
short period.
    (iv) Determination of gross receipts--(A) In general. The term 
``gross receipts'' means gross receipts of the taxable year in which 
such receipts are properly recognized under the taxpayer's accounting 
method used in that taxable year (determined without regard to this 
section) for federal income tax purposes. For this purpose, gross 
receipts include total sales (net of returns and allowances) and all 
amounts received for services. In addition, gross receipts include any 
income from investments, and from incidental or outside sources. For 
example, gross receipts include interest (including original issue 
discount and tax-exempt interest within the meaning of section 103), 
dividends, rents, royalties, and annuities, regardless of whether such 
amounts are derived in the ordinary course of the taxpayer's trade of 
business. Gross receipts are not reduced by cost of goods sold or by the 
cost of property sold if such property is described in section 1221 (1), 
(3), (4) or (5). With respect to sales of capital assets as defined in 
section 1221, or sales of property described in 1221 (2) (relating to 
property used in a trade or business), gross receipts shall be reduced 
by the taxpayer's adjusted basis in such property. Gross receipts do not 
include the repayment of a loan or similar instrument (e.g., a repayment 
of the principal amount of a loan held by a commercial lender). Finally, 
gross receipts do not include amounts received by the taxpayer with 
respect to sales tax or other similar state and local taxes if, under 
the applicable state or local law, the tax is legally imposed on the 
purchaser of the good or service, and the taxpayer merely collects and 
remits the tax to the taxing authority. If, in contrast, the tax is 
imposed on the taxpayer under the applicable law, then gross receipts 
shall include the amounts received that are allocable to the payment of 
such tax.
    (3) Examples. The following examples illustrate the provisions of 
paragraph (f) of this section:

    Example 1. X, a calendar year C corporation, was formed on January 
1, 1986. Assume that in 1986 X has gross receipts of $15 million. For 
taxable year 1987, this section applies to X because in 1986, the period 
during which X was in existence, X has average annual gross receipts of 
more than $5 million.
    Example 2. Y, a calendar year C corporation that is not a qualified 
personal service corporation, has gross receipts of $10 million, $9 
million, and $4 million for taxable years 1984, 1985, and 1986, 
respectively. In taxable year 1986, X has average annual gross receipts 
for the 3-taxable-year period ending with 1986 of $7.67 million ($10 
million + 9 million + 4 million / 3). Thus, for taxable year 1987, this 
section applies and Y must change from the cash method for such year.
    Example 3. Z, a C corporation which is not a qualified personal 
service corporation, has a 5% partnership interest in ZAB partnership, a 
calendar year cash method taxpayer. All other partners of ZAB 
partnership are individuals. Z corporation has average annual gross 
receipts of $100,000 for the 3-taxable-year period ending with 1986 
(i.e., 1984, 1985

[[Page 104]]

and 1986). The ZAB partnership has average annual gross receipts of $6 
million for the same 3-taxable-year period. Since ZAB fails to meet the 
$5,000,000 gross receipts test for 1986, this section applies to ZAB for 
its taxable year beginning January 1, 1987. Accordingly, ZAB must change 
from the cash method for its 1987 taxable year. The gross receipts of Z 
corporation are not relevant in determining whether ZAB is subject to 
this section.
    Example 4. The facts are the same as in Example 3, except that 
during the 1987 taxable year of ZAB, the Z corporation transfers its 
partnership interest in ZAB to an individual. Under paragraph (a)(1) of 
this section, ZAB is treated as a partnership with a C corporation as a 
partner. Thus, this section requires ZAB to change from the cash method 
effective for its taxable year 1987. If ZAB later desires to change its 
method of accounting to the cash method for its taxable year beginning 
January 1, 1988 (or later), ZAB must comply with all requirements of 
law, including sections 446(b), 446(e), and 481, to effect the change.
    Example 5. X, a C corporation that is not a qualified personal 
service corporation, was formed on January 1, 1986, in a transaction 
described in section 351. In the transaction, A, an individual, 
contributed all of the assets and liabilities of B, a trade or business, 
to X, in return for the receipt of all the outstanding stock of X. 
Assume that in 1986 X has gross receipts of $4 million. In 1984 and 
1985, the gross receipts of B, the trade or business, were $10 million 
and $7 million respectively. The gross receipts test is applied for the 
period during which X and its predecessor trade or business were in 
existence. X has average annual gross receipts for the 3-taxable-year 
period ending with 1986 of $7 million ($10 million + $7 million + $4 
million / 3). Thus, for taxable year 1987, this section applies and X 
must change from the cash method for such year.

[T.D. 8143, 52 FR 22766, June 16, 1987, as amended by T.D. 8329, 56 FR 
485, Jan. 7, 1991; T.D. 8514, 58 FR 68299, Dec. 27, 1993; T.D. 9174, 70 
FR 704, Jan. 5, 2005]



Sec.  1.448-2  Limitation on the use of the cash receipts 
and disbursements method of accounting for taxable years beginning 
after December 31, 2017.

    (a) Limitation on method of accounting--(1) In general. The rules of 
this section relate to the limitation on the use of the cash receipts 
and disbursements method of accounting (cash method) by certain 
taxpayers applicable for taxable years beginning after December 31, 
2017. For rules applicable to taxable years beginning before January 1, 
2018, see Sec. Sec.  1.448-1 and 1.448-1T.
    (2) Limitation rule. Except as otherwise provided in this section, 
the computation of taxable income using the cash method is prohibited in 
the case of a:
    (i) C corporation;
    (ii) Partnership with a C corporation as a partner, or a partnership 
that had a C corporation as a partner at any time during the 
partnership's taxable year beginning after December 31, 1986; or
    (iii) Tax shelter.
    (3) Treatment of combination methods--(i) In general. For purposes 
of this section, the use of a method of accounting that records some, 
but not all, items on the cash method is considered the use of the cash 
method. Thus, a C corporation that uses a combination of accounting 
methods including the use of the cash method is subject to this section.
    (ii) Example. The following example illustrates the operation of 
this paragraph (a)(3). In 2020, A is a C corporation with average annual 
gross receipts for the prior three taxable years of greater than $30 
million, is not a tax shelter under section 448(a)(3) and does not 
qualify as a qualified personal service corporation, as defined in 
paragraph (e) of this section. For the last 20 years, A used an accrual 
method for items of income and expenses related to purchases and sales 
of inventory, and the cash method for items related to its provision of 
services. A is using a combination of accounting methods that include 
the cash method. Thus, A is subject to section 448. A is prohibited from 
using the cash method for any item for 2020 and is required to change to 
a permissible method.
    (b) Definitions. For purposes of this section--
    (1) C corporation--(i) In general. The term C corporation means any 
corporation that is not an S corporation (as defined in section 
1361(a)(1)). For example, a regulated investment company (as defined in 
section 851) or a real estate investment trust (as defined in section 
856) is a C corporation for purposes of this section. In addition, a 
trust subject to tax under section 511(b) is treated, for purposes of 
this section, as a C corporation, but only

[[Page 105]]

with respect to the portion of its activities that constitute an 
unrelated trade or business. Similarly, for purposes of this section, a 
corporation that is exempt from Federal income taxes under section 
501(a) is treated as a C corporation only with respect to the portion of 
its activities that constitute an unrelated trade or business. Moreover, 
for purposes of determining whether a partnership has a C corporation as 
a partner, any partnership described in paragraph (a)(2)(ii) of this 
section is treated as a C corporation. Thus, if partnership ABC has a 
partner that is a partnership with a C corporation, then, for purposes 
of this section, partnership ABC is treated as a partnership with a C 
corporation partner.
    (ii) [Reserved]
    (2) Tax shelter--(i) In general. The term tax shelter means any--
    (A) Enterprise, other than a C corporation, if at any time, 
including taxable years beginning before January 1, 1987, interests in 
such enterprise have been offered for sale in any offering required to 
be registered with any Federal or state agency having the authority to 
regulate the offering of securities for sale;
    (B) Syndicate, within the meaning of paragraph (b)(2)(iii) of this 
section; or
    (C) Tax shelter, within the meaning of section 6662(d)(2)(C).
    (ii) Requirement of registration. For purposes of paragraph 
(b)(2)(i)(A) of this section, an offering is required to be registered 
with a Federal or state agency if, under the applicable Federal or state 
law, failure to register the offering would result in a violation of the 
applicable Federal or state law. This rule applies regardless of whether 
the offering is in fact registered. In addition, an offering is required 
to be registered with a Federal or state agency if, under the applicable 
Federal or state law, failure to file a notice of exemption from 
registration would result in a violation of the applicable Federal or 
state law, regardless of whether the notice is in fact filed. However, 
an S corporation is not treated as a tax shelter for purposes of section 
448(d)(3) or this section merely by reason of being required to file a 
notice of exemption from registration with a state agency described in 
section 461(i)(3)(A), but only if all corporations offering securities 
for sale in the state must file such a notice in order to be exempt from 
such registration.
    (iii) Syndicate--(A) In general. For purposes of paragraph 
(b)(2)(i)(B) of this section, the term syndicate means a partnership or 
other entity (other than a C corporation) if more than 35 percent of the 
losses of such entity during the taxable year (for taxable years 
beginning after December 31, 1986) are allocated to limited partners or 
limited entrepreneurs. For purposes of this paragraph (b)(2)(iii), the 
term limited entrepreneur has the same meaning given such term in 
section 461(k)(4). In addition, in determining whether an interest in a 
partnership is held by a limited partner, or an interest in an entity or 
enterprise is held by a limited entrepreneur, section 461(k)(2) applies 
in the case of the trade or business of farming (as defined in paragraph 
(d)(2) of this section), and section 1256(e)(3)(C) applies in all other 
cases. Moreover, for purposes of paragraph (b)(2) of this section, the 
losses of a partnership, entity, or enterprise (entities) means the 
excess of the deductions allowable to the entities over the amount of 
income recognized by such entities under the entities' method of 
accounting used for Federal income tax purposes (determined without 
regard to this section). For this purpose, gains or losses from the sale 
of capital assets or assets described in section 1221(a)(2) are not 
taken into account.
    (B) Irrevocable annual election to test the allocation of losses 
from prior taxable year--(1) In general. For purposes of paragraph 
(b)(2)(iii)(A) of this section, to determine if more than 35 percent of 
the losses of a venture are allocated to limited partners or limited 
entrepreneurs, entities may elect to use the allocations made in the 
immediately preceding taxable year instead of using the current taxable 
year's allocation. An election under this paragraph (b)(2)(iii)(B) 
applies only to the taxable year for which the election is made. Except 
as otherwise provided in guidance published in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2) of this chapter), a taxpayer that 
makes an election under this paragraph (b)(2)(iii)(B) must apply this 
election for other provisions

[[Page 106]]

of the Code that specifically apply the definition of tax shelter in 
section 448(a)(3).
    (2) Time and manner of making election. A taxpayer makes this 
election for the taxable year by attaching a statement to its timely 
filed original Federal income tax return (including extensions) for such 
taxable year. The statement must state that the taxpayer is making the 
election under Sec.  1.448-2(b)(2)(iii)(B). In the case of an S 
corporation or partnership, the election is made by the S corporation or 
the partnership and not by the shareholders or partners. An election 
under this paragraph (b)(2)(iii)(B) may not be made by the taxpayer in 
any other manner. For example, the election cannot be made through a 
request under section 446(e) to change the taxpayer's method of 
accounting. A taxpayer may not revoke an election under this paragraph 
(b)(2)(iii)(B).
    (3) Administrative guidance. The IRS may publish procedural guidance 
in the Internal Revenue Bulletin (see Sec.  601.601(d)(2) of this 
chapter) that provides alternative procedures for complying with 
paragraph (b)(2)(iii)(B)(2) of this section.
    (C) Examples. The following examples illustrate the rules of 
paragraph (b)(2)(iii) of this section. For purposes of the examples, the 
term ``losses'' has the meaning stated in paragraph (b)(2)(iii)(A) of 
this section.
    (1) Example 1. Taxpayer B is a calendar year limited partnership, 
with no active management from its limited partner. For 2019, B is 
profitable and has no losses to allocate to its limited partner. For 
2020, B is not profitable and allocates 60 percent of its losses to its 
general partner and 40 percent of its losses to its limited partner. For 
2021, B is not profitable and allocates 50 percent of its losses to its 
general partner and 50 percent of its losses to its limited partner. For 
taxable year 2020, B makes an election under paragraph (b)(2)(iii)(B) of 
this section to use its prior year allocated amounts. Accordingly, for 
2020, B is not a syndicate because B was profitable for 2019 and did not 
allocate any losses to its limited partner in 2019. For 2021, B is a 
syndicate because B allocated 50 percent of its 2021 losses to its 
limited partner under paragraph (b)(2)(ii)(3)(A) of this section. Even 
if B made an election under paragraph (b)(2)(iii)(B) of this section to 
use prior year allocated amounts, B is a syndicate for 2021 because B 
allocated 40 percent of its 2020 losses to its limited partner in 2020. 
Because B is a syndicate under paragraph (b)(2)(iii)(A) of this section 
for 2021, B is a tax shelter prohibited from using the cash method for 
taxable year 2021 under paragraph (b)(2)(i)(B) of this section.
    (2) Example (2). Same facts as Example (1) in paragraph 
(b)(2)(iii)(C)(1) of this section, except for 2021, B is profitable and 
has no losses to allocate to its limited partner. For 2020, B makes an 
election under paragraph (b)(2)(iii)(B) of this section to use its prior 
year allocated amounts. Accordingly, for 2020, B is not a syndicate 
because it did not any allocate any losses to its limited partner in 
2019. For 2021, B chooses not to make the election under paragraph 
(b)(2)(iii)(B) of this section. For 2021, B is not a syndicate because 
it does not have any 2021 losses to allocate to a limited partner. For 
taxable years 2019, 2020 and 2021, B is not a syndicate under paragraph 
(b)(2)(iii)(A) of this section and is not prohibited from using the cash 
method for taxable years 2019, 2020 or 2021 under paragraph (b)(2)(i)(B) 
of this section.
    (iv) Presumed tax avoidance. For purposes of (b)(2)(i)(C) of this 
section, marketed arrangements in which persons carrying on farming 
activities using the services of a common managerial or administrative 
service will be presumed to have the principal purpose of tax avoidance 
if such persons use borrowed funds to prepay a substantial portion of 
their farming expenses. Payments for farm supplies that will not be used 
or consumed until a taxable year subsequent to the taxable year of 
payment are an example of one type of such prepayment.
    (v) Taxable year tax shelter must change accounting method. A tax 
shelter must change from the cash method for the taxable year that it 
becomes a tax shelter, as determined under paragraph (b)(2) of this 
section.
    (vi) Determination of loss amount. For purposes of section 
448(d)(3), the amount of losses to be allocated under

[[Page 107]]

section 1256(e)(3)(B) is calculated without regard to section 163(j).
    (c) Exception for entities with gross receipts not in excess of the 
amount provided in section 448(c)--(1) In general. Except in the case of 
a tax shelter, this section does not apply to any C corporation or 
partnership with a C corporation as a partner for any taxable year if 
such corporation or partnership (or any predecessor thereof) meets the 
gross receipts test of paragraph (c)(2) of this section.
    (2) Gross receipts test--(i) In general. A corporation meets the 
gross receipts test of this paragraph (c)(2) if the average annual gross 
receipts of such corporation for the 3 taxable years (or, if shorter, 
the taxable years during which such corporation was in existence, 
annualized as required) ending with such prior taxable year does not 
exceed the gross receipts test amount provided in paragraph (c)(2)(v) of 
this section (section 448(c) gross receipts test). In the case of a C 
corporation exempt from Federal income taxes under section 501(a), or a 
trust subject to tax under section 511(b) that is treated as a C 
corporation under paragraph (b)(1) of this section, only gross receipts 
from the activities of such corporation or trust that constitute 
unrelated trades or businesses are taken into account in determining 
whether the gross receipts test is satisfied. A partnership with a C 
corporation as a partner meets the gross receipts test of paragraph 
(c)(2) of this section if the average annual gross receipts of such 
partnership for the 3 taxable years (or, if shorter, the taxable years 
during which such partnership was in existence annualized as required) 
ending with such prior year does not exceed the gross receipts test 
amount of paragraph (c)(2)(v) of this section. Except as provided in 
paragraph (c)(2)(ii) of this section, the gross receipts of the 
corporate partner are not taken into account in determining whether a 
partnership meets the gross receipts test of paragraph (c)(2) of this 
section.
    (ii) Aggregation of gross receipts. The aggregation rules in Sec.  
1.448-1T(f)(2)(ii) apply for purposes of aggregating gross receipts for 
purposes of this section.
    (iii) Treatment of short taxable year. The short taxable year rules 
in Sec.  1.448-1T(f)(2)(iii) apply for purposes of this section.
    (iv) Determination of gross receipts. The determination of gross 
receipts rules in Sec.  1.448-1T(f)(2)(iv) apply for purposes of this 
section.
    (v) Gross receipts test amount--(A) In general. For purposes of 
paragraph (c) of this section, the term gross receipts test amount means 
$25,000,000, adjusted annually for inflation in the manner provided in 
section 448(c)(4). The inflation adjusted gross receipts test amount is 
published annually in guidance published in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2)(ii) of this chapter).
    (B) Example. Taxpayer A, a C corporation, is a plumbing contractor 
that installs plumbing fixtures in customers' homes or businesses. A's 
gross receipts for the 2017-2019 taxable years are $20 million, $16 
million, and $30 million, respectively. A's average annual gross 
receipts for the three taxable-year period preceding the 2020 taxable 
year is $22 million (($20 million + $16 million + $30 million)/3) = $22 
million. A may use the cash method for its trade or business for the 
2020 taxable year because its average annual gross receipts for the 
preceding three taxable years is not more than the gross receipts test 
amount of paragraph (c)(2)(vi) of this section, which is $26 million for 
2020.
    (d) Exception for farming businesses--(1) In general. Except in the 
case of a tax shelter, this section does not apply to any farming 
business. A taxpayer engaged in a farming business and a separate non-
farming business is not prohibited by this section from using the cash 
method with respect to the farming business, even though the taxpayer 
may be prohibited by this section from using the cash method with 
respect to the non-farming business.
    (2) Farming business--(i) In general. For purposes of paragraph (d) 
of this section, the term farming business means--
    (A) The trade or business of farming as defined in section 
263A(e)(4) (including the operation of a nursery or sod farm, or the 
raising or harvesting of trees bearing fruit, nuts or other crops, or 
ornamental trees),
    (B) The raising, harvesting, or growing of trees described in 
section

[[Page 108]]

263A(c)(5) (relating to trees raised, harvested, or grown by the 
taxpayer other than trees described in paragraph (d)(2)(i)(A) of this 
section),
    (C) The raising of timber, or
    (D) Processing activities which are normally incident to the 
growing, raising, or harvesting of agricultural products.
    (ii) Example. Assume a taxpayer is in the business of growing fruits 
and vegetables. When the fruits and vegetables are ready to be 
harvested, the taxpayer picks, washes, inspects, and packages the fruits 
and vegetables for sale. Such activities are normally incident to the 
raising of these crops by farmers. The taxpayer will be considered to be 
in the business of farming with respect to the growing of fruits and 
vegetables, and the processing activities incident to the harvest.
    (iii) Processing activities excluded from farming businesses--(A) In 
general. For purposes of this section, a farming business does not 
include the processing of commodities or products beyond those 
activities normally incident to the growing, raising, or harvesting of 
such products.
    (B) Examples. (1) Example 1. Assume that a C corporation taxpayer is 
in the business of growing and harvesting wheat and other grains. The 
taxpayer processes the harvested grains to produce breads, cereals, and 
similar food products which it sells to customers in the course of its 
business. Although the taxpayer is in the farming business with respect 
to the growing and harvesting of grain, the taxpayer is not in the 
farming business with respect to the processing of such grains to 
produce breads, cereals, and similar food products which the taxpayer 
sells to customers.
    (2) Example 2. Assume that a taxpayer is in the business of raising 
livestock. The taxpayer uses the livestock in a meat processing 
operation in which the livestock are slaughtered, processed, and 
packaged or canned for sale to customers. Although the taxpayer is in 
the farming business with respect to the raising of livestock, the 
taxpayer is not in the farming business with respect to the meat 
processing operation.
    (e) Exception for qualified personal service corporation. The rules 
in Sec.  1.448-1T(e) relating to the exception for qualified personal 
service corporations apply for taxable years beginning after December 
31, 2017.
    (f) Effect of section 448 on other provisions. Except as provided in 
paragraph (b)(2)(iii)(B) of this section, nothing in section 448 shall 
have any effect on the application of any other provision of law that 
would otherwise limit the use of the cash method, and no inference shall 
be drawn from section 448 with respect to the application of any such 
provision. For example, nothing in section 448 affects the requirement 
of section 447 that certain corporations must use an accrual method of 
accounting in computing taxable income from farming, or the requirement 
of Sec.  1.446-1(c)(2) that, in general, an accrual method be used with 
regard to purchases and sales of inventory. Similarly, nothing in 
section 448 affects the authority of the Commissioner under section 
446(b) to require the use of an accounting method that clearly reflects 
income, or the requirement under section 446(e) that a taxpayer secure 
the consent of the Commissioner before changing its method of 
accounting. For example, a taxpayer using the cash method may be 
required to change to an accrual method of accounting under section 
446(b) because such method clearly reflects the taxpayer's income, even 
though the taxpayer is not prohibited by section 448 from using the cash 
method. Similarly, a taxpayer using an accrual method of accounting that 
is not prohibited by section 448 from using the cash method may not 
change to the cash method unless the taxpayer secures the consent of the 
Commissioner under section 446(e).
    (g) Treatment of accounting method change and rules for section 
481(a) adjustment--(1) In general. Any taxpayer to whom section 448 
applies must change its method of accounting in accordance with the 
provisions of this paragraph (g). In the case of any taxpayer required 
by this section to change its method of accounting, the change shall be 
treated as a change initiated by the taxpayer to compute the adjustment 
required under section 481. A taxpayer must change to an overall accrual 
method of accounting for the first taxable year the taxpayer is subject 
to

[[Page 109]]

this section or a subsequent taxable year in which the taxpayer is newly 
subject to this section after previously making a change in method of 
accounting that complies with section 448 (mandatory section 448 year). 
A taxpayer may have more than one mandatory section 448 year. For 
example, a taxpayer may exceed the gross receipts test of section 448(c) 
in non-consecutive taxable years. If the taxpayer complies with the 
provisions of paragraph (g) of this section for its mandatory section 
448 year, the change shall be treated as made with the consent of the 
Commissioner. The change shall be implemented pursuant to the applicable 
administrative procedures to obtain the automatic consent of the 
Commissioner to change a method of accounting under section 446(e) as 
published in the Internal Revenue Bulletin (see Revenue Procedure 2015-
13 (2015-5 IRB 419) (or successor) (see also Sec.  601.601(d)(2) of this 
chapter)). This paragraph (g) applies only to a taxpayer who changes 
from the cash method as required by this section. This paragraph (g) 
does not apply to a change in method of accounting required by any Code 
section (or applicable regulation) other than this section.
    (2) Section 481(a) adjustment. The amount of the net section 481(a) 
adjustment and the adjustment period necessary to implement a change in 
method of accounting required under this section are determined under 
Sec.  1.446-1(e) and the applicable administrative procedures to obtain 
the Commissioner's consent to change a method of accounting as published 
in the Internal Revenue Bulletin (see Revenue Procedure 2015-13 (2015-5 
IRB 419) (or successor) (see also Sec.  601.601(d)(2) of this chapter).
    (h) Applicability dates. The rules of this section apply for taxable 
years beginning on or after January 5, 2021. However, for a taxable year 
beginning after December 31, 2017, and before January 5, 2021, a 
taxpayer may apply the rules provided in this section provided that the 
taxpayer follows all the applicable rules contained in the regulations 
under section 448 for such taxable year and all subsequent taxable 
years.

[T.D. 9942, 86 FR 269, Jan. 5, 2021, as amended by 86 FR 32186, June 17, 
2021]



Sec.  1.448-3  Nonaccrual of certain amounts by service providers.

    (a) In general. This section applies to taxpayers qualified to use a 
nonaccrual-experience method of accounting provided for in section 
448(d)(5) with respect to amounts to be received for the performance of 
services. A taxpayer that satisfies the requirements of this section is 
not required to accrue any portion of amounts to be received from the 
performance of services that, on the basis of the taxpayer's experience, 
and to the extent determined under the computation or formula used by 
the taxpayer and allowed under this section, will not be collected. 
Except as otherwise provided in this section, a taxpayer is qualified to 
use a nonaccrual-experience method of accounting if the taxpayer uses an 
accrual method of accounting with respect to amounts to be received for 
the performance of services by the taxpayer and either--
    (1) The services are in fields referred to in section 448(d)(2)(A) 
and described in Sec.  1.448-1T(e)(4) (health, law, engineering, 
architecture, accounting, actuarial science, performing arts, or 
consulting); or
    (2) The taxpayer meets the gross receipts test of section 448(c) and 
Sec.  1.448-1T(f)(2) (in the case of taxable years beginning before 
January 1, 2018), or Sec.  1.448-2(c) (in the case of taxable years 
beginning after December 31, 2017) for all prior taxable years.
    (b) Application of method and treatment as method of accounting. The 
rules of section 448(d)(5) and the regulations are applied separately to 
each taxpayer. For purposes of section 448(d)(5), the term taxpayer has 
the same meaning as the term person defined in section 7701(a)(1) 
(rather than the meaning of the term defined in section 7701(a)(14)). 
The nonaccrual of amounts to be received for the performance of services 
is a method of accounting (a nonaccrual-experience method). A change to 
a nonaccrual-experience method, from one nonaccrual-experience method to 
another nonaccrual-experience method, or to a periodic system (for 
example, see Notice 88-51 (1988-1 C.B. 535) and Sec.  
601.601(d)(2)(ii)(b) of this chapter), is a change in method of 
accounting to which the provisions of sections 446 and

[[Page 110]]

481 and the regulations apply. See also paragraphs (c)(2)(i), (c)(5), 
(d)(4), and (e)(3)(i) of this section. Except as provided in other 
published guidance, a taxpayer who wishes to adopt or change to any 
nonaccrual-experience method other than one of the safe harbor methods 
described in paragraph (f) of this section must request and receive 
advance consent from the Commissioner in accordance with the applicable 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent.
    (c) Definitions and special rules--(1) Accounts receivable--(i) In 
general. Accounts receivable include only amounts that are earned by a 
taxpayer and otherwise recognized in income through the performance of 
services by the taxpayer. For purposes of determining a taxpayer's 
nonaccrual-experience under any method provided in this section, amounts 
described in paragraph (c)(1)(ii) of this section are not taken into 
account. Except as otherwise provided, for purposes of this section, 
accounts receivable do not include amounts that are not billed (such as 
for charitable or pro bono services) or amounts contractually not 
collectible (such as amounts in excess of a fee schedule agreed to by 
contract). See paragraph (g) Examples 1 and 2 of this section for 
examples of this rule.
    (ii) Method not available for certain receivables--(A) Amounts not 
earned and recognized through the performance of services. A nonaccrual-
experience method of accounting may not be used with respect to amounts 
that are not earned by a taxpayer and otherwise recognized in income 
through the performance of services by the taxpayer. For example, a 
nonaccrual-experience method may not be used with respect to amounts 
owed to the taxpayer by reason of the taxpayer's activities with respect 
to lending money, selling goods, or acquiring accounts receivable or 
other rights to receive payment from other persons (including persons 
related to the taxpayer) regardless of whether those persons earned the 
amounts through the provision of services. However, see paragraph (d)(3) 
of this section for special rules regarding acquisitions of a trade or 
business or a unit of a trade or business.
    (B) If interest or penalty charged on amounts due. A nonaccrual-
experience method of accounting may not be used with respect to amounts 
due for which interest is required to be paid or for which there is any 
penalty for failure to timely pay any amounts due. For this purpose, a 
taxpayer will be treated as charging interest or penalties for late 
payment if the contract or agreement expressly provides for the charging 
of interest or penalties for late payment, regardless of the practice of 
the parties. If the contract or agreement does not expressly provide for 
the charging of interest or penalties for late payment, the 
determination of whether the taxpayer charges interest or penalties for 
late payment will be made based on all of the facts and circumstances of 
the transaction, and not merely on the characterization by the parties 
or the treatment of the transaction under state or local law. However, 
the offering of a discount for early payment of an amount due will not 
be regarded as the charging of interest or penalties for late payment 
under this section, if--
    (1) The full amount due is otherwise accrued as gross income by the 
taxpayer at the time the services are provided; and
    (2) The discount for early payment is treated as an adjustment to 
gross income in the year of payment, if payment is received within the 
time required for allowance of the discount. See paragraph (g) Example 3 
of this section for an example of this rule.
    (2) Applicable period--(i) In general. The applicable period is the 
number of taxable years on which the taxpayer bases its nonaccrual-
experience method. A change in the number of taxable years included in 
the applicable period is a change in method of accounting to which the 
procedures of section 446 apply. A change in the inclusion or exclusion 
of the current taxable year in the applicable period is a change in 
method of accounting to which the procedures of section 446 apply. A 
change in the number of taxable years included in the applicable period 
or the inclusion or exclusion of the current taxable year in the 
applicable period is made on a cut-off basis.

[[Page 111]]

    (ii) Applicable period for safe harbors. For purposes of the safe 
harbors under paragraph (f) of this section the applicable period may 
consist of at least three but not more than six of the immediately 
preceding consecutive taxable years. Alternatively, the applicable 
period may consist of the current taxable year and at least two but not 
more than five of the immediately preceding consecutive taxable years. A 
period shorter than six taxable years is permissible only if the period 
contains the most recent preceding taxable years and all of the taxable 
years in the applicable period are consecutive.
    (3) Bad debts. Bad debts are accounts receivable determined to be 
uncollectible and charged off.
    (4) Charge-offs. Amounts charged off include only those amounts that 
would otherwise be allowable under section 166(a).
    (5) Determination date. The determination date in safe harbor 2 
provided in paragraph (f)(2) of this section is used as a cut-off date 
for determining all known data to be taken into account in the 
computation of the taxable year's uncollectible amount. The 
determination date may not be later than the earlier of the due date, 
including extensions, for filing the taxpayer's Federal income tax 
return for that taxable year or the date on which the taxpayer timely 
files the return for that taxable year. The determination date may be 
different in each taxable year. However, once a determination date is 
selected and used for a particular taxable year, it may not be changed 
for that taxable year. The choice of a determination date is not a 
method of accounting.
    (6) Recoveries. Recoveries are amounts previously excluded from 
income under a nonaccrual-experience method or charged off that the 
taxpayer recovers.
    (7) Uncollectible amount. The uncollectible amount is the portion of 
any account receivable amount due that, under the taxpayer's nonaccrual-
experience method, will be not collected.
    (d) Use of experience to estimate uncollectible amounts--(1) In 
general. In determining the portion of any amount due that, on the basis 
of experience, will not be collected, a taxpayer may use any nonaccrual-
experience method that clearly reflects the taxpayer's nonaccrual-
experience. The determination of whether a nonaccrual-experience method 
clearly reflects the taxpayer's nonaccrual-experience is made in 
accordance with the rules under paragraph (e) of this section. 
Alternatively, the taxpayer may use any one of the five safe harbor 
nonaccrual-experience methods of accounting provided in paragraphs 
(f)(1) through (f)(5) of this section, which are presumed to clearly 
reflect a taxpayer's nonaccrual-experience.
    (2) Application to specific accounts receivable. The nonaccrual-
experience method is applied with respect to each account receivable of 
the taxpayer that is eligible for this method. With respect to a 
particular account receivable, the taxpayer determines, in the manner 
prescribed in paragraphs (d)(1) or (f)(1) through (f)(5) of this section 
(whichever applies), the uncollectible amount. The determination is 
required to be made only once with respect to each account receivable, 
regardless of the term of the receivable. The uncollectible amount is 
not recognized as gross income. Thus, the amount recognized as gross 
income is the amount that would otherwise be recognized as gross income 
with respect to the account receivable, less the uncollectible amount. A 
taxpayer that excludes an amount from income during a taxable year as a 
result of the taxpayer's use of a nonaccrual-experience method may not 
deduct in any subsequent taxable year the amount excluded from income. 
Thus, the taxpayer may not deduct the excluded amount in a subsequent 
taxable year in which the taxpayer actually determines that the amount 
is uncollectible and charges it off. If a taxpayer using a nonaccrual-
experience method determines that an amount that was not excluded from 
income is uncollectible and should be charged off (for example, a 
calendar-year taxpayer determines on November 1st that an account 
receivable that was originated on May 1st of the same taxable year is 
uncollectible and should be charged off), the taxpayer may deduct the 
amount charged off when it is

[[Page 112]]

charged off, but must include any subsequent recoveries in income. The 
reasonableness of a taxpayer's determination that amounts are 
uncollectible and should be charged off may be considered on 
examination. See paragraph (g) Example 12 of this section for an example 
of this rule.
    (3) Acquisitions and dispositions--(i) Acquisitions. If a taxpayer 
acquires the major portion of a trade or business of another person 
(predecessor) or the major portion of a separate unit of a trade or 
business of a predecessor, then, for purposes of applying this section 
for any taxable year ending on or after the acquisition, the experience 
from preceding taxable years of the predecessor attributable to the 
portion of the trade or business acquired, if available, must be used in 
determining the taxpayer's experience.
    (ii) Dispositions. If a taxpayer disposes of a major portion of a 
trade or business or the major portion of a separate unit of a trade or 
business, and the taxpayer furnished the acquiring person the 
information necessary for the computations required by this section, 
then, for purposes of applying this section for any taxable year ending 
on or after the disposition, the experience from preceding taxable years 
attributable to the portion of the trade or business disposed may not be 
used in determining the taxpayer's experience.
    (iii) Meaning of terms. For the meaning of the terms acquisition, 
separate unit, and major portion, see paragraph (b) of Sec.  1.52-2. The 
term acquisition includes an incorporation or a liquidation.
    (4) New taxpayers. The rules of this paragraph (d)(4) apply to any 
newly formed taxpayer to which the rules of paragraph (d)(3)(i) of this 
section do not apply. Any newly formed taxpayer that wants to use a safe 
harbor nonaccrual-experience method of accounting described in paragraph 
(f)(1), (f)(2), (f)(3), (f)(4), or (f)(5) of this section applies the 
methods by using the experience of the actual number of taxable years 
available in the applicable period. A newly formed taxpayer that wants 
to use one of the safe harbor nonaccrual-experience methods of 
accounting described in paragraph (f)(2), (f)(4), or (f)(5) of this 
section in its first taxable year and does not have any accounts 
receivable upon formation may not exclude any portion of its year-end 
accounts receivable from income for its first taxable year. The taxpayer 
must begin creating its moving average in its second taxable year by 
tracking the accounts receivable as of the first day of its second 
taxable year. The use of one of the safe harbor nonaccrual-experience 
methods of accounting described in paragraph (f)(2), (f)(4), or (f)(5) 
of this section in a taxpayer's second taxable year in this situation is 
not a change in method of accounting. Although the taxpayer must 
maintain the books and records necessary to perform the computations 
under the adopted safe harbor nonaccrual-experience method, the taxpayer 
is not required to affirmatively elect the method on its Federal income 
tax return for its first taxable year.
    (5) Recoveries. Regardless of the nonaccrual-experience method of 
accounting used by a taxpayer under this section, the taxpayer must take 
recoveries into account. If, in a subsequent taxable year, a taxpayer 
recovers an amount previously excluded from income under a nonaccrual-
experience method or charged off, the taxpayer must include the 
recovered amount in income in that subsequent taxable year. See 
paragraph (g) Example 13 of this section for an example of this rule.
    (6) Request to exclude taxable years from applicable period. A 
period shorter than the applicable period generally is permissible only 
if the period consists of consecutive taxable years and there is a 
change in the type of a substantial portion of the outstanding accounts 
receivable such that the risk of loss is substantially increased. A 
decline in the general economic conditions in the area, which 
substantially increases the risk of loss, is a relevant factor in 
determining whether a shorter period is appropriate. However, approval 
to use a shorter period will not be granted unless the taxpayer supplies 
evidence that the accounts receivable outstanding at the close of the 
taxable years for the shorter period requested are more comparable in 
nature and risk to accounts receivable outstanding at the close of the 
current taxable

[[Page 113]]

year. A substantial increase in a taxpayer's bad debt experience is not, 
by itself, sufficient to justify the use of a shorter period. If 
approval is granted to use a shorter period, the experience for the 
excluded taxable years may not be used for any subsequent taxable year. 
A request for approval to exclude the experience of a prior taxable year 
must be made in accordance with the applicable procedures for requesting 
a letter ruling and must include a statement of the reasons the 
experience should be excluded. A request will not be considered unless 
it is sent to the Commissioner at least 30 days before the close of the 
first taxable year for which the approval is requested.
    (7) Short taxable years. A taxpayer with a short taxable year that 
uses a nonaccrual-experience method that compares accounts receivable 
balance to total bad debts during the taxable year should make 
appropriate adjustments.
    (8) Recordkeeping requirements--(i) A taxpayer using a nonaccrual-
experience method of accounting must keep sufficient books and records 
to establish the amount of any exclusion from gross income under section 
448(d)(5) for the taxable year, including books and records 
demonstrating--
    (A) The nature of the taxpayer's nonaccrual-experience method;
    (B) Whether, for any particular taxable year, the taxpayer qualifies 
to use its nonaccrual-experience method (including the self-testing 
requirements of paragraph (e) of this section (if applicable));
    (C) The taxpayer's determination that amounts are uncollectible;
    (D) The proper amount that is excludable under the taxpayer's 
nonaccrual-experience method; and
    (E) The taxpayer's determination date under paragraph (c)(5) of this 
section (if applicable).
    (ii) If a taxpayer does not maintain records of the data that are 
sufficient to establish the amount of any exclusion from gross income 
under section 448(d)(5) for the taxable year, the Internal Revenue 
Service may change the taxpayer's method of accounting on examination. 
See Sec.  1.6001-1 for rules regarding records.
    (e) Requirements for nonaccrual method to clearly reflect 
experience--(1) In general. A nonaccrual-experience method clearly 
reflects the taxpayer's experience if the taxpayer's nonaccrual-
experience method meets the self-test requirements described in this 
paragraph (e). If a taxpayer is using one of the safe harbor nonaccrual-
experience methods described in paragraphs (f)(1) through (f)(4) of this 
section, its method is deemed to clearly reflect its experience and is 
not subject to the self-testing requirements in paragraphs (e)(2) and 
(e)(3) of this section.
    (2) Requirement to self-test--(i) In general. A taxpayer using, or 
desiring to use, a nonaccrual-experience method must self-test its 
nonaccrual-experience method for its first taxable year for which the 
taxpayer uses, or desires to use, that nonaccrual-experience method 
(first-year self-test) and every three taxable years thereafter (three-
year self-test). Each self-test must be performed by comparing the 
uncollectible amount (under the taxpayer's nonaccrual-experience method) 
with the taxpayer's actual experience. A taxpayer using the safe harbor 
under paragraph (f)(5) of this section must self-test using the safe 
harbor comparison method in paragraph (e)(3) of this section.
    (ii) First-year self-test. The first-year self-test must be 
performed by comparing the uncollectible amount with the taxpayer's 
actual experience for its first taxable year for which the taxpayer 
uses, or desires to use, that nonaccrual-experience method. If the 
uncollectible amount for the first-year self-test is less than or equal 
to the taxpayer's actual experience for its first taxable year for which 
the taxpayer uses, or desires to use, that nonaccrual-experience method, 
the taxpayer's nonaccrual-experience method is treated as clearly 
reflecting its experience for the first taxable year. If, as a result of 
the first-year self-test, the uncollectible amount for the test period 
is greater than the taxpayer's actual experience, then--
    (A) The taxpayer's nonaccrual-experience method is treated as not 
clearly reflecting its experience;

[[Page 114]]

    (B) The taxpayer is not permitted to use that nonaccrual-experience 
method in that taxable year; and
    (C) The taxpayer must change to (or adopt) for that taxable year 
either--
    (1) Another nonaccrual-experience method that clearly reflects 
experience, that is, a nonaccrual-experience method that meets the 
first-year self-test requirement; or
    (2) A safe harbor nonaccrual-experience method described in 
paragraphs (f)(1) through (f)(5) of this section.
    (iii) Three-year self-test--(A) In general. The three-year self-test 
must be performed by comparing the sum of the uncollectible amounts for 
the current taxable year and prior two taxable years (cumulative 
uncollectible amount) with the sum of the taxpayer's actual experience 
for the current taxable year and prior two taxable years (cumulative 
actual experience amount).
    (B) Recapture. If the cumulative uncollectible amount for the test 
period is greater than the cumulative actual experience amount for the 
test period, the taxpayer's uncollectible amount is limited to the 
cumulative actual experience amount for the test period. Any excess of 
the taxpayer's cumulative uncollectible amount over the taxpayer's 
cumulative actual nonaccrual-experience amount excluded from income 
during the test period must be recaptured into income in the third 
taxable year of the three-year self-test period.
    (C) Determination of whether method is permissible or impermissible. 
If the cumulative uncollectible amount is less than 110 percent of the 
cumulative actual experience amount, the taxpayer's nonaccrual-
experience method is treated as a permissible method and the taxpayer 
may continue to use its alternative nonaccrual-experience method, 
subject to the three-year self-test requirement of this paragraph 
(e)(2)(iii). If the cumulative uncollectible amount is greater than or 
equal to 110 percent of the cumulative actual experience amount, the 
taxpayer's nonaccrual-experience method is treated as impermissible in 
the taxable year subsequent to the three-year self-test year and does 
not clearly reflect its experience. The taxpayer must change to another 
nonaccrual-experience method that clearly reflects experience, 
including, for example, one of the safe harbor nonaccrual-experience 
methods described in paragraphs (f)(1) through (f)(5) of this section, 
for the subsequent taxable year. A change in method of accounting from 
an impermissible method under this paragraph (e)(2)(iii)(C) to a 
permissible method in the taxable year subsequent to the three-year 
self-test year is made on a cut-off basis.
    (iv) Determination of taxpayer's actual experience. [Reserved]
    (3) Safe harbor comparison method--(i) In general. A taxpayer using, 
or desiring to use, a nonaccrual-experience method under the safe harbor 
in paragraph (f)(5) of this section must self-test its nonaccrual-
experience method for its first taxable year for which the taxpayer 
uses, or desires to use, that nonaccrual-experience method (first-year 
self-test) and every three taxable years thereafter (three-year self-
test). A nonaccrual-experience method under the safe harbor in paragraph 
(f)(5) of this section is deemed to clearly reflect experience provided 
all the requirements of the safe harbor comparison method of this 
paragraph (e)(3) are met. Each self-test must be performed by comparing 
the uncollectible amount (under the taxpayer's nonaccrual-experience 
method) with the uncollectible amount that would have resulted from use 
of one of the safe harbor methods described in paragraph (f)(1), (f)(2), 
(f)(3), or (f)(4) of this section. A change from a nonaccrual-experience 
method that uses the safe harbor comparison method for self-testing to a 
nonaccrual-experience method that does not use the safe harbor 
comparison method for self-testing, and vice versa, is a change in 
method of accounting to which the provisions of sections 446 and 481 and 
the regulations apply. A change solely to use or discontinue use of the 
safe harbor comparison method for purposes of determining whether the 
nonaccrual-experience method clearly reflects experience must be made on 
a cut-off basis and without audit protection.
    (ii) Requirements to use safe harbor comparison method--(A) First-
year self-test. The first-year self-test must be

[[Page 115]]

performed by comparing the uncollectible amount with the uncollectible 
amount determined under any of the safe harbor methods described in 
paragraph (f)(1), (f)(2), (f)(3), or (f)(4) of this section (safe harbor 
uncollectible amount) for its first taxable year for which the taxpayer 
uses, or desires to use, that nonaccrual-experience method. If the 
uncollectible amount for the first-year self-test is less than or equal 
to the safe harbor uncollectible amount, then the taxpayer's nonaccrual-
experience method is treated as clearly reflecting its experience for 
the first taxable year. If, as a result of the first-year self-test, the 
uncollectible amount for the test period is greater than the safe harbor 
uncollectible amount, then--
    (1) The taxpayer's nonaccrual-experience method is treated as not 
clearly reflecting its experience;
    (2) The taxpayer is not permitted to use that nonaccrual-experience 
method in that taxable year; and
    (3) The taxpayer must change to (or adopt) for that taxable year 
either--
    (i) Another nonaccrual-experience method that clearly reflects 
experience, that is, a nonaccrual-experience method that meets the 
first-year self-test requirement; or
    (ii) A safe harbor nonaccrual-experience method described in 
paragraphs (f)(1) through (f)(5) of this section.
    (B) Three-year self-test. The three-year self-test must be performed 
by comparing the sum of the uncollectible amounts for the current 
taxable year and prior two taxable years (cumulative uncollectible 
amount) with the sum of the uncollectible amount determined under any of 
the safe harbor methods described in paragraph (f)(1), (f)(2), (f)(3), 
or (f)(4) of this section for the current taxable year and prior two 
taxable years (cumulative safe harbor uncollectible amounts). If the 
cumulative uncollectible amount for the three-year self-test is less 
than or equal to the cumulative safe harbor uncollectible amount for the 
test period, then the taxpayer's nonaccrual-experience method is treated 
as clearly reflecting its experience for the test period and the 
taxpayer may continue to use that nonaccrual-experience method, subject 
to a requirement to self-test again after three taxable years. If the 
cumulative uncollectible amount for the test period is greater than the 
cumulative safe harbor uncollectible amount for the test period, the 
taxpayer's uncollectible amount is limited to the cumulative safe harbor 
uncollectible amount for the test period. Any excess of the taxpayer's 
cumulative uncollectible amount over the taxpayer's cumulative safe 
harbor uncollectible amount excluded from income during the test period 
must be recaptured into income in the third taxable year of the three-
year self-test period. If the cumulative uncollectible amount is less 
than 110 percent of the cumulative safe harbor uncollectible amount, the 
taxpayer's nonaccrual-experience method is treated as a permissible 
method and the taxpayer may continue to use its alternative nonaccrual-
experience method, subject to the three-year self-test requirement of 
this paragraph (e)(3)(ii)(B). If the cumulative uncollectible amount is 
greater than or equal to 110 percent of the cumulative safe harbor 
uncollectible amount, the taxpayer's nonaccrual-experience method is 
treated as impermissible in the taxable year subsequent to the three-
year self-test year and does not clearly reflect its experience. The 
taxpayer must change to another nonaccrual-experience method that 
clearly reflects experience, including, for example, one of the safe 
harbor nonaccrual-experience methods described in paragraphs (f)(1) 
through (f)(5) of this section, for the subsequent taxable year. A 
change in method of accounting from an impermissible method under this 
paragraph (e)(3)(ii)(B) to a permissible method in the taxable year 
subsequent to the three-year self-test year is made on a cut-off basis.
    (4) Methods that do not clearly reflect experience. [Reserved]
    (5) Contemporaneous documentation. For purposes of this paragraph 
(e), including the safe harbor comparison method of paragraph (e)(3) of 
this section, a taxpayer must document in its books and records, in the 
taxable year any first-year or three-year self-test is performed, the 
method used to conduct the self-test, including appropriate 
documentation and computations that

[[Page 116]]

resulted in the determination that the taxpayer's nonaccrual-experience 
method clearly reflected the taxpayer's nonaccrual-experience for the 
applicable test period.
    (f) Safe harbors--(1) Safe harbor 1: revenue-based moving average 
method. A taxpayer may use a nonaccrual-experience method under which 
the taxpayer determines the uncollectible amount by multiplying its 
accounts receivable balance at the end of the current taxable year by a 
percentage (revenue-based moving average percentage). The revenue-based 
moving average percentage is computed by dividing the total bad debts 
sustained, adjusted by recoveries received, throughout the applicable 
period by the total revenue resulting in accounts receivable earned 
throughout the applicable period. See paragraph (g) Example 4 of this 
section for an example of this method. Thus, the uncollectible amount 
under the revenue-based moving average method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.003

    (2) Safe harbor 2: actual experience method--(i) Option A: single 
determination date. A taxpayer may use a nonaccrual-experience method 
under which the taxpayer determines the uncollectible amount by 
multiplying its accounts receivable balance at the end of the current 
taxable year by a percentage (moving average nonaccrual-experience 
percentage) and then increasing the resulting amount by 5 percent. See 
paragraph (g) Example 5 of this section for an example of safe harbor 2 
in general, and paragraph (g) Example 6 of this section for an example 
of the single determination date option of safe harbor 2. The taxpayer's 
moving average nonaccrual-experience percentage is computed by dividing 
the total bad debts sustained, adjusted by recoveries that are allocable 
to the bad debts, by the determination date of the current taxable year 
related to the taxpayer's accounts receivable balance at the beginning 
of each taxable year during the applicable period by the sum of the 
accounts receivable at the beginning of each taxable year during the 
applicable period. Thus, the uncollectible amount under Option A of the 
actual experience method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.004

    (ii) Option B: multiple determination dates. Alternatively, in 
computing its bad debts related to the taxpayer's accounts receivable 
balance at the beginning of each taxable year during the applicable 
period, a taxpayer may use the original determination date for each 
taxable year during the applicable period. That is, the taxpayer may use 
bad debts sustained, adjusted by recoveries received that are allocable 
to the bad debts, by the determination date of each taxable year during 
the applicable period rather than the determination date of the current 
taxable year. See paragraph (g) Example 7 of this section for an example 
of the multiple determination date option of safe harbor 2. Thus, the 
uncollectible amount under Option B of the actual experience method is 
computed:

[[Page 117]]

[GRAPHIC] [TIFF OMITTED] TR06SE06.005

    (iii) Tracing of recoveries--(A) In general. Bad debts related to 
the taxpayer's accounts receivable balance at the beginning of each 
taxable year during the applicable period must be adjusted by the 
portion, if any, of recoveries received that are properly allocable to 
the bad debts.
    (B) Specific tracing. If a taxpayer, without undue burden, can trace 
all recoveries to their corresponding charge-offs, the taxpayer must 
specifically trace all recoveries.
    (C) Recoveries cannot be traced without undue burden. If a taxpayer 
has any recoveries that cannot, without undue burden, be traced to 
corresponding charge-offs, the taxpayer may allocate those or all 
recoveries between charge-offs of amounts in the relevant beginning 
accounts receivable balances and other charge-offs using an allocation 
method that is reasonable under all of the facts and circumstances.
    (1) Reasonable allocations. An allocation method is reasonable if 
there is a cause and effect relationship between the allocation base or 
ratio and the recoveries. A taxpayer may elect to trace recoveries that 
are traceable and allocate all untraceable recoveries to charge-offs of 
amounts in the relevant beginning accounts receivable balances. Such an 
allocation method will be deemed to be reasonable under all the facts 
and circumstances.
    (2) Allocations that are not reasonable. Allocation methods that 
generally will not be considered reasonable include, for example, 
methods in which there is not a cause and effect relationship between 
the allocation base or ratio and methods in which receivables for which 
the nonaccrual-experience method is not allowed to be used are included 
in the allocation. See paragraph (c)(1)(ii) of this section for examples 
of receivables for which the nonaccrual-experience method is not 
allowed.
    (3) Safe harbor 3: modified Black Motor method. A taxpayer may use a 
nonaccrual-experience method under which the taxpayer determines the 
uncollectible amount by multiplying its accounts receivable balance at 
the end of the current taxable year by a percentage (modified Black 
Motor moving average percentage) and then reducing the resulting amount 
by the bad debts written off during the current taxable year relating to 
accounts receivable generated during the current taxable year. The 
modified Black Motor moving average percentage is computed by dividing 
the total bad debts sustained, adjusted by recoveries received, during 
the applicable period by the sum of accounts receivable at the end of 
each taxable year during the applicable period. See paragraph (g) 
Example 8 of this section for an example of this method. Thus, the 
uncollectible amount under the modified Black Motor method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.006


[[Page 118]]


    (4) Safe harbor 4: modified moving average method. A taxpayer may 
use a nonaccrual-experience method under which the taxpayer determines 
the uncollectible amount by multiplying its accounts receivable balance 
at the end of the current taxable year by a percentage (modified moving 
average percentage). The modified moving average percentage is computed 
by dividing the total bad debts sustained, adjusted by recoveries 
received, during the applicable period other than bad debts that were 
written off in the same taxable year the related accounts receivable 
were generated by the sum of accounts receivable at the beginning of 
each taxable year during the applicable period. See paragraph (g) 
Example 9 of this section for an example of this method. Thus, the 
uncollectible amount under the modified moving average method is 
computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.007

    (5) Safe harbor 5: alternative nonaccrual-experience method. A 
taxpayer may use an alternative nonaccrual-experience method that 
clearly reflects the taxpayer's actual nonaccrual-experience, provided 
the taxpayer's alternative nonaccrual-experience method meets the self-
test requirements described in paragraph (e)(3) of this section.
    (g) Examples. The following examples illustrate the provisions of 
this section. In each example, the taxpayer uses a calendar year for 
Federal income tax purposes and an accrual method of accounting, does 
not require the payment of interest or penalties with respect to past 
due accounts receivable (except in the case of Example 3) and, in the 
case of Examples 5 through 7, selects an appropriate determination date 
for each taxable year. The examples are as follows:

    Example 1. Contractual allowance or adjustment. B, a healthcare 
provider, performs a medical procedure on individual C, who has health 
insurance coverage with IC, an insurance company. B bills IC and C for 
$5,000, B's standard charge for this medical procedure. However, B has a 
contract with IC that obligates B to accept $3,500 as full payment for 
the medical procedure if the procedure is provided to a patient insured 
by IC. Under the contract, only $3,500 of the $5,000 billed by B is 
legally collectible from IC and C. The remaining $1,500 represents a 
contractual allowance or contractual adjustment. Under paragraph 
(c)(1)(i) of this section, the remaining $1,500 is not a contractually 
collectible amount for purposes of this section and B may not use a 
nonaccrual-experience method with respect to this portion of the 
receivable.
    Example 2. Charitable or pro bono services. D, a law firm, agrees to 
represent individual E in a legal matter and to provide services to E on 
a pro bono basis. D normally charges $500 for these services. Because D 
provides its services to E pro bono, D's services are never billed or 
intended to result in revenue. Thus, under paragraph (c)(1)(i) of this 
section, the $500 is not a collectible amount for purposes of this 
section and D may not use a nonaccrual-experience method with respect to 
this portion of the receivable.
    Example 3. Charging interest and/or penalties. Z has two billing 
methods for the amounts to be received from Z's provision of services 
described in paragraph (a)(1) of this section. Under one method, for 
amounts that are more than 90 days past due, Z charges interest at a 
market rate until the amounts (together with interest) are paid. Under 
the other billing method, Z charges no interest for amounts past due. 
Under paragraph (c)(1)(ii) of this section, A may not use a nonaccrual-
experience method of accounting with respect to any of the amounts 
billed under the method that charges interest on amounts that are more 
than 90 days past due. Z may, however, use the nonaccrual-experience 
method with respect to the amounts billed under the method that does not 
charge interest for amounts past due.
    Example 4. Safe harbor 1: Revenue-based moving average method. (i) F 
uses the revenue-

[[Page 119]]

based moving average method described in paragraph (f)(1) of this 
section with an applicable period of six taxable years. F's total 
accounts receivable and bad debt experience for the 2006 taxable year 
and the five immediately preceding consecutive taxable years are as 
follows:

------------------------------------------------------------------------
                                          Total accounts
                                            receivable       Bad debts
              Taxable year                 earned during   adjusted for
                                            the taxable     recoveries
                                               year
------------------------------------------------------------------------
2001....................................         $40,000          $5,700
2002....................................          40,000           7,200
2003....................................          40,000          11,000
2004....................................          60,000          10,200
2005....................................          70,000          14,000
2006....................................          80,000          16,800
                                         -------------------------------
  Total.................................         330,000          64,900
------------------------------------------------------------------------

    (ii) F's revenue-based moving average percentage is 19.67% ($64,900/
$330,000). If $49,300 of accounts receivable remains outstanding as of 
the close of that taxable year (2006), F's uncollectible amount using 
the revenue-based moving average safe harbor method is computed by 
multiplying $49,300 by the revenue-based moving average percentage of 
19.67%, or $9,697. Thus, F may exclude $9,697 from gross income for 
2006.
    Example 5. Safe harbor 2: Actual experience method . (i) G is 
eligible to use a nonaccrual-experience method and wishes to adopt the 
actual experience method of paragraph (f)(2) of this section. G elects 
to use a three-year applicable period consisting of the current and two 
immediately preceding consecutive taxable years. G determines that its 
actual accounts receivable collection experience is as follows:

------------------------------------------------------------------------
                                                            Bad debts,
                                                           adjusted for
                                             Total A/R      recoveries,
              Taxable year                  balance at    related to A/R
                                           beginning of     balance at
                                           taxable year    beginning of
                                                           taxable year
------------------------------------------------------------------------
2006....................................      $1,000,000         $35,000
2007....................................         760,000          75,000
2008....................................       1,975,000          65,000
                                         -------------------------------
  Total.................................       3,735,000         175,000
------------------------------------------------------------------------

    (ii) G's ending A/R Balance on December 31, 2008, is $880,000. In 
2008, G computes its uncollectible amount by using a three-year moving 
average under paragraph (f)(2) of this section. G's moving average 
nonaccrual-experience percentage is 4.7%, determined by dividing the sum 
of the amount of G's accounts receivable outstanding on January 1 of 
2006, 2007, and 2008, that were determined to be bad debts (adjusted for 
recoveries allocable to the bad debts) on or before the corresponding 
determination date(s), by the sum of the amount of G's accounts 
receivable outstanding on January 1 of 2006, 2007, and 2008 ($175,000/
$3,735,000 or 4.7%). G's uncollectible amount for 2008 is determined by 
multiplying this percentage by the balance of G's accounts receivable on 
December 31, 2008 ($880,000 x 4.7% = $41,360), and increasing this 
amount by 105% ($41,360 x 105% = $43,428). G may exclude $43,428 from 
gross income for 2008.
    Example 6. Safe harbor 2: Single determination date (Option A). H is 
eligible to use a nonaccrual-experience method and wishes to adopt the 
actual experience method of paragraph (f)(2) of this section. H elects 
to use a six-year applicable period consisting of the current and five 
immediately preceding taxable years. H also elects to use a single 
determination date in accordance with paragraph (f)(2)(i) of this 
section. H selects December 31, its taxable year-end, as its 
determination date. Since H is using a single determination date from 
the current taxable year, its determination date for the 2001-2006 
applicable period is December 31, 2006. H has a $800 charge-off in 2003 
of an account receivable in the 2003 beginning accounts receivable 
balance. In 2005, H has a recovery of $100 which is traceable, without 
undue burden, to the $800 charge-off in 2003. Since the $100 recovery 
occurred prior to H's December 31, 2006, determination date, it reduces 
the amount of H's bad debts in the numerator of the formula for purposes 
of determining H's moving average nonaccrual-experience percentage. In 
addition, H must include the $100 recovery in income in 2005 (see 
paragraph (d)(5) of this section regarding recoveries).
    Example 7. Safe harbor 2: Multiple determination dates (Option B). 
The facts are the same as in Example 6, except H elects to use multiple 
determination dates in accordance with paragraph (f)(2)(ii) of this 
section. Consequently, H's determination date is December 31, 2001, for 
its calculations of the portion of the numerator relating to the 2001 
taxable year, December 31, 2002, for its calculations of the portion of 
the numerator relating to the 2002 taxable year, and so on through the 
final taxable year (2006), which has a determination date of December 
31, 2006. Since the $100 recovery did not occur until after December 31, 
2003 (the determination date for the 2003 taxable year), it does not 
reduce the amount of H's bad debts in the numerator of the formula for 
purposes of determining H's moving average nonaccrual-experience 
percentage. However, H still must include the $100 recovery in income in 
2005 (see paragraph (d)(5) of this section regarding recoveries).
    Example 8. Safe harbor 3: Modified Black Motor method. (i) J uses 
the modified Black Motor method described in paragraph (f)(3) of this 
section and a six-year applicable period. J's total accounts receivable 
and bad debt experience for the 2006 taxable year and the five 
immediately preceding consecutive taxable years are as follows:

[[Page 120]]



------------------------------------------------------------------------
                                             Accounts
                                           receivable at     Bad debts
              Taxable year                end of taxable   (adjusted for
                                               year         recoveries)
------------------------------------------------------------------------
2001....................................        $130,000          $9,100
2002....................................         140,000           7,000
2003....................................         140,000          14,000
2004....................................         160,000          14,400
2005....................................         170,000          20,400
2006....................................         180,000          10,800
                                         -------------------------------
  Total.................................         920,000          75,700
------------------------------------------------------------------------

    (ii) J's modified Black Motor moving average percentage is 8.228% 
($75,700/$920,000). If the accounts receivable generated and written off 
during the current taxable year are $3,600, J's uncollectible amount is 
$11,210, computed by multiplying J's accounts receivable on December 31, 
2006 ($180,000) by the modified Black Motor moving average percentage of 
8.228% and reducing the resulting amount by $3,600 (J's accounts 
receivable generated and written off during the 2006 taxable year). J 
may exclude $11,210 from gross income for 2006.
    Example 9. Safe harbor 4: Modified moving average method. (i) The 
facts are the same as in Example 8, except that the balances represent 
accounts receivable at the beginning of the taxable year, and J uses the 
modified moving average method described in paragraph (f)(4) of this 
section and a six-year applicable period. Furthermore, the accounts 
receivable that were written off in the same taxable year they were 
generated, adjusted for recoveries of bad debts during the period are as 
follows:

------------------------------------------------------------------------
                                                             Accounts
                                                            receivable
                                                          written off in
                                                           same taxable
                      Taxable year                            year as
                                                             generated
                                                           (adjusted for
                                                            recoveries)
------------------------------------------------------------------------
2001....................................................          $3,033
2002....................................................           2,333
2003....................................................           4,667
2004....................................................           4,800
2005....................................................           6,800
2006....................................................           3,600
                                                         ---------------
  Total.................................................          25,233
------------------------------------------------------------------------

    (ii) J's modified moving average percentage is 5.486% (($75,700-
$25,233)/$920,000). J's uncollectible amount is $9,875, computed by 
multiplying J's accounts receivable on December 31, 2006 ($180,000) by 
the modified moving average percentage of 5.486%. J may exclude $9,875 
from gross income for 2006.
    Example 10. First-year self-test. Beginning in 2006, K is eligible 
to use a nonaccrual-experience method and wants to adopt an alternative 
nonaccrual-experience method under paragraph (f)(5) of this section, and 
consequently is subject to the safe harbor comparison method of self-
testing under paragraph (e)(3) of this section. K elects to self-test 
against safe harbor 1 for purposes of conducting its first-year self-
test. K's uncollectible amount for 2006 is $22,000. K's safe harbor 
uncollectible amount under safe harbor 1 is $21,000. Because K's 
uncollectible amount for 2006 ($22,000) is greater than the safe harbor 
uncollectible amount ($21,000), K's alternative nonaccrual-experience 
method is treated as not clearly reflecting its nonaccrual experience 
for 2006. Accordingly, K must adopt either another nonaccrual-experience 
method that clearly reflects experience (subject to the self-testing 
requirements of paragraph (e)(2)(ii) of this section, or a safe harbor 
nonaccrual-experience method described in paragraph (f)(1) (revenue-
based moving average), (f)(2) (actual experience method), (f)(3) 
(modified Black Motor method), (f)(4) (modified moving average method) 
of this section, or another alternative nonaccrual-experience method 
under paragraph (f)(5) of this section that meets the self-testing 
requirements of paragraph (e)(3) of this section.
    Example 11. Three-year self-test. The facts are the same as in 
Example 10, except that K's safe harbor uncollectible amount under safe 
harbor 1 for 2006 is also $22,000. Consequently, K meets the first-year 
self-test requirement and may use its alternative nonaccrual-experience 
method. Subsequently, K's cumulative uncollectible amount for 2007 
through 2009 is $300,000. K's safe harbor uncollectible amount for 2007 
through 2009 under its chosen safe harbor method for self-testing (safe 
harbor 1) is $295,000. Because K's cumulative uncollectible amount for 
the three-year test period (taxable years 2007 through 2009) is greater 
than its safe harbor uncollectible amount for the three-year test period 
($295,000), under paragraph (e)(3)(ii)(B) of this section, the $5,000 
excess of K's cumulative uncollectible amount over K's safe harbor 
uncollectible amount for the three-year test period must be recaptured 
into income in 2009 in accordance with paragraph (e)(3)(ii)(B) of this 
section. Since K's cumulative uncollectible amount for the three-year 
test period ($300,000) is less than 110% of its safe harbor 
uncollectible amount ($295,000 x 110% = $324,500), under paragraph 
(e)(3)(ii)(B) of this section, K may continue to use its alternative 
nonaccrual-experience method, subject to the three-year self-test 
requirement.
    Example 12. Subsequent worthlessness of year-end receivable. The 
facts are the same as in Example 4, except that one of the accounts 
receivable outstanding at the end of 2002 was for $8,000, and in 2003, 
under section 166, the entire amount of this receivable becomes wholly 
worthless. Because F does not accrue as income $1,573 of this account 
receivable ($8,000 x .1967) under the nonaccrual-experience method in 
2002, under paragraph (d)(2) of this section F may not deduct this 
portion

[[Page 121]]

of the account receivable as a bad debt deduction under section 166 in 
2003. F may deduct the remaining balance of the receivable in 2003 as a 
bad debt deduction under section 166 ($8,000-$1,574 = $6,426).
    Example 13. Subsequent collection of year-end receivable. The facts 
are the same as in Example 4. In 2007, F collects in full an account 
receivable of $1,700 that was outstanding at the end of 2006. Under 
paragraph (d)(5) of this section, F must recognize additional gross 
income in 2007 equal to the portion of this receivable that F excluded 
from gross income in the prior taxable year ($1,700 x .1967 = $334). 
That amount ($334) is a recovery under paragraph (d)(5) of this section.

    (h) Applicability dates. (1) Except as provided in paragraph (h)(2) 
of this section, this section is applicable for taxable years ending on 
or after August 31, 2006.
    (2) The rules of paragraph (a)(2) of this section apply for taxable 
years beginning on or after January 5, 2021. However, for a taxable year 
beginning after December 31, 2017, and before January 5, 2021, a 
taxpayer may apply the paragraph described in the first sentence of this 
paragraph (h)(2), provided that the taxpayer follows all the applicable 
rules contained in the regulations under section 448 for such taxable 
year and all subsequent taxable years.

[T.D. 9285, 71 FR 52437, Sept. 6, 2006. Redesignated and amended at T.D. 
9942, 86 FR 272, Jan. 5, 2021]

          taxable year for which items of gross income included



Sec.  1.451-1  General rule for taxable year of inclusion.

    (a) General rule. Gains, profits, and income are to be included in 
gross income for the taxable year in which they are actually or 
constructively received by the taxpayer unless includible for a 
different year in accordance with the taxpayer's method of accounting. 
Under an accrual method of accounting, income is includible in gross 
income when all the events have occurred which fix the right to receive 
such income and the amount thereof can be determined with reasonable 
accuracy (all events test). Therefore, under such a method of accounting 
if, in the case of compensation for services, no determination can be 
made as to the right to such compensation or the amount thereof until 
the services are completed, the amount of compensation is ordinarily 
income for the taxable year in which the determination can be made. 
Under the cash receipts and disbursements method of accounting, such an 
amount is includible in gross income when actually or constructively 
received. Where an amount of income is properly accrued on the basis of 
a reasonable estimate and the exact amount is subsequently determined, 
the difference, if any, shall be taken into account for the taxable year 
in which such determination is made. To the extent that income is 
attributable to the recovery of bad debts for accounts charged off in 
prior years, it is includible in the year of recovery in accordance with 
the taxpayer's method of accounting, regardless of the date when the 
amounts were charged off. For treatment of bad debts and bad debt 
recoveries, see sections 166 and 111 and the regulations thereunder. For 
rules relating to the treatment of amounts received in crop shares, see 
section 61 and the regulations thereunder. For the year in which a 
partner must include his distributive share of partnership income, see 
section 706(a) and paragraph (a) of Sec.  1.706-1. If a taxpayer 
ascertains that an item should have been included in gross income in a 
prior taxable year, he should, if within the period of limitation, file 
an amended return and pay any additional tax due. Similarly, if a 
taxpayer ascertains that an item was improperly included in gross income 
in a prior taxable year, he should, if within the period of limitation, 
file claim for credit or refund of any overpayment of tax arising 
therefrom.
    (b) Timing of income inclusion for accrual method taxpayers with an 
applicable financial statement. For the timing of income inclusion for 
taxpayers that have an applicable financial statement, as defined in 
Sec.  1.451-3(b)(1), and that use an accrual method of accounting, see 
section 451(b) and Sec.  1.451-3.
    (c) Special rule for timing of income inclusion from advance 
payments. For the timing of income inclusion for taxpayers that receive 
advance payments, as defined in Sec.  1.451-8(a)(1), and that use an 
accrual method of accounting, see section 451(c) and Sec.  1.451-8.

[[Page 122]]

    (d) Special rule in case of death. (1) A taxpayer's taxable year 
ends on the date of his death. See section 443(a)(2) and paragraph 
(a)(2) of Sec.  1.443-1. In computing taxable income for such year, 
there shall be included only amounts properly includible under the 
method of accounting used by the taxpayer. However, if the taxpayer used 
an accrual method of accounting, amounts accrued only by reason of his 
death shall not be included in computing taxable income for such year. 
If the taxpayer uses no regular accounting method, only amounts actually 
or constructively received during such year shall be included. (For 
rules relating to the inclusion of partnership income in the return of a 
decedent partner, see subchapter K, chapter 1 of the Code, and the 
regulations thereunder.)
    (2) If the decedent owned an installment obligation the income from 
which was taxable to him under section 453, no income is required to be 
reported in the return of the decedent by reason of the transmission at 
death of such obligation. See section 453(d)(3). For the treatment of 
installment obligations acquired by the decedent's estate or by any 
person by bequest, devise, or inheritance from the decedent, see section 
691(a)(4) and the regulations thereunder.
    (e) Special rule for employee tips. Tips reported by an employee to 
his employer in a written statement furnished to the employer pursuant 
to section 6053(a) shall be included in gross income of the employee for 
the taxable year in which the written statement is furnished the 
employer. For provisions relating to the reporting of tips by an 
employee to his employer, see section 6053 and Sec.  31.6053-1 of this 
chapter (Employment Tax Regulations).
    (f) Special rule for ratable inclusion of original issue discount. 
For ratable inclusion of original issue discount in respect of certain 
corporate obligations issued after May 27, 1969, see section 1232(a)(3).
    (g) Special rule for inclusion of qualified tax refund effected by 
allocation. For rules relating to the inclusion in income of an amount 
paid by a taxpayer in respect of his liability for a qualified State 
individual income tax and allocated or reallocated in such a manner as 
to apply it toward the taxpayer's liability for the Federal income tax, 
see paragraph (f)(1) of Sec.  301.6361-1 of this chapter (Regulations on 
Procedure and Administration).
    (h) Timing of income from notional principal contracts. For the 
timing of income with respect to notional principal contracts, see Sec.  
1.446-3.
    (i) Timing of income from section 467 rental agreements. For the 
timing of income with respect to section 467 rental agreements, see 
section 467 and the regulations thereunder.

[T.D. 6500, 25 FR 11709, Nov. 26, 1960, as amended by T.D. 7001, 34 FR 
997, Jan. 23, 1969; T.D. 7154, 36 FR 24996, Dec. 28, 1971; 43 FR 59357, 
Dec. 20, 1978; T.D. 8491, 58 FR 53135, Oct. 14, 1993; T.D. 8820, 64 FR 
26851, May 18, 1999; T.D. 9941, Jan. 6, 2021, 86 FR 1256, Jan. 8, 2021]



Sec.  1.451-2  Constructive receipt of income.

    (a) General rule. Income although not actually reduced to a 
taxpayer's possession is constructively received by him in the taxable 
year during which it is credited to his account, set apart for him, or 
otherwise made available so that he may draw upon it at any time, or so 
that he could have drawn upon it during the taxable year if notice of 
intention to withdraw had been given. However, income is not 
constructively received if the taxpayer's control of its receipt is 
subject to substantial limitations or restrictions. Thus, if a 
corporation credits its employees with bonus stock, but the stock is not 
available to such employees until some future date, the mere crediting 
on the books of the corporation does not constitute receipt. In the case 
of interest, dividends, or other earnings (whether or not credited) 
payable in respect of any deposit or account in a bank, building and 
loan association, savings and loan association, or similar institution, 
the following are not substantial limitations or restrictions on the 
taxpayer's control over the receipt of such earnings:
    (1) A requirement that the deposit or account, and the earnings 
thereon, must be withdrawn in multiples of even amounts;
    (2) The fact that the taxpayer would, by withdrawing the earnings 
during

[[Page 123]]

the taxable year, receive earnings that are not substantially less in 
comparison with the earnings for the corresponding period to which the 
taxpayer would be entitled had he left the account on deposit until a 
later date (for example, if an amount equal to three months' interest 
must be forfeited upon withdrawal or redemption before maturity of a one 
year or less certificate of deposit, time deposit, bonus plan, or other 
deposit arrangement then the earnings payable on premature withdrawal or 
redemption would be substantially less when compared with the earnings 
available at maturity);
    (3) A requirement that the earnings may be withdrawn only upon a 
withdrawal of all or part of the deposit or account. However, the mere 
fact that such institutions may pay earnings on withdrawals, total or 
partial, made during the last three business days of any calendar month 
ending a regular quarterly or semiannual earnings period at the 
applicable rate calculated to the end of such calendar month shall not 
constitute constructive receipt of income by any depositor or account 
holder in any such institution who has not made a withdrawal during such 
period;
    (4) A requirement that a notice of intention to withdraw must be 
given in advance of the withdrawal. In any case when the rate of 
earnings payable in respect of such a deposit or account depends on the 
amount of notice of intention to withdraw that is given, earnings at the 
maximum rate are constructively received during the taxable year 
regardless of how long the deposit or account was held during the year 
or whether, in fact, any notice of intention to withdraw is given during 
the year. However, if in the taxable year of withdrawal the depositor or 
account holder receives a lower rate of earnings because he failed to 
give the required notice of intention to withdraw, he shall be allowed 
an ordinary loss in such taxable year in an amount equal to the 
difference between the amount of earnings previously included in gross 
income and the amount of earnings actually received. See section 165 and 
the regulations thereunder.
    (b) Examples of constructive receipt. Amounts payable with respect 
to interest coupons which have matured and are payable but which have 
not been cashed are constructively received in the taxable year during 
which the coupons mature, unless it can be shown that there are no funds 
available for payment of the interest during such year. Dividends on 
corporate stock are constructively received when unqualifiedly made 
subject to the demand of the shareholder. However, if a dividend is 
declared payable on December 31 and the corporation followed its usual 
practice of paying the dividends by checks mailed so that the 
shareholders would not receive them until January of the following year, 
such dividends are not considered to have been constructively received 
in December. Generally, the amount of dividends or interest credited on 
savings bank deposits or to shareholders of organizations such as 
building and loan associations or cooperative banks is income to the 
depositors or shareholders for the taxable year when credited. However, 
if any portion of such dividends or interest is not subject to 
withdrawal at the time credited, such portion is not constructively 
received and does not constitute income to the depositor or shareholder 
until the taxable year in which the portion first may be withdrawn. 
Accordingly, if, under a bonus or forfeiture plan, a portion of the 
dividends or interest is accumulated and may not be withdrawn until the 
maturity of the plan, the crediting of such portion to the account of 
the shareholder or depositor does not constitute constructive receipt. 
In this case, such credited portion is income to the depositor or 
shareholder in the year in which the plan matures. However, in the case 
of certain deposits made after December 31, 1970, in banks, domestic 
building and loan associations, and similar financial institutions, the 
ratable inclusion rules of section 1232(a)(3) apply. See Sec.  1.1232-
3A. Accrued interest on unwithdrawn insurance policy dividends is gross 
income to the taxpayer for the first taxable year during which

[[Page 124]]

such interest may be withdrawn by him.

[T.D. 6723, 29 FR 5342, Apr. 21, 1964, as amended by T.D. 7154, 36 FR 
24997, Dec. 28, 1971; T.D. 7663, 44 FR 76782, Dec. 28, 1979]



Sec.  1.451-3  Timing of income inclusion for taxpayers with an applicable 
financial statement using an accrual method of accounting.

    (a) Definitions. The following definitions apply for this section:
    (1) AFS income inclusion amount. The term AFS income inclusion 
amount means the amount of an item of gross income that is required to 
be included in gross income under the AFS income inclusion rule in 
paragraph (b)(1) of this section.
    (2) AFS income inclusion rule. The term AFS income inclusion rule 
has the meaning provided in paragraph (b)(1) of this section.
    (3) AFS inventory inclusion amount. The term AFS inventory inclusion 
amount has the meaning provided in paragraph (c)(2)(i)(A) of this 
section.
    (4) AFS revenue. The term AFS revenue means revenue reported in the 
taxpayer's AFS. The characterization of an amount in the AFS is not 
determinative of whether the amount is AFS revenue. For example, AFS 
revenue can include amounts reported as other comprehensive income or 
adjustments to retained earnings in an AFS. See paragraph (b) of this 
section for adjustments to AFS revenue that may need to be made to apply 
the rules of this section.
    (5) Applicable financial statement (AFS). Subject to the rules in 
paragraph (a)(5)(iv) of this section, the terms applicable financial 
statement and AFS are synonymous and mean the taxpayer's financial 
statement listed in paragraph (a)(5)(i) through (iii) of this section 
that has the highest priority, including priority within paragraphs 
(a)(5)(i)(B) and (a)(5)(ii)(B) of this section. The financial statements 
are, in order of descending priority:
    (i) GAAP statements. A financial statement that is certified as 
being prepared in accordance with United States generally accepted 
accounting principles (GAAP) and is:
    (A) A Form 10-K (or successor form), or annual statement to 
shareholders, filed with the United States Securities and Exchange 
Commission (SEC);
    (B) An audited financial statement of the taxpayer that is used for:
    (1) Credit purposes;
    (2) Reporting to shareholders, partners, or other proprietors, or to 
beneficiaries; or
    (3) Any other substantial non-tax purpose; or
    (C) A financial statement, other than a tax return, filed with the 
Federal Government or any Federal agency, other than the SEC or the 
Internal Revenue Service (IRS);
    (ii) IFRS statements. A financial statement that is certified as 
being prepared in accordance with international financial reporting 
standards (IFRS) and is:
    (A) Filed by the taxpayer with an agency of a foreign government 
that is equivalent to the SEC, and has financial reporting standards not 
less stringent than the standards required by the SEC;
    (B) An audited financial statement of the taxpayer that is used for:
    (1) Credit purposes;
    (2) Reporting to shareholders, partners, or other proprietors, or to 
beneficiaries; or
    (3) Any other substantial non-tax purpose; or
    (C) A financial statement, other than a tax return, filed with the 
Federal Government, Federal agency, a foreign government, or agency of a 
foreign government, other than the SEC, IRS, or an agency that is 
equivalent to the SEC or the IRS; or
    (iii) Other statements. A financial statement, other than a tax 
return, filed with the Federal Government or any Federal agency, a state 
government or state agency, or a self-regulatory organization including, 
for example, a financial statement filed with a state agency that 
regulates insurance companies or the Financial Industry Regulatory 
Authority. Additional financial statements beyond those included in this 
paragraph (a)(5)(iii) may be provided in guidance published in the 
Internal Revenue Bulletin (see Sec.  601.601(d) of this chapter).
    (iv) Additional rules for determining priority. If a taxpayer 
restates AFS revenue for a taxable year prior to the date that the 
taxpayer files its Federal

[[Page 125]]

income tax return for such taxable year, the restated AFS must be used 
instead of the original AFS. If using the restated AFS revenue results 
in a change in method of accounting, the preceding sentence applies only 
if the taxpayer receives permission to change its method of accounting 
to use the restated AFS revenue. In addition, if a taxpayer with 
different financial accounting and taxable years is required to file 
both annual financial statements and periodic financial statements 
covering less than a year with a government or government agency, the 
taxpayer must prioritize the annual financial statement in accordance 
with this paragraph (a)(5).
    (6) Cost of goods. The term cost of goods means the costs that are 
properly capitalized and included in inventory under sections 471 and 
263A or any other applicable provision of the Internal Revenue Code 
(Code) and that are allocable to an item of inventory for which an AFS 
inventory inclusion amount is calculated. See paragraph (c)(5)(iii) of 
this section for specific rules for taxpayers using simplified methods 
under section 263A.
    (7) Cost of goods in progress offset. The term cost of goods in 
progress offset has the meaning provided in paragraph (c)(3) of this 
section.
    (8) Cumulative cost of goods in progress offset. The term cumulative 
cost of goods in progress offset means the cumulative cost of goods in 
progress offset amounts under paragraph (c) of this section for a 
specific item of inventory that have reduced an AFS inventory inclusion 
amount attributable to such item of inventory in prior taxable years.
    (9) Enforceable right. The term enforceable right means any right 
that a taxpayer has under the terms of a contract or under applicable 
Federal, state, or international law, including rights to amounts 
recoverable in equity and liquidated damages. A contract can include, 
but is not limited to, a statement of work, purchase order, or invoice.
    (10) Equity method. The term equity method means a method of 
accounting for financial accounting purposes under which an investment 
is initially recorded at cost and subsequently increased or decreased in 
carrying value by the investor's proportionate share of income and 
losses and such income or losses are reported as separate items on the 
investor's statement of income.
    (11) Performance obligation. The term performance obligation means a 
promise in a contract with a customer to transfer to the customer a 
distinct good, service, or right; or a series of distinct goods, 
services, or rights, or a combination thereof, that are substantially 
the same and that have the same pattern of transfer to the customer. A 
performance obligation includes a promise to grant or transfer a right 
to use or access intangible property. Performance obligations in a 
contract are identified by applying the accounting standards the 
taxpayer uses to prepare its AFS. Additionally, to the extent the 
contract with the customer provides the taxpayer with an enforceable 
right to payment, the revenue from which is not allocated to a 
performance obligation described in the first two sentences of this 
paragraph (a)(11) in the taxpayer's AFS but is accounted for as a 
separate source of revenue in the taxpayer's AFS, such right shall be 
treated as a separate performance obligation under this section. A fee 
described in paragraph (j)(2) of this section is an example of an 
enforceable right that is treated as a separate performance obligation.
    (12) Prior income inclusion amounts. The term prior income inclusion 
amounts means amounts of an item of gross income that were required to 
be included in the taxpayer's gross income under this section or Sec.  
1.451-8 in prior taxable years.
    (13) Special method of accounting. The term special method of 
accounting means a method of accounting expressly permitted or required 
under any provision of the Code, the regulations in this part, or other 
guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d) of this chapter) under which the time for taking an item of 
gross income into account in a taxable year is not determined under the 
all events test in Sec.  1.451-1(a). See, however, paragraph (j) of this 
section relating to certain items of income for debt instruments. The 
term special method of accounting does not include any method

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of accounting expressly permitted or required under this section. The 
following are examples of special methods of accounting to which the AFS 
income inclusion rule does not apply:
    (i) The crop method of accounting under sections 61 and 162;
    (ii) Methods of accounting provided in sections 453 through 460;
    (iii) Methods of accounting for notional principal contracts under 
Sec.  1.446-3;
    (iv) Methods of accounting for hedging transactions under Sec.  
1.446-4;
    (v) Methods of accounting for REMIC inducement fees under Sec.  
1.446-6;
    (vi) Methods of accounting for gain on shares in a money market fund 
under Sec.  1.446-7;
    (vii) Methods of accounting for certain rental payments under 
section 467;
    (viii) The mark-to-market method of accounting under section 475;
    (ix) Timing rules for income and gain associated with a transaction 
that is integrated under Sec.  1.988-5, and income and gain under the 
nonfunctional currency contingent payment debt instrument rules in Sec.  
1.988-6;
    (x) Except as otherwise provided in paragraph (j) of this section, 
timing rules for original issue discount (OID) under section 811(b)(3) 
or 1272 (and the regulations in this part under section 1272 of the 
Code), income under the contingent payment debt instrument rules in 
Sec.  1.1275-4, income under the variable rate debt instrument rules in 
Sec.  1.1275-5, income and gain associated with a transaction that is 
integrated under Sec.  1.1275-6, and income under the inflation-indexed 
debt instrument rules in Sec.  1.1275-7;
    (xi) Timing rules for de minimis OID under Sec.  1.1273-1(d) and for 
de minimis market discount (as defined in section 1278(a)(2)(C));
    (xii) Timing rules for accrued market discount under sections 1276 
and 1278(b);
    (xiii) Timing rules for short-term obligations under sections 1281 
through 1283;
    (xiv) Timing rules for stripped bonds under section 1286; and
    (xv) Methods of accounting provided in sections 1502 and 1503 and 
the regulations thereunder, including the method of accounting relating 
to intercompany transactions under Sec.  1.1502-13.
    (14) Transaction price amount. The term transaction price amount 
means the total amount of consideration to which a taxpayer is, or 
expects to be, entitled from all performance obligations under a 
contract. The transaction price amount is determined under the standards 
the taxpayer uses to prepare its AFS.
    (b) AFS income inclusion rule--(1) In general. Except as otherwise 
provided in this section, if a taxpayer uses an accrual method of 
accounting for Federal income tax purposes and has an AFS, the all 
events test under Sec.  1.451-1(a) for any item of gross income, or 
portion thereof, is met no later than when that item, or portion 
thereof, is taken into account as AFS revenue (AFS income inclusion 
rule). See paragraph (b)(2) of this section for rules regarding when an 
item of gross income, or portion thereof, is treated as taken into 
account as AFS revenue under the AFS income inclusion rule. See 
paragraph (c) of this section for optional rules to determine the AFS 
income inclusion amount for an item of gross income from the sale of 
inventory. See paragraph (d) of this section for rules regarding the 
allocation of the transaction price amount to multiple items of gross 
income. See paragraph (e) of this section for rules to determine the AFS 
income inclusion amount for an item of gross income from a multi-year 
contract. See paragraphs (f) and (g) of this section for limitations of 
the AFS income inclusion rule. See paragraph (h) of this section for 
special rules that may affect the determination of AFS revenue under the 
AFS income inclusion rule. See paragraph (j) of this section for special 
ordering rules for certain items of income with respect to debt 
instruments.
    (2) Amounts taken into account as AFS revenue--(i) General rule. 
Unless the taxpayer uses the alternative AFS revenue method described in 
paragraph (b)(2)(ii) of this section, the amount of the item of gross 
income that is treated as taken into account as AFS revenue under 
paragraph (b)(1) of this section is determined by making adjustments to 
AFS revenue for the amounts described

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in paragraphs (b)(2)(i)(A) through (D) of this section.
    (A) If AFS revenue reflects a reduction for amounts described in 
paragraph (b)(2)(i)(A)(1) or (2) of this section, AFS revenue is 
increased by the amount of the reduction.
    (1) Cost of goods sold and liabilities that are required to be 
accounted for under other provisions of the Code such as section 461, 
including liabilities for allowances, rebates, chargebacks, rewards 
issued in credit card transactions and other reward programs, and 
refunds, regardless of when any amount described in this paragraph 
(b)(2)(i)(A)(1) is incurred.
    (2) Amounts anticipated to be in dispute or anticipated to be 
uncollectable.
    (B) If AFS revenue includes an amount the taxpayer does not have an 
enforceable right to recover if the customer were to terminate the 
contract on the last day of the taxable year (regardless of whether the 
customer actually terminates the contract), AFS revenue is reduced by 
such amount.
    (C) If the transaction price was increased because a significant 
financing component is deemed to exist under the standards the taxpayer 
uses to prepare its AFS, then any AFS revenue attributable to such 
increase is disregarded.
    (D) AFS revenue may be increased or reduced by additional amounts as 
provided in guidance published in the Internal Revenue Bulletin (see 
Sec.  601.601(d) of this chapter).
    (ii) Alternative AFS revenue method. A taxpayer that chooses to 
apply the AFS income inclusion rule by using the alternative AFS revenue 
method described in this paragraph (b)(2)(ii) in lieu of the rules in 
paragraph (b)(2)(i) of this section, determines the amount of the item 
of gross income that is treated as taken into account as AFS revenue 
under paragraph (b)(1) of this section by making adjustments to AFS 
revenue for only the amounts described in paragraphs (b)(2)(i)(A), (C), 
and (D) of this section. A taxpayer that uses the alternative AFS 
revenue method for a trade or business must apply the method to all 
items of gross income in the trade or business that are subject to the 
AFS income inclusion rule.
    (3) Exceptions. The AFS income inclusion rule in paragraph (b)(1) of 
this section does not apply to:
    (i) Any item of gross income, or portion thereof, if the timing of 
income inclusion for that item, or portion thereof, is determined using 
a special method of accounting;
    (ii) Any item of gross income, or portion thereof, in connection 
with a mortgage servicing contract; or
    (iii) Any taxable year that is not covered for the entire year by 
one or more AFS.
    (4) Examples. The following examples illustrate the provisions of 
paragraph (b) of this section. Unless the facts specifically state 
otherwise, the taxpayer has an AFS, is on a calendar year for Federal 
income tax purposes and AFS purposes, and uses an accrual method of 
accounting for Federal income tax purposes. Further, the taxpayer does 
not use the alternative AFS revenue method under paragraph (b)(2)(ii) of 
this section or the AFS cost offset method under paragraph (d) of this 
section, and does not use a special method of accounting:
    (i) Example 1: Provision of installation services--(A) Facts. In 
2021, B enters into a 2-year service contract with a customer to install 
the customer's manufacturing equipment for $100,000. Throughout the term 
of the contract, the customer retains control of the equipment. B begins 
providing the installation services in 2021 and completes the 
installation services in 2022. Under the contract, B bills the customer 
$55,000 in 2021 when installation begins, but does not have a fixed 
right to receive the remaining $45,000 until installation is complete 
and approved by the customer. However, if the customer were to terminate 
the contract prior to completion, B would have an enforceable right to 
payment for all services performed prior to the termination date. For 
its AFS, B reports $60,000 of AFS revenue for 2021 and $40,000 of AFS 
revenue for 2022, in accordance with the services performed in each 
respective year.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), B is 
required to include $55,000 in gross income in 2021 as B has a fixed 
right to receive $55,000 as of the

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end of 2021. However, under the AFS income inclusion rule, because B has 
an enforceable right to recover the entire $60,000 that was reported in 
AFS revenue for 2021 had the customer terminated the contract on the 
last day of 2021, the entire $60,000 is treated as taken into account as 
AFS revenue in 2021. Accordingly, the all events test is met for the 
$60,000 of gross income no later than the end of 2021 and B is required 
to include $60,000 in gross income in 2021.
    (ii) Example 2: Provision of goods included in AFS with enforceable 
right--(A) Facts. In November 2021, C enters into a contract with a 
customer to provide 50 customized computers for $80,000. Under the 
contract, C can bill $80,000 after the customer accepts delivery of the 
computers. However, the contract provides that C has an enforceable 
right to be paid for work performed to date if the customer were to 
terminate the contract prior to delivery. C produces and ships all of 
the computers in 2021. In 2022, the customer accepts delivery of the 
computers and C bills the customer. For its AFS, C reports $80,000 of 
AFS revenue for 2021.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), C does 
not have a fixed right to receive the $80,000 until the customer accepts 
delivery of the computers in 2022. However, under the AFS income 
inclusion rule, because C has an enforceable right to recover the entire 
$80,000 of AFS revenue that was reported for 2021 had the customer 
terminated the contract on the last day of 2021, the entire $80,000 is 
treated as ``taken into account as AFS revenue'' in 2021. Accordingly, 
the all events test is met for the $80,000 no later than in 2021 and C 
is required to include $80,000 in gross income in 2021.
    (iii) Example 3: Provision of services included in AFS with 
enforceable right--(A) Facts. In 2021, D, an engineering services 
provider, enters into a 4-year contract with a customer to provide 
services for a total of $100x. Under the contract, D bills and receives 
$25x for each year of the contract. If the customer were to terminate 
the contract prior to completion, D has an enforceable right to only the 
billed amounts. For its AFS, D reports $60x, $0, $20x, and $20x of AFS 
revenue from the contract for 2021, 2022, 2023, and 2024, respectively.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), D is 
required to include $25x in gross income in 2021 as D has a fixed right 
to receive $25x as of the end of 2021. Although D reports $60x of AFS 
revenue from the provision of services for 2021, D has an enforceable 
right to recover only $25x if the customer were to terminate the 
contract on the last day of 2021. Accordingly, pursuant to paragraph 
(b)(2)(i)(B) of this section, of the $60x of AFS revenue reported for 
2021, only $25x is treated as ``taken into account as AFS revenue'' 
under the AFS income inclusion rule. As a result, D is required to 
include only $25x in gross income in 2021. Similarly, in 2022, 2023 and 
2024, D includes in gross income only the yearly $25x contract payments 
under the all events test as only the billed amounts are treated as 
``taken into account as AFS revenue'' under the AFS income inclusion 
rule.
    (iv) Example 4: Sale of good under cost-plus contract--(A) Facts. In 
2021, E, a manufacturer, enters into a contract with Fire Department for 
the manufacture and delivery of a fire truck. The fire truck takes 10 
months to manufacture at an estimated cost of $60,000. The contract 
provides E with an enforceable right to recover costs incurred in 
manufacturing the fire truck regardless of whether the Fire Department 
accepts delivery of the fire truck or terminates the contract, and an 
enforceable right to an additional $20,000 if the fire truck is accepted 
by the Fire Department. E does not have an enforceable right to recover 
any portion of the additional $20,000 if the Fire Department were to 
terminate the contract before it accepts the fire truck. E has an 
obligation to cure any defects if the customer rejects the fire truck. 
In August 2021, E begins manufacturing the fire truck ordered by Fire 
Department and incurs $30,000 of costs for materials and labor for the 
contract. For its AFS, E reports $40,000 of AFS revenue for 2021 
($30,000 costs plus $10,000 expected profit on the sale of the fire 
truck).
    (B) Analysis for 2021 taxable year. Under the all events test in 
Sec.  1.451-1(a), E is required to include $30,000 in gross income in 
2021 as E has a fixed right to

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receive $30,000 as of the end of 2021. Although E reports $40,000 of AFS 
revenue for 2021, E has an enforceable right to recover only $30,000 if 
the Fire Department were to terminate the contract on the last day of 
2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this section, 
of the $40,000 of AFS revenue reported for 2021, only $30,000 is treated 
as ``taken into account as AFS revenue'' under the AFS income inclusion 
rule. As a result, E is required to include only $30,000 in gross income 
in 2021.
    (v) Example 5: Sale of goods with AFS revenue adjustments--(A) 
Facts. In July 2021, F, a manufacturer of automobile parts, enters into 
a contract to sell 1,000 parts to a customer for $10 per part, for a 
total of $10,000 (1,000 x $10). The contract also provides that F will 
receive a $200 bonus if it delivers all the parts to the customer by 
February 1, 2022. F delivers 500 non-defective parts to the customer on 
December 31, 2021 and schedules the remaining 500 parts for delivery to 
the customer on January 1, 2022. F does not have an enforceable right to 
recover any portion of the $200 bonus if the customer were to terminate 
the contract before all 1,000 parts are delivered. F expects to earn the 
$200 bonus and have 5% of the non-defective parts returned. For its AFS, 
F reports $4,850 ($5,000 + $100-$250) of AFS revenue for 2021, which 
includes a $100 (50% x $200) adjustment to increase AFS revenue for the 
expected bonus and a $250 (5% x $5,000) adjustment to decrease AFS 
revenue for anticipated returns.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), F is 
required to include $5,000, less the corresponding cost of goods sold 
under sections 263A and 471 as applicable, in gross income in 2021 as F 
has a fixed right to receive $5,000 from the delivery of 500 parts to 
the customer in 2021. However, F does not have a fixed right to receive 
any portion of the $200 delivery bonus as of the end of 2021 as the 
remaining 500 parts had yet to be delivered. Under the AFS income 
inclusion rule and, specifically, paragraphs (b)(2)(i)(A)(1) and 
(b)(2)(i)(B) of this section, the amount treated as ``taken into account 
as AFS revenue'' for 2021 is also $5,000, calculated as $4,850 of AFS 
revenue that was reported for 2021, decreased by $100 for the expected 
delivery bonus that F does not have an enforceable right to recover if 
the customer were to terminate the contract as of the end of 2021 and 
increased by $250 for anticipated return liabilities that are accounted 
for under section 461 ($4,850-$100 + $250 = $5,000). Accordingly, F is 
required to include $5,000, less the corresponding cost of goods sold 
determined under sections 263A and 471 as applicable, in gross income in 
2021.
    (vi) Example 6: Chargebacks--(A) Facts. In November 2021, G, a 
pharmaceutical manufacturer, enters into a contract to sell 1,000 units 
to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 x $10). 
The contract also provides that G will credit or pay W $4 per unit (a 
40% ``chargeback'') for sales W makes to certain qualifying customers. G 
delivers 600 units to W on December 31, 2021, and bills W $6,000 under 
the contract. W does not make any sales to qualifying customers in 2021. 
For its AFS, G reports $3,600 ($6,000-$2,400) of AFS revenue for 2021, 
which includes a reduction of the $6,000 of sales revenue by $2,400 (40% 
x $6,000) for anticipated chargebacks.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), G is 
required to include $6,000, less the corresponding cost of goods sold 
under sections 263A and 471 as applicable, in gross income in 2021 as G 
has a fixed right to receive $6,000 from the delivery of 600 units to W 
in 2021. The anticipated chargebacks are liabilities that are accounted 
for under section 461. Under the AFS income inclusion rule and, 
specifically, paragraph (b)(2)(i)(A)(1) of this section, the amount 
treated as ``taken into account as AFS revenue'' for 2021 is also 
$6,000, calculated as $3,600 of AFS revenue reported for 2021, increased 
by $2,400 of anticipated chargeback liabilities that are accounted for 
under section 461 ($3,600 + $2,400 = $6,000). Accordingly, G is required 
to include $6,000, less the corresponding cost of goods sold under 
sections 263A and 471 as applicable, in gross income in 2021.
    (vii) Example 7: Sale of property using a special method of 
accounting. In 2021, H, a financial services provider, sells a building 
for $100,000, payable in five annual payments of $20,000 together with

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adequate stated interest, starting in 2021. For its AFS, H reports 
$100,000 of AFS revenue for 2021 from the sale of the building. For 
Federal income tax purposes, H uses the installment method under section 
453 for the sale of the building. Because the installment method under 
section 453 is a special method of accounting under paragraphs 
(a)(13)(ii) and (b)(3)(i) of this section, the AFS income inclusion rule 
does not apply to H's sale of the building. Accordingly, the gain from 
the sale is included in income as prescribed in section 453.
    (viii) Example 8: Insurance contract renewals--(A) Facts. J, an 
insurance agent, is engaged by an insurance carrier to sell insurance. 
Pursuant to the contract between J and the insurance carrier, J is 
entitled to receive a $50 commission from the insurance carrier at the 
time a policy is sold to a customer. The contract also provides that J 
is entitled to receive an additional $25 commission each time a policy 
is renewed. J does not have an enforceable right to a renewal commission 
if the insurance carrier terminates the contract before a policy is 
renewed. J sells 1,000 one-year policies in 2021, of which 800 are 
expected to be renewed in 2022 and 700 are expected to be renewed in 
2023. J does not have any ongoing obligation to provide additional 
services to the insurance carrier or the customers after the initial 
sale of the policy. For its AFS, J reports $87,500 of AFS revenue for 
2021, which includes $50,000 ($50 x 1,000) of commission income for 
policies sold in 2021 and an estimate of $37,500 ($25 x 1,500) of 
commission income for the policies expected to be renewed in 2022 and 
2023.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), J is 
required to include $50,000 in gross income in 2021 as J has a fixed 
right to receive $50,000 of commission income for the policies it sold 
during 2021. However, as of the end of 2021, J does not have a fixed 
right to receive any commission income from anticipated policy renewals. 
Under the AFS income inclusion rule, although J reports $87,500 of AFS 
revenue for 2021, J does not have an enforceable right to recover the 
$37,500 of anticipated commission income from future policy renewals if 
the insurance carrier were to terminate the contract on the last day of 
2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this section, 
of the $87,500 of AFS revenue reported for 2021, only $50,000 is treated 
as ``taken into account as AFS revenue'' under the AFS income inclusion 
rule. As a result, J is required to include $50,000 in gross income in 
2021. Alternatively, if J uses the alternative AFS revenue method in 
paragraph (b)(2)(ii) of this section, all $87,500 of AFS revenue 
reported for 2021 would be treated as ``taken into account as AFS 
revenue'' under the AFS income inclusion rule and J would be required to 
include $87,500 of commission income in gross income in 2021.
    (ix) Example 9: Escalating rents--(A) Facts. (1) K is a landlord in 
the business of leasing office space. On January 1, 2021, K enters into 
a 5-year lease with a tenant that provides for annual rent of $30,000 
for 2021 and increases by 5% each year over the lease term. The annual 
rents are due at the end of each year. Accordingly, the rent for each 
year (rounded to the nearest dollar) is as follows:

                   Table 1 to Paragraph (b)(4)(ix)(A)
------------------------------------------------------------------------
                Year                      Calculation       Total rent
------------------------------------------------------------------------
2021................................             $30,000         $30,000
2022................................       30,000 * 1.05          31,500
2023................................       31,500 * 1.05          33,075
2024................................       33,075 * 1.05          34,729
2025................................       34,729 * 1.05          36,465
                                     -----------------------------------
    Total Rent for Five Years.......  ..................         165,769
------------------------------------------------------------------------

    (2) The lease is not a section 467 rental agreement as defined under 
section 467(d). If the tenant terminates the lease early, the tenant 
must pay K the balance of the rent due for the remainder of the 
termination year. On its AFS, K reports AFS revenue from rents on a 
straight-line basis over the term of the lease, or approximately $33,154 
per year ($165,769 total rent/5 years). Accordingly, for its AFS, K 
reports $33,154 of AFS revenue for 2021.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), K is 
required to include $30,000 in gross income in 2021 as K has a fixed 
right to receive $30,000 for the 2021 rental period under the terms of

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the lease agreement. Under the AFS income inclusion rule, although K 
reports $33,154 of AFS revenue for 2021, K has an enforceable right to 
recover only $30,000 if the tenant were to cancel the lease on the last 
day of 2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this 
section, of the $33,154 of AFS revenue reported for 2021, only $30,000 
is treated as ``taken into account in AFS revenue'' under the AFS income 
inclusion rule. As a result, K is required to include $30,000 in gross 
income in 2021.
    (x) Example 10: Licensing income from digital services--(A) Facts. M 
is engaged in the business of licensing media entertainment content 
packages. M licenses content packages to customers by entering into 
subscription plans with customers. In January 2021, M enters into a two-
year subscription plan with Customer. M charges Customer $40 per month 
billed monthly in arrears. If Customer terminates the plan prior to the 
two-year term, it must pay the balance of the subscription fee for the 
remaining term of the contract. For its AFS, M reports $960 ($40 x 24 
months) of AFS revenue for 2021.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), M is 
required to include $480 in gross income in 2021 as M has a fixed right 
to receive $480 ($40 x 12) for the 12 months of media content licensed 
to Customer in 2021. M does not have a fixed right to receive any 
portion of the 2022 subscription fee as of the end of 2021 as such fee 
is not due under the terms of the subscription agreement until 2022 and 
M has yet to provide the media content for the 2022 subscription period. 
However, under the AFS income inclusion rule, because M has an 
enforceable right to recover all $960 of AFS revenue reported for 2021 
if Customer were to terminate the contract at the end of 2021, all $960 
is treated as ``taken into account as AFS revenue'' in 2021. 
Accordingly, M is required to include $960 in gross income in 2021.
    (c) Cost offsets--(1) In general. This paragraph (c) provides an 
optional method of accounting that may be used to determine the AFS 
income inclusion amount for an item of gross income from the sale of 
inventory (AFS cost offset method). A taxpayer that uses the AFS cost 
offset method for a trade or business must apply this method to all 
items of gross income in the trade or business that meet the criteria in 
this paragraph (c). Additionally, a taxpayer that uses this method for a 
trade or business must also use the advance payment cost offset method 
described in Sec.  1.451-8(e) to account for all advance payments 
received by such trade or business that meet the criteria in Sec.  
1.451-8(e), if applicable. A taxpayer that uses the AFS cost offset 
method to account for gross income from the sale of an item of 
inventory, but not the advance payment cost offset method because it 
does not receive any advance payments for such item, determines the 
corresponding AFS income inclusion amount for a taxable year by 
following the rules in paragraph (c)(2) of this section. A taxpayer that 
uses the AFS cost offset method and the advance payment cost offset 
method to account for gross income, including advance payments, from the 
sale of an item of inventory, determines the corresponding AFS income 
inclusion amount and the advance payment income inclusion amount, as 
defined in Sec.  1.451-8(a)(2), for a taxable year by following the 
rules in paragraph (c)(2) of this section rather than the rules under 
Sec.  1.451-8(e). However, if all payments received for the sale of an 
item of inventory meet the definition of an advance payment under Sec.  
1.451-8(a)(1), a taxpayer that uses the advance payment cost offset 
method determines the corresponding advance payment income inclusion 
amount for a taxable year by following the rules in Sec.  1.451-8(e).
    (2) AFS cost offset method. A taxpayer that uses the AFS cost offset 
method and, if applicable, the advance payment cost offset method, to 
account for gross income from the sale of an item of inventory 
determines the AFS income inclusion amount, or, if applicable, the 
advance payment income inclusion amount, for a taxable year prior to the 
taxable year in which ownership of the item of inventory is transferred 
to the customer by following the rules in paragraph (c)(2)(i) of this 
section, subject to the additional rules and limitations in paragraphs 
(c)(4) through (6) of this section.

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Such taxpayer determines the AFS income inclusion amount or, if 
applicable, the advance payment income inclusion amount, for the taxable 
year in which ownership of the item of inventory is transferred to the 
customer by following the rules in paragraph (c)(2)(ii) of this section. 
A taxpayer described in this paragraph (c)(2) that receives advance 
payments for the sale of the item of inventory may be required to 
include in gross income for a taxable year an amount that is comprised 
of both an AFS income inclusion amount and an advance payment income 
inclusion amount. In such case, it is not necessary to determine the 
portion of the total inclusion that is comprised of the AFS income 
inclusion amount and the portion of the total inclusion that is 
comprised of the advance payment income inclusion amount.
    (i) Determining gross income for a year prior to the year of sale. 
To determine the amount required to be included in gross income from the 
sale of an item of inventory for a taxable year prior to the taxable 
year in which ownership of the item of inventory is transferred to the 
customer, a taxpayer must first determine the AFS inventory inclusion 
amount for such item for such year by applying the steps in paragraph 
(c)(2)(i)(A) of this section. This AFS inventory inclusion amount is 
then reduced by the cost of goods in progress offset for the taxable 
year, as determined under paragraphs (c)(3) through (5) of this section. 
This net amount is required to be included in gross income for the 
taxable year.
    (A) AFS inventory inclusion amount for a taxable year. To determine 
the AFS inventory inclusion amount for an item of inventory for a 
taxable year:
    (1) The taxpayer first takes the greater of the amount described in 
paragraph (c)(2)(i)(A)(1)(i) of this section, or the amount described in 
paragraph (c)(2)(i)(A)(1)(ii) of this section (or if the two amounts are 
equal, the equal amount).
    (i) The cumulative amount of revenue from the item of inventory that 
satisfies the all events test under Sec.  1.451-1(a) through the last 
day of the taxable year, less any advance payment inventory inclusion 
amount, as defined in Sec.  1.451-8(a)(3), with respect to a subsequent 
taxable year.
    (ii) The cumulative amount of revenue from the item of inventory 
that is treated as ``taken into account as AFS revenue'' under paragraph 
(b)(2) of this section through the last day of the taxable year.
    (2) The taxpayer then reduces the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section by the amount computed under paragraph 
(c)(2)(i)(A)(1) of this section for that item of inventory for the 
immediately preceding taxable year.
    (B) [Reserved]
    (ii) Determining the gross income for the year of sale. To determine 
the amount required to be included in gross income from the sale of an 
item of inventory for the taxable year in which ownership of the item of 
inventory is transferred to the customer:
    (A) The taxpayer first takes the greater of the amount described in 
paragraph (c)(2)(ii)(A)(1) of this section, or the amount described in 
paragraph (c)(2)(ii)(A)(2) of this section (or if the two amounts are 
equal, the equal amount).
    (1) The cumulative amount of revenue from the item of inventory that 
satisfies the all events test under Sec.  1.451-1(a) through the last 
day of the taxable year, including the full amount of any advance 
payment received for the item of inventory.
    (2) The cumulative amount of revenue from the item of inventory that 
is treated as ``taken into account as AFS revenue'' under paragraph 
(b)(2) of this section through the last day of the taxable year.
    (B) The taxpayer then reduces such amount by any prior income 
inclusion amounts with respect to such item of inventory. This net 
amount is required to be included in gross income for the taxable year. 
The taxpayer does not further reduce such amount by a cost of goods in 
progress offset under paragraph (c)(3) of this section. However, the 
taxpayer is entitled to recover the costs capitalized to the item of 
inventory as cost of goods sold in accordance with sections 471 and 263A 
or any other applicable provision of the Internal Revenue Code. See 
Sec.  1.61-3.

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    (3) Cost of goods in progress offset for a taxable year. The cost of 
goods in progress offset for the taxable year is calculated as:
    (i) The cost of goods allocable to the item of inventory through the 
last day of the taxable year; reduced by
    (ii) The cumulative cost of goods in progress offset attributable to 
the item of inventory, if any.
    (4) Limitations to the cost of goods in progress offset. The cost of 
goods in progress offset is determined separately for each item of 
inventory. Further, the cost of goods in progress offset attributable to 
one item of inventory cannot reduce the AFS inventory inclusion amount 
attributable to a separate item of inventory. The cost of goods in 
progress offset cannot reduce the AFS inventory inclusion amount for the 
taxable year below zero.
    (5) Inventory methods--(i) Inventory costs not affected by cost of 
goods in progress offset. The cost of goods comprising the cost of goods 
in progress offset does not reduce the costs that are capitalized to the 
items of inventory produced or items of inventory acquired for resale by 
the taxpayer. While the cost of goods in progress offset reduces the AFS 
inventory inclusion amount, the cost of goods in progress offset does 
not affect how and when costs are capitalized to inventory under 
sections 471 and 263A or any other applicable provision of the Internal 
Revenue Code or when those capitalized costs will be recovered.
    (ii) Consistency between inventory methods and AFS cost offset 
method. The costs of goods comprising the cost of goods in progress 
offset must be determined by applying the taxpayer's method of 
accounting for inventory for Federal income tax purposes. A taxpayer 
using the AFS cost offset method and, if applicable, the advance payment 
cost offset method must calculate its cost of goods in progress offset 
by reference to all costs that the taxpayer has permissibly capitalized 
and allocated to items of inventory under its method of accounting for 
inventory for Federal income tax purposes, but including no more costs 
than what the taxpayer has permissibly capitalized and allocated to 
items of inventory.
    (iii) Allocation of ``additional section 263A costs'' for taxpayers 
using simplified methods. If a taxpayer uses the simplified production 
method as defined under Sec.  1.263A-2(b), the modified simplified 
production method as defined under Sec.  1.263A-2(c), or the simplified 
resale method as defined under Sec.  1.263A-3(d) to determine the amount 
of its additional section 263A costs, as defined under Sec.  1.263A-
1(d)(3), to be included in ending inventory, then solely to compute the 
cost of goods in progress offset, the taxpayer must determine the 
portion of additional section 263A costs allocable to an item of 
inventory by multiplying its total additional section 263A costs 
accounted for under the simplified method for all items of inventory 
subject to the simplified method by the following ratio:
    Section 471 costs allocable to the specific item of inventory
    Total section 471 costs for all items of inventory subject to the 
simplified method
    (6) Acceleration of gross income. A taxpayer that uses the AFS cost 
offset method or the advance payment cost offset method must include in 
gross income for a taxable year prior to the taxable year in which an 
item of inventory is transferred to the customer, all payments received 
for the item of inventory that were not previously included in gross 
income:
    (i) If, in that taxable year, the taxpayer either dies or ceases to 
exist in a transaction other than a transaction to which section 381(a) 
applies; or
    (ii) If, and to the extent that, in that taxable year, the 
taxpayer's obligation to the customer with respect to the item of 
inventory ends other than in:
    (A) A transaction to which section 381(a) applies; or
    (B) A section 351(a) transfer that is part of a section 351 
transaction in which:
    (1) Substantially all assets of the trade or business, including the 
item of inventory, are transferred;
    (2) The transferee adopts or uses, in the year of the transfer, the 
same methods of accounting for the item of inventory under this section 
and Sec.  1.451-8 as those used by the transferor; and

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    (3) The transferee and the transferor are members of the same 
consolidated group, as defined in Sec.  1.1502-1(h).
    (7) Additional procedural guidance. The IRS may publish procedural 
guidance in the Internal Revenue Bulletin (see Sec.  601.601(d) of this 
chapter) that provides alternative procedures for complying with the 
rules under this paragraph (c), including alternative methods of 
accounting for cost offsets.
    (8) Examples. The following examples illustrate the AFS cost offset 
method. Unless the facts specifically state otherwise, the taxpayer has 
an AFS, is on a calendar year for both Federal income tax purposes and 
AFS purposes, uses an accrual method of accounting for Federal income 
tax purposes, and does not use a special method of accounting. Further, 
the taxpayer properly applies its inventory accounting method, uses the 
AFS cost offset method under paragraph (c) of this section, and, except 
as otherwise provided, does not receive advance payments. Lastly, the 
taxpayer does not produce unique items, as described in Sec.  1.460-
2(a)(1) and (b), or any item that normally requires more than 12 
calendar months to complete, as determined under Sec.  1.460-2(a)(2) and 
(c). Any production period that exceeds 12 calendar months is due to 
unforeseen production delays.
    (i) Example 1--(A) Facts. During 2021, A enters into a contract with 
Customer to manufacture and deliver a good with a total contract price 
of $100x. The costs to produce the good are required to be capitalized 
under sections 471 and 263A as the good is inventory in the hands of A. 
Ownership of the good is transferred from A to Customer upon its 
delivery in 2022. A determines, under paragraph (c)(2)(i)(A) of this 
section, that its AFS inventory inclusion amount for 2021 is $20x. A 
incurs $12x of costs in 2021, and $48x of costs in 2022 ($60x in total) 
that are permissibly capitalized and allocated to the produced good 
under sections 471 and 263A. A has a fixed right to receive the $100x 
contract price when it delivers the good in 2022. A does not receive any 
payments from Customer prior to delivery. Further, all $100x is treated 
as ``taken into account as AFS revenue'' as of the last day of 2022.
    (B) Analysis for 2021. For 2021, A's AFS income inclusion amount, as 
determined under paragraph (c)(2)(i) of this section, is $8x ($20x AFS 
inventory inclusion amount less $12x cost of goods in progress offset, 
which is the cost of goods incurred through December 31, 2021).
    (C) Analysis for 2022. During 2022, ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) 
of this section, A determines the AFS income inclusion amount for 2022 
by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($100x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2022 ($100x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($100x) the prior income 
inclusion amounts attributable to the transferred good ($8x). This net 
amount of $92x is the AFS income inclusion amount for 2022. Although A 
does not reduce such amount by a cost of goods in progress offset under 
this paragraph (c), A is entitled to recover the $60x of costs 
capitalized to the good as cost of goods sold in 2022 in accordance with 
sections 471 and 263A. See Sec.  1.61-3. Accordingly, A's gross income 
for 2022 is $32x.
    (ii) Example 2--(A) Facts. In December of 2021, A enters into a 
contract with Customer to manufacture and deliver 10 items of inventory 
at a price of $10x per item by the end of 2023. A determines, under 
paragraph (c)(2)(i)(A) of this section, that the AFS inventory inclusion 
amount attributable to each item of inventory under the contract is $3x 
for 2021. A also incurs $10x of inventory costs during 2021. Such costs 
are permissibly capitalized and allocated under sections 471 and 263A 
and are allocated equally to each item of inventory under the contract 
($1x per item). During 2022, the taxpayer incurs $18x of costs to finish 
manufacturing 6 of the 10 items and delivers such items to Customer in 
October of 2022. Such costs are permissibly capitalized and allocated 
under sections 471 and 263A and

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are allocated equally to each of the 6 items delivered in October of 
2022 ($3x per item). Upon delivering the 6 items, ownership of the 
delivered items transfers to Customer, A has a fixed right to receive 
$60x of the total contract price, and all $60x is treated as ``taken 
into account as AFS revenue.'' A does not incur any inventory costs 
during 2022 that are allocable to the 4 remaining undelivered items, nor 
does the taxpayer have an AFS inventory inclusion amount attributable to 
such items for 2022. During 2023, A incurs $12x of costs to finish 
manufacturing the 4 remaining items and delivers such items to Customer. 
Such costs are permissibly capitalized and allocated under sections 471 
and 263A and are allocated equally to each of the 4 items delivered in 
2023 ($3x per item). Upon delivering the 4 remaining items, ownership of 
the items transfers to Customer, A has a fixed right to receive the 
remaining $40x contract price, and all $40x is treated as ``taken into 
account as AFS revenue.''
    (B) Analysis for 2021 A's AFS income inclusion amount for 2021 is 
$2x per item ($3x AFS inventory inclusion amount per item less $1x cost 
of goods in progress offset per item, which is the cost of goods as of 
December 31, 2021). Accordingly, A's total gross income inclusion for 
2021 is $20x.
    (C) Analysis for 2022. During 2022, ownership of 6 of the 10 items 
is transferred to Customer. Accordingly, pursuant to paragraph 
(c)(2)(ii) of this section, A determines the AFS income inclusion amount 
for 2022 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($10x per 
item); or
    (ii) The cumulative amount of revenue that is treated as taken into 
account as AFS revenue through the last day of 2022 ($10x per item) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($10x per item) the prior 
income inclusion amounts attributable to each transferred item ($2x per 
item). This net amount of $8x per item is the AFS income inclusion 
amount for each transferred item for 2022. Although A does not reduce 
such amount by a cost of goods in progress offset under this paragraph 
(c), A is entitled to recover the $4x of costs capitalized to each item 
delivered as cost of goods sold in 2022 in accordance with sections 471 
and 263A. Accordingly, on an aggregate basis, A's gross income for 2022 
is $24x (aggregate AFS income inclusion amount for the 6 items delivered 
in 2022 of $ 48x less aggregate cost of goods sold of $24x). A does not 
include any amounts in gross income for 2022 with respect to the 4 items 
of inventory that were not delivered to Customer until 2023 as A does 
not have an AFS inventory inclusion amount attributable to such items 
for 2022.
    (D) Analysis for 2023. During 2023, ownership of the 4 remaining 
items are transferred to Customer. Based on the facts, A did not have an 
AFS inventory inclusion amount attributable to the 4 remaining items for 
2022, nor did it incur any cost for such items in 2022 so the analysis 
for the 4 remaining items for 2023 is similar to the analysis for the 6 
items transferred to the customer in 2022 on a per item basis. Pursuant 
to paragraph (c)(2)(ii) of this section, A determines the AFS income 
inclusion amount for 2023 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($10x per 
item); or
    (ii) The cumulative amount of revenue that is treated as taken into 
account as AFS revenue through the last day of 2023 ($10x per item) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($10x per item) the prior 
income inclusion amounts attributable to each transferred item ($2x per 
item). This net amount of $8x per item is the AFS income inclusion 
amount for each transferred item for 2023. Although A does not reduce 
such amount by a cost of goods in progress offset under this paragraph 
(c), A is entitled to recover the $4x of costs capitalized to each item 
delivered as cost of goods sold in 2023 in accordance with sections 471 
and 263A. On an aggregate basis, A's gross income for 2023 is $16x 
(aggregate AFS income inclusion amount for the 4 items delivered in 2023 
of $32x less aggregate cost of goods sold of $16x).

[[Page 136]]

    (iii) Example 3--(A) Facts. In December of 2021, A enters into a 
contract with Customer to manufacture and deliver a good with a total 
contract price of $100x. The costs to produce the good are required to 
be capitalized under sections 471 and 263A as the good is inventory in 
the hands of the taxpayer. Ownership of the good is transferred from A 
to Customer upon its delivery in January of 2023. A determines, under 
paragraph (c)(2)(i)(A) of this section, that its AFS inventory inclusion 
amount for 2021 and 2022 is $40x per year. A incurs $25x of costs each 
year ($75x in total) that are permissibly capitalized and allocated to 
the manufactured good under sections 471 and 263A. A has a fixed right 
to receive the $100x contract price when it delivers the good in January 
of 2023. A does not receive any payments from Customer prior to 
delivery. Further, all $100x is treated as ``taken into account as AFS 
revenue'' as of the last day of 2023.
    (B) Analysis for 2021 and 2022. For 2021, A's AFS income inclusion 
amount, as determined under paragraph (c)(2)(i) of this section, is $15x 
($40x AFS inventory inclusion amount for 2021 less the $25x cost of 
goods in progress offset for 2021, which is equal to the cost of goods 
as of December 31, 2021). For 2022, A's AFS income inclusion amount is 
$15x ($40x AFS inventory inclusion amount for 2022 less the $25x cost of 
goods in progress offset for 2022, which is the $50x cost of goods as of 
December 31, 2022 less the 25x cumulative cost of goods in progress 
offset amount taken into account in 2021).
    (C) Analysis for 2023. During 2023, ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) 
of this section, A determines the AFS income inclusion amount for 2023 
by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($100x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2023 ($100x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($100x) the prior income 
inclusion amounts attributable to the transferred good of $30x ($15x for 
2021 and $15x for 2022). This net amount of $70x is the AFS income 
inclusion amount for 2023. Although A does not reduce such amount by a 
cost of goods in progress offset under this paragraph (c), A is entitled 
to recover the $75x of costs capitalized to the good as cost of goods 
sold in 2023 in accordance with sections 471 and 263A. See Sec.  1.61-3. 
Accordingly, A's gross income for 2025 is -$5x.
    (iv) Example 4--(A) Facts. In December 2021, A enters into a 
contract with Customer to manufacture and deliver a good with a total 
contract price of $100x. A reports $5x of AFS revenue for 2021, $90x of 
cumulative AFS revenue through the end of 2022, and $100x of cumulative 
AFS revenue through the end of 2023. A has an enforceable right to 
recover all AFS revenue reported through the end of each contract year 
if Customer were to terminate the contract on the last day of each year. 
Under the terms of the contract, A is entitled to and receives a payment 
of $40x in 2021 and a payment of $60x when Customer accepts delivery of 
the good in 2023, which is also when ownership of the good transfers to 
Customer. The costs to produce the good are required to be capitalized 
under sections 471 and 263A as the good is inventory in the hands of A. 
A incurs $10x of costs in 2021, $55x of costs in 2022, and $5x of costs 
in 2023 ($70x in total). Such costs are permissibly capitalized and 
allocated to the produced good under sections 471 and 263A. A uses the 
AFS cost offset method under paragraph (c) of this section and accounts 
for advance payments, as defined in Sec.  1.451-8(a)(1), under the 
deferral method and advance payment cost offset method under Sec.  
1.451-8(c) and (e), respectively.
    (B) Analysis for 2021. The $40x payment A receives in 2021 meets the 
definition of an advance payment under Sec.  1.451-8(a)(1) as the full 
inclusion of $40x in gross income in the year of receipt is a 
permissible method of accounting, a portion of the payment ($35x) is 
``taken into account as AFS revenue'' in a subsequent year, and the 
payment is for a good. Pursuant to Sec.  1.451-8(a)(3), A's advance 
payment inventory inclusion amount for 2022 is

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$35x (the portion of the payment deferred for AFS purposes). Pursuant to 
paragraph (c)(2)(i) of this section, A must first determine the AFS 
inventory inclusion amount for 2021 by applying the rules in paragraph 
(c)(2)(i)(A) of this section. A then reduces such amount by the cost of 
goods in progress offset for 2021, as determined under paragraphs (c)(3) 
through (5) of this section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2021, less any 
advance payment inventory inclusion amount attributable to a subsequent 
year ($5x, determined as the $40x under the all events test, less the 
$35x of advance payment inventory inclusion amount attributable to 
2022); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2021 ($5x) (or if 
the two amounts are equal, the equal amount).
    (2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then 
subtracts from such amount ($5x) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for the 
immediately preceding year ($0). This net amount of $5x is the AFS 
inventory inclusion amount for 2021.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$5x AFS inventory inclusion amount by the cost of goods in progress 
offset for 2021 of $5x, determined as the cost of goods as of December 
31, 2021 of $10x, less the cumulative cost of goods in progress offset 
taken into account in prior years of $0, less 5x for the AFS inventory 
inclusion amount limitation under paragraph (c)(4) of this section. 
Accordingly, A is required to include $0 in gross income for 2021.
    (C) Analysis for 2022. Pursuant to paragraph (c)(2)(i) of this 
section, A must first determine the AFS inventory inclusion amount for 
2022 by applying the rules in paragraph (c)(2)(i)(A) of this section. A 
then reduces such amount by the cost of goods in progress offset for 
2022, as determined under paragraphs (c)(3) through (5) of this section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($40x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2022 ($90x).
    (2) Pursuant to (c)(2)(i)(A)(2) of this section, A then subtracts 
from such amount ($90x) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for 2021 
($5x). This net amount of $85x is the AFS inventory inclusion amount for 
2022.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$85x AFS inventory inclusion amount by the cost of goods in progress 
offset for 2022 of $60x, determined as the cost of goods as of December 
31, 2022 of $65x, less the cumulative cost of goods in progress offset 
taken into account in prior years of $5x. Accordingly, A is required to 
include $25x in gross income for 2022.
    (D) Analysis for 2023. During 2023, ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) 
of this section, A determines its gross income inclusion for 2023 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($100x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2023 ($100x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($100x) the prior income 
inclusion amounts attributable to the transferred good of $25x ($0 for 
2021 plus $25x for 2022). A is required to include this net amount of 
$75x in gross income for 2023. Although A does not reduce such amount by 
a cost of goods in progress offset under this paragraph (c), A is 
entitled to recover the $70x of costs capitalized to the good as cost of 
goods sold in 2023 in accordance with sections

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471 and 263A. See Sec.  1.61-3. Accordingly, A's gross income for 2023 
is $5x.
    (v) Example 5--(A) Facts. The same facts as in paragraph (c)(8)(iv) 
of this section (Example 4) apply, except that in 2022, A's obligation 
to Customer with respect to the good ends other than in a transaction to 
which section 381(a) applies, or a section 351 transaction described in 
paragraph (c)(6)(ii)(B) of this section. A does not receive any 
additional payments in 2022.
    (B) Analysis for 2021. The analysis for 2021 is the same as in 
paragraph (c)(8)(iv) of this section (Example 4).
    (C) Analysis for 2022. Because, in 2022, A's obligation to Customer 
with respect to the good ends in a transaction other than a transaction 
described in paragraph (c)(6)(ii)(A) or (B) of this section, A is 
required to apply the acceleration rules in paragraph (c)(6) of this 
section. Accordingly, because A received $40x of payments as of the date 
of the transaction, but did not include any portion of such payments in 
gross income in prior years, A is required to include the remaining $40x 
of the payments received in gross income in 2022 pursuant to paragraph 
(c)(6) of this section. A is not permitted to further reduce the $40x 
income inclusion by a cost of goods in progress offset under this 
paragraph (c).
    (vi) Example 6--(A) Facts. In 2021, A enters into a contract with 
Customer to produce and deliver a good. The contract provides that A 
will receive payments equal to AFS costs plus a 100% mark-up, however, A 
can only bill the customer on December 31, 2022 and, if the good is not 
delivered by December 31, 2022, A can also bill Customer upon delivery 
of the good, for the AFS costs (plus markup) incurred to date, less any 
amounts previously billed. A recognizes AFS revenue based on a 
percentage of completion (cost to cost) method. A recognizes AFS revenue 
of $100 through the last day of 2021, $150 through the last day of 2022, 
and $300 through the last day of 2023, and has an enforceable right to 
all AFS revenue reported as of the end of each year if the customer were 
to terminate the contract on the last day of the year. A bills the 
customer $150 on December 31 of 2022 and $150 in 2023 when A delivers 
the good and ownership transfers to Customer. The costs to produce the 
good are required to be capitalized under sections 471 and 263A as the 
good is inventory in the hands of the taxpayer. A incurs the following 
costs each year that are permissibly capitalized and allocated to the 
produced good under sections 471 and 263A: $125 in 2021; $0 in 2022; and 
$25 in year 2023.
    (B) Analysis for taxable year 2021. Pursuant to paragraph (c)(2)(i) 
of this section, A must first determine the AFS inventory inclusion 
amount for 2021 by applying the rules in paragraph (c)(2)(i)(A) of this 
section. A then reduces such amount by the cost of goods in progress 
offset for 2021, as determined under paragraphs (c)(3) through (5) of 
this section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2021 ($0); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2021 ($100).
    (2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then 
subtracts from such amount ($100) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for the 
immediately preceding year ($0). This net amount of $100 is the AFS 
inventory inclusion amount for 2021.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$100 AFS inventory inclusion amount by the cost of goods in progress 
offset for 2021 of $100. Although A's cost of goods in progress as of 
the end of 2021 is $125, the cost of goods in progress offset is limited 
to $100, the amount of A's AFS inventory inclusion amount for 2021. 
Accordingly, A is required to include $0 in gross income in 2021.
    (C) Analysis for taxable year 2022. Pursuant to paragraph (c)(2)(i) 
of this section, A must first determine the AFS inventory inclusion 
amount for 2022 by applying the rules in paragraph (c)(2)(i)(A) of this 
section. A then reduces such amount by the cost of goods

[[Page 139]]

in progress offset for 2022, as determined under paragraphs (c)(3) 
through (5) of this section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($150 due under 
the terms of the contract); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2022 ($150) (or if 
the two amounts are equal, the equal amount).
    (2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then 
subtracts from such amount ($150) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for the 
immediately preceding year ($100). This net amount of $50 is the AFS 
inventory inclusion amount for 2022.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$50 AFS inventory inclusion amount by the cost of goods in progress 
offset for 2022 of $25, determined as $125 cost of goods as of December 
31, 2022 minus $100 cumulative cost of goods in progress offset amount 
taken into account in 2021. Accordingly, A is required to include $25 in 
gross income for 2022.
    (D) Analysis for taxable year 2023. During 2023, ownership of the 
good is transferred to the customer. Accordingly, pursuant to paragraph 
(c)(2)(ii) of this section, A determines its gross income inclusion for 
2023 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($300x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2025 ($300x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($300x) the prior income 
inclusion amounts attributable to the transferred good of $25 ($0 for 
2021 plus $25 for 2022). This net amount of $275 is the AFS income 
inclusion amount for 2023. Although A does not reduce such amount by a 
cost of goods in progress offset under this paragraph (c), A is entitled 
to recover the $150 of costs capitalized to the good as cost of goods 
sold in 2023 in accordance with sections 471 and 263A. See Sec.  1.61-3. 
Accordingly, A's gross income for 2023 is $125 ($275 AFS income 
inclusion amount less $150 cost of goods sold).
    (d) Contracts with multiple performance obligations--(1) In general. 
Each performance obligation generally yields a corresponding item of 
gross income that must be accounted for separately under the AFS income 
inclusion rule in paragraph (b)(1) of this section. Except as provided 
in paragraph (d)(5) of this section, if a contract contains more than 
one performance obligation, and thus yields more than one corresponding 
item of gross income, the transaction price amount shall be allocated to 
each corresponding item of gross income in accordance with the 
transaction price amount allocated to each performance obligation for 
AFS purposes, subject to the adjustments to the transaction price amount 
and special allocation rules in paragraph (d)(3) of this section.
    (2) Single performance obligation with more than one item of gross 
income. If a single performance obligation yields more than one 
corresponding item of gross income, the transaction price amount 
allocated to the single performance obligation for AFS purposes must be 
further allocated among the corresponding items of gross income using 
any reasonable method.
    (3) Adjustments to transaction price amount and special allocation 
rules--(i) Increases to transaction price amount. If the transaction 
price amount includes a reduction for amounts described in paragraph 
(b)(2)(i)(A)(1) or (2) of this section, or has been reduced because a 
significant financing component is deemed to exist under the standards 
the taxpayer uses to prepare its AFS, the taxpayer must determine the 
specific performance obligation to which such reduction relates and 
increase the transaction price amount allocable to the corresponding 
item of gross income by the amount of such reduction (specific 
identification approach). If it is impracticable from the taxpayer's 
records to use the specific identification approach, the taxpayer may 
use

[[Page 140]]

any reasonable method to allocate the reduction amount to the items of 
gross income in the contract. A pro-rata allocation of the reduction 
amount across all items of gross income under the contract based on the 
relative transaction price amounts allocated to such items under 
paragraph (d)(1) of this section is a reasonable method.
    (ii) Decrease to transaction price amount. If the transaction price 
amount has been increased because a significant financing component is 
deemed to exist under the standards the taxpayer uses to prepare its 
AFS, the taxpayer must determine the specific performance obligation to 
which such amount relates and decrease the transaction price amount 
allocable to the corresponding item of gross income by such amount 
(specific identification approach). If it is impracticable from the 
taxpayer's records to use the specific identification approach, the 
taxpayer may use any reasonable method to allocate such amount to the 
items of gross income in the contract. A pro-rata allocation of such 
amount across all items of gross income under the contract based on the 
relative transaction price amounts allocated to such items under 
paragraph (d)(1) of this section is a reasonable method.
    (4) Examples. The following examples illustrate the rules of 
paragraph (d)(1) through (3) of this section. Unless the facts 
specifically state otherwise, the taxpayer has an AFS, is on a calendar 
year for Federal income tax purposes and AFS purposes, and uses an 
accrual method of accounting for Federal income tax purposes.
    (i) Example 1--(A) Facts. On November 1, 2021, A, a software 
developer, enters into a contract with a customer to transfer a software 
license, perform software installation services, and provide technical 
support for a two-year period for $100x. The installation service does 
not significantly modify the software and the software remains 
functional without the technical support. A receives an additional $10x 
bonus if the installation service is performed before February 1, 2022, 
which A expects to receive. Further, the customer is entitled to a 
refund of $2x if technical support does not meet performance standards 
set forth in the contract, which A expects it will pay to the customer. 
For its AFS, A identifies three performance obligations in the contract:
    (1)(i) The software license;
    (ii) The installation service; and
    (iii) Technical support.
    (2) Also, for its AFS, A determines that the transaction price 
amount is $108x, determined as $100x contract price plus $10x bonus for 
installation services minus $2x customer refund. Finally, for its AFS, A 
allocates the $108x transaction price amount to the three performance 
obligations as follows: $60x to the software license; $40x to the 
installation service ($30x + $10x bonus); and $8x to technical support 
($10x-$2x refund).
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, A's 
contract with the customer has three performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, A is required to allocate the $108x transaction price amount to 
each corresponding item of gross income in accordance with the 
transaction price amount allocated to each respective performance 
obligation for AFS purposes. Accordingly, A initially allocates $60x to 
the software license item, $40x to the installation service item, and $8 
to the technical support item. However, because the transaction price 
amount was reduced by the anticipated refund of $2x, which relates 
specifically to the technical support item, A must increase the 
transaction price allocable to that item of gross income pursuant to the 
specific identification approach in paragraph (d)(3) of this section. 
Accordingly, the amount allocated to the item of gross income related to 
technical support is $10x.
    (ii) Example 2--(A) Facts. In 2021, B, a manufacturer and servicer 
of airplane parts, enters into a contract with a customer to sell 
airplane parts in 2021 and to service those parts, as necessary, in 
2021, 2022, and 2023 for $100x. B regularly sells the airline parts and 
the services separately. For its AFS, B identifies two performance 
obligations in the contract:
    (1)(i) The sale of airplane parts; and
    (ii) The services for those parts.

[[Page 141]]

    (2) The customer receives a refund of $5x if it does not require a 
specified level of service for the parts, which B expects it will pay to 
the customer. Also, for its AFS, B determines that the transaction price 
amount is $95x, determined as the $100x contract price minus the $5x 
refund that it expects to pay the customer. Finally, for its AFS, B 
allocates the $95x transaction price amount to the two performance 
obligations as follows: $40x to the sale of parts and $55x to the 
provision of services ($60x-$5x refund).
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, B's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, B is required to allocate the $95x transaction price amount to 
each corresponding item of gross income in accordance with the 
transaction price amount allocated to each respective performance 
obligation for AFS purposes. Accordingly, B initially allocates $40x to 
the sale of parts item and $55x to the provision of services item. 
However, because the transaction price amount was reduced by the 
anticipated refund of $5x, which relates specifically to provision of 
services item, B must increase the transaction price allocable to that 
item of gross income pursuant to the specific identification approach in 
paragraph (d)(3) of this section. Accordingly, the amount allocated to 
the item of gross income related to servicing the parts is $60x.
    (iii) Example 3: Reward points--(A) Facts. On December 31, 2021, U, 
in the business of selling consumer electronics, sells a new TV for 
$1,000 and gives the customer 50 reward points. Each reward point is 
redeemable for a $1 discount on any future purchase of U's products. For 
its AFS, U identifies two performance obligations from the transaction:
    (1)(i) The sale of the TV; and
    (ii) The provision of rewards points.
    (2) Also, for its AFS, U allocates $950 of transaction price amount 
to the sale of the TV and the remaining $50 of the transaction price 
amount to the reward points.
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, U's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, U is required to allocate the $1,000 transaction price amount 
to each corresponding item of gross income in accordance with the 
transaction price amount allocated to each respective performance 
obligation for AFS purposes. Accordingly, U allocates the transaction 
price amount as follows: $950 to the TV sale item and $50 to the reward 
points item. If U reports any portion of the $50 payment allocated to 
the reward points as AFS revenue for 2022, or later, the payment is an 
advance payment, as defined in Sec.  1.451-8(a)(1), and may be accounted 
for under the deferral method if U satisfies the criteria in Sec.  
1.451-8(c).
    (iv) Example 4: Airline reward miles--(A) Facts. On January 1, 2021, 
W, a passenger airline company, sells a customer a $700 airline ticket 
to fly roundtrip in 2021. As part of the purchase, the customer receives 
7,000 points (air miles) from W to be redeemed for future air travel. 
For its AFS, W identifies two performance obligations in the contract:
    (1)(i) The sale of the airline ticket; and
    (ii) The provision of air miles.
    (2) W also anticipates that it will issue a rebate to the customer 
for $10. Also, for its AFS, W determines that the transaction price 
amount is $690, determined as the $700 ticket price minus the 
anticipated $10 rebate. Finally, for its AFS, W allocates the $690 
transaction price amount to the separate performance obligations as 
follows: $660 to the ticket ($670-$10 rebate = $660) and $30 to the air 
miles.
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, W's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, W must allocate the $690 transaction price amount to each 
corresponding item of gross income in accordance with the transaction 
price

[[Page 142]]

amount allocated to each respective performance obligation for AFS 
purposes. Accordingly, W initially allocates $660 to the ticket sale 
item and $30 to the air miles item. However, because the transaction 
price amount was reduced by the anticipated rebate of $10x, which 
relates to the ticket sale item, W must increase the transaction price 
allocable to that item of gross income pursuant to paragraph (d)(3) of 
this section. Accordingly, the amount allocated to the item of gross 
income related to the ticket sale is $670. If W reports any portion of 
the $30 payment allocated to the air miles item as AFS revenue for 2022, 
or later, the payment is an advance payment, as defined in Sec.  1.451-
8(a)(1), and may be accounted for under the deferral method if W 
satisfies the criteria in Sec.  1.451-8(c).
    (v) Example 5: Contract with significant financing component 
amounts--(A) Facts. On January 1, 2021, C, a manufacturer and servicer 
of airline parts, enters into a contract with a customer to sell airline 
parts in December 2022, and to service those parts, as necessary, 
through 2024. The contract contains two alternative payment options: 
payment of $5,000 in December 2022 when the customer obtains control of 
the parts or payment of $4,000 when the contract is signed. The customer 
pays $4,000 when the contract is signed, which reflects an implicit 
interest rate of 11.8% and is C's incremental borrowing rate. C 
regularly sells the airline parts and the services separately. For its 
AFS, C identifies two performance obligations in the contract:
    (1)(i) The sale of airplane parts; and
    (ii) The services for those parts.
    (2) Also, for its AFS, although the contract only requires the 
customer to pay $4,000, the transaction price is increased by $1,000 to 
$5,000 because the customer is deemed to provide financing to C under 
the standards C uses to prepare its AFS. The $1,000 increase is 
attributable to a significant financing component. Finally, for its AFS, 
C allocates the $5,000 transaction price amount to the separate 
performance obligations as follows: $3,750 to the sale of parts ($3,000 
upfront payment plus $750 financing component) and $1,250 ($1,000 
upfront payment plus $250 financing component) to the provision of 
services.
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, C's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, C must allocate the $5,000 transaction price amount to each 
corresponding item of gross income in accordance with the transaction 
price amount allocated to each respective performance obligation for AFS 
purposes. Accordingly, C initially allocates $3,750 to the sale of the 
parts item and $1,250 to the provision of services item. However, 
because the transaction price was increased by a significant financing 
component of $1,000, $750 of which was allocated to sale of the parts 
item and $250 of which was allocated to the provision of services item, 
pursuant to paragraph (d)(3) of this section, C must decrease the 
transaction price amount allocable to the sale of parts item from $3,750 
to $3,000 and must decrease the transaction price allocable to the 
provision of services from $1,250 to $1,000.
    (5) Contracts accounted for in part under this section and in part 
under a special method of accounting--(i) In general. If a taxpayer has 
a contract with a customer that includes one or more items of gross 
income that are subject to a special method of accounting and one or 
more items of gross income that are subject to this section (special 
method/451 contract), the transaction price allocation rule in paragraph 
(d)(1) of this section does not apply to determine the amount of each 
item of gross income that is subject to a special method of accounting. 
For purposes of this paragraph (d)(5)(i), a special method of accounting 
has the meaning set forth in paragraph (a)(13) of this section, except 
as otherwise provided in guidance published in the Internal Revenue 
Bulletin (see Sec.  601.601(d) of this chapter). For special method/451 
contracts, paragraphs (d)(5)(ii) and (iii) of this section apply to 
determine the transaction price amount and the portion of such amount 
that is allocated to each item of gross income that is subject to this 
section.

[[Page 143]]

    (ii) Transaction price adjustments. If the transaction price amount 
for the special method/451 contract includes a reduction for amounts 
described in paragraph (b)(2)(i)(A)(1) or (2) of this section, or has 
been reduced because a significant financing component is deemed to 
exist under the standards the taxpayer uses to prepare its AFS, the 
taxpayer must increase the transaction price amount by the amount of 
such reduction. If the transaction price amount for the special method/
451 contract has been increased because a significant financing 
component is deemed to exist under the standards the taxpayer uses to 
prepare its AFS, the taxpayer must decrease the transaction price amount 
by the amount of such increase.
    (iii) Transaction price allocation. After the taxpayer determines 
the adjusted transaction price amount for the special method/451 
contract under paragraph (d)(5)(ii) of this section, the taxpayer first 
allocates such amount to the item(s) of gross income subject to a 
special method of accounting and then allocates the remainder (residual 
amount) to the item(s) of gross income that are subject to this section. 
If the contract contains more than one item of gross income that is 
subject to this section, the taxpayer allocates the residual amount to 
such items in proportion to the amounts allocated to the corresponding 
performance obligations for AFS purposes or as otherwise provided in 
guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d) of this chapter).
    (iv) Example--(1) Facts. B is a calendar-year accrual method 
taxpayer with an AFS. In 2020, B enters into a $100x contract to design, 
build, operate and maintain a toll road. The contract meets the 
definition of a long-term contract under Sec.  1.460-1(b)(1). B 
determines that the obligations to design and build the toll road are 
long-term contract activities under Sec.  1.460-1(d)(1) and accounts for 
the gross income from these activities under section 460 and the 
regulations in this part under section 460 of the Code. In addition, B 
determines that the obligations to operate and maintain the toll road 
are non-long-term contract activities under Sec.  1.460-1(d)(2) and that 
the gross income attributable to these activities is required to be 
accounted for under this section. B determines that of the $100x 
transaction price amount, $60x is properly allocable to the items of 
gross income that are subject to section 460 and the regulations in this 
part under section 460 of the Code. However, for its AFS, B allocates 
$55x of the transaction price amount to performance obligations that are 
long-term contract activities, $30x to the toll road operation 
performance obligation and $15x to the toll road maintenance performance 
obligation.
    (2) Analysis. A method of accounting under section 460 is a special 
method of accounting that is within the scope of paragraph (d)(5) of 
this section. Pursuant to paragraph (d)(5) of this section, B first 
allocates $60x of the transaction price amount to the items of gross 
income that are subject to section 460 and the regulations in this part 
under section 460 of the Code and then allocates the residual amount of 
$40x to the two items of gross income that are required to be accounted 
for under this section in proportion to the amounts allocated to the 
corresponding performance obligations for AFS purposes. Accordingly, B 
allocates $26.7 x ($30x/$45x x $40x residual amount) to the toll road 
operations item of gross income and $13.3x ($15x/$45x x $40x residual 
amount) to the toll road maintenance item of gross income.
    (e) Cumulative rule for multi-year contracts--(1) In general. In the 
case of an item of gross income from a multi-year contract, a taxpayer 
determines the AFS income inclusion amount for a taxable year by 
applying the steps in paragraph (e)(1)(i) or (ii) of this section. For 
this paragraph (e), the term multi-year contract means a contract that 
spans more than one taxable year.
    (i) Inventory items. If the item of gross income is from the sale of 
an item of inventory and the taxpayer uses the cost offset method under 
paragraph (c) of this section, see paragraph (c) of this section.
    (ii) Other items of gross income. For all other items of gross 
income, the taxpayer first compares the cumulative amount of the item of 
gross income that satisfies the all events test under Sec.  1.451-1(a) 
through the last day of the

[[Page 144]]

taxable year, including the full amount of any advance payment received 
for such item in a prior taxable year, with the cumulative amount of the 
item of gross income that is treated as ``taken into account as AFS 
revenue'' under paragraph (b)(2) of this section through the last day of 
the taxable year and identifies the larger of the two amounts (or, if 
the two amounts are equal, the equal amount). The taxpayer then reduces 
such amount by all prior year inclusion amounts attributable to the item 
of gross income, if any, to determine the AFS income inclusion amount 
for the current taxable year. If, however, the taxpayer receives an 
advance payment, as defined in Sec.  1.451-8(a)(1), that is allocable to 
an item of gross income from a multi-year contract, the taxpayer applies 
the applicable rules in Sec.  1.451-8, rather than the rules in this 
paragraph (e)(1)(ii), to determine the amount of the item of gross 
income that is required to be included in gross income in the taxable 
year in which such advance payment is received, or, if applicable, in a 
short taxable year described in Sec.  1.451-8(c)(6).
    (2) Examples. The following examples illustrate the rules of 
paragraph (e)(1) of this section. Unless the facts specifically state 
otherwise, the taxpayer has an AFS, is on a calendar year for both 
Federal income tax purposes and AFS purposes and uses an accrual method 
of accounting for Federal income tax purposes. Further, the taxpayer 
does not use a special method of accounting.
    (i) Example 1: Provision of services included in AFS revenue with 
full inclusion method for advance payments--(A) Facts. In 2021, D, an 
engineering services provider, enters into a nonseverable contract with 
a customer to provide engineering services through 2024 for a total of 
$100x. Under the contract, D receives payments of $25x in each calendar 
year of the contract. For its AFS, D reports $50x, $0, $20x, and $30x of 
AFS revenue from the contract for 2021, 2022, 2023, and 2024, 
respectively. D has an enforceable right to recover all amounts reported 
as AFS revenue through the end of a given contract year if the customer 
were to terminate the contract on the last day of such year. The $25x 
payment received in 2023 is an advance payment, as defined in Sec.  
1.451-8(a)(1), because $5x of the $25x payment is reported as AFS 
revenue for 2024. D uses the full inclusion method for advance payments.
    (B) Taxable year 2021. Under the all events test in Sec.  1.451-
1(a), D is required to include $25x in gross income in 2021 as $25x is 
due under the terms of the contract and received by D during 2021. D 
does not have a fixed right to receive any portion of the remaining $75 
as such amount is not due under the terms of the contract until future 
years and is also contingent on D's completion of the nonseverable 
services. Under the AFS income inclusion rule, because D has an 
enforceable right to recover all $50x reported as AFS revenue for 2021 
if the customer were to terminate the contract on the last day of such 
year, all $50x is treated as ``taken into account as AFS revenue'' in 
2021. Accordingly, D is required to include $50x in gross income in 
2021.
    (C) Taxable year 2022. Under the all events test in Sec.  1.451-
1(a), D is required to include $50x in gross income through the end of 
2022 as $50x is due under the terms of the contract and received by D as 
of the end of 2022. D does not have a fixed right to receive any portion 
of the remaining $50 as such amount is not due under the terms of the 
contract until future years and is also contingent on D's completion of 
the nonseverable services. Under the AFS income inclusion rule, because 
D has an enforceable right to recover all $50x reported as AFS revenue 
through the end of 2022 if the customer were to terminate the contract 
on the last day of such year, all $50x is treated as ``taken into 
account as AFS revenue'' as of the last day of 2022. Under the 
cumulative rule in paragraph (e)(1)(ii) of this section, D compares the 
cumulative all events test amount of $50x with the cumulative AFS 
revenue amount of $50x and selects the larger of the two amounts (or if 
the two amounts are equal, the equal amount). From this equal amount of 
$50x, D subtracts the prior income inclusion amount of $50x. 
Accordingly, under the cumulative rule D is not required to include any 
amount in gross income in 2022.

[[Page 145]]

    (D) Taxable year 2023. The payment received during 2023 meets the 
definition of an advance payment under Sec.  1.451-8(a)(1). Accordingly, 
pursuant to paragraph (e)(1)(ii) of this section, D must determine the 
amount that is required to be included in gross income in 2023 under the 
rules in Sec.  1.451-8. Because D uses the full inclusion method under 
Sec.  1.451-8(b), D is required to include the $25x that was due and 
received during 2023 in gross income in 2023.
    (E) Taxable year 2024. Under the all events test in Sec.  1.451-
1(a), D is required to include $100x in gross income through the end of 
2024 as $100x is due under the terms of the contract and received by D 
as of the end of 2024. Under the AFS income inclusion rule, because D 
has an enforceable right to recover all $100x reported as AFS revenue 
through the end of 2024 if the customer were to terminate the contract 
on the last day of such year, all $100x is treated as ``taken into 
account as AFS revenue'' through the last day of 2024. Under the 
cumulative rule in paragraph (e)(1)(ii) of this section, D compares the 
cumulative all events test amount of $100x with the cumulative AFS 
revenue amount of $100x and selects the larger of the two amounts (or, 
if the two amounts are equal, the equal amount). From this equal amount 
of $100x, D subtracts the prior income inclusion amount of $75x ($50x 
from 2021 plus $0x from 2022 plus $25x from 2023). Accordingly, under 
the cumulative rule D is required to include $25 in gross income in 
2024. The example in this paragraph (e)(2)(i)(E) is summarized in the 
following table:

                                        Table 2 to Paragraph (e)(2)(i)(E)
----------------------------------------------------------------------------------------------------------------
                                       2021            2022            2023            2024            Total
----------------------------------------------------------------------------------------------------------------
All Events/Full Inclusion Income            $25x            $25x            $25x            $25x           $100x
AFS Revenue.....................             50x               0             20x             30x            100x
Cumulative rule income..........             50x               0             25x             25x            100x
----------------------------------------------------------------------------------------------------------------

    (ii) Example 2: Provision of services included in AFS revenue with 
deferral method for advance payments--(A) Facts. The facts are the same 
as in paragraph (e)(2)(i) of this section (Example 1), except D elects 
to use the deferral method under Sec.  1.451-8(c) to account for advance 
payments.
    (B) Taxable years 2021 and 2022. The analysis for tax years 2021 and 
2022 is the same as in paragraph (e)(2)(i) of this section (Example 1).
    (C) Taxable year 2023. The payment received during 2023 meets the 
definition of an advance payment under Sec.  1.451-8(a)(1). Accordingly, 
pursuant to paragraph (e)(1)(ii) of this section, D must determine the 
amount that is required to be included in gross income in 2023 under the 
rules in Sec.  1.451-8. Because D uses the deferral method under Sec.  
1.451-8(b), D is required to include $20x of the $25x payment in gross 
income in 2023 as $20x of such payment was treated as ``taken into 
account as AFS revenue'' as of the end of 2023.
    (D) Taxable year 2024. Under the all events test in Sec.  1.451-
1(a), D is required to include $100x in gross income through the end of 
2024. Under the AFS income inclusion rule, because D has an enforceable 
right to recover all $100x reported as AFS revenue through the end of 
2024 if the customer were to terminate the contract on the last day of 
such year, all $100x is treated as ``taken into account as AFS revenue'' 
through the last day of 2024. Under the cumulative rule in paragraph 
(e)(1)(ii) of this section, D compares the cumulative all events test 
amount of $100x, which includes the full amount of the $25 advance 
payment received in 2023, with the cumulative AFS revenue amount of 
$100x and selects the larger of the two amounts (or, if the two amounts 
are equal, the equal amount). From this equal amount of $100x, D 
subtracts the prior income inclusion amount of $70x ($50x from 2021 plus 
$0x from 2022 plus $20x from 2023). Accordingly, under the cumulative 
rule D is required to include $30x in gross income in 2024. The example 
in this paragraph (e)(2)(ii)(D) is summarized in the following table:

[[Page 146]]



                                       Table 3 to Paragraph (e)(2)(ii)(D)
----------------------------------------------------------------------------------------------------------------
                                       2021            2022            2023            2024            Total
----------------------------------------------------------------------------------------------------------------
All Events Test/Deferral Method             $25x            $25x        \1\ $20x            $30x           $100x
 Income.........................
AFS Revenue amount..............             50x               0             20x             30x            100x
Cumulative rule income..........             50x               0             20x             30x            100x
----------------------------------------------------------------------------------------------------------------
\1\ $5x of the advance payment in 2023 is deferred and taken into income in 2024.

    (f) No change in the treatment of a transaction. Except as provided 
in paragraph (j) of this section and Sec.  1.1275-2(l), the AFS income 
inclusion rule does not change the treatment of a transaction or the 
character of an item for Federal income tax purposes. The following are 
examples of transactions where the treatment or character for AFS 
purposes does not change the treatment of the transaction or character 
of the item for Federal income tax purposes:
    (1) A transaction treated as a lease, license, or similar 
transaction for Federal income tax purposes that is treated as a sale or 
financing for AFS purposes, and vice versa;
    (2) A transaction or instrument that is not required to be marked-
to-market for Federal income tax purposes but that is marked-to-market 
for AFS purposes;
    (3) Asset sale and liquidation treatment under section 336(e) or 
338(h)(10);
    (4) A distribution of a corporation or the allocable share of 
partnership items or an income inclusion under section 951, 951A, or 
1293(a) for Federal income tax purposes that is accounted for under the 
equity method for AFS purposes;
    (5) A distribution of previously taxed earnings and profits of a 
foreign corporation; and
    (6) A deposit, return of capital, or conduit payment that is not 
gross income for Federal income tax purposes that is treated as AFS 
revenue.
    (g) No change to exclusion provisions and the treatment of non-
recognition transactions--(1) In general. The AFS income inclusion rule 
accelerates the time at which the all events test under Sec.  1.451-1(a) 
is treated as satisfied, and therefore does not change the applicability 
of any exclusion provision, or the treatment of non-recognition 
transactions, in the Code, the regulations in this part, or other 
guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d) of this chapter). The following are examples of exclusion 
provisions and non-recognition transactions that are not affected by the 
AFS income inclusion rule:
    (i) Any non-recognition transaction, within the meaning of section 
7701(a)(45), including, for example, a liquidation described in sections 
332 and 337, an exchange described in section 351, a distribution 
described in section 355, a reorganization described in section 368, a 
contribution described in section 721, or transactions described in 
sections 1031 through 1045; and
    (ii) Items specifically excluded from income under sections 101 
through 140.
    (2) Example: Non-recognition provisions not changed for Federal 
income tax purposes--(i) Facts. Taxpayer (Distributing) is a calendar-
year accrual method C corporation with an AFS. On December 31, 2021, 
Distributing:
    (A)(1) Contributes assets to a wholly owned subsidiary (Controlled) 
in exchange for Controlled stock and $100x; and
    (2) Distributes all the Controlled stock pro rata to its 
shareholders.
    (B) The transaction qualifies as a reorganization under section 
368(a)(1)(D) and a distribution to which section 355 applies (D 
reorganization). Distributing's realized gain on the transferred assets 
for book and tax purposes is $150x. On January 15, 2022, in pursuance of 
the plan of reorganization, Distributing distributes the $100x to its 
shareholders. Consequently, no gain to Distributing is recognized under 
section 361(b)(1)(A). On Distributing's 2021 AFS, Distributing 
recognizes revenue of $150x related to the D reorganization.
    (ii) Analysis. For Federal income tax purposes, under section 361, 
Distributing does not recognize gain on Distributing's:
    (A)(1) Contribution of assets to Controlled;

[[Page 147]]

    (2) Receipt of Controlled stock and cash; and
    (3) Distribution of Controlled stock and cash to Distributing's 
shareholders.
    (B) Pursuant to paragraph (g) of this section, the AFS income 
inclusion rule does not change the result of this paragraph (g)(2).
    (h) Additional AFS issues--(1) AFS covering groups of entities--(i) 
In general. If a taxpayer's financial results are reported on the AFS 
for a group of entities (consolidated AFS), the taxpayer's AFS is the 
consolidated AFS. However, if the taxpayer's financial results are also 
reported on a separate AFS that is of equal or higher priority to the 
consolidated AFS under paragraph (a)(5) of this section, then the 
taxpayer's AFS is the separate AFS.
    (ii) Example. Taxpayer B, a reseller of computers and electronics, 
is a calendar-year accrual method taxpayer. In 2021, B's financial 
results are included in P's consolidated financial statement, which is 
certified as being prepared in accordance with GAAP, and is a Form 10-K 
filed with the SEC. B also has a separate audited financial statement 
prepared in accordance with GAAP that is used for credit purposes. B 
must use its parent corporation's consolidated Form 10-K as its AFS.
    (2) Separately listed items. If a consolidated AFS is treated as the 
taxpayer's AFS, the taxpayer must include the amount of any items listed 
separately in the consolidated AFS, including any notes or other 
supplementary data that is considered part of the consolidated AFS, in 
determining the amount of AFS revenue allocated to the taxpayer.
    (3) Non-separately listed items. If a consolidated AFS does not 
separately list items for the taxpayer, the portion of the AFS revenue 
allocable to the taxpayer is determined by relying on the taxpayer's 
separate source documents that were used to create the consolidated AFS 
and includes amounts subsequently eliminated in the consolidated AFS. 
Whether a taxpayer that changes the source documents it uses for this 
purpose from one taxable year to another taxable year has changed its 
method of accounting is determined under the rules of section 446.
    (4) Computation of AFS revenue for the taxable year when the AFS 
covers mismatched reportable periods--(i) In general. If a taxpayer's 
AFS is prepared on the basis of a financial accounting year that differs 
from the taxpayer's taxable year, the taxpayer must use one of the 
following permissible methods of accounting described in paragraph 
(h)(4)(i)(A) through (C) of this section to determine the AFS income 
inclusion amount for the taxable year:
    (A) The taxpayer computes AFS revenue as if its financial reporting 
period is the same as its taxable year by conducting an interim closing 
of its books using the accounting principles it uses to prepare its AFS.
    (B) The taxpayer computes AFS revenue by including a pro rata 
portion of AFS revenue for each financial accounting year that includes 
any part of the taxpayer's taxable year. If the taxpayer's AFS for part 
of the taxable year is not available by the due date of the return (with 
extension), the taxpayer must make a reasonable estimate of AFS revenue 
for the pro rata portion of the taxable year for which an AFS is not yet 
available. See Sec.  1.451-1(a) for adjustments after actual amounts are 
determined.
    (C) If a taxpayer's financial accounting year ends five or more 
months after the end of its taxable year, the taxpayer computes AFS 
revenue for the taxable year based on the AFS revenue reported on the 
AFS prepared for the financial accounting year ending within the 
taxpayer's taxable year. For this paragraph (h)(4)(i)(C), if a taxpayer 
uses a 52-53 week year for financial accounting or Federal income tax 
purposes, the last day of such year shall be deemed to occur on the last 
day of the calendar month ending closest to the end of such year.
    (ii) Examples. The following examples illustrate the principles of 
paragraph (j)(4) of this section.
    (A) Example 1: Interim closing of the books. A is a calendar year 
taxpayer. For its AFS, A's financial results are reported on a June 30 
fiscal year. Using the method described in paragraph (h)(4)(i)(A) of 
this section, for the taxable year 2021, A uses the financial results 
reported on its June 30, 2021 AFS to determine whether an item of gross

[[Page 148]]

income is treated as ``taken into account as AFS revenue'' from January 
1, 2021, through June 30, 2021, and uses financial data and accounting 
procedures from its June 30, 2022 AFS to prepare an interim closing of 
the books as of December 31, 2021 to determine whether an item of gross 
income is treated as ``taken into account as AFS revenue'' from July 1, 
2021, through December 31, 2021.
    (B) Example 2: Pro rata approach. A is a calendar year taxpayer. For 
its AFS, A's financial results are reported on a June 30 fiscal year. 
Using the method described in paragraph (h)(4)(i)(B) of this section, 
for the taxable year 2021, A computes AFS revenue for the 2021 tax year 
by taking the AFS revenue for the financial accounting year ending June 
30, 2021 and multiplying it by a ratio equal to the number of days in 
the financial accounting year that are part of the 2021 tax year/365 and 
then adding to that amount the AFS revenue for the financial accounting 
year ending June 30, 2022 multiplied by the number of days in the 
financial accounting year that are part of the 2021 tax year/365.
    (C) Example 3: AFS revenue for the taxable year based on AFS ending 
in taxpayer's taxable year. The same facts as in paragraph (h)(4)(ii)(B) 
of this section (Example 2) apply, except that A uses the method 
described in paragraph (h)(4)(i)(C) of this section. For the taxable 
year 2021, A uses the financial results reported on its June 30, 2021 
AFS to determine whether an item of gross income is treated as ``taken 
into account as AFS revenue'' as of the end of its 2021 taxable year. 
Accordingly, any AFS revenue reported on the taxpayer's June 30, 2022 
AFS is disregarded when determining whether an item of gross income is 
treated as ``taken into account as AFS revenue'' as of the end of the 
2021 taxable year.
    (i) [Reserved]
    (j) Special ordering rule for certain items of income for debt 
instruments--(1) In general. If an item of income, or portion thereof, 
with respect to a debt instrument is described in paragraph (j)(2) of 
this section, the rules of this section apply before the rules in 
sections 1271 through 1275 and Sec. Sec.  1.1271-1 through 1.1275-7 (OID 
rules). Therefore, an item of income, or portion thereof, described in 
paragraph (j)(2) of this section may not be included in income later 
than when that item, or portion thereof, is treated as taken into 
account as AFS revenue, as determined under paragraph (b)(2) of this 
section, regardless of whether the timing of income inclusion for that 
item is normally determined using a special method of accounting. See 
also Sec.  1.1275-2(l) for the treatment of the items described in 
paragraph (j)(2) of this section under the OID rules.
    (2) Specified fees. Paragraph (j)(1) of this section applies to fees 
(specified fees) that are not spread over a period of time as discount 
or as an adjustment to the yield of a debt instrument (such as points) 
in the taxpayer's AFS and, but for paragraph (j) of this section and 
Sec.  1.1275-2(l), would be treated as creating or increasing OID for 
Federal income tax purposes. For example, the following specified fees 
(specified credit card fees) are described in this paragraph (j)(2):
    (i) A payment of additional interest or a similar charge provided 
with respect to amounts that are not paid when due on a credit card 
account (for example, credit card late fees);
    (ii) Amounts charged under a credit card agreement when the 
cardholder uses the credit card to conduct a cash advance transaction 
(for example, credit card cash advance fees); and
    (iii) Amounts a credit or debit card issuer is entitled to upon a 
purchase of goods or services by one of its cardholders (for example, 
interchange fees, which are sometimes labeled merchant discount in 
certain private label credit card transactions).
    (3) Example. C, a credit card issuer, is a calendar-year accrual 
method taxpayer with a calendar year AFS. In 2021, a cardholder uses C's 
credit card to purchase $100 of merchandise from a merchant and the 
cardholder earns a reward of 1% of the purchase price of $100 ($1) as 
part of C's cardholder loyalty program. Upon purchase, C becomes 
entitled to an interchange fee equal to 2% of the purchase price of $100 
($2). For its AFS, C reports the $2 of interchange fees as AFS revenue 
for 2021. C's $2 of interchange fees is described in paragraph 
(j)(2)(iii) of this

[[Page 149]]

section. Under paragraph (j)(1) of this section, C must apply the rules 
in this section before applying the OID rules. See also Sec.  1.1275-
2(l). Therefore, C's $2 of interchange fees is included in gross income 
in 2021, the year it is treated as ``taken into account as AFS 
revenue.'' Under paragraph (b)(2)(i)(A) of this section, the $2 of 
interchange revenue is not reduced by the $1 reward. Even if C reports 
interchange fees net of rewards in its AFS for 2021 ($2 of interchange 
fee minus $1 reward liability), under paragraph (b)(2)(i)(A) of this 
section, C includes $2 of interchange revenue in gross income in 2021. 
See sections 162 and 461(h) for the treatment of the reward by C.
    (k) Treatment of adjustments to deferred revenue in an AFS--(1) In 
general. If a taxpayer treats an item of gross income as deferred 
revenue in its AFS and writes down or adjusts that item, or portion 
thereof, to an equity account (for example, retained earnings) or 
otherwise writes down or adjusts that item of deferred revenue in a 
subsequent taxable year, AFS revenue for that subsequent taxable year is 
increased or decreased, as applicable by the amount of that item, or 
portion thereof, that is written down or adjusted. See Sec.  1.451-
8(c)(5).
    (2) Example--(i) Facts. D, a remanufacturer of industrial equipment, 
is a calendar-year, accrual method taxpayer with a calendar year AFS. On 
January 1, 2021, D enters into a contract with a customer and receives a 
payment of $100x to remanufacture equipment in 2021 and 2022. The 
contract is not a long-term contract under section 460. For its AFS 
2021, D performs remanufacturing services and reports $40x of the $100x 
payment as AFS revenue for 2021, and treats $60x of the $100x payment as 
deferred revenue.
    (ii) Facts for taxable year 2022. On January 1, 2022, all of the 
stock of D is acquired by an unrelated third party and D adjusts 
deferred AFS revenue to $50x (the expected cost to provide the services) 
by charging $10x ($60x-$50x = $10x) to retained earnings. In addition, 
for 2022, D performs remanufacturing services and reports $50x of the 
deferred revenue as AFS revenue.
    (iii) Analysis for taxable year 2022. Under paragraph (k)(1) of this 
section, D's $10x write down to deferred revenue for 2022 is treated as 
``taken into account as AFS revenue'' for 2022.
    (l) Methods of accounting--(1) In general. Except as otherwise 
provided in this section, a change to comply with this section is a 
change in method of accounting to which the provisions of sections 446 
and 481 and the regulations in this part under sections 446 and 481 of 
the Code apply. A taxpayer seeking to change to a method of accounting 
permitted in this section must secure the consent of the Commissioner in 
accordance with Sec.  1.446-1(e) and follow the administrative 
procedures issued under Sec.  1.446-1(e)(3)(ii) for obtaining the 
Commissioner's consent to change its accounting method. For example, the 
use of the AFS income inclusion rule under paragraph (b)(1) of this 
section under which the taxpayer determines the amount of the item of 
gross income that is treated as ``taken into account as AFS revenue'' by 
making the adjustments provided in paragraph (b)(2)(i) of this section, 
the use of the AFS income inclusion rule under paragraph (b)(1) of this 
section under which the taxpayer determines the amount of the item of 
gross income that is treated as ``taken into account as AFS revenue'' by 
making only the adjustments provided in paragraph (b)(2)(ii) of this 
section (the alternative AFS revenue method), the AFS cost offset method 
under paragraph (c) of this section, the use of a method of determining 
AFS revenue under paragraph (i)(4) of this section, are methods of 
accounting under section 446 and the regulations in this part under 
section 446 of the Code. In addition, a change in the manner of 
recognizing revenue in an AFS that changes or could change the timing of 
the inclusion of income for Federal income tax purposes is generally a 
change in method of accounting under section 446 and the regulations in 
this part under section 446 of the Code. However, a change resulting 
from the restatement of AFS revenue may not always constitute a change 
in method of accounting under section 446 and the regulations in this 
part under section 446 of the Code. For example, a restatement of AFS 
revenue to correct an error described in Sec.  1.446-1(e)(2)(ii)(b) does 
not

[[Page 150]]

constitute a change in method of accounting under section 446.
    (2) Transition rule for changes in method of accounting--(i) In 
general. Except as provided in paragraph (l)(2)(ii) of this section, a 
taxpayer that makes a qualified change in method of accounting for the 
taxpayer's first taxable year beginning after December 31, 2017, is 
treated as making a change in method of accounting initiated by the 
taxpayer under section 481(a)(2). A taxpayer obtains the consent of the 
Commissioner to make the change in method of accounting by using the 
applicable administrative procedures that govern changes in method of 
accounting under section 446(e). See Sec.  1.446-1(e)(3).
    (ii) Special rules for OID and specified credit card fees. The rules 
of paragraph (l)(2)(i) of this section apply to a qualified change in 
method of accounting for the taxpayer's first taxable year beginning 
after December 31, 2018, if the change relates to a specified credit 
card fee as defined in paragraph (j)(2) of this section. For paragraph 
(l) of this section, the section 481(a) adjustment period for any 
adjustment under section 481(a) for a change in method of accounting 
described in the preceding sentence is six taxable years.
    (iii) Qualified change in method of accounting. For paragraph (l)(2) 
of this section, a qualified change in method of accounting means any 
change in method of accounting that is required by section 13221 of 
Public Law 115-97, 131 Stat. 2054 (2017) (TCJA), or was prohibited under 
the Internal Revenue Code of 1986 prior to TCJA section 13221 and is now 
permitted as a result of TCJA section 13221.
    (m) Applicability date--(1) In general. Except as provided in 
paragraph (m)(2) of this section, this section applies for taxable years 
beginning on or after January 1, 2021.
    (2) Delayed application with respect to certain fees. 
Notwithstanding paragraph (m)(1) of this section, paragraph (j) of this 
section applies to specified fees (as defined in paragraph (j)(2) of 
this section) that are not specified credit card fees (as defined in 
paragraph (j)(2) of this section) for taxable years beginning on or 
after January 6, 2022.
    (3) Early application of this section--(i) In general. Except as 
provided in paragraph (m)(3)(ii) of this section, taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b), may 
apply both the rules in this section and, to the extent relevant, the 
rules in Sec.  1.451-8, in their entirety and in a consistent manner, to 
a taxable year beginning after December 31, 2017, and before January 1, 
2021, provided that, once applied to a taxable year, the rules in this 
section and, to the extent relevant, the rules in Sec.  1.451-8, are 
applied in their entirety and in a consistent manner to all subsequent 
taxable years. See section 7508(b)(7) and Sec.  1.451-8(h).
    (ii) Certain fees--(A) Specified credit card fees. In the case of 
specified credit card fees, a taxpayer and its related parties, within 
the meaning of sections 267(b) and 707(b), may apply both the rules in 
this section and the rules in Sec.  1.1275-2(l), in their entirety and 
in a consistent manner, to a taxable year beginning after December 31, 
2018, and before January 1, 2021, provided that, once applied to a 
taxable year, the rules in this section and Sec.  1.1275-2(l) that apply 
to specified credit card fees are applied in their entirety and in a 
consistent manner to all subsequent taxable years (other than the rules 
applicable to specified fees that are not specified credit card fees). 
See section 7508(b)(7) and Sec.  1.1275-2(l)(2).
    (B) Specified fees. Paragraphs (m)(3)(i) and (m)(3)(ii)(A) of this 
section do not apply to specified fees that are not specified credit 
card fees.

[T.D. 9941, 86 FR 836, Jan. 6, 2021, as amended by 86 FR 1256, Jan. 8, 
2021]



Sec.  1.451-4  Accounting for redemption of trading stamps and coupons.

    (a) In general--(1) Subtraction from receipts. If an accrual method 
taxpayer issues trading stamps or premium coupons with sales, or an 
accrual method taxpayer is engaged in the business of selling trading 
stamps or premium coupons, and such stamps or coupons are redeemable by 
such taxpayer in merchandise, cash, or other property, the taxpayer 
should, in computing the income from such sales, subtract from gross 
receipts with respect to sales of such stamps or coupons (or from gross 
receipts with respect to sales with

[[Page 151]]

which trading stamps or coupons are issued) an amount equal to--
    (i) The cost to the taxpayer of merchandise, cash, and other 
property used for redemptions in the taxable year,
    (ii) Plus the net addition to the provision for future redemptions 
during the taxable year (or less the net subtraction from the provision 
for future redemptions during the taxable year).
    (2) Trading stamp companies. For purposes of this section, a 
taxpayer will be considered as being in the business of selling trading 
stamps or premium coupons if--
    (i) The trading stamps or premium coupons sold by him are issued by 
purchasers to promote the sale of their merchandise or services,
    (ii) The principal activity of the trade or business is the sale of 
such stamps or coupons,
    (iii) Such stamps or coupons are redeemable by the taxpayer for a 
period of at least 1 year from the date of sale, and
    (iv) Based on his overall experience, it is estimated that not more 
than two-thirds of the stamps or coupons sold which it is estimated, 
pursuant to paragraph (c) of this section, will be ultimately redeemed, 
will be redeemed within 6 months of the date of sale.
    (b) Computation of the net addition to or subtraction from the 
provision for future redemptions--(1) Determination of the provision for 
future redemptions. (i) The provision for future redemptions as of the 
end of a taxable year is computed by multiplying ``estimated future 
redemptions'' (as defined in subdivision (ii) of this subparagraph) by 
the estimated average cost of redeeming each trading stamp or coupon 
(computed in accordance with subdivision (iii) of this subparagraph).
    (ii) For purposes of this section, the term ``estimated future 
redemptions'' as of the end of a taxable year means the number of 
trading stamps or coupons outstanding as of the end of such year that it 
is reasonably estimated will ultimately be presented for redemption. 
Such estimate shall be determined in accordance with the rules contained 
in paragraph (c) of this section.
    (iii) For purposes of this section, the estimated average cost of 
redeeming each trading stamp or coupon shall be computed by including 
only the costs to the taxpayer of acquiring the merchandise, cash, or 
other property needed to redeem such stamps or coupons. The term ``the 
costs to the taxpayer of acquiring the merchandise, cash, or other 
property needed to redeem such stamps or coupons'' includes only the 
price charged by the seller (less trade or other discounts, except 
strictly cash discounts approximating a fair interest rate, which may be 
deducted or not at the option of the taxpayer provided a consistent 
course is followed) plus transportation or other necessary charges in 
acquiring possession of the goods. Items such as the costs of 
advertising, catalogs, operating redemption centers, transporting 
merchandise or other property from a central warehouse to a branch 
warehouse (or from a warehouse to a redemption center), and storing the 
merchandise or other property used to redeem stamps or coupons should 
not be included in costs of redeeming stamps or premium coupons, but 
rather should be accounted for in accordance with the provisions of 
sections 162 and 263.
    (2) Changes in provision for future redemptions. For purposes of 
this section, a ``net addition to'' or ``net subtraction from'' the 
provision for future redemptions for a taxable year is computed as 
follows:
    (i) Carry over the provision for future redemptions (if any) as of 
the end of the preceding taxable year,
    (ii) Compute the provision for future redemptions as of the end of 
the taxable year in accordance with subparagraph (1) of this paragraph, 
and
    (iii) If the amount referred to in subdivision (ii) of this 
subparagraph exceeds the amount referred to in subdivision (i) of this 
subparagraph, such excess is the net addition to the provision for 
future redemptions for the taxable year. On the other hand, if the 
amount referred to in such subdivision (i) exceeds the amount referred 
to in such subdivision (ii), such excess is the net subtraction from the 
provision for future redemptions for the taxable year.
    (3) Example. The provisions of this paragraph and paragraph (a)(1) 
of this

[[Page 152]]

section may be illustrated by the following example:

    Example. (a) X Company, a calendar year accrual method taxpayer, is 
engaged in the business of selling trading stamps to merchants. In 1971, 
its first year of operation, X sells 10 million stamps at $5 per 1,000; 
it redeems 3 million stamps for merchandise and cash of an average value 
of $3 per 1,000 stamps. At the end of 1971 it is estimated (pursuant to 
paragraph (c) of this section) that a total of 9 million stamps of the 
10 million stamps issued in 1971 will eventually be presented for 
redemption. At this time it is estimated that the average cost of 
redeeming stamps (as described in subparagraph (1)(iii) of this 
paragraph) would continue to be $3 per 1,000 stamps. Under these 
circumstances, X computes its gross income from sales of trading stamps 
as follows:

Gross receipts from sales (10 million stamps at $5    ........   $50,000
 per 1,000).........................................
Less:
  Cost of actual redemptions (3 million stamps at $3    $9,000  ........
   per 1,000).......................................
  Provision for future redemptions on December 31,      18,000  ........
   1971 (9 million stamps - 3 million stamps x $3
   per 1,000).......................................
                                                     ----------
                                                      ........    27,000
                                                               ---------
1971 gross income from sales of stamps..............  ........    23,000
 

    (b) In 1972, X also sells 10 million stamps at $5 per 1,000 stamps. 
During 1972 X redeems 7 million stamps at an average cost of $3.01 per 
1,000 stamps. At the end of 1972 it is determined that the estimated 
future redemptions (within the meaning of subparagraph (1)(ii) of this 
paragraph) is 8 million. It is further determined that the estimated 
average cost of redeeming stamps would continue to be $3.01 per 1,000 
stamps. X thus computes its gross income from sales of trading stamps 
for 1972 as follows:

Gross receipts from sales (10 million stamps at $5 per 1,000).  $50,000
Less:
  Cost of actual redemptions (7 million stamps at      $21,070
   $3.01 per 1,000).................................
Plus:
  Provision for future redemptions on Dec. 31, 1972     24,080
   (8 million stamps at $3.01 per 1,000)............
Minus provision for future redemptions on Dec. 31,      18,000
 1971...............................................
                                                     ----------
Addition to provision for future redemptions........     6,080
                                                     ----------
   Total cost of redemptions..................................    27,150
                                                               ---------
1972 Gross income from sales of stamps..............  ........    22,850
 

    (c) Estimated future redemptions--(1) In general. A taxpayer may use 
any method of determining the estimated future redemptions as of the end 
of a year so long as--
    (i) Such method results in a reasonably accurate estimate of the 
stamps or coupons outstanding at the end of such year that will 
ultimately be presented for redemption,
    (ii) Such method is used consistently, and
    (iii) Such taxpayer complies with the requirements of this paragraph 
and paragraphs (d) and (e) of this section.
    (2) Utilization of prior redemption experience. Normally, the 
estimated future redemptions of a taxpayer shall be determined on the 
basis of such taxpayer's prior redemption experience. However, if the 
taxpayer does not have sufficient redemption experience to make a 
reasonable determination of his ``estimated future redemptions,'' or if 
because of a change in his mode of operation or other relevant factors 
the determination cannot reasonably be made completely on the basis of 
the taxpayer's own experience, the experiences of similarly situated 
taxpayers may be used to establish an experience factor.
    (3) One method of determining estimated future redemptions. One 
permissible method of determining the estimated future redemptions as of 
the end of the current taxable year is as follows:
    (i) Estimate for each preceding taxable year and the current taxable 
year the number of trading stamps or coupons issued for each such year 
which will ultimately be presented for redemption.
    (ii) Determine the sum of the estimates under subdivision (i) of 
this subparagraph for each taxable year prior to and including the 
current taxable year.
    (iii) The difference between the sum determined under subdivision 
(ii) of this subparagraph and the total number of trading stamps or 
coupons which have already been presented for redemption is the 
estimated future redemptions as of the end of the current taxable year.
    (4) Determination of an ``estimated redemption percentage.'' For 
purposes of applying subparagraph (3)(i) of this paragraph, one 
permissible method of estimating the number of trading stamps or coupons 
issued for a taxable

[[Page 153]]

year that will ultimately be presented for redemption is to multiply 
such number of stamps issued for such year by an ``estimated redemption 
percentage.'' For purposes of this section the term ``estimated 
redemption percentage'' for a taxable year means a fraction, the 
numerator of which is the number of trading stamps or coupons issued 
during a taxable year that it is reasonably estimated will ultimately be 
redeemed, and the denominator of which is the number of trading stamps 
or coupons issued during such year. Consequently, the product of such 
percentage and the number of stamps issued for such year equals the 
number of trading stamps or coupons issued for such year that it is 
estimated will ultimately be redeemed.
    (5) Five-year rule. (i) One permissible method of determining the 
``estimated redemption percentage'' for a taxable year is to--
    (a) Determine the percentage which the total number of stamps or 
coupons redeemed in the taxable year and the 4 preceding taxable years 
is of the total number of stamps or coupons issued or sold in such 5 
years; and
    (b) Multiply such percentage by an appropriate growth factor as 
determined pursuant to guidelines published by the Commissioner.
    (ii) If a taxpayer uses the method described in subdivision (i) of 
this subparagraph for a taxable year, it will normally be presumed that 
such taxpayer's ``estimated redemption percentage'' is reasonably 
accurate.
    (6) Other methods of determining estimated future redemptions. (i) 
If a taxpayer uses a method of determining his ``estimated future 
redemptions'' (other than a method which applies the 5-year rule as 
described in subparagraph (5)(i) of this paragraph) such as a 
probability sampling technique, the appropriateness of the method 
(including the appropriateness of the sampling technique, if any) and 
the accuracy and reliability of the results obtained must, if requested, 
be demonstrated to the satisfaction of the district director.
    (ii) No inference shall be drawn from subdivision (i) of this 
subparagraph that the use of any method to which such subdivision 
applies is less acceptable than the method described in subparagraph 
(5)(i) of this paragraph. Therefore, certain probability sampling 
techniques used in determining estimated future redemptions may result 
in reasonably accurate and reliable estimates. Such a sampling technique 
will be considered appropriate if the sample is--
    (a) Taken in accordance with sound statistical sampling principles,
    (b) In accordance with such principles, sufficiently broad to 
produce a reasonably accurate result, and
    (c) Taken with sufficient frequency as to produce a reasonably 
accurate result.


In addition, if the sampling technique is appropriate, the results 
obtained therefrom in determining estimated future redemptions will be 
considered accurate and reliable if the evaluation of such results is 
consistent with sound statistical principles. Ordinarily, samplings and 
recomputations of the estimated future redemptions will be required 
annually. However, the facts and circumstances in a particular case may 
justify such a recomputation being taken less frequently than annually. 
In addition, the Commissioner may prescribe procedures indicating that 
samples made to update the results of a sample of stamps redeemed in a 
prior year need not be the same size as the sample of such prior year.
    (d) Consistency with financial reporting--(1) Estimated future 
redemptions. For taxable years beginning after August 22, 1972, the 
estimated future redemptions must be no greater than the estimate that 
the taxpayer uses for purposes of all reports (including consolidated 
financial statements) to shareholders, partners, beneficiaries, other 
proprietors, and for credit purposes.
    (2) Average cost of redeeming stamps. For taxable years beginning 
after August 22, 1972, the estimated average cost of redeeming each 
stamp or coupon must be no greater than the average cost of redeeming 
each stamp or coupon (computed in accordance with paragraph (b)(1)(iii) 
of this section) that the taxpayer uses for purposes of all reports 
(including consolidated financial statements) to shareholders, partners, 
beneficiaries, other proprietors, and for credit purposes.

[[Page 154]]

    (e) Information to be furnished with return--(1) In general. For 
taxable years beginning after August 22, 1972, a taxpayer described in 
paragraph (a) of this section who uses a method of determining the 
``estimated future redemptions'' other than that described in paragraph 
(c)(5)(i) of this section shall file a statement with his return showing 
such information as is necessary to establish the correctness of the 
amount subtracted from gross receipts in the taxable year.
    (2) Taxpayers using the 5-year rule. If a taxpayer uses the method 
of determining estimated future redemptions described in paragraph 
(c)(5)(i) of this section, he shall file a statement with his return 
showing, with respect to the taxable year and the 4 preceding taxable 
years--
    (i) The total number of stamps or coupons issued or sold during each 
year, and
    (ii) The total number of stamps or coupons redeemed in each such 
year.
    (3) Trading stamp companies. In addition to the information required 
by subparagraph (1) or (2) of this paragraph, a taxpayer engaged in the 
trade or business of selling trading stamps or premium coupons shall 
include with the statement described in subparagraph (1) or (2) of this 
paragraph such information as may be necessary to satisfy the 
requirements of paragraph (a)(2)(iv) of this section.

[T.D. 7201, 37 FR 16911, Aug. 23, 1972, as amended by T.D. 7201, 37 FR 
18617, Sept. 14, 1972]



Sec.  1.451-6  Election to include crop insurance proceeds in gross income 
in the taxable year following the taxable year of destruction or damage.

    (a) In general. (1) For taxable years ending after December 30, 
1969, a taxpayer reporting gross income on the cash receipts and 
disbursements method of accounting may elect to include insurance 
proceeds received as a result of the destruction of, or damage to, crops 
in gross income for the taxable year following the taxable year of the 
destruction or damage, if the taxpayer establishes that, under the 
taxpayer's normal business practice, the income from those crops would 
have been included in gross income for any taxable year following the 
taxable year of the destruction or damage. However, if the taxpayer 
receives the insurance proceeds in the taxable year following the 
taxable year of the destruction or damage, the taxpayer shall include 
the proceeds in gross income for the taxable year of receipt without 
having to make an election under section 451(d) and this section. For 
the purposes of this section only, federal payments received as a result 
of destruction or damage to crops caused by drought, flood, or any other 
natural disaster, or the inability to plant crops because of such a 
natural disaster, shall be treated as insurance proceeds received as a 
result of destruction or damage to crops. The preceding sentence shall 
apply to payments that are received by the taxpayer after December 31, 
1973.
    (2) In the case of a taxpayer who receives insurance proceeds as a 
result of the destruction of, or damage to, two or more specific crops, 
if such proceeds may, under section 451(d) and this section, be included 
in gross income for the taxable year following the taxable year of such 
destruction or damage, and if such taxpayer makes an election under 
section 451(d) and this section with respect to any portion of such 
proceeds, then such election will be deemed to cover all of such 
proceeds which are attributable to crops representing a single trade or 
business under section 446(d). A separate election must be made with 
respect to insurance proceeds attributable to each crop which represents 
a separate trade or business under section 446(d).
    (b)(1) Time and manner of making election. The election to include 
in gross income insurance proceeds received as a result of destruction 
of, or damage to, the taxpayer's crops in the taxable year following the 
taxable year of such destruction or damage shall be made by means of a 
statement attached to the taxpayer's return (or an amended return) for 
the taxable year of destruction or damage. The statement shall include 
the name and address of the taxpayer (or his duly authorized 
representative), and shall set forth the following information:

[[Page 155]]

    (i) A declaration that the taxpayer is making an election under 
section 451(d) and this section;
    (ii) Identification of the specific crop or crops destroyed or 
damaged;
    (iii) A declaration that under the taxpayer's normal business 
practice the income derived from the crops which were destroyed or 
damaged would have been included in this gross income for a taxable year 
following the taxable year of such destruction or damage;
    (iv) The cause of destruction or damage of crops and the date or 
dates on which such destruction or damage occurred;
    (v) The total amount of payments received from insurance carriers, 
itemized with respect to each specific crop and with respect to the date 
each payment was received;
    (vi) The name(s) of the insurance carrier or carriers from whom 
payments were received.
    (2) Scope of election. Once made, an election under section 451(d) 
is binding for the taxable year for which made unless the district 
director consents to a revocation of such election. Requests for consent 
to revoke an election under section 451(d) shall be made by means of a 
letter to the district director for the district in which the taxpayer 
is required to file his return, setting forth the taxpayer's name, 
address, and identification number, the year for which it is desired to 
revoke the election, and the reasons therefor.

[T.D. 7097, 36 FR 5215, Mar. 18, 1971, as amended by T.D. 7526, 42 FR 
64624, Dec. 27, 1977; T.D. 8429, 57 FR 38595, Aug. 26, 1992]



Sec.  1.451-7  Election relating to livestock sold on account of drought.

    (a) In general. Section 451(e) provides that for taxable years 
beginning after December 31, 1975, a taxpayer whose principal trade or 
business is farming (within the meaning of Sec.  6420 (c)(3)) and who 
reports taxable income on the cash receipts and disbursements method of 
accounting may elect to defer for one year a certain portion of income. 
The income which may be deferred is the amount of gain realized during 
the taxable year from the sale or exchange of that number of livestock 
sold or exchanged solely on account of a drought which caused an area to 
be designated as eligible for assistance by the Federal Government 
(regardless of whether the designation is made by the President or by an 
agency or department of the Federal Government). That number is equal to 
the excess of the number of livestock sold or exchanged over the number 
which would have been sold or exchanged had the taxpayer followed its 
usual business practices in the absence of such drought. For example, if 
in the past it has been a taxpayer's practice to sell or exchange 
annually 400 head of beef cattle but due to qualifying drought 
conditions 550 head were sold in a given taxable year, only income from 
the sale of 150 head may qualify for deferral under this section. The 
election is not available with respect to livestock described in section 
1231(b)(3) (relating to cattle, horses (and other livestock) held by the 
taxpayer for 24 months (12 months) and used for draft, breeding, dairy, 
or sporting purposes).
    (b) Usual business. The determination of the number of animals which 
a taxpayer would have sold if it had followed its usual business 
practice in the absence of drought will be made in light of all facts 
and circumstances. In the case of taxpayers who have not established a 
usual business practice, reliance will be placed upon the usual business 
practice of similarly situated taxpayers in the same general region as 
the taxpayer.
    (c) Special rules--(1) Connection with drought area. To qualify 
under section 451(e) and this section, the livestock need not be raised, 
and the sale or exchange need not take place, in a drought area. 
However, the sale or exchange of the livestock must occur solely on 
account of drought conditions, the existence of which affected the 
water, grazing, or other requirements of the livestock so as to 
necessitate their sale or exchange.
    (2) Sale prior to designation of area as eligible for Federal 
assistance. The provisions of this section will apply regardless of 
whether all or a portion of the excess number of animals were sold or 
exchanged before an area becomes eligible for Federal assistance, so 
long as

[[Page 156]]

the drought which caused such dispositions also caused the area to be 
designated as eligible for Federal assistance.
    (d) Classifications of livestock with respect to which the election 
may be made. The election to have the provisions of section 451(e) apply 
must be made separately for each broad generic classification of animals 
(e.g., hogs, sheep, cattle) for which the taxpayer wishes the provisions 
to apply. Separate elections shall not be made solely by reason of the 
animals' age, sex, or breed.
    (e) Computation--(1) Determination of amount deferred. The amount of 
income which may be deferred for a classification of livestock pursuant 
to this section shall be determined in the following manner. The total 
amount of income realized from the sale or exchange of all livestock in 
the classification during the taxable year shall be divided by the total 
number of all such livestock sold. The resulting quotient shall then be 
multiplied by the excess number of such livestock sold on account of 
drought.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. A, a calendar year taxpayer, normally sells 100 head of 
beef cattle a year. As the result of drought conditions existing during 
1976, A sells 135 head during that year. A realizes $35,100 of income 
from the sale of the 135 head. On August 9, 1976, as a result of the 
drought, the affected area was declared a disaster area thereby eligible 
for Federal assistance. The amount of income which A may defer until 
1977, presuming the other provisions of this section are met, is 
determined as follows:

$35,100 (total income from sales of beef cattle)/135 (total number of 
          beef cattle sold) x 35 (excess number of beef cattle sold, 
          i.e. 135 - 100) = $9,100 (amount which A may defer until 1977)

    (f) Successive elections. If a taxpayer makes an election under 
section 451(e) for successive years, the amount deferred from one year 
to the next year shall not be deemed to have been received from the sale 
or exchange of livestock during the later year. In addition, in 
determining the taxpayer's normal business practice for the later year, 
earlier years for which an election under section 451(e) was made shall 
not be considered.
    (g) Time and manner of making election. The election provided for in 
this section must be made by the later of (1) the due date for filing 
the income tax return (determined with regard to any extensions of time 
granted the taxpayer for filing such return) for the taxable year in 
which the early sale of livestock occurs, or (2) (the 90th day after the 
date these regulations are published as a Treasury decision in the 
Federal Register). The election must be made separately for each taxable 
year to which it is to apply. It must be made by attaching a statement 
to the return or an amended return for such taxable year. The statement 
shall include the name and address of the taxpayer and shall set forth 
the following information for each classification of livestock for which 
the election is made:
    (1) A declaration that the taxpayer is making an election under 
section 451(e);
    (2) Evidence of the existence of the drought conditions which forced 
the early sale or exchange of the livestock and the date, if known, on 
which an area was designated as eligible for assistance by the Federal 
Government as a result of the drought conditions.
    (3) A statement explaining the relationship of the drought area to 
the taxpayer's early sale or exchange of the livestock;
    (4) The total number of animals sold in each of the three preceding 
years;
    (5) The number of animals which would have been sold in the taxable 
year had the taxpayer followed its normal business practice in the 
absence of drought;
    (6) The total number of animals sold, and the number sold on account 
of drought, during the taxable year; and
    (7) A computation, pursuant to paragraph (e) of this section, of the 
amount of income to be deferred for each such classification.
    (h) Revocation of election. Once an election under this section is 
made for a taxable year, it may be revoked only with the approval of the 
Commissioner.
    (i) Cross reference. For provisions relating to the involuntary 
conversion of livestock sold on account of drought

[[Page 157]]

see section 1033(e) and the regulations thereunder.

[T.D. 7526, 42 FR 64624, Dec. 27, 1977]



Sec.  1.451-8  Advance payments for goods, services, and certain other items.

    (a) Definitions. Except as otherwise provided in this section, the 
following definitions apply for this section:
    (1) Advance payment--(i) In general. An advance payment is a payment 
received by a taxpayer if:
    (A) The full inclusion of the payment in the gross income of the 
taxpayer for the taxable year of receipt is a permissible method of 
accounting, without regard to this section;
    (B) Any portion of the payment is taken into account as AFS revenue 
for a subsequent taxable year, or, if the taxpayer does not have an 
applicable financial statement any portion of the payment is earned by 
the taxpayer in a subsequent taxable year. To determine the amount of 
the payment that is treated as ``taken into account as AFS revenue,'' 
the taxpayer must adjust AFS revenue for any amounts described in Sec.  
1.451-3(b)(2)(i)(A), (C), and (D);
    (C) The payment is for:
    (1) Services;
    (2) The sale of goods;
    (3) The use, including by license or lease, of intellectual 
property, including copyrights, patents, trademarks, service marks, 
trade names, and similar intangible property rights, such as franchise 
rights and arena naming rights;
    (4) The occupancy or use of property if the occupancy or use is 
ancillary to the provision of services, for example, advance payments 
for the use of rooms or other quarters in a hotel, booth space at a 
trade show, campsite space at a mobile home park, and recreational or 
banquet facilities, or other uses of property, so long as the use is 
ancillary to the provision of services to the property user;
    (5) The sale, lease, or license of computer software;
    (6) Guaranty or warranty contracts ancillary to an item or items 
described in paragraph (a)(1)(i)(C)(1), (2), (3), (4), or (5) of this 
section;
    (7) Subscriptions in tangible or intangible format. Subscriptions 
for which an election under section 455 is in effect is not included in 
this paragraph (a)(1)(i)(C)(7);
    (8) Memberships in an organization. Memberships for which an 
election under section 456 is in effect are not included in this 
paragraph (a)(1)(i)(C)(8);
    (9) An eligible gift card sale;
    (10) Any other payment identified by the Secretary of the Treasury 
or his delegate (Secretary) under section 451(c)(4)(A)(iii), including 
in guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter); or
    (11) Any combination of items described in paragraphs 
(a)(1)(i)(C)(1) through (10) of this section.
    (ii) Exclusions from the definition of advance payment. An advance 
payment does not include:
    (A) Rent, except for amounts paid for an item or items described in 
paragraph (a)(1)(i)(C)(3), (4), or (5) of this section;
    (B) Insurance premiums, to the extent the inclusion of those 
premiums is governed by Subchapter L of the Internal Revenue Code;
    (C) Payments with respect to financial instruments (for example, 
debt instruments, deposits, letters of credit, notional principal 
contracts, options, forward contracts, futures contracts, foreign 
currency contracts, credit card agreements (including rewards or loyalty 
points under such agreements), financial derivatives, or similar items), 
including purported prepayments of interest;
    (D) Payments with respect to service warranty contracts for which 
the taxpayer uses the accounting method provided in Revenue Procedure 
97-38, 1997-2 C.B. 479 (see Sec.  601.601(d)(2) of this chapter);
    (E) Payments with respect to warranty and guaranty contracts under 
which a third party is the primary obligor;
    (F) Payments subject to section 871(a), 881, 1441, or 1442;
    (G) Payments in property to which section 83 applies;
    (H) Payments received in a taxable year earlier than the taxable 
year immediately preceding the taxable year of the contractual delivery 
date for a

[[Page 158]]

specified good (specified good exception) unless the taxpayer uses the 
method under paragraph (f) of this section;
    (I) Any other payment identified by the Secretary under section 
451(c)(4)(B)(vii), including in guidance published in the Internal 
Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter); and
    (J) Any combination of items described in paragraphs (a)(1)(ii)(A) 
through (I) of this section.
    (2) Advance payment income inclusion amount. The term advance 
payment income inclusion amount means the amount of the advance payment 
that is required to be included in gross income for the taxable year 
under the applicable rules in this section.
    (3) Advance payment inventory inclusion amount. The term advance 
payment inventory inclusion amount means the amount of the advance 
payment from the sale of an item of inventory that, but for the cost of 
goods in progress offset, would be includable in gross income under 
paragraph (b), (c), or (d) of this section, as applicable, for the 
taxable year.
    (4) AFS revenue. The term AFS revenue has the same meaning as 
provided in Sec.  1.451-3(a)(4).
    (5) Applicable financial statement. The term applicable financial 
statement (AFS) has the same meaning as provided in Sec.  1.451-3(a)(5).
    (6) Contractual delivery date. The term contractual delivery date 
means the month and year of delivery listed in the original written 
contract to the transaction entered into between the parties prior to 
initial receipt of any payments.
    (7) Cost of goods. The term cost of goods means the costs that are 
properly capitalized and included in inventory under sections 471 and 
263A or any other applicable provision of the Internal Revenue Code and 
that are allocable to an item of inventory for which an advance payment 
inventory inclusion amount is calculated. See paragraph (e)(6) of this 
section for specific rules for a taxpayer using the simplified methods 
under section 263A.
    (8) Cost of goods in progress offset. The term cost of goods in 
progress offset has the meaning provided in paragraph (e)(4) of this 
section.
    (9) Cumulative cost of goods in progress offset. The term cumulative 
cost of goods in progress offset means the cumulative cost of goods in 
progress offset amounts under paragraph (e) of this section for a 
specific item of inventory that have reduced an advance payment 
inventory inclusion amount attributable to such item of inventory in 
prior taxable years.
    (10) Eligible gift card sale. The term eligible gift card sale means 
the sale of a gift card or gift certificate if:
    (i) The taxpayer is primarily liable to the customer, or holder of 
the gift card, for the value of the card until redemption or expiration; 
and
    (ii) The gift card is redeemable by the taxpayer or by any other 
entity that is legally obligated to the taxpayer to accept the gift card 
from a customer as payment for items listed in paragraphs 
(a)(1)(i)(C)(1) through (11) of this section.
    (11) Enforceable right. The term enforceable right has the same 
meaning as provided in Sec.  1.451-3(a)(9).
    (12) Performance obligation. The term performance obligation has the 
same meaning as provided in Sec.  1.451-3(a)(11).
    (13) Prior income inclusion amounts. The term prior income inclusion 
amounts means the amount of an item of gross income that was included in 
the taxpayer's gross income under this section or Sec.  1.451-3 in a 
prior taxable year.
    (14) Received. An item of gross income is received by the taxpayer 
if it is actually or constructively received, or if it is due and 
payable to the taxpayer.
    (15) Specified good. The term specified good means a good for which:
    (i) During the taxable year a payment is received, the taxpayer does 
not have on hand, or available to it in such year through its normal 
source of supply, goods of a substantially similar kind and in a 
sufficient quantity to satisfy the contract to transfer the good to the 
customer; and
    (ii) All the revenue from the sale of the good is recognized in the 
taxpayer's AFS in the year of delivery.
    (16) Transaction price. The term transaction price has the same 
meaning as provided in Sec.  1.451-3(a)(14).

[[Page 159]]

    (b) In general. Except as provided in paragraph (c) or (d) of this 
section, an accrual method taxpayer shall include an advance payment in 
gross income no later than in the taxable year in which the taxpayer 
receives the advance payment.
    (c) Deferral method for taxpayers with an applicable financial 
statement (AFS)--(1) In general. An accrual method taxpayer with an AFS 
that receives an advance payment may elect the deferral method described 
in this paragraph (c) if the taxpayer can determine the extent to which 
the advance payment is taken into account as AFS revenue as of the end 
of the taxable year of receipt and, if applicable, a short taxable year 
described in paragraph (c)(6) of this section. Except as otherwise 
provided in this section, a taxpayer that uses the deferral method 
described in this paragraph (c) must:
    (i) Include the advance payment, or any portion thereof, in gross 
income in the taxable year of receipt to the extent taken into account 
as AFS revenue as of the end of such taxable year, as determined under 
paragraph (c)(2) of this section; and
    (ii) Include the remaining portion of such advance payment in gross 
income in the taxable year following the taxable year in which such 
payment is received (next succeeding year).
    (2) Adjustments to AFS revenue. The amount of an advance payment 
that is treated as ``taken into account as AFS revenue'' as of the end 
of the taxable year of receipt under paragraph (c)(1)(i) of this section 
is determined by adjusting AFS revenue by amounts described in Sec.  
1.451-3(b)(2)(i)(A), (C), and (D), as applicable.
    (3) Examples. The following examples demonstrate the rules in 
paragraphs (c)(1) and (2) of this section.
    (i) Example 1: Gift cards not eligible for deferral method. E, a 
hair styling salon, receives advance payments for gift cards that may 
later be redeemed at the salon for hair styling services or hair care 
products at the face value of the gift card. The gift cards may not be 
redeemed for cash and have no expiration date. E does not track the sale 
date of the gift cards and includes advance payments for gift cards in 
AFS revenue when redeemed. Because E is unable to determine the extent 
to which advance payments are taken into account as AFS revenue for the 
taxable year of receipt, E cannot use the deferral method for these 
advance payments.
    (ii) Example 2: Gift cards eligible for deferral method. The same 
facts as in paragraph (c)(3)(i) of this section (Example 1) apply, 
except that the gift cards have an expiration date 12 months from the 
date of sale, E does not accept expired gift cards, and E includes 
unredeemed gift cards in AFS revenue for the taxable year in which the 
cards expire. Because E tracks the sale date and the expiration date of 
the gift cards for its AFS, E can determine the extent to which advance 
payments are taken into account as AFS revenue for the taxable year of 
receipt. Therefore, E meets the requirement of paragraph (c)(1) of this 
section and may elect the deferral method for these advance payments.
    (4) Acceleration of advance payments--(i) In general. A taxpayer 
that uses the deferral method described in this paragraph (c) must 
include in gross income for the taxable year, all advance payments not 
previously included in gross income:
    (A) If, in that taxable year, the taxpayer either dies or ceases to 
exist in a transaction other than a transaction to which section 381(a) 
applies; or
    (B) If, and to the extent that, in that taxable year, the taxpayer's 
obligation for the advance payments is satisfied or otherwise ends other 
than in:
    (1) A transaction to which section 381(a) applies; or
    (2) A section 351(a) transfer that is part of a section 351 
transaction in which:
    (i) Substantially all assets of the trade or business, including 
advance payments, are transferred;
    (ii) The transferee adopts or uses the deferral method in the year 
of transfer; and
    (iii) The transferee and the transferor are members of the same 
consolidated group, as defined in Sec.  1.1502-1(h).
    (ii) Examples. The following examples illustrate the rules in 
paragraph (c)(4) of this section. In each of the following

[[Page 160]]

examples, the taxpayer is a C corporation, uses an accrual method of 
accounting for Federal income tax purposes and files its returns on a 
calendar year basis. In addition, the taxpayer has an AFS and uses the 
deferral method in paragraph (c) of this section.
    (A) Example 1: Ceasing to exist. A is in the business of selling and 
licensing off the shelf, fully customized, and semi-customized computer 
software and providing customer support. On July 1, 2021, A enters into 
a 2-year software maintenance contract and receives an advance payment. 
Under the contract, A will provide software updates if it develops an 
update within the contract period, as well as online and telephone 
customer support. A ceases to exist on December 1, 2021, in a 
transaction that does not involve a section 351(a) transfer described in 
paragraph (c)(4)(i)(B)(2) of this section and is not a transaction to 
which section 381(a) applies. For Federal income tax purposes, A must 
include the entire advance payment in gross income in its 2021 taxable 
year.
    (B) Example 2: Satisfaction of obligation--(1) Facts. On November 1, 
2021, J, a travel agent, receives payment from a customer for an airline 
flight that will take place in April 2022. J purchases and delivers the 
airline ticket to the customer on November 14, 2021. J retains the 
excess of the customer's payment over the cost of the airline ticket as 
its commission. The customer may cancel the flight and receive a refund 
from J only to the extent the airline itself provides refunds. In its 
AFS, J includes its commission in revenue for 2022.
    (2) Analysis. The payment for commission income is an advance 
payment. Because J is not required to provide any services after the 
ticket is delivered to the customer on November 14, 2021, J satisfies 
its obligation to the customer for its commission when the airline 
ticket is delivered. Thus, for Federal income tax purposes, J must 
include the commission in gross income for 2021.
    (5) Financial statement adjustments--(i) In general. If a taxpayer 
treats an advance payment as an item of deferred revenue in its AFS and 
writes-down or adjusts that item, or portion thereof, to an equity 
account such as retained earnings, or otherwise writes-down or adjusts 
that item of deferred revenue in a subsequent taxable year, AFS revenue 
for that subsequent taxable year is increased or decreased, as 
applicable, by the amount that is written down or adjusted. See Sec.  
1.451-3(k).
    (ii) Examples. The following examples illustrate the rules in 
paragraph (c)(5) of this section. In each of the following examples, the 
taxpayer is a C corporation, uses an accrual method of accounting for 
Federal income tax purposes and files its returns on a calendar year 
basis. In addition, the taxpayer has an AFS and uses the deferral method 
in paragraph (c) of this section.
    (A) Example 1--(1) Facts. On May 1, 2021, A received $100 as an 
advance payment for a 2-year contract to provide services. For financial 
accounting purposes, A recorded $100 as a deferred revenue liability in 
its AFS, expecting to report \1/4\ ($25) of the advance payment in AFS 
revenue for 2021, \1/2\ ($50) for 2022, and \1/4\ ($25) for 2023. On 
August 31, 2021, C, an unrelated corporation that files its Federal 
income tax return on a calendar year basis and that is a member of a 
consolidated group, acquired all of the stock of A, and A joined C's 
consolidated group. A's short taxable year ended on August 31, 2021, 
and, as of that date, A had included \1/4\ ($25) of the advance payment 
in AFS revenue. On September 1, 2021, after the stock acquisition, and 
in accordance with purchase accounting rules, C wrote down A's deferred 
revenue liability to its fair value of $10 as of the date of the 
acquisition. The $10 is included in revenue on A's AFS in accordance 
with the method of accounting A uses for financial accounting purposes.
    (2) Analysis. For Federal income tax purposes, A must take \1/4\ 
($25) of the advance payment into income for its short taxable year 
ending August 31, 2021 and must include the remainder of the advance 
payment ($75) ($65 write down + $10 future financial statement revenue) 
in income for its next succeeding taxable year.
    (B) Example 2--(1) Facts. On May 1, 2021, B received $100 as an 
advance payment for a contract to be performed in 2021, 2022, and 2023. 
On August 31, 2021, D, a corporation that is not a member

[[Page 161]]

of a consolidated group for Federal income tax purposes, acquired all of 
the stock of B. Before the stock acquisition, for 2021, B included $40 
of the advance payment in AFS revenue, and $60 as a deferred revenue 
liability. On September 1, 2021, after the stock acquisition and in 
accordance with purchase accounting rules, B, at D's direction, wrote 
down its $60 deferred revenue liability to $10 (its fair value) as of 
the date of the acquisition. After the acquisition, B does not take into 
account as AFS revenue any of the $10 deferred revenue liability in its 
2021 AFS. B does include $5 in revenue in 2022, and $5 in revenue in 
2023.
    (2) Analysis. For Federal income tax purposes, B must include $40 of 
the advance payment into income in 2021 and must include the remainder 
of the advance payment ($60) ($50 write down plus $10 future financial 
statement revenue) in income for the 2022 taxable year.
    (6) Short taxable year rule--(i) In general. If the taxpayer's next 
succeeding taxable year is a short taxable year, other than a taxable 
year in which the taxpayer dies or ceases to exist in a transaction 
other than a transaction to which section 381(a) applies, and the short 
taxable year consists of 92 days or less, a taxpayer using the deferral 
method must include the portion of the advance payment not included in 
the taxable year of receipt in gross income for the short taxable year 
to the extent taken into account as AFS revenue as of the end of such 
taxable year, as determined under paragraph (c)(2) of this section. Any 
amount of the advance payment not included in gross income in the 
taxable year of receipt or the short taxable year, must be included in 
gross income for the taxable year immediately following the short 
taxable year.
    (ii) Example 1--(A) Facts. A is a calendar year taxpayer and is in 
the business of selling and licensing off the shelf, fully customized, 
and semi-customized computer software and providing customer support. On 
July 1, 2021, A enters into a 2-year software maintenance contract and 
receives an advance payment of $240 under the contract. Under the 
contract, A will provide software updates if it develops an update 
within the contract period, as well as provides online and telephone 
customer support. A changes its taxable period to a fiscal year ending 
March 31. As a result, A has a short taxable year beginning January 1, 
2022, and ending March 31, 2022. In its AFS, A includes 6/24 ($60) of 
the payment in revenue for the taxable year ending December 31, 2021 to 
account for the six-month period July 1 through December 31, 2021; 3/24 
($30) in revenue for the short taxable year ending March 31, 2022 to 
account for the three-month period January 1 through March 31, 2022; 12/
24 ($120) in revenue for the taxable year ending March 31, 2023; and 3/
24 ($30) in revenue for the taxable year ending March 31, 2024.
    (B) Analysis. Because the taxable year ending March 31, 2021, is 92 
days or less, A must include 6/24 ($60) of the payment in gross income 
for the taxable year ending December 31, 2021, 3/24 ($30) in gross 
income for the short taxable year ending March 31, 2022, and 15/24 
($150), the remaining amount, in gross income for the taxable year 
ending March 31, 2023.
    (iii) Example 2--(A) Facts. On May 1, 2021, B received $100 as an 
advance payment for a contract to be performed in 2021, 2022, and 2023. 
On October 31, 2021, C, an unrelated corporation that files its federal 
income tax return on a calendar year basis and that is a member of a 
consolidated group, acquired all the stock of B and B joined C's 
consolidated group. Before the stock acquisition, for 2021, B included 
$40 of the advance payment in AFS revenue, and $60 as a deferred revenue 
liability. On November 1, 2021, after the stock acquisition and in 
accordance with purchase accounting rules, C wrote down B's $60 deferred 
revenue liability to $10 (its fair value) as of the date of the 
acquisition. After the acquisition, B does not include in revenue any of 
the $10 deferred revenue liability in its 2021 AFS. B includes $5 in 
revenue in 2022, and $5 in revenue in 2023.
    (B) Analysis. For Federal income tax purposes, B must take $40 of 
the advance payment into income in its short tax year ending October 31, 
2021. B's subsequent tax year, the short tax year ending December 31, 
2021, is a tax year that is 92 days or less. Therefore, under

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paragraph (c)(6)(i) of this section, B generally will include the 
portion of the advance payment not included in the taxable year of 
receipt in gross income for this short taxable year to the extent taken 
into account as AFS revenue. Although for AFS purposes, no amount is 
recognized in revenue for the short period beginning November 1, 2021 
and ending on December 31, 2021, under paragraph (c)(5)(i) of this 
section, B must treat the amount of the write-down as AFS revenue in the 
taxable year in which the write-down occurs. Therefore, B must include 
$50 of the advance payment into income in the short tax year ending 
December 31, 2021 (equal to the $50 write down plus $0 recognized in B's 
AFS for the period beginning on November 1, 2021 and ending December 31, 
2021), and must include the remainder of the advance payment ($10) in 
income for the 2022 taxable year.
    (7) Financial statement conformity requirement. A taxpayer that uses 
an AFS to apply the rules under Sec.  1.451-3 must use the same AFS and, 
if applicable, the same method of accounting under Sec.  1.451-3(h)(4), 
to apply the deferral method in paragraph (c) of this section. 
Additionally, the AFS rules under Sec.  1.451-3(h) also apply for 
purposes of this section.
    (8) Contracts with multiple performance obligations--(i) General 
rule. If a taxpayer is using the deferral method under this paragraph 
(c) and the taxpayer's contract with a customer has more than one 
performance obligation, then any payments received under the contract 
are allocated to the corresponding item of gross income in the same 
manner as such payments are allocated to the performance obligations in 
the taxpayer's AFS.
    (ii) Example: Computer software subscription with multiple 
performance obligations--(A) Facts. P is in the business of licensing 
off the shelf, fully customized, and semi-customized computer software 
and providing customer support. P uses an accrual method of accounting 
for Federal income tax purposes, files its returns on a calendar year 
basis, and has an AFS. On July 1, 2021, P receives an advance payment of 
$100 for a 2-year software subscription comprised of:
    (1)(i) A 1-year ``software maintenance contract'' under which P will 
provide software updates within the contract period; and
    (ii) A ``customer support agreement'' for online and telephone 
customer support.
    (2) P reflects the software maintenance contract and the customer 
support agreement as two separate performance obligations in its AFS and 
allocates $80 of the payment to the software maintenance contract and 
$20 to the customer support agreement. P includes the $80 allocable to 
the software maintenance payment in AFS revenue as follows: \1/4\ ($20) 
in AFS revenue for 2021; \1/2\ ($40) in AFS revenue for 2022; and the 
remaining \1/4\ ($20) in AFS revenue for 2023. Regarding the $20 
allocable to the customer support payment, P includes \1/2\ ($10) in AFS 
revenue for 2021, and the remaining \1/2\ ($10) in AFS revenue for 2022 
regardless of when P provides the customer support.
    (B) Analysis. Since the software maintenance contract and the 
customer support agreement are two separate performance obligations, 
each yielding a separate item of gross income, paragraph (c)(8) of this 
section requires P to allocate the $100 payment to each item of gross 
income in the same manner as the payment is allocated to each 
performance obligation in P's AFS. For Federal income tax purposes, P 
must include $30 in gross income for 2021 ($20 allocable to the software 
maintenance contract and $10 allocable to the customer support 
agreement) and the remaining $70 is included in gross income for 2022.
    (iii) Contracts with advance payments that include items subject to 
a special method of accounting--(A) In general. The portion of the 
payment allocable to the items of gross income described in paragraph 
(a)(1)(i)(C) of this section from a contract that includes one or more 
items of gross income subject to a special method of accounting and one 
or more items of gross income described in paragraph (a)(1)(i)(C) of 
this section must be determined based on objective criteria.
    (B) Allocation deemed to be based on objective criteria. A 
taxpayer's allocation method is based on objective criteria if an 
allocation of the payment to

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each item of gross income is in proportion to the amounts determined in 
Sec.  1.451-3(d)(5) or as otherwise provided in guidance published in 
the Internal Revenue Bulletin (see Sec.  601.601(d) of this chapter).
    (iv) Example--(A) Facts. B is a calendar-year accrual method 
taxpayer with an AFS. In 2020, B enters into a $100x contract to design, 
build, operate and maintain a toll road and receives an up-front payment 
of $100x. The contract meets the definition of a long-term contract 
under Sec.  1.460-1(b)(1). B properly determines that the obligations to 
design and build the toll road are long-term contract activities under 
Sec.  1.460-1(d)(1) and accounts for the gross income from these 
activities under section 460. In addition, B properly determines that 
the obligations to operate and maintain the toll road are non-long-term 
contract activities under Sec.  1.460-1(d)(2) and that the gross income 
attributable to these activities is accounted for under section 451(b). 
B allocates $60x of the transaction price amount to the long-term 
contract activities and the remaining $40x to the non-long-term contract 
activity pursuant to Sec.  1.451-3(d)(5). For AFS purposes, B allocates 
$55x of the transaction price amount to the performance obligations that 
are long-term contract activities and $45x to the non-long-term contract 
activities. B uses the deferral method of accounting.
    (B) Analysis. For Federal income tax purposes, a method of 
accounting under section 460 is a special method of accounting under 
paragraph (c)(8)(iv) of this section. Pursuant to paragraph (c)(8)(iv) 
of this section, B must allocate the payment among the item(s) of gross 
income that are subject to section 460 and the item(s) of gross income 
described in paragraph (a)(1)(i)(C) of this section based on objective 
criteria. B's allocation is deemed to be based on objective criteria if 
it allocates the payment in proportion to the amounts determined under 
Sec.  1.451-3(d)(5). That is, $60x to the items of gross income subject 
to section 460 and $40x to the items of gross income described in 
paragraph (a)(1)(i)(C) of this section.
    (9) Special rule relating to eligible gift card sales. For 
paragraphs (a)(1)(i)(B) and (c)(1) of this section, if an eligible gift 
card is redeemable by an entity described in paragraph (a)(10)(ii) of 
this section whose financial results are not included in the taxpayer's 
AFS, a payment will be treated as included by the taxpayer in its AFS 
revenue to the extent the gift card is redeemed by such entity during 
the taxable year.
    (10) Examples. The following examples illustrate the rules of 
paragraph (c) of this section. In each of the following examples, the 
taxpayer uses an accrual method of accounting for Federal income tax 
purposes and files its returns on a calendar year basis. In addition, 
the taxpayer in each example has an AFS and uses the deferral method 
under paragraph (c) of this section. Further, the taxpayer does not use 
the advance payment cost offset method in paragraph (e) of this section.
    (i) Example 1: Services. On November 1, 2021, A, in the business of 
giving dancing lessons, receives an advance payment of $480 for a 1-year 
contract commencing on that date and providing for up to 48 individual, 
1-hour lessons. A provides eight lessons in 2021 and another 35 lessons 
in 2022. A takes into account \1/6\ ($80) of the payment as AFS revenue 
for 2021, and \5/6\ ($400) of the payment as AFS revenue for 2022. For 
Federal income tax purposes, under the deferral method in paragraph (c) 
of this section, A must include \1/6\ ($80) of the payment in gross 
income for 2021, and the remaining \5/6\ ($400) of the payment in gross 
income for 2022.
    (ii) Example 2: Services. The same facts as in paragraph (c)(10)(i) 
of this section (Example 1) apply. A receives an advance payment of $960 
for a 3-year contract under which A provides up to 96 lessons. A 
provides eight lessons in 2021, 48 lessons in 2022, and 40 lessons in 
2023. A takes into account 1/12 ($80) of the payment as AFS revenue for 
2021, \1/2\ ($480) of the payment as AFS revenue for 2022, and 5/12 
($400) of the payment as AFS revenue for 2023. For Federal income tax 
purposes, under the deferral method in paragraph (c) of this section, A 
must include 1/12 ($80) of the payment in gross income for 2021, and the 
remaining 11/12 ($880) of the payment in gross income for 2022.
    (iii) Example 3: Services. On June 1, 2021, B, a landscape 
architecture firm, receives an advance payment of $100 for

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landscape services that, under the terms of the agreement, must be 
provided by December 2022. On December 31, 2021, B estimates that \3/4\ 
of the work under the agreement has been completed. B takes into account 
\3/4\ ($75) of the payment as AFS revenue for 2021, and \1/4\ ($25) of 
the payment as AFS revenue for 2022. For Federal income tax purposes, 
under the deferral method in paragraph (c) of this section, B must 
include \3/4\ ($75) of the payment in gross income for 2021, and the 
remaining \1/4\ ($25) of the payment in gross income for 2022, 
regardless of whether B completes the job in 2022.
    (iv) Example 4: Repair contracts. On July 1, 2021, C, in the 
business of selling and repairing television sets, receives an advance 
payment of $100 for a 2-year contract under which C agrees to repair the 
customer's television set. C takes into account \1/4\ ($25) of the 
payment as AFS revenue for 2021, \1/2\ ($50) of the payment as AFS 
revenue for 2022, and \1/4\ ($25) of the payment as AFS revenue for 
2023. For Federal income tax purposes, under the deferral method in 
paragraph (c) of this section, C must include \1/4\ ($25) of the payment 
in gross income for 2021 and the remaining \3/4\ ($75) of the payment in 
gross income for 2022.
    (v) Example 5: Online website design. On July 20, 2021, D, a website 
designer, receives an online payment of $75 to design a website for 
Customer to be completed on February 1, 2023. D designs and completes 
Customer's website on February 1, 2023. D takes into account the $75 
payment for Customer's website as AFS revenue for 2023. The $75 payment 
D receives for Customer's website is an advance payment. For Federal 
income tax purposes, under the deferral method in paragraph (c) of this 
section, D must include the $75 payment for the website in gross income 
for 2022.
    (vi) Example 6: Online subscriptions. G is in the business of 
compiling and providing business information for a particular industry 
in an online format accessible over the internet. On September 1, 2021, 
G receives an advance payment from a subscriber for 1 year of access to 
its online database, beginning on that date. G takes into account \1/3\ 
of the payment as AFS revenue for 2021 and the remaining \2/3\ as AFS 
revenue for 2022. For Federal income tax purposes, under the deferral 
method in paragraph (c) of this section, G must include \1/3\ of the 
payment in gross income for 2021 and the remaining \2/3\ of the payment 
in gross income for 2022.
    (vii) Example 7: Membership fees. On December 1, 2021, H, in the 
business of operating a chain of ``shopping club'' retail stores, 
receives advance payments for membership fees. The membership fees are 
not prepaid dues income subject to section 456. Upon payment of the fee, 
a member is allowed access for a 1-year period to H's stores, which 
offer discounted merchandise and services. H takes into account 1/12 of 
the payment as AFS revenue for 2021 and 11/12 of the payment as AFS 
revenue for 2022. For Federal income tax purposes, under the deferral 
method in paragraph (c) of this section, H must include 1/12 of the 
payment in gross income for 2021, and the remaining 11/12 of the payment 
in gross income for 2022.
    (viii) Example 8: Cruise. In 2021, I, in the business of operating 
tours, receives $20x payments from customers for a 10-day cruise that 
will take place in April 2022. Under the agreement, I charters a cruise 
ship, hires a crew and a tour guide, and arranges for entertainment and 
shore trips for the customers. I takes into account the $20x payments as 
AFS revenue for 2022. For Federal income tax purposes, I must include 
the $20x payments in gross income for 2022.
    (ix) Example 9: Broadcasting rights--(A) Facts. K, a professional 
sports franchise, is a member of a sports league that enters into 
contracts with television networks for the right to broadcast games to 
be played between teams in the league. The league entered into a 2-year 
broadcasting contract beginning October 1, 2021. K receives two payments 
of $100x on October 1 of each contract year, beginning in 2021. K 
estimates that for each contract year, 25% of the broadcasting rights 
are transferred by December 31 of the year of payment, and the remaining 
75% of the broadcasting rights are transferred in the following year. K 
takes into account \1/4\ ($25x) of the first installment payment as AFS 
revenue for 2021 and \3/4\ ($75x) as AFS revenue for 2022. K takes

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into account \1/4\ ($25x) of the second payment as AFS revenue for 2022 
and \3/4\ ($75x) as AFS revenue for 2023.
    (B) Analysis. Each installment payment is an advance payment under 
paragraph (a)(1) of this section because a portion of each payment is 
included in AFS revenue for a subsequent taxable year and the payment 
relates to the use of intellectual property. For Federal income tax 
purposes, under the deferral method in paragraph (c) of this section, K 
must include \1/4\ ($25x) of the first $100x installment payment in 
gross income for 2021 and \3/4\ ($75x) of the first installment payment 
in gross income for 2022. In addition, K must include \1/4\ ($25x) of 
the second $100x payment in gross income for 2022 and \3/4\ ($75x) of 
the second installment payment in gross income for 2023.
    (x) Example 10: Insurance claims administration--(A) Facts. L is in 
the business of negotiating, placing, and servicing insurance coverage 
and administering claims for insurance companies. On December 1, 2021, L 
enters into a contract with an insurance company to provide property and 
casualty claims administration services for a 4-year period beginning 
January 1, 2022. Pursuant to the contract, the insurance company makes 
four equal annual payments to L; each payment relates to a year of 
service and is made during the month prior to the service year. Since L 
does not perform any services related to the payment prior to the 
service year, L does not meet the requirements of Sec.  1.451-1(a) for 
the payment prior to the service year. For example, L is paid on 
December 1, 2021, for the service year beginning January 1, 2022. L 
takes into account the first payment as AFS revenue for 2022; the second 
payment as AFS revenue for 2023; the third payment as AFS revenue for 
2024; and the fourth payment as AFS revenue for 2025.
    (B) Analysis. Each annual payment is an advance payment under 
paragraph (a)(1) of this section because each payment is taken into 
account as AFS revenue for a subsequent taxable year and the payment 
relates to services. For Federal income tax purposes, under the deferral 
method in paragraph (c) of this section, L must include: The first 
payment in gross income for 2022; the second payment in gross income for 
2023; the third payment in gross income for 2024; and the fourth payment 
in gross income for 2025.
    (xi) Example 11: internet services--(A) Facts. M is a cable internet 
service provider that enters into contracts with subscribers to provide 
internet services for a monthly fee that is paid prior to the service 
month. For those subscribers who do not own a compatible modem, M 
provides a rental cable modem for an additional monthly charge, that is 
also paid prior to the service month. Pursuant to the contract, M will 
replace or repair the cable modem if it proves defective during the 
contract period. In December 2021, M receives $100x payments from 
subscribers for January 2022 internet service and cable modem use. M 
takes into account the entire $100x payments as AFS revenue for 2022.
    (B) Analysis. For Federal income tax purposes, the $100x payments 
are advance payments. Because M uses the deferral method in paragraph 
(c) of this section, M must include $100x in gross income for 2022.
    (xii) Example 12: License agreement--(A) Facts. On January 1, 2021, 
N receives a payment of $250 for entering into a 3-year license 
agreement for the use of N's trademark throughout the term of the 
agreement. The $250 payment reflects the first year (2021) license fee 
of $100 and the third year (2023) license fee of $150. The fee of $125 
for the second year is payable on January 1, 2022. N takes into account 
$100 of the $250 upfront payment as AFS revenue for 2021, $125 as AFS 
revenue for 2022, and $150 of the $250 payment as AFS revenue for 2023.
    (B) Analysis. For Federal income tax purposes, N received an advance 
payment of $150, the 2023 license fee, in 2021. Because N uses the 
deferral method in paragraph (c) of this section, N must defer the $150 
payment and include it in gross income for 2022.
    (xiii) Example 13: Computer software subscription with one 
performance obligation--(A) Facts. On July 1, 2021, O, in the business 
of licensing off the shelf, fully customized, and semi-customized 
computer software and providing customer support, receives a payment of 
$100 for a 2-year ``software subscription

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contract'' under which O will provide software updates if it develops an 
update within the contract period, as well as online and telephone 
customer support. O determines that its obligations under the software 
subscription contract are one performance obligation for financial 
accounting purposes, which yields one item of gross income. O takes into 
account \1/4\ ($25) of the payment as AFS revenue for 2021, \1/2\ ($50) 
as AFS revenue for 2022, and the remaining \1/4\ ($25) as AFS revenue 
for 2023, regardless of when O provides updates or customer support.
    (B) Analysis. For Federal income tax purposes, the $100 payment is 
an advance payment. Because O uses the deferral method in paragraph (c) 
of this section, O must include \1/4\ ($25) of the payment in gross 
income for 2021 and \3/4\ ($75) in gross income for 2022.
    (xiv) Example 14: Gift cards administered by another--(A) General 
facts. Q is a corporation that operates department stores and is the 
common parent of a consolidated group (the Q group). U, V, and W are 
domestic corporations wholly owned by Q and members of the Q group. X is 
a foreign corporation wholly owned by Q and not a member of the Q group. 
U sells Brand A goods, V sells Brand B goods, X sells Brand C goods, and 
Z is an unrelated entity that sells Brand D goods. W administers a gift 
card program for the members of the Q group, X, and Z. Pursuant to the 
underlying agreements, W issues gift cards that are redeemable for goods 
or services offered by U, V, X, and Z. In addition, U, V, X, and Z sell 
gift cards to customers on behalf of W and remit amounts received to W. 
The agreements provide that W is primarily liable to the customer for 
the value of the gift card until redemption, and U, V, X, and Z are 
obligated to accept the gift card as payment for goods or services. When 
a customer purchases goods or services with a gift card at U, V, X, or 
Z, W reimburses that entity for the sales price of the goods or services 
purchased with the gift card, up to the total gift card value.
    (B) Facts for taxable year 2021. In 2021, W sells gift cards with a 
total value of $900, and, at the end of 2021, the unredeemed balance of 
the gift cards is $100. In Q group's AFS, the group includes revenue 
from the sale of a gift card when the gift card is redeemed. 
Accordingly, of the $900 of gift cards sold in 2021, $800 were redeemed 
and taken into account as AFS revenue for 2021. W tracks sales and 
redemptions of gift cards electronically, determines the extent to which 
advance payments are taken into account as AFS revenue in Q group's AFS 
for the taxable year of receipt and meets the requirements of paragraph 
(c)(1) of this section.
    (C) Analysis. The payments W receives from the sale of gift cards 
are advance payments because they are payments for eligible gift cards. 
Under the deferral method, W must include $800 of the payments from gift 
card sales in gross income in 2021 and the remaining $100 of the 
payments in gross income in 2022.
    (xv) Example 15: Gift cards of affiliates--(A) Facts. R is a 
Subchapter S corporation that operates an affiliated restaurant 
corporation and manages other affiliated restaurants. These other 
restaurants are owned by other Subchapter S corporations, partnerships, 
and limited liability companies. R has a partnership interest or an 
equity interest in some of the restaurants. R administers a gift card 
program for participating restaurants. Each participating restaurant 
operates under a different trade name. Under the gift card program, R 
and each of the participating restaurants sell gift cards, which are 
issued with R's brand name and are redeemable at all participating 
restaurants. Participating restaurants sell the gift cards to customers 
and remit the proceeds to R, R is primarily liable to the customer for 
the value of the gift card until redemption, and the participating 
restaurants are obligated under an agreement with R to accept the gift 
card as payment for food, beverages, taxes, and gratuities. When a 
customer uses a gift card to make a purchase at a participating 
restaurant, R is obligated to reimburse that restaurant for the amount 
of the purchase, up to the total gift card value. In R's AFS, R includes 
revenue from the sale of a gift card when a gift card is redeemed at a 
participating restaurant. R tracks sales and redemptions of gift cards 
electronically, is able to determine the extent to which

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advance payments are taken into account as AFS revenue for the taxable 
year of receipt and meet the requirements of paragraph (c)(1) of this 
section.
    (B) Analysis. The payments R receives from the sale of gift cards 
are advance payments because they are payments for eligible gift card 
sales. For Federal income tax purposes, R is eligible to use the 
deferral method. Using the deferral method, in the taxable year of 
receipt, R must include the advance payment in income to the extent 
taken into account as AFS revenue and must include any remaining amount 
in income in the taxable year following the taxable year of receipt. 
Under paragraph (c)(9) of this section, R is treated as taking into 
account revenue from the sale of a gift card as AFS revenue when a gift 
card is redeemed at a participating restaurant.
    (xvi) Example 16: Gift cards for domestic and international hotels--
(A) Facts. S is a corporation that operates for the benefit of its 
franchisee members, who own and operate domestic and international 
individual member hotels. S administers a gift card program for its 
members by selling gift cards that may be redeemed for hotel rooms and 
food or beverages provided by any member hotel. The agreements 
underlying the gift card program provide that S is entitled to the 
proceeds from the sale of the gift cards, must reimburse the member 
hotel for the value of a gift card redeemed, and until redemption 
remains primarily liable to the customer for the value of the card. In 
S's AFS, S includes payments from the sale of a gift card when the card 
is redeemed. S tracks sales and redemptions of gift cards 
electronically, determines the extent to which advance payments are 
included in AFS revenue for the taxable year of receipt and meets the 
requirements of paragraph (c)(1) of this section.
    (B) Analysis. The payments S receives from the sale of gift cards 
are advance payments because they are payments for eligible gift card 
sales. Thus, for Federal income tax purposes, S is eligible to use the 
deferral method. Under the deferral method, in the taxable year of 
receipt, S must include in income the advance payment to the extent 
taken into account as AFS revenue and must include any remaining amount 
in income in the taxable year following the taxable year of receipt.
    (xvii) Example 17: Discount voucher--(A) Facts. On December 10, 
2021, T, in the business of selling home appliances, sells a washing 
machine for $500. As part of the sale, T gives the customer a 40% 
discount voucher for any future purchases of T's goods up to $100 in the 
next 60 days. In its AFS, T treats the discount voucher as a separate 
performance obligation and allocates $30 of the $500 sales price to the 
discount voucher. T takes into account $12 of the amount allocated to 
the discount voucher as AFS revenue for 2021 and includes $18 of the 
discount voucher as AFS revenue for 2022.
    (B) Analysis. For Federal income tax purposes, the $30 payment 
allocated to the discount voucher is an advance payment. Using the 
deferral method, T must include the $12 allocable to the discount 
voucher in gross income in 2021 and the remaining $18 allocated to the 
discount voucher in gross income in 2022.
    (xviii) Example 18: Rewards--(A) Facts. On December 31, 2021, U, in 
the business of selling consumer electronics, sells a new TV for $1,000 
and gives the customer 50 reward points. Each reward point is redeemable 
for a $1 discount on any future purchase of U's products. The reward 
points are not redeemable for cash and have a 2-year expiration date. U 
tracks the issue date, redemption date, and expiration date of each 
customer's reward points. Under the terms of U's reward program, when 
the customer redeems reward points they are deemed to use the earliest 
issued points first. In its AFS, U treats the rewards points as a 
separate performance obligation and allocates $50 of the $1,000 sales 
price to the rewards points. U is able to determine the extent to which 
a payment that is allocated to a reward point is taken into account in 
AFS revenue in the year of receipt. U does not take any of the amount 
allocated to the reward points into account as AFS revenue for 2021. U 
takes into account $25 of the reward points as AFS revenue for 2022 and 
$25 of the reward points as AFS revenue for 2023.

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    (B) Analysis. For Federal income tax purposes, U's treatment of the 
reward points as a separate performance obligation for AFS purposes 
yields an item of gross income that must be accounted for separately. 
The $50 payment allocated to the reward points item is an advance 
payment as the full inclusion of the payment in gross income in the year 
of receipt is a permissible method of accounting without regard to this 
section, a portion of the payment is taken into account as AFS revenue 
in a subsequent taxable year, and the reward points are redeemable for 
an item described in paragraph (a)(1)(i)(C) of this section (goods). 
Because the entire amount of the $50 advance payment is taken into 
account as AFS revenue in tax years following the year of receipt, U 
defers the payment and includes the $50 payment in gross income in 2022.
    (xix) Example 19: Credit card rewards--(A) Facts. V issues credit 
cards and has a loyalty program under which cardholders earn reward 
points when they use V's credit card to make purchases. Each reward 
point is redeemable for $1 on any future purchases.
    (B) Analysis. Payments under credit card agreements, including 
rewards for credit card purchases, are excluded from the definition of 
an advance payment under paragraph (a)(1)(ii)(C) of this section. 
Accordingly, V cannot use the deferral method for these amounts.
    (xx) Example 20: Airline reward miles--(A) Facts. On January 1, 
2021, W, a passenger airline company, sells a customer a $700 airline 
ticket to fly roundtrip in 2021. As part of the purchase, the customer 
receives 7,000 reward points (air miles) from W to be used for future 
air travel. The reward points are not redeemable for cash and have a 2-
year expiration date. W tracks the issue date, redemption date, and 
expiration date of each customer's reward points. Under the terms of U's 
reward program, when the customer redeems reward points they are deemed 
to use the earliest issued points first. In its AFS, W treats the 
rewards points as a separate performance obligation and allocates $35 of 
the $700 ticket price to the reward points. W is able to determine the 
extent to which a payment that is allocated to a reward point is taken 
into account in AFS revenue in the year of receipt. W takes into account 
all $35 as AFS revenue in 2023 when the customer redeems the air miles.
    (B) Analysis. For Federal income tax purposes, W's treatment of the 
reward points as a separate performance obligation for AFS purposes 
yields an item of gross income that must be accounted for separately. 
The $35 allocated to the reward points item is an advance payment as the 
full inclusion of the payment in gross income in the taxable year of 
receipt is a permissible method of accounting without regard to this 
section, a portion of the payment is taken into account as AFS revenue 
in a subsequent taxable year, and the reward points are redeemable for 
an item described in paragraph (a)(1)(i)(C) of this section (services). 
Because the entire amount of the $35 advance payment is taken into 
account as AFS revenue in a tax year following the year of receipt, W 
defers the payment and includes the $35 payment in gross income in 2022.
    (xxi) Example 21: Chargebacks--(A) Facts. In 2021, X, a manufacturer 
of pharmaceuticals, enters into a contract to sell 1,000 units to W, a 
wholesaler, for $10 per unit, totaling $10,000 (1,000 x $10 = $10,000). 
The contract also provides that X will credit W $4 per unit (chargeback) 
for sales W makes to qualifying customers. X delivers 600 units to W on 
December 31, 2021, and bills W $6,000 under the contract. X anticipates 
that all of W's sales will be to qualifying customers and subject to 
chargeback. For AFS purposes, X adjusts its 2021 AFS revenue of $6,000 
by $2,400, the anticipated chargebacks, and reports $3,600 of AFS 
revenue.
    (B) Analysis. For Federal income tax purposes, under paragraph 
(a)(1)(i)(B) of this section, for a payment to qualify as an advance 
payment, a portion of the payment must be taken into account as AFS 
revenue for a subsequent taxable year. Under paragraph (a)(1)(i)(B) of 
this section, the amount of the payment included in AFS revenue for a 
subsequent taxable year is $0, calculated as the $6,000 payment reduced 
by $6,000 that is treated as taken into account as AFS revenue for 2021 
($3,600 of AFS revenue for 2021 + $2,400

[[Page 169]]

of anticipated chargebacks (section 461 liabilities) which had reduced 
AFS revenue for 2021). Because no portion of the $6,000 is taken into 
account as AFS revenue in a subsequent taxable year (that is, on an AFS 
after 2021), the $6,000 payment received in 2021 is not an advance 
payment under paragraph (a)(1)(i) of this section.
    (d) Deferral method for taxpayers without an AFS (non-AFS deferral 
method)--(1) In general. Only a taxpayer described in paragraph (d)(2) 
of this section may elect to use the non-AFS deferral method of 
accounting described in paragraph (d)(4) of this section.
    (2) Taxpayers eligible to use the non-AFS deferral method. A 
taxpayer is eligible to use the non-AFS deferral method if the taxpayer 
does not have an applicable financial statement and can determine the 
extent to which advance payments are earned in the taxable year of 
receipt and, if applicable, a short taxable year described in paragraph 
(d)(6) of this section. The determination whether the advance payment is 
earned in the taxable year of receipt, or a short taxable year described 
in paragraph (d)(6) of this section, if applicable, is determined on an 
item by item basis.
    (3) Deferral of advance payments based on when payment is earned--
(i) In general. Except as otherwise provided in this section, a taxpayer 
that uses the non-AFS deferral method of accounting includes the advance 
payment in gross income for the taxable year of receipt to the extent 
that it is earned in that taxable year and includes the remaining 
portion of the advance payment in gross income in the next succeeding 
taxable year.
    (ii) When payment is earned. Under the non-AFS deferral method, a 
payment is earned when the all events test described in Sec.  1.451-1(a) 
is met, without regard to when the amount is received, as defined under 
paragraph (a)(14) of this section, by the taxpayer. If a taxpayer is 
unable to determine the extent to which a payment is earned in the 
taxable year of receipt, or a short taxable year described in paragraph 
(d)(6) of this section, if applicable, the taxpayer may calculate the 
amount:
    (A) On a statistical basis if adequate data are available to the 
taxpayer;
    (B) On a straight-line basis over the term of the agreement if the 
taxpayer receives the advance payment under a fixed term agreement and 
if it is reasonable to anticipate at the end of the taxable year of 
receipt that the advance payment will be earned ratably over the term of 
the agreement; or
    (C) Using any other method that may be provided in guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d) of this 
chapter).
    (4) Contracts with multiple items of gross income--(i) In general. 
If a taxpayer receives a payment that is attributable to one or more 
items described in paragraph (a)(1)(i)(C) of this section, the taxpayer 
must determine the portion of the payment that is allocable to such 
item(s) by using an allocation method that is based on objective 
criteria.
    (ii) Objective criteria. A taxpayer's allocation method for a 
payment described in paragraph (d)(4)(i) of this section is deemed to be 
based on objective criteria if the allocation method is based on 
payments the taxpayer receives for an item or items it regularly sells 
or provides separately or any method that may be provided in guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d) of this 
chapter).
    (5) Acceleration of advance payments. The acceleration rules in 
paragraph (c)(4) of this section also apply to a taxpayer that uses the 
non-AFS deferral method under paragraph (d) of this section.
    (6) Short taxable year rule. If the taxpayer's next succeeding 
taxable year is a short taxable year, other than a taxable year in which 
the taxpayer dies or ceases to exist in a transaction other than a 
transaction to which section 381(a) applies, and the short taxable year 
consists of 92 days or less, a taxpayer using the non-AFS deferral 
method must include the portion of the advance payment not included in 
the taxable year of receipt in gross income for the short taxable year 
to the extent earned in such taxable year. Any amount of the advance 
payment not included in gross income in the taxable year of receipt, or 
the short taxable year, must be included in gross income

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for the taxable year immediately following the short taxable year.
    (7) Eligible gift card sale. For paragraphs (a)(1)(i)(B) and (d)(3) 
of this section, if an eligible gift card is redeemable by an entity 
described in paragraph (a)(10)(ii) of this section, including an entity 
whose financial results are not included in the taxpayer's financial 
statement, a payment will be treated as earned by the taxpayer to the 
extent the gift card is redeemed by such entity during the taxable year.
    (8) Examples. The following examples illustrate the rules of 
paragraph (d) of this section. In the examples in this paragraph (d)(8), 
the taxpayer is a calendar year taxpayer that uses the non-AFS deferral 
method described in paragraph (d) of this section. None of the taxable 
years are short taxable years.
    (i) Example 1--(A) Facts. A, a video arcade operator, receives 
payments in 2021 for tokens that customers use to play A's arcade games. 
The tokens cannot be redeemed for cash, are imprinted with the name of 
the arcade, but are not individually marked for identification. A 
completed a study on a statistical basis, based on adequate data 
available to A, and concluded that for payments received in 2021, 70% of 
tokens are expected to be used in 2021, 20% of tokens are expected to be 
used in 2022, and 10% of tokens are expected to never be used. Based on 
the study, under paragraph (d)(3)(ii)(A) of this section, A determines 
that 80% of the advance payments are earned for 2021 (70% for tokens 
expected to be used in 2021 plus 10% for tokens that are expected to 
never be used).
    (B) Analysis. For Federal income tax purposes, A must include 80% of 
the advance payments in gross income for 2021 and 20% of the advance 
payments in gross income for 2022.
    (ii) Example 2--(A) Facts. B is in the business of providing 
internet services. On September 1, 2021, B receives an advance payment 
from a customer for a 2-year term for access to its internet services, 
beginning on that date. B does not have an AFS. B is unable to determine 
the extent to which the payment is earned in the taxable year of 
receipt. However, at the close of the 2021 taxable year, it is 
reasonable for B to anticipate that the advance payment will be earned 
ratably over the term of the agreement.
    (B) Analysis. For Federal income tax purposes, pursuant to paragraph 
(d)(3)(ii)(B) of this section, B determines the extent to which the 
payment is earned in tax year 2021 on a straight-line basis over the 
term of the agreement and takes that amount into income in 2021. The 
remaining amount of the advance payment is taken into gross income in 
the 2022 taxable year.
    (e) Advance payment cost offset method--(1) In general. This 
paragraph (e) provides an optional method of accounting for advance 
payments from the sale of inventory (advance payment cost offset 
method). A taxpayer that chooses to use the advance payment cost offset 
method for a trade or business must use the method of accounting for all 
advance payments received by that trade or business that meet the 
criteria in this paragraph (e). Additionally, a taxpayer that chooses to 
use this method for a trade or business and that has an AFS must also 
use the AFS cost offset method described in Sec.  1.451-3(c). A taxpayer 
that uses the AFS cost offset method and the advance payment cost offset 
method to account for gross income, including advance payments, from the 
sale of an item of inventory, determines the corresponding AFS income 
inclusion amount, as defined in Sec.  1.451-3(a)(1), and the advance 
payment income inclusion amount for a taxable year by following the 
rules in Sec.  1.451-3(c)(2) rather than the rules under this paragraph 
(e). However, if all payments received for the sale of item of inventory 
meet the definition of an advance payment under paragraph (a)(1) of this 
section, a taxpayer that uses the advance payment cost offset method 
determines the corresponding advance payment income inclusion amount for 
a taxable year by:
    (i) Following the rules in paragraph (e)(2) of this section, subject 
to the additional rules and limitations in paragraphs (e)(5) through (8) 
of this section, if the taxable year is a taxable year prior to the 
taxable year in which ownership of the item of inventory is transferred 
to the customer; and

[[Page 171]]

    (ii) Following the rules in paragraph (e)(3) of this section, 
subject to the additional rules and limitations in paragraphs (e)(5) 
through (8) of this section, if the taxable year is the taxable year in 
which ownership of the item of inventory is transferred to the customer.
    (2) Determining the advance payment income inclusion amount in a 
year prior to the year of sale. To determine the advance payment income 
inclusion amount for a taxable year prior to the year in which ownership 
of the item of inventory is transferred to the customer, the taxpayer 
must first determine the advance payment inventory inclusion amount for 
such item for such year. This advance payment inventory inclusion amount 
is then reduced by the cost of goods in progress offset for the taxable 
year, as determined under paragraphs (e)(4), (5), and (8) of this 
section. This net amount is the advance payment income inclusion amount 
for the taxable year.
    (3) Determining the advance payment income inclusion amount in the 
year of sale. The advance payment income inclusion amount for the 
taxable year in which ownership of the item of inventory is transferred 
to the customer is equal to the portion of any advance payment for such 
item that was not required to be included in gross income in a prior 
taxable year. This amount is not reduced by a cost of goods in progress 
offset under paragraph (e)(4) of this section. However, the taxpayer is 
entitled to recover the costs capitalized to the item of inventory as 
cost of goods sold in accordance with sections 471 and 263A or any other 
applicable provision of the Internal Revenue Code. See Sec.  1.61-3.
    (4) Cost of goods in progress offset. The cost of goods in progress 
offset for the taxable year is calculated as:
    (i) The cost of goods allocable to the item of inventory through the 
last day of the taxable year; reduced by
    (ii) The cumulative cost of goods in progress offset attributable to 
the item of inventory, if any.
    (5) Limitations to the cost of goods in progress offset. The cost of 
goods in progress offset is determined separately for each item of 
inventory. The cost of goods in progress offset attributable to one item 
of inventory cannot reduce the advance payment inventory inclusion 
amount attributable to a different item of inventory. Further, the cost 
of goods in progress offset cannot reduce the advance payment inventory 
inclusion amount for the taxable year below zero.
    (6) Exception for gift cards. The cost of goods in progress offset 
in this paragraph (e) does not apply to eligible gift card sales or 
payments received for customer reward points.
    (7) Acceleration of advance payments. The acceleration rules in 
paragraph (c)(4) of this section also apply to a taxpayer that uses the 
advance payment cost offset method under this paragraph (e), regardless 
of whether the taxpayer uses such method in connection with the full 
inclusion method under paragraph (b) of this section, or the deferral 
method under paragraph (c) or (d) of this section. If an advance payment 
is subject to the acceleration rules, paragraph (e)(2) of this section 
does not apply to determine the advance payment income inclusion amount 
for the taxable year described in paragraph (c)(4) of this section. 
Further, a taxpayer that uses the advance payment cost offset method 
under this paragraph (e) applies paragraph (c)(4)(i)(B)(2)(ii) of this 
section by substituting ``same advance payment method as the 
transferor'' for ``deferral method.''
    (8) Inventory costs for the advance payment cost offset method--(i) 
Inventory costs not affected by cost of goods in progress offset. The 
cost of goods comprising the cost of goods in progress offset does not 
reduce the costs that are capitalized to the items of inventory produced 
or items of inventory acquired for resale by the taxpayer. While the 
cost of goods in progress offset reduces the amount of the advance 
payment inventory inclusion amount, the cost of goods in progress offset 
does not affect how and when costs are capitalized to inventory under 
sections 471 and 263A or any other applicable provision of the Internal 
Revenue Code or when those capitalized costs will be recovered.
    (ii) Consistency between inventory methods and advance payment cost 
offset method. The costs of goods comprising the cost of goods in 
progress offset

[[Page 172]]

must be determined by applying the taxpayer's methods of accounting for 
inventory for Federal income tax purposes. A taxpayer using the advance 
payment cost offset method must calculate its cost of goods in progress 
offset by reference to all costs that the taxpayer has permissibly 
capitalized and allocated to items of inventory under its methods of 
accounting for inventory for Federal income tax purposes, but including 
no more costs than what the taxpayer has permissibly capitalized and 
allocated to items of inventory.
    (iii) Allocation of ``additional section 263A costs'' for taxpayers 
using simplified methods. If a taxpayer uses the simplified production 
method as defined under Sec.  1.263A-2(b), the modified simplified 
production method as defined under Sec.  1.263A-2(c), or the simplified 
resale method as defined under Sec.  1.263A-3(d) to determine the amount 
of its ``additional section 263A costs,'' as defined under Sec.  1.263A-
1(d)(3), to be included in ending inventory, then solely for computing 
the cost of goods in progress offset, the taxpayer must determine the 
portion of additional section 263A costs allocable to an item of 
inventory by multiplying its total additional section 263A costs 
accounted for under the simplified method for all items of inventory 
subject to the simplified method by the following ratio:

Section 471 costs allocable to the specific item of inventory
------------------------------------------------------------------------
Total section 471 costs for all items of inventory subject to the
 simplified method
 

    (9) Additional procedural guidance. The IRS may publish procedural 
guidance in the Internal Revenue Bulletin (see Sec.  601.601(d) of this 
chapter) that provides alternative procedures for complying with the 
rules under this paragraph (e), including alternative methods of 
accounting for cost offsets.
    (10) Examples. The following examples illustrate the rules of 
paragraph (e) of this section. In each of the following examples, the 
taxpayer is a C corporation, has an AFS, uses an accrual method of 
accounting for Federal income tax purposes, and uses a calendar year for 
Federal income tax purposes and AFS purposes. In addition, in each 
example, the taxpayer uses the deferral method and the advance payment 
cost offset method under paragraph (e) of this section. Lastly, the 
taxpayer does not produce unique items, as described in Sec.  1.460-
2(a)(1) and (b), or any item that normally requires more than 12 
calendar months to complete, as determined under Sec.  1.460-2(a)(2) and 
(c). Any production period that exceeds 12 calendar months is due to 
unforeseen production delays.
    (i) Example 1--(A) Facts. In December 2021, A enters into a contract 
with Customer to manufacture and deliver a good in 2024, with a total 
contract price of $100x. The costs to produce the good are required to 
be capitalized under sections 471 and 263A as the good is inventory in 
the hands of A. On the same day, A receives a payment of $40x from the 
customer. For its AFS, A reports all of the revenue from the sale of the 
good as AFS revenue in the year of delivery, which is also the year in 
which ownership of the good transfers from A to Customer. As of December 
31, 2021, A has not incurred any cost to manufacture the good. The 
payment of $40x does not satisfy the specified good exception in 
paragraph (a)(1)(ii)(H) of this section, and thus qualifies as an 
advance payment. During 2022, A does not receive any additional payments 
on the contract and incurs $10x of costs to manufacture the good. A 
properly capitalizes and allocates such costs to the manufactured good 
under sections 471 and 263A.
    (B) Analysis. Because no portion of the $40x advance payment is 
taken into account as AFS revenue as of the end of 2021, A is not 
required to include any portion of the advance payment in gross income 
for 2021. For 2022, A's advance payment inventory inclusion amount is 
$40x, which is the amount of the advance payment that, but for the cost 
of goods in progress offset, would be includable in gross income in 2022 
under the deferral method. Pursuant to

[[Page 173]]

paragraph (e)(2) of this section, A reduces such amount by the $10x cost 
of goods in progress offset, determined as the costs of goods through 
the end of 2022 ($0 costs incurred in 2021 plus 10x of costs incurred in 
2022 = $10x). A is required to include this net amount of $30x in gross 
income in 2022. The remaining portion of the payment ($10x) is deferred 
and included in gross income in 2024, the taxable year in which 
ownership of the good is transferred to Customer.
    (ii) Example 2--(A) Facts. The same facts as in paragraph (e)(10)(i) 
of this section (Example 1) apply. In addition, in 2023, A incurs costs 
of $20x to manufacture the good but does not receive any additional 
payments from Customer.
    (B) Analysis. A includes $0 in gross income in 2023. A's cost of 
goods in progress offset for 2023 is $20x under paragraph (e)(4) of this 
section ($30x costs of goods through the last day of 2023 ($10x for 2022 
plus $20x for 2023 = $30x) less $10x cumulative cost of goods in 
progress offset amounts taken in prior taxable years). However, because 
A's advance payment inventory inclusion amount for 2023 is $0, which is 
the amount of the advance payment that, but for the cost of goods in 
progress offset, would be includable in gross income in 2023 under the 
deferral method, paragraph (e)(5) of this section limits the cost offset 
to $0.
    (iii) Example 3--(A) Facts. The same facts as in paragraph 
(e)(10)(i) of this section (Example 1) apply, except that in taxable 
year 2022, A incurs additional costs of $25x to manufacture the good, 
resulting in total costs of $35x to manufacture the good in taxable year 
2022.
    (B) Analysis. For 2022, A's advance payment inventory inclusion 
amount is $40x, which is the amount of the advance payment that, but for 
the cost of goods in progress offset, would be includable in gross 
income in 2022 under the deferral method. Pursuant to paragraph (e)(2) 
of this section A reduces such amount by the $35x cost of goods in 
progress offset, determined as the costs of goods through the end of 
2022 ($0 costs incurred in 2021 plus $35x costs incurred in 2022 = 
$35x). A is required to include this net amount of $5x in gross income 
in 2022. The remaining portion of the payment ($35x) is deferred and 
included in gross income in 2024, the taxable year in which ownership of 
the good is transferred to the customer.
    (iv) Example 4--(A) Facts. The same facts as in paragraph 
(e)(10)(iii) of this section (Example 3) apply, except that for tax year 
2023, A receives an additional advance payment of $60x, and does not 
incur any costs to manufacture the good in 2023. In 2024, A incurs the 
remaining $10x to manufacture the good, and delivers the good to 
Customer.
    (B) Analysis for 2023. Because no portion of the $60x advance 
payment is taken into account as AFS revenue as of the end of 2023, A is 
not required to include any portion of the $60x advance payment in gross 
income for 2023.
    (C) Analysis for 2024. In 2024, the ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (e)(3) of 
this section, A is required to include $95x, the remaining portion of 
all advance payments that were not required to be included in gross 
income in a prior taxable year ($100x of total advance payments received 
less $5x that was required to be included in gross income in 2022). 
Although A does not reduce such amount by a cost offset, it reduces 
gross income in 2024 by recovering the $45x of costs capitalized to 
inventory as cost of goods sold ($35x costs incurred in 2022 plus $10x 
costs incurred in 2024) in accordance with sections 471 and 263A. 
Accordingly, A's gross income for 2024 is $50x.
    (f) Method treating payments qualifying for the specified goods 
exception as advance payments--(1) In general. A taxpayer may choose to 
use the specified good section 451(c) method to treat all payments that 
qualify for the specified goods exception in paragraph (a)(1)(ii)(H) of 
this section as advance payments that are eligible to be accounted for 
under this section. Under the specified good section 451(c) method, an 
advance payment is a payment received by the taxpayer in a taxable year 
earlier than the taxable year immediately preceding the taxable year of 
the contractual delivery date for a specified good. A taxpayer that 
chooses to use the specified good section 451(c)

[[Page 174]]

method for a trade or business must apply this method of accounting for 
all advance payments that meet the criteria described in paragraph 
(a)(1)(ii)(H) of this section.
    (2) Example: Method for the specified goods exception to not apply. 
On May 1, 2021, A, a corporation that files its Federal income tax 
return on the calendar year basis, receives a prepayment for $100x, for 
a contract to manufacture and deliver a good in September of 2023. All 
of the revenue from the sale of the good is recognized in A's AFS in the 
year of delivery. During 2021, A does not have on hand, or available to 
it in such year through its normal source of supply, goods of a 
substantially similar kind and in a sufficient quantity to satisfy the 
contract to transfer the good to the customer. The payment of $100x 
satisfies the specified good exception. A uses the method under 
paragraph (f) of this section to treat all payments that otherwise 
satisfy the specified good exception as advance payments under this 
section. For Federal income tax purposes, A must treat the payment of 
$100x as an advance payment and account for such payment under the full 
inclusion method in paragraph (b) of this section, or the deferral 
method in paragraph (c) of this section, as applicable. Additionally, 
the taxpayer may choose to apply the advance payment cost offset method 
in paragraph (e) of this section.
    (g) Election and methods of accounting--(1) Procedures for making 
election under section 451(c)(1)(B). An election to apply the deferral 
method under section 451(c)(1)(B) is made by the taxpayer filing a 
Federal income tax return reflecting the deferral method in computing 
its taxable income. If the application of the deferral method under 
section 451(c)(1)(B) results in the taxpayer changing its method of 
accounting, the election may only be made by the taxpayer complying with 
the method change procedures under this paragraph (g).
    (2) Methods of accounting. A change to comply with this section is a 
change in method of accounting to which the provisions of sections 446 
and 481 and the regulations in this part under sections 446 and 481 of 
the Code apply. A taxpayer seeking to change to a method of accounting 
permitted in this section must secure the consent of the Commissioner in 
accordance with Sec.  1.446-1(e) and follow the administrative 
procedures issued under Sec.  1.446-1(e)(3)(ii) for obtaining the 
Commissioner's consent to change its accounting method. For example, use 
of the full inclusion method under paragraph (b) of this section, the 
AFS deferral method under paragraph (c) of this section, the non-AFS 
deferral method under paragraph (d) of this section, the advance payment 
cost offset method under paragraph (e) of this section, and the 
specified good section 451(c) method under paragraph (f) of this section 
are adoptions of, or changes in, a method of accounting under section 
446 of the Internal Revenue Code or the regulations in this part under 
section 446 of the Code. In addition, a change in the manner of 
recognizing advance payments in revenue in an AFS that changes or could 
change the timing of the inclusion of income for Federal income tax 
purposes is a change in method of accounting under section 446 and the 
regulations in this part under section 446 of the Code.
    (h) Applicability date--(1) In general. The rules of this section 
apply to taxable years beginning on or after January 1, 2021.
    (2) Early application. Taxpayers and their related parties, within 
the meaning of sections 267(b) and 707(b), may apply both the rules in 
this section and, to the extent relevant, the rules in Sec.  1.451-3, in 
their entirety and in a consistent manner, to a taxable year beginning 
after December 31, 2017, and before January 1, 2021, provided that, once 
applied to a taxable year, the rules in this section and, to the extent 
relevant, the rules in Sec.  1.451-3, are applied in their entirety and 
in a consistent manner to all subsequent taxable years. See section 
7805(b)(7) and Sec.  1.451-3(m).

[T.D. 9941, Jan. 6, 2021, as amended by 86 FR 1256, Jan. 8, 2021]

[[Page 175]]



Sec. Sec.  1.453-1--1.453-2  [Reserved]



Sec.  1.453-3  Purchaser evidences of indebtedness payable on demand 
or readily tradable.

    (a) In general. A bond or other evidence of indebtedness 
(hereinafter in this section referred to as an obligation) issued by any 
person and payable on demand shall not be treated as an evidence of 
indebtedness of the purchaser in applying section 453(b) to a sale or 
other disposition of real property or to a casual sale or other casual 
disposition of personal property. In addition, an obligation issued by a 
corporation or a government or political subdivision thereof--
    (1) With interest coupons attached (whether or not the obligation is 
readily tradable in an established securities market),
    (2) In registered form (other than an obligation issued in 
registered form which the taxpayer establishes will not be readily 
tradable in an established securities market), or
    (3) In any other form designed to render such obligation readily 
tradable in an established securities market shall not be treated as an 
evidence of indebtedness of the purchaser in applying section 453(b) to 
a sale or other disposition of real property or to a casual sale or 
other casual disposition of personal property. For purposes of this 
section, an obligation is to be considered in registered form if it is 
registered as to principal, interest, or both and if its transfer must 
be effected by the surrender of the old instrument and either the 
reissuance by the corporation of the old instrument to the new holder or 
the issuance by the corporation of a new instrument to the new holder.
    (b) Treatment as payment. If under section 453(b)(3) an obligation 
is not treated as an evidence of indebtedness of the purchaser, then--
    (1) For purposes of determining whether the payments received in the 
taxable year of the sale or disposition exceed 30 percent of the selling 
price, and
    (2) For purposes of returning income on the installment method 
during the taxable year of the sale or disposition or in a subsequent 
taxable year, the receipt by the seller of such obligation shall be 
treated as a payment. The rules stated in this paragraph may be 
illustrated by the following examples:
[GRAPHIC] [TIFF OMITTED] TR25SE06.004

    Example 1. On July 1, 1970, A, an individual on the cash method of 
accounting reporting on a calendar year basis, transferred all of his 
stock in corporation X (traded on an established securities market and 
having a fair market value of $1 million) to corporation Y in exchange 
for 250 of corporation Y's registered bonds (which are traded in an 
over-the-counter bond market) each with a principal amount and fair 
market value of $1,000 (with interest payable at the rate of 8 percent 
per year), and Y's unsecured promissory note, with a principal amount of 
$750,000. At the time of such exchange A's basis in the corporation X 
stock is $900,000. The promissory note is payable at the rate of $75,000 
annually, due on July 1, of each year following 1970, until the 
principal balance is paid. The note provides for the payment of interest 
at the rate of 10 percent per year also payable on July 1 of each year. 
Under the rule stated in subparagraph (1) of this paragraph, the 250 
registered bonds of corporation Y are treated as a payment for purposes 
of the 30 percent test described in section 453(b)(2)(A)(ii). The 
payment on account of the bonds equals 25 percent of the selling price 
determined as follows:

[[Page 176]]

    Since the payments received in the taxable year of the sale do not 
exceed 30 percent of the selling price and the sales price exceeds 
$1,000, A may report the income received on the sale of his corporation 
X stock on the installment method. A elects to report the income on the 
installment method. The gross profit to be realized when the corporation 
X stock is fully paid for is 10 percent of the total contract price, 
computed as follows: $100,000 gross profit (i.e., $1 million contract 
price less $900,000 basis in corporation X stock) over $1 million 
contract price. However, since subparagraph (2) of this paragraph also 
treats the 250 corporation Y registered bonds as a payment for purposes 
of reporting income, A must include $25,000 (i.e., 10 percent times 
$250,000) in his gross income for calendar year 1970, the taxable year 
of sale.
    Example 2. Assume the same facts as in Example 1. Assume further 
that on July 1, 1971, corporation Y makes its first installment payment 
to A under the terms of the unsecured promissory note with 75 more of 
its $1,000 registered bonds. A must include $7,500 (i.e., 10 percent 
gross profit percentage times $75,000) in his gross income for calendar 
year 1971. In addition, A includes the interest payment made by 
corporation Y on July 1, in his gross income for 1971.

    (c) Payable on demand. Under section 453(b)(3), an obligation shall 
be treated as payable on demand only if the obligation is treated as 
payable on demand under applicable state or local law.
    (d) Designed to be readily tradable in an established securities 
market--(1) In general. Obligations issued by a corporation or 
government or political subdivision thereof will be deemed to be in a 
form designed to render such obligations readily tradable in an 
established securities market if--
    (i) Steps necessary to create a market for them are taken at the 
time of issuance (or later, if taken pursuant to an expressed or implied 
agreement or understanding which existed at the time of issuance),
    (ii) If they are treated as readily tradable in an established 
securities market under subparagraph (2) of this paragraph, or
    (iii) If they are convertible obligations to which paragraph (e) of 
this section applies.
    (2) Readily tradable in an established securities market. An 
obligation will be treated as readily tradable in an established 
securities market if--
    (i) The obligation is part of an issue or series of issues which are 
readily tradable in an established securities market, or
    (ii) The corporation issuing the obligation has other obligations of 
a comparable character which are described in subdivision (i) of this 
subparagraph.

For purposes of subdivision (ii) of this subparagraph, the determination 
as to whether there exist obligations of a comparable character depends 
upon the particular facts and circumstances. Factors to be considered in 
making such determination include, but are not limited to, substantial 
similarity with respect to the presence and nature of security for the 
obligation, the number of obligations issued (or to be issued), the 
number of holders of such obligation, the principal amount of the 
obligation, and other relevant factors.
    (3) Readily tradable. For purposes of subparagraph (2)(i) of this 
paragraph, an obligation shall be treated as readily tradable if it is 
regularly quoted by brokers or dealers making a market in such 
obligation or is part of an issue a portion of which is in fact traded 
in an established securities market.
    (4) Established securities market. For purposes of this paragraph, 
the term established securities market includes (i) a national 
securities exchange which is registered under section 6 of the 
Securities and Exchange Act of 1934 (15 U.S.C. 78f), (ii) an exchange 
which is exempted from registration under section 5 of the Securities 
Exchange Act of 1935 (15 U.S.C. 78e) because of its limited volume of 
transactions, and (iii) any over-the-counter market. For purposes of 
this subparagraph, an over-the-counter market is reflected by the 
existence of an interdealer quotation system. An interdealer quotation 
system is any system of general circulation to brokers and dealers which 
regularly disseminates quotations of obligations by identified brokers 
or dealers, other than a quotation sheet prepared and distributed by a 
broker or dealer in the regular course of his business and containing 
only quotations of such broker or dealer.
    (5) Examples. The rules stated in this paragraph may be illustrated 
by the following examples:


[[Page 177]]


    Example 1. On June 1, 1971, 25 individuals owning equal interests in 
a tract of land with a fair market value of $1 million sell the land to 
corporation Y. The $1 million sales price is represented by 25 bonds 
issued by corporation Y each having a face value of $40,000. The bonds 
are not in registered form and do not have interest coupons attached, 
and, in addition, are payable in 120 equal installments each due on the 
first business day of each month. In addition, the bonds are negotiable 
and may be assigned by the holder to any other person. However, the 
bonds are not quoted by any brokers or dealers who deal in corporate 
bonds, and, furthermore, there are no comparable obligations of 
corporation Y (determined with reference to the characteristics set 
forth in subparagraph (2) of this paragraph) which are so quoted. 
Therefore, the bonds are not treated as readily tradable in an 
established securities market. In addition, under the particular facts 
and circumstances stated, the bonds will not be considered to be in a 
form designed to render them readily tradeable in an established 
securities market. Since the bonds are not in registered form, do not 
have coupons attached, are not in a form designed to render them readily 
tradable in an established securities market, the receipt of such bonds 
by the holder is not treated as a payment for purposes of section 
453(b), notwithstanding that they are freely assignable.
    Example 2. On April 1, 1972, corporation M purchases in a casual 
sale of personal property a fleet of trucks from corporation N in 
exchange for corporation M's negotiable notes, not in registered form 
and without coupons attached. The corporation M notes are comparable to 
earlier notes issued by corporation M, which notes are quoted in the 
Eastern Bond section of the National daily quotation sheet, which is an 
interdealer quotation system. Both issues of notes are unsecured, held 
by more than 100 holders, have a maturity date of more than 5 years, and 
were issued for a comparable principal amount. On the basis of these 
similar characteristics it appears that the latest notes will also be 
readily tradable. Since an interdealer system reflects an over-the-
counter market, the earlier notes are treated as readily tradable in an 
established securities market. Since the later notes are obligations 
comparable to the earlier ones, which are treated as readily tradable in 
an established securities market, the later notes are also treated as 
readily tradable in an established securities market (whether or not 
such notes are actually traded).

    (e) Special rule for convertible securities--(1) General rule. For 
purposes of paragraph (d)(1) of this section, if an obligation contains 
a right whereby the holder of such obligation may convert it directly or 
indirectly into another obligation which would be treated as a payment 
under paragraph (b) of this section or may convert it directly or 
indirectly into stock which would be treated as readily tradable or 
designed to be readily tradable in an established securities market 
under paragraph (d) of this section, the convertible obligation shall be 
considered to be in a form designed to render such obligation readily 
tradable in an established securities market unless such obligation is 
convertible only at a substantial discount. In determining whether the 
stock or obligation, into which an obligation is convertible, is readily 
tradable or designed to be readily tradable in an established securities 
market, the rules stated in paragraph (d) of this section shall apply, 
and for purposes of such paragraph (d) if such obligation is convertible 
into stock then the term ``stock'' shall be substituted for the term 
``obligation'' wherever it appears in such paragraph (d).
    (2) Substantial discount rule. Whether an obligation is convertible 
at a substantial discount depends upon the particular facts and 
circumstances. A substantial discount shall be considered to exist if at 
the time the convertible obligation is issued, the fair market value of 
the stock or obligation into which the obligation is convertible is less 
than 80 percent of the fair market value of the obligation (determined 
by taking into account all relevant factors, including proper discount 
to reflect the fact that the convertible obligation is not readily 
tradable in an established securities market and any additional 
consideration required to be paid by the taxpayer). Also, if a privilege 
to convert an obligation into stock or an obligation which is readily 
tradable in an established securities market may not be exercised within 
a period of 1 year from the date the obligation is issued, a substantial 
discount shall be considered to exist.
    (f) Effective date. The provisions of this section shall apply to 
sales or other dispositions occurring after May 27, 1969, which are not 
made pursuant to a binding written contract entered into on or before 
such date. No inference shall be drawn from this section

[[Page 178]]

as to any question of law concerning the application of section 453 to 
sales or other dispositions occurring on or before May 27, 1969.

[T.D. 7197, 37 FR 13532, July 11, 1972]



Sec. Sec.  1.453-4--1.453.8  [Reserved]



Sec.  1.453-9  Gain or loss on disposition of installment obligations.

    (a) In general. Subject to the exceptions contained in section 
453(d)(4) and paragraph (c) of this section, the entire amount of gain 
or loss resulting from any disposition or satisfaction of installment 
obligations, computed in accordance with section 453(d), is recognized 
in the taxable year of such disposition or satisfaction and shall be 
considered as resulting from the sale or exchange of the property in 
respect of which the installment obligation was received by the 
taxpayer.
    (b) Computation of gain or loss. (1) The amount of gain or loss 
resulting under paragraph (a) of this section is the difference between 
the basis of the obligation and (i) the amount realized, in the case of 
satisfaction at other than face value or in the case of a sale or 
exchange, or (ii) the fair market value of the obligation at the time of 
disposition, if such disposition is other than by sale or exchange.
    (2) The basis of an installment obligation shall be the excess of 
the face value of the obligation over an amount equal to the income 
which would be returnable were the obligation satisfied in full.
    (3) The application of subparagraphs (1) and (2) of this paragraph 
may be illustrated by the following examples:

    Example 1. In 1960 the M Corporation sold a piece of unimproved real 
estate to B for $20,000. The company acquired the property in 1948 at a 
cost of $10,000. During 1960 the company received $5,000 cash and 
vendee's notes for the remainder of the selling price, or $15,000, 
payable in subsequent years. In 1962, before the vendee made any further 
payments, the company sold the notes for $13,000 in cash. The 
corporation makes its returns on the calendar year basis. The income to 
be reported for 1962 is $5,500, computed as follows:

Proceeds of sale of notes...........................  ........   $13,000
Selling price of property...........................   $20,000
Cost of property....................................    10,000
                                                     ----------
  Total profit......................................    10,000
  Total contract price..............................    20,000
                                                     ==========
Percent of profit, or proportion of each payment
 returnable as income, $10,000 divided by $20,000,
 50 percent.
Face value of notes.................................    15,000
Amount of income returnable were the notes satisfied     7,500
 in full, 50 percent of $15,000.....................
                                                     ----------
Basis of obligation--excess of face value of notes       7,500
 over amount of income returnable were the notes
 satisfied in full..................................
                                                     ----------
   Taxable income to be reported for 1962.....................     5,500
 

    Example 2. Suppose in Example 1 the M Corporation, instead of 
selling the notes, distributed them in 1962 to its shareholders as a 
dividend, and at the time of such distribution, the fair market value of 
the notes was $14,000. The income to be reported for 1962 is $6,500, 
computed as follows:

Fair market value of notes....................................   $14,000
Basis of obligation--excess of face value of notes over amount     7,500
 of income returnable were the notes satisfied in full
 (computed as in Example 1)...................................
                                                               =========
  Taxable income to be reported for 1962......................     6,500
 

    (c) Disposition from which no gain or loss is recognized. (1)(i) 
Under section 453(d)(4)(A), no gain or loss shall be recognized to a 
distributing corporation with respect to the distribution made after 
November 13, 1966, of installment obligations if (a) the distribution is 
made pursuant to a plan for the complete liquidation of a subsidiary 
under section 332, and (b) the basis of the such obligations in the 
hands of the distributee is determined under section 334(b)(1).
    (ii) Under section 453(d)(4)(B), no gain or loss shall be recognized 
to a distributing corporation with respect to the distribution of 
installment obligations if the distribution is made, pursuant to a plan 
for the complete liquidation of a corporation which meets the 
requirements of section 337, under conditions whereby no gain or loss 
would have been recognized to the corporation had such installment 
obligations been sold or exchanged on the day of the distribution. The 
preceding sentence shall not apply to the extent that under section 
453(d)(1) gain to the distributing corporation would be considered as 
gain to which section 341(f)(2), 617(d)(1), 1245(a)(1), 1250(a)(1), 
1251(c)(1),

[[Page 179]]

1252(a)(1), or 1254(a)(1) applies, computed under the principles of the 
regulations under such provisions. See paragraph (d) of Sec.  1.1245-6, 
paragraph (c)(6) of Sec.  1.1250-1, paragraph (e)(6) of Sec.  1.1251-1, 
paragraph (d)(3) of Sec.  1.1252-1, and paragraph (d) of Sec.  1.1254-1.
    (2) Where the Code provides for exceptions to the recognition of 
gain or loss in the case of certain dispositions, no gain or loss shall 
result under section 453(d) in the case of a disposition of an 
installment obligation. Such exceptions include: Certain transfers to 
corporations under sections 351 and 361; contributions of property to a 
partnership by a partner under section 721; and distributions by a 
partnership to a partner under section 731 (except as provided by 
section 736 and section 751).
    (3) Any amount received by a person in payment or settlement of an 
installment obligation acquired in a transaction described in 
subparagraphs (1) or (2) of this paragraph (other than an amount 
received by a stockholder with respect to an installment obligation 
distributed to him pursuant to section 337) shall be considered to have 
the character it would have had in the hands of the person from whom 
such installment obligation was acquired.
    (d) Carryover of installment method. For the treatment of income 
derived from installment obligations received in transactions to which 
section 381 (a) is applicable, see section 381(c)(8) and the regulations 
thereunder.
    (e) Installment obligations transmitted at death. Where installment 
obligations are transmitted at death, see section 691(a)(4) and the 
regulations thereunder for the treatment of amounts considered income in 
respect of a decedent.
    (f) Losses. See subchapter P (section 1201 and following), chapter 1 
of the Code, as to the limitation on capital losses sustained by 
corporations and the limitation as to both capital gains and capital 
losses of individuals.
    (g) Disposition of installment obligations to life insurance 
companies. (1) Notwithstanding the provisions of section 453(d)(4) and 
paragraph (c) of this section or any provision of subtitle A relating to 
the nonrecognition of gain, the entire amount of any gain realized on 
the disposition of an installment obligation by any person, other than a 
life insurance company (as defined in section 801(a) and paragraph (b) 
of Sec.  1.801-3), to a life insurance company or to a partnership of 
which a life insurance company is a partner shall be recognized and 
treated in accordance with section 453(d)(1) and paragraphs (a) and (b) 
of this section. If a corporation which is a life insurance company for 
the taxable year was a corporation which was not a life insurance 
company for the preceding taxable year, such corporation shall be 
treated, for purposes of section 453(d)(1) and this paragraph, as having 
transferred to a life insurance company, on the last day of the 
preceding taxable year, all installment obligations which it held on 
such last day. The gain, if any, realized by reason of the installment 
obligations being so transferred shall be recognized and treated in 
accordance with section 453(d)(1) and paragraphs (a) and (b) of this 
section. Similarly, a partnership of which a life insurance company 
becomes a partner shall be treated, for purposes of section 453(d)(1) 
and this paragraph, as having transferred to a life insurance company, 
on the last day of the preceding taxable year of such partnership, all 
installment obligations which it holds at the time such life insurance 
company becomes a partner. The gain, if any, realized by reason of the 
installment obligations being so transferred shall be recognized and 
treated in accordance with section 453(d)(1) and paragraphs (a) and (b) 
of this section.
    (2) The provisions of section 453(d)(5) and subparagraph (1) of this 
paragraph shall not apply to losses sustained in connection with the 
disposition of installment obligations to a life insurance company.
    (3) For the effective date of the provisions of section 453(d)(5) 
and this paragraph, see paragraph (f) of Sec.  1.453-10.
    (4) Application of the provisions of this paragraph may be 
illustrated by the following examples:

    Example 1. A, an individual, in a transaction to which section 351 
applies, transfers in 1961 certain assets, including installment 
obligations, to a new corporation, X, which qualifies as a life 
insurance company (as defined in section 801(a)) for the year 1961. A 
makes his return on the calendar year basis.

[[Page 180]]

Section 453(d)(5) provides that the nonrecognition provisions of section 
351 will not apply to the installment obligations transferred by A to X 
Corporation. Therefore, the entire amount of any gain realized by A on 
the transfer of the installment obligations shall be recognized in 1961, 
with the amount of any such gain computed in accordance with the 
provisions of section 453(d)(1) and paragraph (b) of this section.
    Example 2. The M Corporation did not qualify as a life insurance 
company (as defined in section 801(a)) for the taxable year 1958. On 
December 31, 1958, it held $60,000 of installment obligations. The M 
Corporation qualified as a life insurance company for the taxable year 
1959. Accordingly, the M Corporation is treated as having transferred to 
a life insurance company, on December 31, 1958, the $60,000 of 
installment obligations it held on such date. The gain, if any, realized 
by M by reason of such installment obligations being so transferred 
shall be recognized in the taxable year 1958, with the amount of any 
such gain computed in accordance with the provisions of section 
453(d)(1) and paragraph (b) of this section.
    Example 3. During its taxable year 1958, none of the partners of the 
N partnership qualified as a life insurance company (as defined in 
section 801(a)). The N partnership held $30,000 of installment 
obligations on December 31, 1958. On July 30, 1959, the O Corporation, a 
life insurance company (as defined in section 801(a)), became a partner 
in the partnership. The N partnership held $50,000 of installment 
obligations on July 30, 1959. Pursuant to section 453(d)(5), the N 
partnership is treated as having transferred to a life insurance 
company, on December 31, 1958, the $50,000 of installment obligations it 
held on July 30, 1959. The gain, if any, realized by the N partnership 
by reason of such installment obligations being so transferred shall be 
recognized in the taxable year 1958, with the amount of any such gain 
computed in accordance with the provisions of section 453(d)(1) and 
paragraph (b) of this section.
    Example 4. In 1960, the P Corporation, in a reorganization 
qualifying under section 368(a), transferred certain assets (including 
installment obligations) to the R Corporation, a life insurance company 
as defined in section 801(a). P realized a loss upon the transfer of the 
installment obligations, which was not recognized under section 361. 
Pursuant to subparagraph (2) of paragraph (c) of this section, no loss 
with respect to the transfer of these obligations will be recognized to 
P under section 453(d)(1).

[T.D. 6500, 25 FR 11718, Nov. 26, 1960, as amended by T.D. 6590, 27 FR 
1319, Feb. 13, 1962; T.D. 7084, 36 FR 267, Jan. 8, 1971; T.D. 7418, 41 
FR 18812, May 7, 1976; T.D. 8586, 60 FR 2500, Jan. 10, 1995]



Sec.  1.453-10  [Reserved]



Sec.  1.453-11  Installment obligations received from 
a liquidating corporation.

    (a) In general--(1) Overview. Except as provided in section 
453(h)(1)(C) (relating to installment sales of depreciable property to 
certain closely related persons), a qualifying shareholder (as defined 
in paragraph (b) of this section) who receives a qualifying installment 
obligation (as defined in paragraph (c) of this section) in a 
liquidation that satisfies section 453(h)(1)(A) treats the receipt of 
payments in respect of the obligation, rather than the receipt of the 
obligation itself, as a receipt of payment for the shareholder's stock. 
The shareholder reports the payments received on the installment method 
unless the shareholder elects otherwise in accordance with Sec.  
15a.453-1(d) of this chapter.
    (2) Coordination with other provisions--(i) Deemed sale of stock for 
installment obligation. Except as specifically provided in section 
453(h)(1)(C), a qualifying shareholder treats a qualifying installment 
obligation, for all purposes of the Internal Revenue Code, as if the 
obligation is received by the shareholder from the person issuing the 
obligation in exchange for the shareholder's stock in the liquidating 
corporation. For example, if the stock of a corporation that is 
liquidating is traded on an established securities market, an 
installment obligation distributed to a shareholder of the corporation 
in exchange for the shareholder's stock does not qualify for installment 
reporting pursuant to section 453(k)(2).
    (ii) Special rules to account for the qualifying installment 
obligation--(A) Issue price. A qualifying installment obligation is 
treated by a qualifying shareholder as newly issued on the date of the 
distribution. The issue price of the qualifying installment obligation 
on that date is equal to the sum of the adjusted issue price of the 
obligation on the date of the distribution (as determined under Sec.  
1.1275-1(b)) and the amount of any qualified stated interest (as defined 
in Sec.  1.1273-1(c)) that has accrued prior to the distribution but 
that

[[Page 181]]

is not payable until after the distribution. For purposes of the 
preceding sentence, if the qualifying installment obligation is subject 
to Sec.  1.446-2 (e.g., a debt instrument that has unstated interest 
under section 483), the adjusted issue price of the obligation is 
determined under Sec.  1.446-2(c) and (d).
    (B) Variable rate debt instrument. If the qualifying installment 
obligation is a variable rate debt instrument (as defined in Sec.  
1.1275-5), the shareholder uses the equivalent fixed rate debt 
instrument (within the meaning of Sec.  1.1275-5(e)(3)(ii)) constructed 
for the qualifying installment obligation as of the date the obligation 
was issued to the liquidating corporation to determine the accruals of 
original issue discount, if any, and interest on the obligation.
    (3) Liquidating distributions treated as selling price. All amounts 
distributed or treated as distributed to a qualifying shareholder 
incident to the liquidation, including cash, the issue price of 
qualifying installment obligations as determined under paragraph 
(a)(2)(ii)(A) of this section, and the fair market value of other 
property (including obligations that are not qualifying installment 
obligations) are considered as having been received by the shareholder 
as the selling price (as defined in Sec.  15a.453-1(b)(2)(ii) of this 
chapter) for the shareholder's stock in the liquidating corporation. For 
the proper method of reporting liquidating distributions received in 
more than one taxable year of a shareholder, see paragraph (d) of this 
section. An election not to report on the installment method an 
installment obligation received in the liquidation applies to all 
distributions received in the liquidation.
    (4) Assumption of corporate liability by shareholders. For purposes 
of this section, if in the course of a liquidation a shareholder assumes 
secured or unsecured liabilities of the liquidating corporation, or 
receives property from the corporation subject to such liabilities 
(including any tax liabilities incurred by the corporation on the 
distribution), the amount of the liabilities is added to the 
shareholder's basis in the stock of the liquidating corporation. These 
additions to basis do not affect the shareholder's holding period for 
the stock. These liabilities do not reduce the amounts received in 
computing the selling price.
    (5) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples. Except as otherwise provided, assume in each 
example that A, an individual who is a calendar-year taxpayer, owns all 
of the stock of T corporation. A's adjusted tax basis in that stock is 
$100,000. On February 1, 1998, T, an accrual method taxpayer, adopts a 
plan of complete liquidation that satisfies section 453(h)(1)(A) and 
immediately sells all of its assets to unrelated B corporation in a 
single transaction. The examples are as follows:

    Example 1. (i) The stated purchase price for T's assets is 
$3,500,000. In consideration for the sale, B makes a down payment of 
$500,000 and issues a 10-year installment obligation with a stated 
principal amount of $3,000,000. The obligation provides for interest 
payments of $150,000 on January 31 of each year, with the total 
principal amount due at maturity.
    (ii) Assume that for purposes of section 1274, the test rate on 
February 1, 1998, is 8 percent, compounded semi-annually. Also assume 
that a semi-annual accrual period is used. Under Sec.  1.1274-2, the 
issue price of the obligation on February 1, 1998, is $2,368,450. 
Accordingly, the obligation has $631,550 of original issue discount 
($3,000,000-$2,368,450). Between February 1 and July 31, $19,738 of 
original issue discount and $75,000 of qualified stated interest accrue 
with respect to the obligation and are taken into account by T.
    (iii) On July 31, 1998, T distributes the installment obligation to 
A in exchange for A's stock. No other property is ever distributed to A. 
On January 31, 1999, A receives the first annual payment of $150,000 
from B.
    (iv) When the obligation is distributed to A on July 31, 1998, it is 
treated as if the obligation is received by A in an installment sale of 
shares directly to B on that date. Under Sec.  1.1275-1(b), the adjusted 
issue price of the obligation on that date is $2,388,188 (original issue 
price of $2,368,450 plus accrued original issue discount of $19,738). 
Accordingly, the issue price of the obligation under paragraph 
(a)(2)(ii)(A) of this section is $2,463,188, the sum of the adjusted 
issue price of the obligation on that date ($2,388,188) and the amount 
of accrued but unpaid qualified stated interest ($75,000).
    (v) The selling price and contract price of A's stock in T is 
$2,463,188, and the gross profit is $2,363,188 ($2,463,188 selling price 
less A's adjusted tax basis of $100,000). A's gross profit ratio is thus 
96 percent (gross profit of

[[Page 182]]

$2,363,188 divided by total contract price of $2,463,188).
    (vi) Under Sec. Sec.  1.446-2(e)(1) and 1.1275-2(a), $98,527 of the 
$150,000 payment is treated as a payment of the interest and original 
issue discount that accrued on the obligation from July 31, 1998, to 
January 31, 1999 ($75,000 of qualified stated interest and $23,527 of 
original issue discount). The balance of the payment ($51,473) is 
treated as a payment of principal. A's gain recognized in 1999 is 
$49,414 (96 percent of $51,473).
    Example 2. (i) T owns Blackacre, unimproved real property, with an 
adjusted tax basis of $700,000. Blackacre is subject to a mortgage 
(underlying mortgage) of $1,100,000. A is not personally liable on the 
underlying mortgage and the T shares held by A are not encumbered by the 
underlying mortgage. The other assets of T consist of $400,000 of cash 
and $600,000 of accounts receivable attributable to sales of inventory 
in the ordinary course of business. The unsecured liabilities of T total 
$900,000.
    (ii) On February 1, 1998, T adopts a plan of complete liquidation 
complying with section 453(h)(1)(A), and promptly sells Blackacre to B 
for a 4-year mortgage note (bearing adequate stated interest and 
otherwise meeting all of the requirements of section 453) in the face 
amount of $4 million. Under the agreement between T and B, T (or its 
successor) is to continue to make principal and interest payments on the 
underlying mortgage. Immediately thereafter, T completes its liquidation 
by distributing to A its remaining cash of $400,000 (after payment of 
T's tax liabilities), accounts receivable of $600,000, and the $4 
million B note. A assumes T's $900,000 of unsecured liabilities and 
receives the distributed property subject to the obligation to make 
payments on the $1,100,000 underlying mortgage. A receives no payments 
from B on the B note during 1998.
    (iii) Unless A elects otherwise, the transaction is reported by A on 
the installment method. The selling price is $5 million (cash of 
$400,000, accounts receivable of $600,000, and the B note of $4 
million). The total contract price also is $5 million. A's adjusted tax 
basis in the T shares, initially $100,000, is increased by the $900,000 
of unsecured T liabilities assumed by A and by the obligation (subject 
to which A takes the distributed property) to make payments on the 
$1,100,000 underlying mortgage on Blackacre, for an aggregate adjusted 
tax basis of $2,100,000. Accordingly, the gross profit is $2,900,000 
(selling price of $5 million less aggregate adjusted tax basis of 
$2,100,000). The gross profit ratio is 58 percent (gross profit of 
$2,900,000 divided by the total contract price of $5 million). The 1998 
payments to A are $1 million ($400,000 cash plus $600,000 receivables) 
and A recognizes gain in 1998 of $580,000 (58 percent of $1 million).
    (iv) In 1999, A receives payment from B on the B note of $1 million 
(exclusive of interest). A's gain recognized in 1999 is $580,000 (58 
percent of $1 million).

    (b) Qualifying shareholder. For purposes of this section, qualifying 
shareholder means a shareholder to which, with respect to the 
liquidating distribution, section 331 applies. For example, a creditor 
that receives a distribution from a liquidating corporation, in exchange 
for the creditor's claim, is not a qualifying shareholder as a result of 
that distribution regardless of whether the liquidation satisfies 
section 453(h)(1)(A).
    (c) Qualifying installment obligation--(1) In general. For purposes 
of this section, qualifying installment obligation means an installment 
obligation (other than an evidence of indebtedness described in Sec.  
15a.453-1(e) of this chapter, relating to obligations that are payable 
on demand or are readily tradable) acquired in a sale or exchange of 
corporate assets by a liquidating corporation during the 12-month period 
beginning on the date the plan of liquidation is adopted. See paragraph 
(c)(4) of this section for an exception for installment obligations 
acquired in respect of certain sales of inventory. Also see paragraph 
(c)(5) of this section for an exception for installment obligations 
attributable to sales of certain property that do not generally qualify 
for installment method treatment.
    (2) Corporate assets. Except as provided in section 453(h)(1)(C), in 
paragraph (c)(4) of this section (relating to certain sales of 
inventory), and in paragraph (c)(5) of this section (relating to certain 
tax avoidance transactions), the nature of the assets sold by, and the 
tax consequences to, the selling corporation do not affect whether an 
installment obligation is a qualifying installment obligation. Thus, for 
example, the fact that the fair market value of an asset is less than 
the adjusted basis of that asset in the hands of the corporation; or 
that the sale of an asset will subject the corporation to depreciation 
recapture (e.g., under section 1245 or section 1250); or that the assets 
of a trade or business sold by the corporation for an installment 
obligation include depreciable property, certain marketable securities, 
accounts

[[Page 183]]

receivable, installment obligations, or cash; or that the distribution 
of assets to the shareholder is or is not taxable to the corporation 
under sections 336 and 453B, does not affect whether installment 
obligations received in exchange for those assets are treated as 
qualifying installment obligations by the shareholder. However, an 
obligation received by the corporation in exchange for cash, in a 
transaction unrelated to a sale or exchange of noncash assets by the 
corporation, is not treated as a qualifying installment obligation.
    (3) Installment obligations distributed in liquidations described in 
section 453(h)(1)(E)--(i) In general. In the case of a liquidation to 
which section 453(h)(1)(E) (relating to certain liquidating subsidiary 
corporations) applies, a qualifying installment obligation acquired in 
respect of a sale or exchange by the liquidating subsidiary corporation 
will be treated as a qualifying installment obligation if distributed by 
a controlling corporate shareholder (within the meaning of section 
368(c)) to a qualifying shareholder. The preceding sentence is applied 
successively to each controlling corporate shareholder, if any, above 
the first controlling corporate shareholder.
    (ii) Examples. The provisions of this paragraph (c)(3) are 
illustrated by the following examples:

    Example 1. (i) A, an individual, owns all of the stock of T 
corporation, a C corporation. T has an operating division and three 
wholly-owned subsidiaries, X, Y, and Z. On February 1, 1998, T, Y, and Z 
all adopt plans of complete liquidation.
    (ii) On March 1, 1998, the following sales are made to unrelated 
purchasers: T sells the assets of its operating division to B for cash 
and an installment obligation. T sells the stock of X to C for an 
installment obligation. Y sells all of its assets to D for an 
installment obligation. Z sells all of its assets to E for cash. The B, 
C, and D installment obligations bear adequate stated interest and meet 
the requirements of section 453.
    (iii) In June 1998, Y and Z completely liquidate, distributing their 
respective assets (the D installment obligation and cash) to T. In July 
1998, T completely liquidates, distributing to A cash and the 
installment obligations respectively issued by B, C, and D. The 
liquidation of T is a liquidation to which section 453(h) applies and 
the liquidations of Y and Z into T are liquidations to which section 332 
applies.
    (iv) Because T is in control of Y (within the meaning of section 
368(c)), the D obligation acquired by Y is treated as acquired by T 
pursuant to section 453(h)(1)(E). A is a qualifying shareholder and the 
installment obligations issued by B, C, and D are qualifying installment 
obligations. Unless A elects otherwise, A reports the transaction on the 
installment method as if the cash and installment obligations had been 
received in an installment sale of the stock of T corporation. Under 
section 453B(d), no gain or loss is recognized by Y on the distribution 
of the D installment obligation to T. Under sections 453B(a) and 336, T 
recognizes gain or loss on the distribution of the B, C, and D 
installment obligations to A in exchange for A's stock.
    Example 2. (i) A, a cash-method individual taxpayer, owns all of the 
stock of P corporation, a C corporation. P owns 30 percent of the stock 
of Q corporation. The balance of the Q stock is owned by unrelated 
individuals. On February 1, 1998, P adopts a plan of complete 
liquidation and sells all of its property, other than its Q stock, to B, 
an unrelated purchaser for cash and an installment obligation bearing 
adequate stated interest. On March 1, 1998, Q adopts a plan of complete 
liquidation and sells all of its property to an unrelated purchaser, C, 
for cash and installment obligations. Q immediately distributes the cash 
and installment obligations to its shareholders in completion of its 
liquidation. Promptly thereafter, P liquidates, distributing to A cash, 
the B installment obligation, and a C installment obligation that P 
received in the liquidation of Q.
    (ii) In the hands of A, the B installment obligation is a qualifying 
installment obligation. In the hands of P, the C installment obligation 
was a qualifying installment obligation. However, in the hands of A, the 
C installment obligation is not treated as a qualifying installment 
obligation because P owned only 30 percent of the stock of Q. Because P 
did not own the requisite 80 percent stock interest in Q, P was not a 
controlling corporate shareholder of Q (within the meaning of section 
368(c)) immediately before the liquidation. Therefore, section 
453(h)(1)(E) does not apply. Thus, in the hands of A, the C obligation 
is considered to be a third-party note (not a purchaser's evidence of 
indebtedness) and is treated as a payment to A in the year of 
distribution. Accordingly, for 1998, A reports as payment the cash and 
the fair market value of the C obligation distributed to A in the 
liquidation of P.
    (iii) Because P held 30 percent of the stock of Q, section 453B(d) 
is inapplicable to P. Under sections 453B(a) and 336, accordingly, Q 
recognizes gain or loss on the distribution of the C obligation. P also 
recognizes gain or loss on the distribution of the B and C installment 
obligations to A in exchange for A's stock. See sections 453B and 336.


[[Page 184]]


    (4) Installment obligations attributable to certain sales of 
inventory--(i) In general. An installment obligation acquired by a 
corporation in a liquidation that satisfies section 453(h)(1)(A) in 
respect of a broken lot of inventory is not a qualifying installment 
obligation. If an installment obligation is acquired in respect of a 
broken lot of inventory and other assets, only the portion of the 
installment obligation acquired in respect of the broken lot of 
inventory is not a qualifying installment obligation. The portion of the 
installment obligation attributable to other assets is a qualifying 
installment obligation. For purposes of this section, the term broken 
lot of inventory means inventory property that is sold or exchanged 
other than in bulk to one person in one transaction involving 
substantially all of the inventory property attributable to a trade or 
business of the corporation. See paragraph (c)(4)(ii) of this section 
for rules for determining what portion of an installment obligation is 
not a qualifying installment obligation and paragraph (c)(4)(iii) of 
this section for rules determining the application of payments on an 
installment obligation only a portion of which is a qualifying 
installment obligation.
    (ii) Rules for determining nonqualifying portion of an installment 
obligation. If a broken lot of inventory is sold to a purchaser together 
with other corporate assets for consideration consisting of an 
installment obligation and either cash, other property, the assumption 
of (or taking property subject to) corporate liabilities by the 
purchaser, or some combination thereof, the installment obligation is 
treated as having been acquired in respect of a broken lot of inventory 
only to the extent that the fair market value of the broken lot of 
inventory exceeds the sum of unsecured liabilities assumed by the 
purchaser, secured liabilities which encumber the broken lot of 
inventory and are assumed by the purchaser or to which the broken lot of 
inventory is subject, and the sum of the cash and fair market value of 
other property received. This rule applies solely for the purpose of 
determining the portion of the installment obligation (if any) that is 
attributable to the broken lot of inventory.
    (iii) Application of payments. If, by reason of the application of 
paragraph (c)(4)(ii) of this section, a portion of an installment 
obligation is not a qualifying installment obligation, then for purposes 
of determining the amount of gain to be reported by the shareholder 
under section 453, payments on the obligation (other than payments of 
qualified stated interest) shall be applied first to the portion of the 
obligation that is not a qualifying installment obligation.
    (iv) Example. The following example illustrates the provisions of 
this paragraph (c)(4). In this example, assume that all obligations bear 
adequate stated interest within the meaning of section 1274(c)(2) and 
that the fair market value of each nonqualifying installment obligation 
equals its face amount. The example is as follows:

    Example. (i) P corporation has three operating divisions, X, Y, and 
Z, each engaged in a separate trade or business, and a minor amount of 
investment assets. On July 1, 1998, P adopts a plan of complete 
liquidation that meets the criteria of section 453(h)(1)(A). The 
following sales are promptly made to purchasers unrelated to P: P sells 
all of the assets of the X division (including all of the inventory 
property) to B for $30,000 cash and installment obligations totalling 
$200,000. P sells substantially all of the inventory property of the Y 
division to C for a $100,000 installment obligation, and sells all of 
the other assets of the Y division (excluding cash but including 
installment receivables previously acquired in the ordinary course of 
the business of the Y division) to D for a $170,000 installment 
obligation. P sells \1/3\ of the inventory property of the Z division to 
E for $100,000 cash, \1/3\ of the inventory property of the Z division 
to F for a $100,000 installment obligation, and all of the other assets 
of the Z division (including the remaining \1/3\ of the inventory 
property worth $100,000) to G for $60,000 cash, a $240,000 installment 
obligation, and the assumption by G of the liabilities of the Z 
division. The liabilities assumed by G, which are unsecured liabilities 
and liabilities encumbering the inventory property acquired by G, 
aggregate $30,000. Thus, the total purchase price G pays is $330,000.
    (ii) P immediately completes its liquidation, distributing the cash 
and installment obligations, which otherwise meet the requirements of 
section 453, to A, an individual cash-method taxpayer who is its sole 
shareholder. In 1999, G makes a payment to A of

[[Page 185]]

$100,000 (exclusive of interest) on the $240,000 installment obligation.
    (iii) In the hands of A, the installment obligations issued by B, C, 
and D are qualifying installment obligations because they were timely 
acquired by P in a sale or exchange of its assets. In addition, the 
installment obligation issued by C is a qualifying installment 
obligation because it arose from a sale to one person in one transaction 
of substantially all of the inventory property of the trade or business 
engaged in by the Y division.
    (iv) The installment obligation issued by F is not a qualifying 
installment obligation because it is in respect of a broken lot of 
inventory. A portion of the installment obligation issued by G is a 
qualifying installment obligation and a portion is not a qualifying 
installment obligation, determined as follows: G purchased part of the 
inventory property (with a fair market value of $100,000) and all of the 
other assets of the Z division by paying cash ($60,000), issuing an 
installment obligation ($240,000), and assuming liabilities of the Z 
division ($30,000). The assumed liabilities ($30,000) and cash ($60,000) 
are attributed first to the inventory property. Therefore, only $10,000 
of the $240,000 installment obligation is attributed to inventory 
property. Accordingly, in the hands of A, the G installment obligation 
is a qualifying installment obligation to the extent of $230,000, but is 
not a qualifying installment obligation to the extent of the $10,000 
attributable to the inventory property.
    (v) In the 1998 liquidation of P, A receives a liquidating 
distribution as follows:

------------------------------------------------------------------------
                                                   Qualifying   Cash and
                      Item                        installment    other
                                                  obligations   property
------------------------------------------------------------------------
Cash............................................  ...........   $190,000
B note..........................................    $200,000   .........
C note..........................................    $100,000   .........
D note..........................................    $170,000   .........
F note..........................................  ...........   $100,000
G note \1\......................................    $230,000    $ 10,000
                                                 -----------------------
    Total.......................................    $700,000    $300,000
------------------------------------------------------------------------
\1\ Face amount $240,000.

    (vi) Assume that A's adjusted tax basis in the stock of P is 
$100,000. Under the installment method, A's selling price and the 
contract price are both $1 million, the gross profit is $900,000 
(selling price of $1 million less adjusted tax basis of $100,000), and 
the gross profit ratio is 90 percent (gross profit of $900,000 divided 
by the contract price of $1 million). Accordingly, in 1998, A reports 
gain of $270,000 (90 percent of $300,000 payment in cash and other 
property). A's adjusted tax basis in each of the qualifying installment 
obligations is an amount equal to 10 percent of the obligation's 
respective face amount. A's adjusted tax basis in the F note, a 
nonqualifying installment obligation, is $100,000, i.e., the fair market 
value of the note when received by A. A's adjusted tax basis in the G 
note, a mixed obligation, is $33,000 (10 percent of the $230,000 
qualifying installment obligation portion of the note, plus the $10,000 
nonqualifying portion of the note).
    (vii) With respect to the $100,000 payment received from G in 1999, 
$10,000 is treated as the recovery of the adjusted tax basis of the 
nonqualifying portion of the G installment obligation and $9,000 (10 
percent of $90,000) is treated as the recovery of the adjusted tax basis 
of the portion of the note that is a qualifying installment obligation. 
The remaining $81,000 (90 percent of $90,000) is reported as gain from 
the sale of A's stock. See paragraph (c)(4)(iii) of this section.

    (5) Installment obligations attributable to sales of certain 
property--(i) In general. An installment obligation acquired by a 
liquidating corporation, to the extent attributable to the sale of 
property described in paragraph (c)(5)(ii) of this section, is not a 
qualifying obligation if the corporation is formed or availed of for a 
principal purpose of avoiding section 453(b)(2) (relating to dealer 
dispositions and certain other dispositions of personal property), 
section 453(i) (relating to sales of property subject to recapture), or 
section 453(k) (relating to dispositions under a revolving credit plan 
and sales of stock or securities traded on an established securities 
market) through the use of a party bearing a relationship, either 
directly or indirectly, described in section 267(b) to any shareholder 
of the corporation.
    (ii) Covered property. Property is described in this paragraph 
(c)(5)(ii) if, within 12 months before or after the adoption of the plan 
of liquidation, the property was owned by any shareholder and--
    (A) The shareholder regularly sold or otherwise disposed of personal 
property of the same type on the installment plan or the property is 
real property that the shareholder held for sale to customers in the 
ordinary course of a trade or business (provided the property is not 
described in section 453(l)(2) (relating to certain exceptions to the 
definition of dealer dispositions));
    (B) The sale of the property by the shareholder would result in 
recapture income (within the meaning of section 453(i)(2)), but only if 
the amount of the recapture income is equal to or greater

[[Page 186]]

than 50 percent of the property's fair market value on the date of the 
sale by the corporation;
    (C) The property is stock or securities that are traded on an 
established securities market; or
    (D) The sale of the property by the shareholder would have been 
under a revolving credit plan.
    (iii) Safe harbor. Paragraph (c)(5)(i) of this section will not 
apply to the liquidation of a corporation if, on the date the plan of 
complete liquidation is adopted and thereafter, less than 15 percent of 
the fair market value of the corporation's assets is attributable to 
property described in paragraph (c)(5)(ii) of this section.
    (iv) Example. The provisions of this paragraph (c)(5) are 
illustrated by the following example:

    Example. Ten percent of the fair market value of the assets of T is 
attributable to stock and securities traded on an established securities 
market. T owns no other assets described in paragraph (c)(5)(ii) of this 
section. T, after adopting a plan of complete liquidation, sells all of 
its stock and securities holdings to C corporation in exchange for an 
installment obligation bearing adequate stated interest, sells all of 
its other assets to B corporation for cash, and distributes the cash and 
installment obligation to its sole shareholder, A, in a complete 
liquidation that satisfies section 453(h)(1)(A). Because the C 
installment obligation arose from a sale of publicly traded stock and 
securities, T cannot report the gain on the sale under the installment 
method pursuant to section 453(k)(2). In the hands of A, however, the C 
installment obligation is treated as having arisen out of a sale of the 
stock of T corporation. In addition, the general rule of paragraph 
(c)(5)(i) of this section does not apply, even if a principal purpose of 
the liquidation was the avoidance of section 453(k)(2), because the fair 
market value of the publicly traded stock and securities is less than 15 
percent of the total fair market value of T's assets. Accordingly, 
section 453(k)(2) does not apply to A, and A may use the installment 
method to report the gain recognized on the payments it receives in 
respect of the obligation.

    (d) Liquidating distributions received in more than one taxable 
year. If a qualifying shareholder receives liquidating distributions to 
which this section applies in more than one taxable year, the 
shareholder must reasonably estimate the gain attributable to 
distributions received in each taxable year. In allocating basis to 
calculate the gain for a taxable year, the shareholder must reasonably 
estimate the anticipated aggregate distributions. For this purpose, the 
shareholder must take into account distributions and other relevant 
events or information that the shareholder knows or reasonably could 
know up to the date on which the federal income tax return for that year 
is filed. If the gain for a taxable year is properly taken into account 
on the basis of a reasonable estimate and the exact amount is 
subsequently determined the difference, if any, must be taken into 
account for the taxable year in which the subsequent determination is 
made. However, the shareholder may file an amended return for the 
earlier year in lieu of taking the difference into account for the 
subsequent taxable year.
    (e) Effective date. This section is applicable to distributions of 
qualifying installment obligations made on or after January 28, 1998.

[T.D. 8762, 63 FR 4170, Jan. 28, 1998]



Sec.  1.453-12  Allocation of unrecaptured section 1250 gain reported 
on the installment method.

    (a) General rule. Unrecaptured section 1250 gain, as defined in 
section 1(h)(7), is reported on the installment method if that method 
otherwise applies under section 453 or 453A and the corresponding 
regulations. If gain from an installment sale includes unrecaptured 
section 1250 gain and adjusted net capital gain (as defined in section 
1(h)(4)), the unrecaptured section 1250 gain is taken into account 
before the adjusted net capital gain.
    (b) Installment payments from sales before May 7, 1997. The amount 
of unrecaptured section 1250 gain in an installment payment that is 
properly taken into account after May 6, 1997, from a sale before May 7, 
1997, is determined as if, for all payments properly taken into account 
after the date of sale but before May 7, 1997, unrecaptured section 1250 
gain had been taken into account before adjusted net capital gain.
    (c) Installment payments received after May 6, 1997, and on or 
before August 23, 1999. If the amount of unrecaptured

[[Page 187]]

section 1250 gain in an installment payment that is properly taken into 
account after May 6, 1997, and on or before August 23, 1999, is less 
than the amount that would have been taken into account under this 
section, the lesser amount is used to determine the amount of 
unrecaptured section 1250 gain that remains to be taken into account.
    (d) Examples. In each example, the taxpayer, an individual whose 
taxable year is the calendar year, does not elect out of the installment 
method. The installment obligation bears adequate stated interest, and 
the property sold is real property held in a trade or business that 
qualifies as both section 1231 property and section 1250 property. In 
all taxable years, the taxpayer's marginal tax rate on ordinary income 
is 28 percent. The following examples illustrate the rules of this 
section:

    Example 1. General rule. This example illustrates the rule of 
paragraph (a) of this section as follows:
    (i) In 1999, A sells property for $10,000, to be paid in ten equal 
annual installments beginning on December 1, 1999. A originally 
purchased the property for $5000, held the property for several years, 
and took straight-line depreciation deductions in the amount of $3000. 
In each of the years 1999-2008, A has no other capital or section 1231 
gains or losses.
    (ii) A's adjusted basis at the time of the sale is $2000. Of A's 
$8000 of section 1231 gain on the sale of the property, $3000 is 
attributable to prior straight-line depreciation deductions and is 
unrecaptured section 1250 gain. The gain on each installment payment is 
$800.
    (iii) As illustrated in the table in this paragraph (iii) of this 
Example 1., A takes into account the unrecaptured section 1250 gain 
first. Therefore, the gain on A's first three payments, received in 
1999, 2000, and 2001, is taxed at 25 percent. Of the $800 of gain on the 
fourth payment, received in 2002, $600 is taxed at 25 percent and the 
remaining $200 is taxed at 20 percent. The gain on A's remaining six 
installment payments is taxed at 20 percent. The table is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1999       2000       2001       2002       2003    2004-2008     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Taxed at 25%.......................        800        800        800        600  .........  .........       3000
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    Example 2. Installment payments from sales prior to May 7, 1997. 
This example illustrates the rule of paragraph (b) of this section as 
follows:
    (i) The facts are the same as in Example 1 except that A sold the 
property in 1994, received the first of the ten annual installment 
payments on December 1, 1994, and had no other capital or section 1231 
gains or losses in the years 1994-2003.
    (ii) As in Example 1, of A's $8000 of gain on the sale of the 
property, $3000 was attributable to prior straight-line depreciation 
deductions and is unrecaptured section 1250 gain.
    (iii) As illustrated in the following table, A's first three 
payments, in 1994, 1995, and 1996, were received before May 7, 1997, and 
taxed at 28 percent. Under the rule described in paragraph (b) of this 
section, A determines the allocation of unrecaptured section 1250 gain 
for each installment payment after May 6, 1997, by taking unrecaptured 
section 1250 gain into account first, treating the general rule of 
paragraph (a) of this section as having applied since the time the 
property was sold, in 1994. Consequently, of the $800 of gain on the 
fourth payment, received in 1997, $600 is taxed at 25 percent and the 
remaining $200 is taxed at 20 percent. The gain on A's remaining six 
installment payments is taxed at 20 percent. The table is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1994       1995       1996       1997       1998    1999-2003     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Taxed at 28%.......................        800        800        800  .........  .........  .........       2400
Taxed at 25%.......................  .........  .........  .........        600  .........  .........        600
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------


[[Page 188]]

    Example 3. Effect of section 1231(c) recapture. This example 
illustrates the rule of paragraph (a) of this section when there are 
non-recaptured net section 1231 losses, as defined in section 
1231(c)(2), from prior years as follows:
    (i) The facts are the same as in Example 1, except that in 1999 A 
has non-recaptured net section 1231 losses from the previous four years 
of $1000.
    (ii) As illustrated in the table in paragraph (iv) of this Example 
3, in 1999, all of A's $800 installment gain is recaptured as ordinary 
income under section 1231(c). Under the rule described in paragraph (a) 
of this section, for purposes of determining the amount of unrecaptured 
section 1250 gain remaining to be taken into account, the $800 
recaptured as ordinary income under section 1231(c) is treated as 
reducing unrecaptured section 1250 gain, rather than adjusted net 
capital gain. Therefore, A has $2200 of unrecaptured section 1250 gain 
remaining to be taken into account.
    (iii) In the year 2000, A's installment gain is taxed at two rates. 
First, $200 is recaptured as ordinary income under section 1231(c). 
Second, the remaining $600 of gain on A's year 2000 installment payment 
is taxed at 25 percent. Because the full $800 of gain reduces 
unrecaptured section 1250 gain, A has $1400 of unrecaptured section 1250 
gain remaining to be taken into account.
    (iv) The gain on A's installment payment received in 2001 is taxed 
at 25 percent. Of the $800 of gain on the fourth payment, received in 
2002, $600 is taxed at 25 percent and the remaining $200 is taxed at 20 
percent. The gain on A's remaining six installment payments is taxed at 
20 percent. The table is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1999       2000       2001       2002       2003    2004-2008     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Taxed at ordinary rates under              800        200  .........  .........  .........  .........       1000
 section 1231(c)...................
Taxed at 25%.......................  .........        600        800        600  .........  .........       2000
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Remaining non-recaptured net               200  .........  .........  .........  .........  .........  .........
 section 1231 losses...............
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    Example 4. Effect of a net section 1231 loss. This example 
illustrates the application of paragraph (a) of this section when there 
is a net section 1231 loss as follows:
    (i) The facts are the same as in Example 1 except that A has section 
1231 losses of $1000 in 1999.
    (ii) In 1999, A's section 1231 installment gain of $800 does not 
exceed A's section 1231 losses of $1000. Therefore, A has a net section 
1231 loss of $200. As a result, under section 1231(a) all of A's section 
1231 gains and losses are treated as ordinary gains and losses. As 
illustrated in the following table, A's entire $800 of installment gain 
is ordinary gain. Under the rule described in paragraph (a) of this 
section, for purposes of determining the amount of unrecaptured section 
1250 gain remaining to be taken into account, A's $800 of ordinary 
section 1231 installment gain in 1999 is treated as reducing 
unrecaptured section 1250 gain. Therefore, A has $2200 of unrecaptured 
section 1250 gain remaining to be taken into account.
    (iii) In the year 2000, A has $800 of section 1231 installment gain, 
resulting in a net section 1231 gain of $800. A also has $200 of non-
recaptured net section 1231 losses. The $800 gain is taxed at two rates. 
First, $200 is taxed at ordinary rates under section 1231(c), 
recapturing the $200 net section 1231 loss sustained in 1999. Second, 
the remaining $600 of gain on A's year 2000 installment payment is taxed 
at 25 percent. As in Example 3, the $200 of section 1231(c) gain is 
treated as reducing unrecaptured section 1250 gain, rather than adjusted 
net capital gain. Therefore, A has $1400 of unrecaptured section 1250 
gain remaining to be taken into account.
    (iv) The gain on A's installment payment received in 2001 is taxed 
at 25 percent, reducing the remaining unrecaptured section 1250 gain to 
$600. Of the $800 of gain on the fourth payment, received in 2002, $600 
is taxed at 25 percent and the remaining $200 is taxed at 20 percent. 
The gain on A's remaining six installment payments is taxed at 20 
percent. The table is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Total
                                        1999       2000       2001       2002       2003    2004-2008     gain
----------------------------------------------------------------------------------------------------------------
Installment gain...................        800        800        800        800        800       4000       8000
Ordinary gain under section 1231(a)        800  .........  .........  .........  .........  .........        800
Taxed at ordinary rates under        .........        200  .........  .........  .........  .........        200
 section 1231(c)...................
Taxed at 25%.......................  .........        600        800        600  .........  .........       2000
Taxed at 20%.......................  .........  .........  .........        200        800       4000       5000
Net section 1231 loss..............        200  .........  .........  .........  .........  .........  .........

[[Page 189]]

 
Remaining to be taxed at 25%.......       2200       1400        600  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    (e) Effective date. This section applies to installment payments 
properly taken into account after August 23, 1999.

[T.D. 8836, 64 FR 45875, Aug. 23, 1999]



Sec.  1.453A-0  Table of contents.

    This section lists the paragraphs and subparagraphs contained in 
Sec. Sec.  1.453A-1 through 1.453A-3.

  Sec.  1.453A-1 Installment method of reporting income by dealers in 
                           personal property.

    (a) In general.
    (b) Effect of security.
    (c) Definition of dealer, sale, and sale on the installment plan.
    (d) Installment plans.
    (1) Traditional installment plans.
    (2) Revolving credit plans.
    (e) Installment income of dealers in personal property.
    (1) In general.
    (2) Gross profit and total contract price.
    (3) Carrying changes not included in total contract price.
    (f) Other accounting methods.
    (g) Records.
    (h) Effective date.

  Sec.  1.453A-3 Requirements for adoption of or change to installment 
                 method by dealers in personal property.

    (a) In general.
    (b) Time and manner of electing installment method reporting.
    (1) Time for election.
    (2) Adoption of installation method.
    (3) Change to installment method.
    (4) Deemed elections.
    (c) Consent.
    (d) Cut-off method for amounts previously accrued.
    (e) Effective date.

[T.D. 8270, 54 FR 46376, Nov. 3, 1989, as amended by T.D. 9849, 84 FR 
9235, Mar. 14, 2019]



Sec.  1.453A-1  Installment method of reporting income by dealers 
on personal property.

    (a) In general. A dealer (as defined in paragraph (c)(1) of this 
section) may elect to return the income from the sale of personal 
property on the installment method if such sale is a sale on the 
installment plan (as defined in paragraphs (c)(3) and (d) of this 
section). Under the installment method of accounting, a taxpayer may 
return as income from installment sales in any taxable year that 
proportion of the installment payments actually received in that year 
which the gross profit realized or to be realized when the property is 
paid for bears to the total contract price. For this purpose, gross 
profit means sales less cost of goods sold. See paragraph (d) of this 
section for additional rules relating to the computation of income under 
the installment method of accounting.
    (b) Effect of security. A dealer may adopt (but is not required to 
do so) one of the following four ways of protecting against loss in case 
of default by the purchaser:
    (1) An agreement that title is to remain in the vendor until 
performance of the purchaser's part of the transaction is completed;
    (2) A form of contract in which title is conveyed to the purchaser 
immediately, but subject to a lien for the unpaid portion of the selling 
price;
    (3) A present transfer of title to the purchaser, who at the same 
time executes a reconveyance in the form of a chattel mortgage to the 
vendor; or
    (4) A conveyance to a trustee pending performance of the contract 
and subject to its provisions.
    (c) Definitions of dealer, sale, and sale on the installment plan. 
For purposes of the regulations under section 453A--
    (1) The term ``dealer'' means a person who regularly sells or 
otherwise disposes of personal property on the installment plan;
    (2) The term ``sale'' includes sales and other dispositions; and
    (3) Except as provided in paragraph (d)(2) of this section, the term 
``sale on the installment plan'' means--
    (i) A sale of personal property by the taxpayer under any plan for 
the sale of personal property, which plan, by its terms and conditions, 
contemplates that each sale under the plan will be paid for in two or 
more payments; or

[[Page 190]]

    (ii) A sale of personal property by the taxpayer under any plan for 
the sale of personal property--
    (A) Which plan, by its terms and conditions, contemplates that such 
sale will be paid for in two or more payments; and
    (B) Which sale is in fact paid for in two or more payments.
    (d) Installment plans--(1) Traditional installment plans. A 
traditional installment plan usually has the following characteristics:
    (i) The execution of a separate installment contract for each sale 
or disposition of personal property; and
    (ii) The retention by the dealer of some type of security interest 
in such property.

Normally, a sale under a traditional installment plan meets the 
requirements of paragraph (c)(3)(i) of this section.
    (2) Revolving credit plans. Sales under a revolving credit plan 
(within the meaning of Sec.  1.453A-2(c)(1))--
    (i) Are treated, for taxable years beginning on or before December 
31, 1986, as sales on the installment plan to the extent provided in 
Sec.  1.453A-2, which provides for the application of the requirements 
of paragraph (c)(3)(ii) of this section to sales under revolving credit 
plans; and
    (ii) Are not treated as sales on the installment plan for taxable 
years beginning after December 31, 1986.
    (e) Installment income of dealers in personal property--(1) In 
general. The income from sales on the installment plan of a dealer may 
be ascertained by treating as income that proportion of the total 
payments received in the taxable year from sales on the installment plan 
(such payments being allocated to the year against the sales of which 
they apply) which the gross profit realized or to be realized on the 
total sales on the installment plan made during each year bears to the 
total contract price of all such sales made during that respective year. 
However, if the dealer demonstrates to the satisfaction of the district 
director that income from sales on the installment plan is clearly 
reflected, the income from such sales may be ascertained by treating as 
income that proportion of the total payments received in the taxable 
year from sales on the installment plan (such payments being allocated 
to the year against the sales of which they apply) which either:
    (i) The gross profit realized or to be realized on the total credit 
sales made during each year bears to the total contract price of all 
credit sales during that respective year, or
    (ii) The gross profit realized or to be realized on all sales made 
during each year bears to the total contract price of all sales made 
during that respective year.

A dealer who desires to compute income by the installment method shall 
maintain accounting records in such a manner as to enable an accurate 
computation to be made by such method in accordance with the provisions 
of this section, section 446, and Sec.  1.446-1.
    (2) Gross profit and total contract price. For purposes of paragraph 
(e)(1) of this section, in computing the gross profit realized or to be 
realized on the total sales on the installment plan, there shall be 
included in the total selling price and, thus, in the total contract 
price of all such sales.
    (i) The amount of carrying charges or interest which is determined 
at the time of each sale and is added to the established cash selling 
price of such property and is treated as part of the selling price for 
customer billing purposes, and
    (ii) In the case of sales made in taxable years beginning on or 
after January 1, 1960, the amount of carrying charges or interest 
determined with respect to such sales which are added contemporaneously 
with the sale on the books of account of the seller but are treated as 
periodic service charges for customer billing purposes.

Any change in the amount of the carrying charges or interest in a year 
subsequent to the sale will not affect the computation of the gross 
profit for the year of sale but will be taken into account at the time 
the carrying charges or interest are adjusted. The application of this 
paragraph (e)(2) to carrying charges or interest described in paragraph 
(e)(2)(ii) of this section may be illustrated by the following example:

    Example. X Corporation makes sales on the traditional installment 
plan. The customer's order specifies that the total price consists

[[Page 191]]

of a cash price plus a ``time price differential'' of 1\1/2\ percent per 
month on the outstanding balance in the customer's account, and the 
customer is billed in this manner. On its books and for purposes of 
reporting to stockholders, X Corporation consistently makes the 
following entries each month when it records its sales. A debit entry is 
make to accounts receivable (for the total price) and balancing credit 
entries are made to sales (for the established selling price) and to a 
reserve account for collection expense (for the amount of the time price 
differential). In computing the gross profit realized or to be realized 
on the total sales on the installment plan, the total selling price and, 
thus, the total contract price for purposes of this paragraph (e) would, 
with respect to sales made in taxable years beginning on or after 
January 1, 1960, include the time price differential.

    (3) Carrying charges not included in total contract price. In the 
case of sales by dealers in personal property made during taxable years 
beginning after December 31, 1963, the income from which is returned on 
the installment method, if the carrying charges or interest with respect 
to such sales is not included in the total contract price, payments 
received with respect to such sales shall be treated as applying first 
against such carrying charges or interest.
    (f) Other accounting methods. If the vendor chooses as a matter of 
consistent practice to return the income from installment sales on an 
accrual method (,) such a course is permissible.
    (g) Records. In adopting the installment method of accounting the 
seller must maintain such records as are necessary to clearly reflect 
income in accordance with this section, section 446 and Sec.  1.446-1.
    (h) Effective date. This section applies for taxable years beginning 
after December 31, 1953, and ending after August 16, 1954, but generally 
does not apply to sales made after December 31, 1987, in taxable years 
ending after such date. For sales made after December 31, 1987, sales 
made by a dealer in personal or real property shall not be treated as 
sales on the installment plan. (However, see section 453(l)(2) for 
exceptions to this rule.)

[T.D. 8270, 54 FR 46377, Nov. 3, 1989, as amended by T.D. 9849, 84 FR 
9235, Mar. 14, 2019]



Sec.  1.453A-2  [Reserved]



Sec.  1.453A-3  Requirements for adoption of or change to 
installment method by dealers in personal property.

    (a) In general. A dealer (within the meaning of Sec.  1.453A-
1(c)(1)) may adopt or change to the installment method for a type or 
types of sales on the installment plan (within the meaning of Sec.  
1.453A-1(c)(3) and (d)) in the manner prescribed in this section. This 
section applies only to dealers and only with respect to their sales on 
the installment plan.
    (b) Time and manner of electing installment method reporting--(1) 
Time for election. An election to adopt or change to the installment 
method for a type or types of sales must be made on an income tax return 
for the taxable year of the election, filed on or before the time 
specified (including extensions thereof) for filing such return.
    (2) Adoption of installment method. A taxpayer who adopts the 
installment method for the first taxable year in which sales are made on 
an installment plan of any kind must indicate in the income tax return 
for that taxable year that the installment method of accounting is being 
adopted and specify the type or types of sales included within the 
election. If a taxpayer in the year of the initial election made only 
one type of sale on the installment plan, but during a subsequent 
taxable year makes another type of sale on the installment plan and 
adopts the installment method for that other type of sale, the taxpayer 
must indicate in the income tax return for the subsequent year that an 
election is being made to adopt the installment method of accounting for 
the additional type of sale.
    (3) Change to installment method. A taxpayer who changes to the 
installment method for a particular type or types of sales on the 
installment plan in acordance with this section must, for each type of 
sale on the installment plan for which the installment method is to be 
used, attach a separate statement to the income tax return for the 
taxable year with respect to which the change is made. Each statement 
must show the method of accounting used in computing taxable income 
before the

[[Page 192]]

change and the type of sale on the installment plan for which the 
installment method is being elected.
    (4) Deemed elections. A dealer (including a person who is a dealer 
as a result of the recharacterization of transactions as sales) is 
deemed to have elected the installment method if the dealer treats a 
sale on the installment plan as a transaction other than a sale and 
fails to report the full amount of gain in the year of the sale. For 
example, if a transaction treated by a dealer as a lease is 
recharacterized by the Internal Revenue Service as a sale on the 
installment plan, the dealer will be deemed to have elected the 
installment method assuming the dealer failed to report the full amount 
of gain in the year of the transaction.
    (c) Consent. A dealer may adopt or change to the installment method 
for sales on the installment plan without the consent of the 
Commissioner. However, a dealer may not change from the installment 
method to the accrual method of accounting or to any other method of 
accounting without the consent of the Commissioner.
    (d) Cut-off method for amounts previously accrued. An election to 
change to the installment method for a type of sale applies only with 
respect to sales made on or after the first day of the taxable year of 
change. Thus, payments received in the taxable year of the change, or in 
subsequent years, in respect of an installment obligation which arose in 
a taxable year prior to the taxable year of change are not taken into 
account on the installment method, but rather must be accounted for 
under the taxpayer's method of accounting in use in the prior year.
    (e) Effective date. This section applies to sales by dealers in 
taxable years ending after October 19, 1980, but generally does not 
apply to sales made after December 31, 1987. For sales made after 
December 31, 1987, sales by a dealer in personal or real property shall 
not be treated as sales on the installment plan. (However, see section 
453(l)(2) for certain exceptions to this rule.) For rules relating to 
sales by dealers in taxable years ending before October 20, 1980, see 26 
CFR 1.453-7 and 1.453-8 (rev. as of April 1, 1987).

[T.D. 8269, 54 FR 46375, Nov. 3, 1989]



Sec.  1.454-1  Obligations issued at discount.

    (a) Certain non-interest-bearing obligations issued at discount--(1) 
Election to include increase in income currently. If a taxpayer owns--
    (i) A non-interest-bearing obligation issued at a discount and 
redeemable for fixed amounts increasing at stated intervals (other than 
an obligation issued by a corporation after May 27, 1969, as to which 
ratable inclusion of original issue discount is required under section 
1232(a)(3)), or
    (ii) An obligation of the United States, other than a current income 
obligation, in which he retains his investment in a matured series E 
U.S. savings bond, or
    (iii) A nontransferable obligation (whether or not a current income 
obligation) of the United States for which a series E U.S. savings bond 
was exchanged (whether or not at final maturity) in an exchange upon 
which gain is not recognized because of section 1037(a) (or so much of 
section 1031(b) as relates to section 1037),

and if the increase, if any, in redemption price of such obligation 
described in subdivision (i), (ii), or (iii) of this subparagraph during 
the taxable year (as described in subparagraph (2) of this paragraph) 
does not constitute income for such year under the method of accounting 
used in computing his taxable income, then the taxpayer may, at his 
election, treat the increase as constituting income for the year in 
which such increase occurs. If the election is not made and section 1037 
(or so much of section 1031 as relates to section 1037) does not apply, 
the taxpayer shall treat the increase as constituting income for the 
year in which the obligation is redeemed or disposed of, or finally 
matures, whichever is earlier. Any such election must be made in the 
taxpayer's return and may be made for any taxable year. If an election 
is made with respect to any such obligation described in subdivision 
(i), (ii), or (iii) of this subparagraph, it shall apply also to all 
other obligations of the type described in such subdivisions owned by 
the taxpayer at the beginning of the first taxable year to which the 
election applies, and to those thereafter acquired by him, and shall be 
binding for

[[Page 193]]

the taxable year for which the return is filed and for all subsequent 
taxable years, unless the Commissioner permits the taxpayer to change to 
a different method of reporting income from such obligations. See 
section 446(e) and paragraph (e) of Sec.  1.446-1, relating to 
requirement respecting a change of accounting method. Although the 
election once made is binding upon the taxpayer, it does not apply to a 
transferee of the taxpayer.
    (2) Amount of increase in case of non-interest-bearing obligations. 
In any case in which an election is made under section 454, the amount 
which accrues in any taxable year to which the election applies is 
measured by the actual increase in the redemption price occurring in 
that year. This amount does not accrue ratably between the dates on 
which the redemption price changes. For example, if two dates on which 
the redemption price increases (February 1 and August 1) fall within a 
taxable year and if the redemption price increases in the amount of 50 
cents on each such date, the amount accruing in that year would be $1 
($0.50 on February 1 and $0.50 on August 1). If the taxpayer owns a non-
interest-bearing obligation of the character described in subdivision 
(i), (ii), or (iii) of subparagraph (1) of this paragraph acquired prior 
to the first taxable year to which his election applies, he must also 
include in gross income for such first taxable year (i) the increase in 
the redemption price of such obligation occurring between the date of 
acquisition of the obligation and the first day of such first taxable 
year and (ii), in a case where a series E bond was exchanged for such 
obligation, the increase in the redemption price of such series E bond 
occurring between the date of acquisition of such series E bond and the 
date of the exchange.
    (3) Amount of increase in case of current income obligations. If an 
election is made under section 454 and the taxpayer owns, at the 
beginning of the first taxable year to which the election applies, a 
current income obligation of the character described in subparagraph 
(1)(iii) of this paragraph acquired prior to such taxable year, he must 
also include in gross income for such first taxable year the increase in 
the redemption price of the series E bond which was surrendered to the 
United States in exchange for such current income obligation; the amount 
of the increase is that occurring between the date of acquisition of the 
series E bond and the date of the exchange.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Throughout the calendar year 1954, a taxpayer who uses 
the cash receipts and disbursements method of accounting holds series E 
U.S. savings bonds having a maturity value of $5,000 and a redemption 
value at the beginning of the year 1954 of $4,050 and at the end of the 
year 1954 of $4,150. He purchased the bonds on January 1, 1949, for 
$3,750, and holds no other obligation of the type described in this 
section. If the taxpayer exercises the election in his return for the 
calendar year 1954, he is required to include $400 in taxable income 
with respect to such bonds. Of this amount, $300 represents the increase 
in the redemption price before 1954 and $100 represents the increase in 
the redemption price in 1954. The increases in redemption value 
occurring in subsequent taxable years are includible in gross income for 
such taxable years.
    Example 2. In 1958 B, a taxpayer who uses the cash receipts and 
disbursements method of accounting and the calendar year as his taxable 
year, purchased for $7,500 a series E United States savings bond with a 
face value of $10,000. In 1965, when the stated redemption value of the 
series E bond is $9,760, B surrenders it to the United States in 
exchange solely for a $10,000 series H U.S. current income savings bond 
in an exchange qualifying under section 1037(a), after paying $240 
additional consideration. On the exchange of the series E bond for the 
series H bond in 1965, B realizes a gain of $2,260 ($9,760 less $7,500), 
none of which is recognized for that year by reason of section 1037(a). 
B retains the series H bond and redeems it at maturity in 1975 for 
$10,000, but in 1966 he exercises the election under section 454(a) in 
his return for that year with respect to five series E bonds he 
purchased in 1960. B is required to include in gross income for 1966 the 
increase in redemption price occurring before 1966 and in 1966 with 
respect to the series E bonds purchased in 1960; he is also required to 
include in gross income for 1966 the $2,260 increase in redemption price 
of the series E bond which was exchanged in 1965 for the series H bond.

    (b) Short-term obligations issued on a discount basis. In the case 
of obligations of the United States or any of its possessions, or of a 
State, or Territory, or any political subdivision thereof, or of

[[Page 194]]

the District of Columbia, issued on a discount basis and payable without 
interest at a fixed maturity date not exceeding one year from the date 
of issue, the amount of discount at which such obligation originally 
sold does not accrue until the date on which such obligation is 
redeemed, sold, or otherwise disposed of. This rule applies regardless 
of the method of accounting used by the taxpayer. For examples 
illustrating rules for computation of income from sale or other 
disposition of certain obligations of the type described in this 
paragraph, see section 1221 and the regulations thereunder.
    (c) Matured U.S. savings bonds--(1) Inclusion of increase in income 
upon redemption or final maturity. If a taxpayer (other than a 
corporation) holds--
    (i) A matured series E U.S. savings bond,
    (ii) An obligation of the United States, other than a current income 
obligation, in which he retains his investment in a matured series E 
U.S. savings bond, or
    (iii) A nontransferable obligation (whether or not a current income 
obligation) of the United States for which a series E U.S. savings bond 
was exchanged (whether or not at final maturity) in an exchange upon 
which gain is not recognized because of section 1037(a) (or so much of 
section 1031(b) as relates to section 1037(a)),

the increase in redemption price of the series E bond in excess of the 
amount paid for such series E bond shall be included in the gross income 
of such taxpayer for the taxable year in which the obligation described 
in subdivision (i), (ii), or (iii) of this subparagraph is redeemed or 
disposed of, or finally matures, whichever is earlier, but only to the 
extent such increase has not previously been includible in the gross 
income of such taxpayer or any other taxpayer. If such obligation is 
partially redeemed before final maturity, or partially disposed of by 
being partially reissued to another owner, such increase in redemption 
price shall be included in the gross income of such taxpayer for such 
taxable year on a basis proportional to the total denomination of 
obligations redeemed or disposed of. The provisions of section 454 (c) 
and of this subparagraph shall not apply in the case of any taxable year 
for which the taxpayer's taxable income is computed under an accrual 
method of accounting or for a taxable year for which an election made by 
the taxpayer under section 454(a) and paragraph (a) of this section 
applies. For rules respecting the character of the gain realized upon 
the disposition or redemption of an obligation described in subdivision 
(iii) of this subparagraph, see paragraph (b) of Sec.  1.1037-1.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples, in which it is assumed that the 
taxpayer uses the cash receipts and disbursements method of accounting 
and the calendar year as his taxable year:

    Example 1. On June 1, 1941, A purchased for $375 a series E U.S. 
savings bond which was redeemable at maturity (10 years from issue date) 
for $500. At maturity of the bond, A exercised the option of retaining 
the matured series E bond for the 10-year extended maturity period. On 
June 2, 1961, A redeemed the series E bond, at which time the stated 
redemption value was $674.60. A never elected under section 454(a) to 
include the annual increase in redemption price in gross income 
currently. Under section 454(c), A is required to include $299.60 
($674.60 less $375) in gross income for 1961 by reason of his redemption 
of the bond.
    Example 2. The facts are the same as in Example 2 in paragraph 
(a)(4) of this section. On redemption of the series H bond received in 
the exchange qualifying under section 1037(a), B realizes a gain of 
$2,260, determined as provided in Example 5 in paragraph (b)(4) of Sec.  
1.1037-1. None of this amount is includible in B's gross income for 
1975, such amount having already been includible in his gross income for 
1966 because of his election under section 454(a).
    Example 3. C, who had elected under section 454(a) to include the 
annual increase in the redemption price of his non-interest-bearing 
obligations in gross income currently, owned a $1,000 series E U.S. 
savings bond, which was purchased on October 1, 1949, for $750, C died 
on February 1, 1955, when the redemption value of the bond was $820. The 
bond was immediately reissued to D, his only heir, who has not made an 
election under section 454(a). On January 15, 1960, when the redemption 
value of the bond is $1,000, D surrenders it to the United States in 
exchange solely for a $1,000 series H U.S. savings bond in an exchange 
qualifying under the provisions of section 1037(a). For 1960 D properly 
does not return any income from the exchange of bonds, although he 
returns the interest payments on the series H bond for the taxable

[[Page 195]]

years in which they are received. On September 1, 1964, prior to 
maturity of the series H bond, D redeems it for $1,000. For 1964, D must 
include $180 in gross income under section 454(c) from the redemption of 
the series H bond, that is, the amount of the increase in the redemption 
price of the series E bond ($1,000 less $820) occurring between February 
1, 1955, and January 15, 1960, the period during which he owned the 
series E bond.

[T.D. 6500, 25 FR 11719, Nov. 26, 1960, as amended by T.D. 6935, 32 FR 
15820, Nov. 17, 1967; T.D. 7154, 36 FR 24997, Dec. 28, 1971]



Sec.  1.455-1  Treatment of prepaid subscription income.

    Effective with respect to taxable years beginning after December 31, 
1957, section 455 permits certain taxpayers to elect with respect to a 
trade or business in connection with which prepaid subscription income 
is received, to include such income in gross income for the taxable 
years during which a liability exists to furnish or deliver a newspaper, 
magazine, or other periodical. If a taxpayer does not elect to treat 
prepaid subscription income under the provisions of section 455, such 
income is includible in gross income for the taxable year in which 
received by the taxpayer, unless under the method or practice of 
accounting used in computing taxable income such amount is to be 
properly accounted for as of a different period.

[T.D. 6591, 27 FR 1798, Feb. 27, 1962]



Sec.  1.455-2  Scope of election under section 455.

    (a) If a taxpayer makes an election under section 455 and Sec.  
1.455-6 with respect to a trade or business, all prepaid subscription 
income from such trade or business shall be included in gross income for 
the taxable years during which the liability exists to furnish or 
deliver a newspaper, magazine, or other periodical. Such election shall 
be applicable to all prepaid subscription income received in connection 
with the trade or business for which the election is made; except that 
the taxpayer may further elect to include in gross income for the 
taxable year of receipt (as described in section 455(d)(3) and paragraph 
(c) of Sec.  1.455-5) the entire amount of any prepaid subscription 
income if the liability from which it arose is to end within 12 months 
after the date of receipt, hereinafter sometimes referred to as ``within 
12 months'' election.
    (b) If the taxpayer is engaged in more than one trade or business in 
which a liability is incurred to furnish or deliver a newspaper, 
magazine, or other periodical, a separate election 455 with respect to 
each such trade or business. In addition, a taxpayer may make a separate 
``within 12 months'' election for each separate trade or business for 
which it has made an election under section 455.
    (c) An election made under section 455 shall be binding for the 
first taxable year for which the election is made and for all subsequent 
taxable years, unless the taxpayer secures the consent of the 
Commissioner to the revocation of such election. Thus, in any case where 
the taxpayer has elected a method prescribed by section 455 for the 
inclusion of prepaid subscription income in gross income, such method of 
reporting income may not be changed without the prior approval of the 
Commissioner. In order to secure the Commissioner's consent to the 
revocation of such election, an application must be filed with the 
Commissioner in accordance with section 446(e) and the regulations 
thereunder. For purposes of subtitle A of the Code, the computation of 
taxable income under an election made under section 455 shall be treated 
as a method of accounting. For adjustments required by changes in method 
of accounting, see section 481 and the regulations thereunder.
    (d) An election made under section 455 shall not apply to any 
prepaid subscription income received before the first taxable year to 
which the election applies. For example, Corporation M, which computes 
its taxable income under an accrual method of accounting and files its 
income tax returns on the calendar year basis, publishes a monthly 
magazine and customarily sells subscriptions on a 3-year basis. In 1958 
it received $135,000 of 3-year prepaid subscription income for 
subscriptions beginning during 1958, and in 1959 it received $142,000 of 
prepaid subscription income for subscriptions beginning after December 
31, 1958. In February 1959 it elected, with the consent of the 
Commissioner, to report its prepaid

[[Page 196]]

subscription income under the provisions of section 455 for the year 
1959 and subsequent taxable years. The $135,000 received in 1958 from 
prepaid subscriptions must be included in gross income in full in that 
year, and no part of such 1958 income shall be allocated to the years 
1959, 1960, and 1961 during which M was under a liability to deliver its 
magazine. The $142,000 received in 1959 from prepaid subscriptions shall 
be allocated to the years 1959, 1960, 1961, and 1962.
    (e) No election may be made under section 455 with respect to a 
trade or business if, in computing taxable income, the cash receipts and 
disbursements method of accounting is used with respect to such trade or 
business. However, if the taxpayer is on a ``combination'' method of 
accounting under section 446(c)(4) and the regulations thereunder, it 
may elect the benefits of section 455 if it uses an accrual method of 
accounting for subscription income

[T.D. 6591, 27 FR 1798, Feb. 27, 1962]



Sec.  1.455-3  Method of allocation.

    (a) Prepaid subscription income to which section 455 applies shall 
be included in gross income for the taxable years during which the 
liability to which the income relates is discharged or is deemed to be 
discharged on the basis of the taxpayer's experience.
    (b) For purposes of determining the period or periods over which the 
liability of the taxpayer extends, and for purposes of allocating 
prepaid subscription income to such periods, the taxpayer may aggregate 
similar transactions during the taxable year in any reasonable manner, 
provided the method of aggregation and allocation is consistently 
followed.

[T.D. 6591, 27 FR 1798, Feb. 27, 1962]



Sec.  1.455-4  Cessation of taxpayer's liability.

    (a) If a taxpayer has elected to apply the provisions of section 455 
to a trade or business in connection with which prepaid subscription 
income is received, and if its liability to furnish or deliver a 
newspaper, magazine, or other periodical ends for any reason, then so 
much of the prepaid subscription income attributable to such liability 
as was not includible in its gross income under section 455 for 
preceding taxable years shall be included in its gross income for the 
taxable year in which such liability ends. A taxpayer's liability may 
end, for example, because of the cancellation of a subscription. See 
section 381(c)(4) and the regulations thereunder for the treatment of 
prepaid subscription income in a transaction to which section 381(a) 
applies.
    (b) If a taxpayer who has elected to apply the provisions of section 
455 to a trade or business dies or ceases to exist, then so much of the 
prepaid subscription income attributable to such trade or business which 
was not includible in its gross income under section 455 for preceding 
taxable years shall be included in its gross income for the taxable year 
in which such death or cessation of existence occurs. See section 
381(c)(4) and the regulations thereunder for the treatment of prepaid 
subscription income in a transaction to which section 381(a) applies.

[T.D. 6591, 27 FR 1799, Feb. 27, 1962]



Sec.  1.455-5  Definitions and other rules.

    (a) Prepaid subscription income. (1) The term ``prepaid subscription 
income'' means any amount includible in gross income which is received 
in connection with, and is directly attributable to, a liability of the 
taxpayer which extends beyond the close of the taxable year in which 
such amount is received and which is income from a newspaper, magazine, 
or other periodical. For example where Corporation X, a publisher of 
newspapers, magazines, and other periodicals makes sales on a 
subscription basis and the purchaser pays the subscription price in 
advance, prepaid subscription income would include the amounts actually 
received by X in connection with its liability to furnish or deliver the 
newspaper, magazine, or other periodical.
    (2) For purposes of section 455, prepaid subscription income does 
not include amounts received by a taxpayer in connection with sales of 
subscriptions on a prepaid basis where such taxpayer does not have the 
liability to furnish or deliver a newspaper, magazine, or other 
periodical. The provisions of this subparagraph may be illustrated by 
the following example.

[[Page 197]]

Corporation D has a contract with each of several large publishers which 
grants it the right to sell subscriptions to their periodicals. 
Corporation D collects the subscription price from the subscribers, 
retains a portion thereof as its commission and remits the balance to 
the publishers. The amount retained by Corporation D represents 
commissions on the sale of subscriptions, and is not prepaid 
subscription income for purposes of section 455 since the commissions 
represent compensation for services rendered and are not directly 
attributable to a liability of Corporation D to furnish or deliver a 
newspaper, magazine, or other periodical.
    (b) Liability. The term ``liability'' means a liability of the 
taxpayer to furnish or deliver a newspaper, magazine, or other 
periodical.
    (c) Receipt of prepaid subscription income. For purposes of section 
455, prepaid subscription income shall be treated as received during the 
taxable year for which it is includible in gross income under section 
451, relating to general rule for taxable year of inclusion, without 
regard to section 455.
    (d) Treatment of prepaid subscription income under an established 
accounting method. Notwithstanding the provisions of section 455 and 
Sec.  1.455-1, any taxpayer who, for taxable years beginning before 
January 1, 1958, has reported prepaid subscription income for income tax 
purposes under an established and consistent method or practice of 
deferring such income may continue to report such income in accordance 
with such method or practice for all subsequent taxable years to which 
section 455 applies without making an election under section 455.

[T.D. 6591, 27 FR 1799, Feb. 27, 1962]



Sec.  1.455-6  Time and manner of making election.

    (a) Election without consent. (1) A taxpayer may, without consent, 
elect to treat prepaid subscription income of a trade or business under 
section 455 for the first taxable year--
    (i) Which begins after December 31, 1957, and
    (ii) In which there is received prepaid subscription income from the 
trade or business for which the election is made. Such an election shall 
be made not later than the time prescribed by law for filing the income 
tax return for such year (including extensions thereof), and shall be 
made by means of a statement attached to such return.
    (2) The statement shall indicate that the taxpayer is electing to 
apply the provisions of section 455 to his trade or business, and shall 
contain the following information:
    (i) The name and a description of the taxpayer's trade or business 
to which the election is to apply;
    (ii) The method of accounting used in such trade or business;
    (iii) The total amount of prepaid subscription income from such 
trade or business for the taxable year;
    (iv) The period or periods over which the liability of the taxpayer 
to furnish or deliver a newspaper, magazine, or other periodical 
extends;
    (v) The amount of prepaid subscription income applicable to each 
such period; and
    (vi) A description of the method used in allocating the prepaid 
subscription income to each such period.

In any case in which prepaid subscription income is received from more 
than one trade or business, the statement shall set forth the required 
information with respect to each trade or business subject to the 
election.
    (3) See paragraph (c) of this section for additional information 
required to be submitted with the statement if the taxpayer also elects 
to include in gross income for the taxable year of receipt the entire 
amount of prepaid subscription income attributable to a liability which 
is to end within 12 months after the date of receipt.
    (b) Election with consent. A taxpayer may, with the consent of the 
Commissioner, elect at any time to apply the provisions of section 455 
to any trade or business in which it receives prepaid subscription 
income. The request for such consent shall be in writing, signed by the 
taxpayer or its authorized representative, and shall be addressed to the 
Commissioner of Internal Revenue, Attention: T:R:C, Washington, D.C. 
20224. The request must be filed on or before the later of the following 
dates:

[[Page 198]]

    (1) 90 days after the beginning of the first taxable year to which 
the election is to apply or
    (2) May 28, 1962, and must contain the information described in 
paragraph (a)(2) of this section.

See paragraph (c) of this section for additional information required to 
be submitted with the request if the taxpayer also elects to include in 
gross income for the taxable year of receipt the entire amount of 
prepaid subscription income attributable to a liability which is to end 
within 12 months after the date of receipt.
    (c) ``Within 12 months'' election. (1) A taxpayer who elects to 
apply the provisions of section 455 to any trade or business may also 
elect to include in gross income for the taxable year of receipt (as 
described in section 455(d)(3) and paragraph (c) of Sec.  1.455-5) the 
entire amount of any prepaid subscription income from such trade or 
business if the liability from which it arose is to end within 12 months 
after the date of receipt. Any such election is binding for the first 
taxable year for which it is effective and for all subsequent taxable 
years, unless the taxpayer secures permission from the Commissioner to 
treat such income differently. Application to revoke or change a 
``within 12 months'' election shall be made in accordance with the 
provisions of section 446(e) and the regulations thereunder.
    (2) The ``within 12 months'' election shall be made by including in 
the statement required by paragraph (a) of this section or the request 
described in paragraph (b) of this section, whichever is applicable, a 
declaration that the taxpayer elects to include such income in gross 
income in the taxable year of receipt, and the amount of such income. If 
the taxpayer is engaged in more than one trade or business for which the 
election under section 455 is made, it must include, in such statement 
or request, a declaration for each trade or business for which it makes 
the ``within 12 months'' election. See also paragraph (e) of Sec.  
1.455-2.
    (3) If the taxpayer does not make the ``within 12 months'' election 
for its trade or business at the time prescribed for making the election 
to include prepaid subscription income in gross income for the taxable 
years during which its liability to furnish or deliver a newspaper, 
magazine, or other periodical exists for such trade or business, but 
later wishes to make such election, it must apply for permission from 
the Commissioner. Such application shall be made in accordance with the 
provisions of section 446(e) and the regulations thereunder.

[T.D. 6591, 27 FR 1799, Feb. 27, 1962]



Sec.  1.456-1  Treatment of prepaid dues income.

    Effective for taxable years beginning after December 31, 1960, a 
taxpayer which is a membership organization (as described in paragraph 
(c) of Sec.  1.456-5) and which receives prepaid dues income as 
described in paragraph (a) of Sec.  1.456-5 in connection with its trade 
or business of rendering services or making available membership 
privileges may elect under section 456 to include such income in gross 
income ratably over the taxable years during which its liability (as 
described in paragraph (b) of Sec.  1.456-5) to render such services or 
extend such privileges exists, if such liability does not extend over a 
period of time in excess of 36 months. If the taxpayer does not elect to 
treat prepaid dues income under section 456, or if such income may not 
be reported under section 456, as for example, where the income relates 
to a liability to render services or make available membership 
privileges which extends beyond 36 months, then such income is 
includible in gross income for the taxable year in which it is received 
(as described in paragraph (d) of Sec.  1.456-5).

[T.D. 6937, 32 FR 16394, Nov. 30, 1967]



Sec.  1.456-2  Scope of election under section 456.

    (a) An election made under section 456 and Sec.  1.456-6, shall be 
applicable to all prepaid dues income received in connection with the 
trade or business for which the election is made. However, the taxpayer 
may further elect to include in gross income for the taxable year of 
receipt the entire amount of any prepaid dues income attributable to a 
liability extending beyond the close of the taxable year but ending

[[Page 199]]

within 12 months after the date of receipt, hereinafter referred to as 
the ``within 12 months'' election.
    (b) If the taxpayer is engaged in more than one trade or business in 
connection with which prepaid dues income is received, a separate 
election may be made under section 456 with respect to each such trade 
or business. In addition, a taxpayer may make a separate ``within 12 
months'' election for each separate trade or business for which it has 
made an election under section 456.
    (c) A section 456 election and a ``within 12 months'' election shall 
be binding for the first taxable year for which the election is made and 
for all subsequent taxable years, unless the taxpayer secures the 
consent of the Commissioner to the revocation of either election. In 
order to secure the Commissioner's consent to the revocation of the 
section 456 election or the ``within 12 months'' election, an 
application must be filed with the Commissioner in accordance with 
section 446(e) and the regulations thereunder. However, an application 
for consent to revoke the section 456 election or the ``within 12 
months'' election in the case of all taxable years which end before 
November 30, 1967 must be filed on or before February 28, 1968. For 
purposes of Subtitle A of the Code, the computation of taxable income 
under an election made under section 456 or under the ``within 12 
months'' election shall be treated as a method of accounting. For 
adjustments required by changes in method of accounting, see section 481 
and the regulations thereunder.
    (d) Except as provided in section 456(d) and Sec.  1.456-7, an 
election made under section 456 shall not apply to any prepaid dues 
income received before the first taxable year to which the election 
applies. For example, Corporation X, a membership organization which 
files its income tax returns on a calendar year basis, customarily sells 
3-year memberships, payable in advance. In 1961 it received $160,000 of 
prepaid dues income for 3-year memberships beginning during 1961, and in 
1962 it received $185,000 of prepaid dues income for 3-year memberships 
beginning on January 1, 1962. In March 1962 it elected, with the consent 
of the Commissioner, to report its prepaid dues income under the 
provisions of section 456 for the year 1962 and subsequent taxable 
years. The $160,000 received in 1961 from prepaid dues must be included 
in gross income in full in that year, and except as provided in section 
456(d) and Sec.  1.456-7, no part of such income shall be allocated to 
the taxable years 1962, 1963, and 1964 during which X was under a 
liability to make available its membership privileges. The $185,000 
received in 1962 from prepaid dues income shall be allocated to the 
years 1962, 1963, and 1964.
    (e) No election may be made under section 456 with respect to a 
trade or business if, in computing taxable income, the cash receipts and 
disbursements method (or a hybrid thereof) of accounting is used with 
respect to such trade or business, unless the combination of the section 
456 election and the taxpayer's hybrid method of accounting does not 
result in a material distortion of income.

[T.D. 6937, 32 FR 16394, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]



Sec.  1.456-3  Method of allocation.

    (a) Prepaid dues income for which an election has been made under 
section 456 shall be included in gross income over the period of time 
during which the liability to render services or make available 
membership privileges exists. The liability to render the services or 
make available the membership privileges shall be deemed to exist 
ratably over the period of time such services are required to be 
rendered, or such membership privileges are required to be made 
available. Thus, the prepaid dues income shall be included in gross 
income ratably over the period of the membership contract. For example, 
Corporation X, a membership organization, which files its income tax 
returns on a calendar year basis, elects, for its taxable year beginning 
January 1, 1961, to report its prepaid dues income in accordance with 
the provisions of section 456. On March 31, 1961, it sells a 2-year 
membership for $48 payable in advance, the membership to extend from May 
1, 1961, to April 30, 1963. X shall include in its gross income for the 
taxable year 1961 \8/24\ of the $48, or $16, and for the taxable year 
1962 \12/24\ of the $48, or $24,

[[Page 200]]

and for the taxable year 1963 \4/24\ of the $48, or $8.
    (b) For purposes of determining the period or periods over which the 
liability of the taxpayer exists, and for purposes of allocating prepaid 
dues income to such periods, the taxpayer may aggregate similar 
transactions during the taxable year in any reasonable manner, provided 
the method of aggregation and allocation is consistently followed.

[T.D. 6937, 32 FR 16395, Nov. 30, 1967]



Sec.  1.456-4  Cessation of liability or existence.

    (a) If a taxpayer has elected to apply the provisions of section 456 
to a trade or business in connection with which prepaid dues income is 
received, and if the taxpayer's liability to render services or make 
available membership privileges ends for any reason, as for example, 
because of the cancellation of a membership then so much of the prepaid 
dues income attributable to such liability as was not includible in the 
taxpayer's gross income under section 456 for preceding taxable years 
shall be included in gross income for the taxable year in which such 
liability ends. This paragraph shall not apply to amounts includible in 
gross income under Sec.  1.456-7.
    (b) If a taxpayer which has elected to apply the provisions of 
section 456 ceases to exist, then the prepaid dues income which was not 
includible in gross income under section 456 for preceding taxable years 
shall be included in the taxpayer's gross income for the taxable year in 
which such cessation of existence occurs. This paragraph shall not apply 
to amounts includible in gross income under Sec.  1.456-7.
    (c) If a taxpayer is a party to a transaction to which section 
381(a) applies and the taxpayer's method of accounting with respect to 
prepaid dues income is used by the acquiring corporation under the 
provisions of section 381(c)(4), then neither the liability nor the 
existence of the taxpayer shall be deemed to have ended or ceased. In 
such cases see section 381(c)(4) and the regulations thereunder for the 
treatment of the portion of prepaid dues income which was not included 
in gross income under section 456 for preceding taxable years.

[T.D. 6937, 32 FR 16395, Nov. 30, 1967]



Sec.  1.456-5  Definitions and other rules.

    (a) Prepaid dues income. (1) The term ``prepaid dues income'' means 
any amount for membership dues includible in gross income which is 
received by a membership organization in connection with, and is 
directly attributable to, a liability of the taxpayer to render services 
or make available membership privileges over a period of time which 
extends beyond the close of the taxable year in which such amount is 
received.
    (2) For purposes of section 456, prepaid dues income does not 
include amounts received by a taxpayer in connection with sales of 
memberships on a prepaid basis where the taxpayer does not have the 
liability to furnish the services or make available the membership 
privileges. For example, where a taxpayer has a contract with several 
membership organizations to sell memberships in such organizations and 
retains a portion of the amounts received from the sale of such 
memberships and remits the balance to the membership organizations, the 
amounts retained by such taxpayer represent commissions and do not 
constitute prepaid dues income for purposes of section 456.
    (b) Liability. The term ``liability'' means a liability of the 
taxpayer to render services or make available membership privileges over 
a period of time which does not exceed 36 months. Thus, if during the 
taxable year a taxpayer sells memberships for more than 36 months and 
also memberships for 36 months or less, section 456 does not apply to 
the income from the sale of memberships for more than 36 months. For the 
purpose of determining the duration of a liability, a bona fide renewal 
of a membership shall not be considered to be a part of the existing 
membership.
    (c) Membership organization. (1) The term ``membership 
organization'' means a corporation, association, federation, or other 
similar organization meeting the following requirements:
    (i) It is organized without capital stock of any kind.
    (ii) Its charter, bylaws, or other written agreement or contract 
expressly

[[Page 201]]

prohibits the distribution of any part of the net earnings directly or 
indirectly, in money, property, or services, to any member, and
    (iii) No part of the net earnings of which is in fact distributed to 
any member either directly or indirectly, in money, property, or 
services.
    (2) For purposes of this paragraph an increase in services or 
reduction in dues to all members shall generally not be considered 
distributions of net earnings.
    (3) If a corporation, association, federation, or other similar 
organization subsequent to the time it elects to report its prepaid dues 
income in accordance with the provisions of section 456, (i) issues any 
kind of capital stock either to any member or nonmember, (ii) amends its 
charter, bylaws, or other written agreement or contract to permit 
distributions of its net earnings to any member or, (iii) in fact, 
distributes any part of its net earnings either in money, property, or 
services to any member, then immediately after such event the 
organization shall not be considered a membership organization within 
the meaning of section 456(e)(3).
    (d) Receipt of prepaid dues income. For purposes of section 456, 
prepaid dues income shall be treated as received during the taxable year 
for which it is includible in gross income under section 451, relating 
to the general rule for taxable year of inclusion, without regard to 
section 456.

[T.D. 6937, 32 FR 16395, Nov. 30, 1967]



Sec.  1.456-6  Time and manner of making election.

    (a) Election without consent. A taxpayer may make an election under 
section 456 without the consent of the Commissioner for the first 
taxable year beginning after December 31, 1960, in which it receives 
prepaid dues income in the trade or business for which such election is 
made. The election must be made not later than the time prescribed by 
law for filing the income tax return for such year (including extensions 
thereof). The election must be made by means of a statement attached to 
such return. In addition, there should be attached a copy of a typical 
membership contract used by the organization and a copy of its charter, 
bylaws, or other written agreement or contract of organization or 
association. The statement shall indicate that the taxpayer is electing 
to apply the provisions of section 456 to the trade or business, and 
shall contain the following information:
    (1) The taxpayer's name and a description of the trade or business 
to which the election is to apply.
    (2) The method of accounting used for prepaid dues income in the 
trade or business during the first taxable year for which the election 
is to be effective and during each of 3 preceding taxable years, and if 
there was a change in the method of accounting for prepaid dues income 
during such 3-year period, a detailed explanation of such change 
including the adjustments necessary to prevent duplications or omissions 
of income.
    (3) Whether any type of deferral method for prepaid dues income has 
been used during any of the 3 taxable years preceding the first taxable 
year for which the election is effective. Where any type of such 
deferral method has been used during this period, an explanation of the 
method and a schedule showing the amounts received in each such year and 
the amounts deferred to each succeeding year.
    (4) A schedule with appropriate explanations showing:
    (i) The total amount of prepaid dues income received in the trade or 
business in the first taxable year for which the election is effective 
and the amount of such income to be included in each taxable year in 
accordance with the election,
    (ii) The total amount, if any, of prepayments of dues received in 
the first taxable year for which the election is effective which are 
directly attributable to a liability of the taxpayer to render services 
or make available membership privileges over a period of time in excess 
of 36 months, and
    (iii) The total amount, if any, of prepaid dues income received in 
the trade or business in--
    (a) The taxable year preceding the first taxable year for which the 
election is effective if all memberships sold by the taxpayer are for 
periods of 1 year or less,

[[Page 202]]

    (b) Each of the 2 taxable years preceding the first taxable year for 
which the election is effective if any memberships are sold for periods 
in excess of 1 year but none are sold for periods in excess of 2 years, 
or
    (c) Each of the 3 taxable years preceding the first taxable year for 
which the election is effective if any memberships are sold for periods 
in excess of 2 years.


In each case there shall be set forth the amount of such income which 
would have been includible in each taxable year had the election been 
effective for the years for which the information is required.

In any case in which prepaid dues income is received from more than one 
trade or business, the statement shall set forth separately the required 
information with respect to each trade or business for which the 
election is made. See paragraph (c) of this section for additional 
information required to be submitted with the statement if the taxpayer 
also elects to include in gross income for the taxable year of receipt 
the entire amount of prepaid dues income attributable to a liability 
which is to end within 12 months after the date of receipt.
    (b) Election with consent. A taxpayer may elect with the consent of 
the Commissioner, to apply the provisions of section 456 to any trade or 
business in which it receives prepaid dues income. The request for such 
consent shall be in writing, signed by the taxpayer or its authorized 
representative, and shall be addressed to the Commissioner of Internal 
Revenue, Washington, D.C. 20224. The request must be filed on or before 
the later of the following dates:
    (1) 90 days after the beginning of the first taxable year to which 
the election is to apply, or
    (2) February 28, 1968 and should contain the information described 
in paragraph (a) of this section.

See paragraph (c) of this section for additional information required to 
be submitted with the request if the taxpayer also elects to include in 
gross income for the taxable year of receipt the entire amount of 
prepaid dues income attributable to a liability which is to end within 
12 months after the date of receipt.
    (c) ``Within 12 months'' election. (1) The ``within 12 months'' 
election shall be made by including in the statement required by 
paragraph (a) of this section or the request described in paragraph (b) 
of this section, whichever is applicable, a declaration that the 
taxpayer elects to include such income in gross income in the taxable 
year of receipt, and the amount of such income for each taxable year to 
which the election is to apply which has ended prior to the time such 
statement or request is filed. If the taxpayer is engaged in more than 
one trade or business for which the election under section 456 is made, 
it must include, in such statement or request, a declaration for each 
trade or business for which it wishes to make the ``within 12 months'' 
election.
    (2) If the taxpayer does not make the ``within 12 months'' election 
for a trade or business at the time it makes the election under 
paragraph (a) or (b) of this section, but later wishes to make such 
election, it must apply for permission from the Commissioner. Such 
application shall be made in accordance with the provisions of section 
446(e).

[T.D. 6937, 32 FR 16395, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]



Sec.  1.456-7  Transitional rule.

    (a) Under section 456(d)(1), a taxpayer making an election under 
section 456 shall include in its gross income for the first taxable year 
to which the election applies and for each of the 2 succeeding taxable 
years not only that portion of prepaid dues income which is includible 
in gross income for each such taxable year under section 456(a), but 
also an additional amount equal to that portion of the total prepaid 
dues income received in each of the 3 taxable years preceding the first 
taxable year to which the election applies which would have been 
includible in gross income for such first taxable year and such 2 
succeeding taxable years had the election under section 456 been 
effective during such 3 preceding taxable years. In computing such 
additional amounts--
    (1) In the case of taxpayers who did not include in gross income for 
the taxable year preceding the first taxable

[[Page 203]]

year for which the election is effective, that portion of the prepaid 
dues income received in such year attributable to a liability which is 
to end within 12 months after the date of receipt, no effect shall be 
given to a ``within 12 months'' election made under paragraph (c) of 
Sec.  1.456-6, and
    (2) There shall be taken into account only prepaid dues income 
arising from a trade or business with respect to which an election is 
made under section 456 and Sec.  1.456-6.

Section 481 and the regulations thereunder shall have no application to 
the additional amounts includible in gross income under section 456(d) 
and this section, but section 481 and the regulations thereunder shall 
apply to prevent other amounts from being duplicated or omitted.
    (b) A taxpayer who makes an election with respect to prepaid dues 
income, and who includes in gross income for any taxable year to which 
the election applies an additional amount computed under section 
456(d)(1) and paragraph (a) of this section, shall be permitted under 
section 456(d)(2) to deduct for such taxable year and for each of the 4 
succeeding taxable years an amount equal to one-fifth of such additional 
amount, but only to the extent that such additional amount was also 
included in the taxpayer's gross income for any of the 3 taxable years 
preceding the first taxable year to which such election applies. The 
taxpayer shall maintain books and records in sufficient detail to enable 
the district director to determine upon audit that the additional 
amounts were included in the taxpayer's gross income for any of the 3 
taxable years preceding such first taxable year. If, however, the 
taxpayer ceases to exist, as described in paragraph (b) of Sec.  1.456-
4, and there is included in gross income, under such paragraph, of the 
year of cessation the entire portion of prepaid dues income not 
previously includible in gross income under section 456 for preceding 
taxable years (other than for amounts received prior to the first year 
for which an election was made), all the amounts not previously deducted 
under this paragraph shall be permitted as a deduction in the year of 
cessation of existence.
    (c) The provisions of this section may be illustrated by the 
following example:

    Example. (1) Assume that X Corporation, a membership organization 
qualified to make the election under section 456, elects to report its 
prepaid dues income in accordance with the provisions of section 456 for 
its taxable year ending December 31, 1961. Assume further that X 
Corporation receives in the middle of each taxable year $3,000 of 
prepaid dues income in connection with a liability to render services 
over a 3-year period beginning with the date of receipt. Under section 
456(a), X Corporation will report income received in 1961 and subsequent 
years as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  Total
                        Year of receipt                         receipts    1961      1962      1963      1964      1965      1966      1967      1968
--------------------------------------------------------------------------------------------------------------------------------------------------------
1961..........................................................    $3,000      $500    $1,000    $1,000      $500  ........  ........  ........  ........
1962..........................................................     3,000  ........       500     1,000     1,000      $500  ........  ........  ........
1963..........................................................     3,000  ........  ........       500     1,000     1,000      $500  ........  ........
1964..........................................................     3,000  ........  ........  ........       500     1,000     1,000      $500  ........
1965..........................................................     3,000  ........  ........  ........  ........       500     1,000     1,000      $500
1966..........................................................     3,000  ........  ........  ........  ........  ........       500     1,000     1,000
1967..........................................................     3,000  ........  ........  ........  ........  ........  ........       500     1,000
1968..........................................................     3,000  ........  ........  ........  ........  ........  ........  ........       500
--------------------------------------------------------------------------------------------------------------------------------------------------------
  Total reportable under section 456(a).................................       500     1,500     2,500     3,000     3,000     3,000     3,000     3,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (2) Under section 456(d) (1), X Corporation must include in its 
gross income for the first taxable year to which the election applies 
and for each of the 2 succeeding taxable years, the amounts which would 
have been included in those years had the election been effective 3 
years earlier. If the election had been effective in 1958, the following 
amounts received in 1958, 1959, and 1960 would have been reported in 
1961 and subsequent years:

[[Page 204]]



----------------------------------------------------------------------------------------------------------------
                                                                                 Years of including additional
                                                                    Amount                  amounts
                         Year of receipt                           received  -----------------------------------
                                                                                 1961        1962        1963
----------------------------------------------------------------------------------------------------------------
1958............................................................      $3,000        $500  ..........  ..........
1959............................................................       3,000       1,000        $500  ..........
1960............................................................       3,000       1,000       1,000        $500
----------------------------------------------------------------------------------------------------------------
 Total additional amounts to be included under section 456(d)(1)       2,500       1,500         500
----------------------------------------------------------------------------------------------------------------

    (3) Having included the additional amounts as required by section 
456(d)(1), and assuming such amounts were actually included in gross 
income in the 3 taxable years preceding the first taxable year for which 
the election is effective, X Corporation is entitled to deduct under 
section 456(d)(2) in the year of inclusion and in each of the succeeding 
4 years an amount equal to one-fifth of the amounts included, as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                         Years of deduction
           Year of inclusion              Amount  --------------------------------------------------------------
                                                     1961     1962     1963     1964     1965     1966     1967
----------------------------------------------------------------------------------------------------------------
1961...................................    $2,500     $500     $500     $500     $500     $500  .......  .......
1962...................................     1,500  .......      300      300      300      300     $300  .......
1963...................................       500  .......  .......      100      100      100      100      $10
                                        -----------
  Total amount deductible under section       500      800      900      900      900      400      100
   456(d)(2)...........................
----------------------------------------------------------------------------------------------------------------

    (4) The net result of the inclusions under section 456(d)(1) and the 
deductions under section 456(d)(2) may be summarized as follows:

----------------------------------------------------------------------------------------------------------------
                                            1961     1962     1963     1964     1965     1966     1967     1968
----------------------------------------------------------------------------------------------------------------
Amount includible under section 456(a)..     $500   $1,500   $2,500   $3,000   $3,000   $3,000   $3,000   $3,000
Amount includible under section             2,500    1,500      500  .......  .......  .......  .......  .......
 456(d)(1)..............................
                                         -----------------------------------------------------------------------
   Total................................    3,000    3,000    3,000    3,000    3,000    3,000    3,000    3,000
Amount deductible under section               500      800      900      900      900      400      100  .......
 456(d)(2)..............................
                                         -----------------------------------------------------------------------
   Net amount reportable under section      2,500    2,200    2,100    2,100    2,100    2,600    2,900    3,000
   456..................................
----------------------------------------------------------------------------------------------------------------


[T.D. 6937, 32 FR 16396, Nov. 30, 1967]



Sec.  1.457-1  General overviews of section 457.

    Section 457 provides rules for nonqualified deferred compensation 
plans established by eligible employers as defined under Sec.  1.457-
2(d). Eligible employers can establish either deferred compensation 
plans that are eligible plans and that meet the requirements of section 
457(b) and Sec. Sec.  1.457-3 through 1.457-10, or deferred compensation 
plans or arrangements that do not meet the requirements of section 
457(b) and Sec. Sec.  1.457-3 through 1.457-10 and that are subject to 
tax treatment under section 457(f) and Sec.  1.457-11.

[T.D. 9075, 68 FR 41234, July 11, 2003]



Sec.  1.457-2  Definitions.

    This section sets forth the definitions that are used under 
Sec. Sec.  1.457-1 through 1.457-11.
    (a) Amount(s) deferred. Amount(s) deferred means the total annual 
deferrals under an eligible plan in the current and prior years, 
adjusted for gain or loss. Except as provided at Sec. Sec.  1.457-
4(c)(1)(iii) and 1.457-6(a), amount(s) deferred includes any rollover 
amount held by an eligible plan as provided under Sec.  1.457-10(e).
    (b) Annual deferral(s)--(1) Annual deferral(s) means, with respect 
to a taxable year, the amount of compensation deferred under an eligible 
plan, whether by salary reduction or by nonelective employer 
contribution. The amount of compensation deferred

[[Page 205]]

under an eligible plan is taken into account as an annual deferral in 
the taxable year of the participant in which deferred, or, if later, the 
year in which the amount of compensation deferred is no longer subject 
to a substantial risk of forfeiture.
    (2) If the amount of compensation deferred under the plan during a 
taxable year is not subject to a substantial risk of forfeiture, the 
amount taken into account as an annual deferral is not adjusted to 
reflect gain or loss allocable to the compensation deferred. If, 
however, the amount of compensation deferred under the plan during the 
taxable year is subject to a substantial risk of forfeiture, the amount 
of compensation deferred that is taken into account as an annual 
deferral in the taxable year in which the substantial risk of forfeiture 
lapses must be adjusted to reflect gain or loss allocable to the 
compensation deferred until the substantial risk of forfeiture lapses.
    (3) If the eligible plan is a defined benefit plan within the 
meaning of section 414(j), the annual deferral for a taxable year is the 
present value of the increase during the taxable year of the 
participant's accrued benefit that is not subject to a substantial risk 
of forfeiture (disregarding any such increase attributable to prior 
annual deferrals). For this purpose, present value must be determined 
using actuarial assumptions and methods that are reasonable (both 
individually and in the aggregate), as determined by the Commissioner.
    (4) For purposes solely of applying Sec.  1.457-4 to determine the 
maximum amount of the annual deferral for a participant for a taxable 
year under an eligible plan, the maximum amount is reduced by the amount 
of any deferral for the participant under a plan described at paragraph 
(k)(4)(i) of this section (relating to certain plans in existence before 
January 1, 1987) as if that deferral were an annual deferral under 
another eligible plan of the employer.
    (c) Beneficiary. Beneficiary means a person who is entitled to 
benefits in respect of a participant following the participant's death 
or an alternate payee as described in Sec.  1.457-10(c).
    (d) Catch-up. Catch-up amount or catch-up limitation for a 
participant for a taxable year means the annual deferral permitted under 
section 414(v) (as described in Sec.  1.457-4(c)(2)) or section 
457(b)(3) (as described in Sec.  1.457-4(c)(3)) to the extent the amount 
of the annual deferral for the participant for the taxable year is 
permitted to exceed the plan ceiling applicable under section 457(b)(2) 
(as described in Sec.  1.457-4(c)(1)).
    (e) Eligible employer. Eligible employer means an entity that is a 
State that establishes a plan or a tax-exempt entity that establishes a 
plan. The performance of services as an independent contractor for a 
State or local government or a tax-exempt entity is treated as the 
performance of services for an eligible employer. The term eligible 
employer does not include a church as defined in section 3121(w)(3)(A), 
a qualified church-controlled organization as defined in section 
3121(w)(3)(B), or the Federal government or any agency or 
instrumentality thereof. Thus, for example, a nursing home which is 
associated with a church, but which is not itself a church (as defined 
in section 3121(w)(3)(A)) or a qualified church-controlled organization 
as defined in section 3121(w)(3)(B)), would be an eligible employer if 
it is a tax-exempt entity as defined in paragraph (m) of this section.
    (f) Eligible plan. An eligible plan is a plan that meets the 
requirements of Sec. Sec.  1.457-3 through 1.457-10 that is established 
and maintained by an eligible employer. An eligible governmental plan is 
an eligible plan that is established and maintained by an eligible 
employer as defined in paragraph (l) of this section. An arrangement 
does not fail to constitute a single eligible governmental plan merely 
because the arrangement is funded through more than one trustee, 
custodian, or insurance carrier. An eligible plan of a tax-exempt entity 
is an eligible plan that is established and maintained by an eligible 
employer as defined in paragraph (m) of this section.
    (g) Includible compensation. Includible compensation of a 
participant means, with respect to a taxable year, the participant's 
compensation, as defined in section 415(c)(3), for services performed

[[Page 206]]

for the eligible employer. The amount of includible compensation is 
determined without regard to any community property laws.
    (h) Ineligible plan. Ineligible plan means a plan established and 
maintained by an eligible employer that is not maintained in accordance 
with Sec. Sec.  1.457-3 through 1.457-10. A plan that is not established 
by an eligible employer as defined in paragraph (e) of this section is 
neither an eligible nor an ineligible plan.
    (i) Nonelective employer contribution. A nonelective employer 
contribution is a contribution made by an eligible employer for the 
participant with respect to which the participant does not have the 
choice to receive the contribution in cash or property. Solely for 
purposes of section 457 and Sec. Sec.  1.457-2 through 1.457-11, the 
term nonelective employer contribution includes employer contributions 
that would be described in section 401(m) if they were contributions to 
a qualified plan.
    (j) Participant. Participant in an eligible plan means an individual 
who is currently deferring compensation, or who has previously deferred 
compensation under the plan by salary reduction or by nonelective 
employer contribution and who has not received a distribution of his or 
her entire benefit under the eligible plan. Only individuals who perform 
services for the eligible employer, either as an employee or as an 
independent contractor, may defer compensation under the eligible plan.
    (k) Plan. Plan includes any agreement or arrangement between an 
eligible employer and a participant or participants (including an 
individual employment agreement) under which the payment of compensation 
is deferred (whether by salary reduction or by nonelective employer 
contribution). The following types of plans are not treated as 
agreements or arrangements under which compensation is deferred: a bona 
fide vacation leave, sick leave, compensatory time, severance pay, 
disability pay, or death benefit plan described in section 
457(e)(11)(A)(i) and any plan paying length of service awards to bona 
fide volunteers (and their beneficiaries) on account of qualified 
services performed by such volunteers as described in section 
457(e)(11)(A)(ii). Further, the term plan does not include any of the 
following (and section 457 and Sec. Sec.  1.457-2 through 1.457-11 do 
not apply to any of the following)--
    (1) Any nonelective deferred compensation under which all 
individuals (other than those who have not satisfied any applicable 
initial service requirement) with the same relationship with the 
eligible employer are covered under the same plan with no individual 
variations or options under the plan as described in section 457(e)(12), 
but only to the extent the compensation is attributable to services 
performed as an independent contractor;
    (2) An agreement or arrangement described in Sec.  1.457-11(b);
    (3) Any plan satisfying the conditions in section 1107(c)(4) of the 
Tax Reform Act of 1986 (100 Stat. 2494) (TRA '86) (relating to certain 
plans for State judges); and
    (4) Any of the following plans or arrangements (to which specific 
transitional statutory exclusions apply)--
    (i) A plan or arrangement of a tax-exempt entity in existence prior 
to January 1, 1987, if the conditions of section 1107(c)(3)(B) of the 
TRA '86, as amended by section 1011(e)(6) of the Technical and 
Miscellaneous Revenue Act of 1988 (102 Stat. 3700) (TAMRA), are 
satisfied (see Sec.  1.457-2(b)(4) for a special rule regarding such 
plan);
    (ii) A collectively bargained nonelective deferred compensation plan 
in effect on December 31, 1987, if the conditions of section 6064(d)(2) 
of TAMRA are satisfied;
    (iii) Amounts described in section 6064(d)(3) of TAMRA (relating to 
certain nonelective deferred compensation arrangements in effect before 
1989); and
    (iv) Any plan satisfying the conditions in section 1107(c)(4) or (5) 
of TRA '86 (relating to certain plans for certain individuals with 
respect to which the Service issued guidance before 1977).
    (l) State. State means a State (treating the District of Columbia as 
a State as provided under section 7701(a)(10)), a political subdivision 
of a State, and any agency or instrumentality of a State.
    (m) Tax-exempt entity. Tax-exempt entity includes any organization 
exempt

[[Page 207]]

from tax under subtitle A of the Internal Revenue Code, except that a 
governmental unit (including an international governmental organization) 
is not a tax-exempt entity.
    (n) Trust. Trust means a trust described under section 457(g) and 
Sec.  1.457-8. Custodial accounts and contracts described in section 
401(f) are treated as trusts under the rules described in Sec.  1.457-
8(a)(2).

[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003]



Sec.  1.457-3  General introduction to eligible plans.

    (a) Compliance in form and operation. An eligible plan is a written 
plan established and maintained by an eligible employer that is 
maintained, in both form and operation, in accordance with the 
requirements of Sec. Sec.  1.457-4 through 1.457-10. An eligible plan 
must contain all the material terms and conditions for benefits under 
the plan. An eligible plan may contain certain optional features not 
required for plan eligibility under section 457(b), such as 
distributions for unforeseeable emergencies, loans, plan-to-plan 
transfers, additional deferral elections, acceptance of rollovers to the 
plan, and distributions of smaller accounts to eligible participants. 
However, except as otherwise specifically provided in Sec. Sec.  1.457-4 
through 1.457-10, if an eligible plan contains any optional provisions, 
the optional provisions must meet, in both form and operation, the 
relevant requirements under section 457 and Sec. Sec.  1.457-2 through 
1.457-10.
    (b) Treatment as single plan. In any case in which multiple plans 
are used to avoid or evade the requirements of Sec. Sec.  1.457-4 
through 1.457-10, the Commissioner may apply the rules under Sec. Sec.  
1.457-4 through 1.457-10 as if the plans were a single plan. See also 
Sec.  1.457-4(c)(3)(v) (requiring an eligible employer to have no more 
than one normal retirement age for each participant under all of the 
eligible plans it sponsors), the second sentence of Sec.  1.457-4(e)(2) 
(treating deferrals under all eligible plans under which an individual 
participates by virtue of his or her relationship with a single employer 
as a single plan for purposes of determining excess deferrals), and 
Sec.  1.457-5 (combining annual deferrals under all eligible plans).

[T.D. 9075, 68 FR 41234, July 11, 2003]



Sec.  1.457-4  Annual deferrals, deferral limitations, 
and deferral agreements under eligible plans.

    (a) Taxation of annual deferrals. Annual deferrals that satisfy the 
requirements of paragraphs (b) and (c) of this section are excluded from 
the gross income of a participant in the year deferred or contributed 
and are not includible in gross income until paid to the participant in 
the case of an eligible governmental plan, or until paid or otherwise 
made available to the participant in the case of an eligible plan of a 
tax-exempt entity. See Sec.  1.457-7.
    (b) Agreement for deferral. In order to be an eligible plan, the 
plan must provide that compensation may be deferred for any calendar 
month by salary reduction only if an agreement providing for the 
deferral has been entered into before the first day of the month in 
which the compensation is paid or made available. A new employee may 
defer compensation payable in the calendar month during which the 
participant first becomes an employee if an agreement providing for the 
deferral is entered into on or before the first day on which the 
participant performs services for the eligible employer. An eligible 
plan may provide that if a participant enters into an agreement 
providing for deferral by salary reduction under the plan, the agreement 
will remain in effect until the participant revokes or alters the terms 
of the agreement. Nonelective employer contributions are treated as 
being made under an agreement entered into before the first day of the 
calendar month.
    (c) Maximum deferral limitations--(1) Basic annual limitation. (i) 
Except as described in paragraphs (c)(2) and (3) of this section, in 
order to be an eligible plan, the plan must provide that the annual 
deferral amount for a taxable year (the plan ceiling) may not exceed the 
lesser of--
    (A) The applicable annual dollar amount specified in section 
457(e)(15): $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; 
$14,000 for 2005; and $15,000 for 2006 and thereafter. After 2006, the 
$15,000 amount is adjusted for cost-of-

[[Page 208]]

living in the manner described in paragraph (c)(4) of this section; or
    (B) 100 percent of the participant's includible compensation for the 
taxable year.
    (ii) The amount of annual deferrals permitted by the 100 percent of 
includible compensation limitation under paragraph (c)(1)(i)(B) of this 
section is determined under section 457(e)(5) and Sec.  1.457-2(g).
    (iii) For purposes of determining the plan ceiling under this 
paragraph (c), the annual deferral amount does not include any rollover 
amounts received by the eligible plan under Sec.  1.457-10(e).
    (iv) The provisions of this paragraph (c)(1) are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant A, who earns $14,000 a year, 
enters into a salary reduction agreement in 2006 with A's eligible 
employer and elects to defer $13,000 of A's compensation for that year. 
A is not eligible for the catch-up described in paragraph (c)(2) or (3) 
of this section, participates in no other retirement plan, and has no 
other income exclusions taken into account in computing includible 
compensation.
    (ii) Conclusion. The annual deferral limit for A in 2006 is the 
lesser of $15,000 or 100 percent of includible compensation, $14,000. 
A's annual deferral of $13,000 is permitted under the plan because it is 
not in excess of $14,000 and thus does not exceed 100 percent of A's 
includible compensation.
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
that A's eligible employer provides an immediately vested, matching 
employer contribution under the plan for participants who make salary 
reduction deferrals under A's eligible plan. The matching contribution 
is equal to 100 percent of elective contributions, but not in excess of 
10 percent of compensation (in A's case, $1,400).
    (ii) Conclusion. Participant A's annual deferral exceeds the 
limitations of this paragraph (c)(1). A's maximum deferral limitation in 
2006 is $14,000. A's salary reduction deferral of $13,000 combined with 
A's eligible employer's nonelective employer contribution of $1,400 
exceeds the basic annual limitation of this paragraph (c)(1) because A's 
annual deferrals total $14,400. A has an excess deferral for the taxable 
year of $400, the amount exceeding A's permitted annual deferral 
limitation. The $400 excess deferral is treated as described in 
paragraph (e) of this section.
    Example 3. (i) Facts. Beginning in year 2002, Eligible Employer X 
contributes $3,000 per year for five years to B's eligible plan account. 
B's interest in the account vests in 2006. B has annual compensation of 
$50,000 in each of the five years 2002 through 2006. B is 41 years old. 
B is not eligible for the catch-up described in paragraph (c)(2) or (3) 
of this section, participates in no other retirement plan, and has no 
other income exclusions taken into account in computing includible 
compensation. Adjusted for gain or loss, the value of B's benefit when 
B's interest in the account vests in 2006 is $17,000.
    (ii) Conclusion. Under this vesting schedule, $17,000 is taken into 
account as an annual deferral in 2006. B's annual deferrals under the 
plan are limited to a maximum of $15,000 in 2006. Thus, the aggregate of 
the amounts deferred, $17,000, is in excess of B's maximum deferral 
limitation by $2,000. The $2,000 is treated as an excess deferral 
described in paragraph (e) of this section.

    (2) Age 50 catch-up--(i) In general. In accordance with section 
414(v) and the regulations thereunder, an eligible governmental plan may 
provide for catch-up contributions for a participant who is age 50 by 
the end of the year, provided that such age 50 catch-up contributions do 
not exceed the catch-up limit under section 414(v)(2) for the taxable 
year. The maximum amount of age 50 catch-up contributions for a taxable 
year under section 414(v) is as follows: $1,000 for 2002; $2,000 for 
2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and 
thereafter. After 2006, the $5,000 amount is adjusted for cost-of-
living. For additional guidance, see regulations under section 414(v).
    (ii) Coordination with special section 457 catch-up. In accordance 
with sections 414(v)(6)(C) and 457(e)(18), the age 50 catch-up described 
in this paragraph (c)(2) does not apply for any taxable year for which a 
higher limitation applies under the special section 457 catch-up under 
paragraph (c)(3) of this section. Thus, for purposes of this paragraph 
(c)(2)(ii) and paragraph (c)(3) of this section, the special section 457 
catch-up under paragraph (c)(3) of this section applies for any taxable 
year if and only if the plan ceiling taking into account paragraph 
(c)(1) of this section and the special section 457 catch-up described in 
paragraph (c)(3) of this section (and disregarding the age 50 catch-up 
described in this paragraph (c)(2)) is larger than the plan ceiling 
taking into account paragraph (c)(1) of this section and the age 50 
catch-up described in this paragraph (c)(2) (and disregarding

[[Page 209]]

the special section 457 catch-up described in paragraph (c)(3) of this 
section). Thus, if a plan so provides, a participant who is eligible for 
the age 50 catch-up for a year and for whom the year is also one of the 
participant's last three taxable years ending before the participant 
attains normal retirement age is eligible for the larger of--
    (A) The plan ceiling under paragraph (c)(1) of this section and the 
age 50 catch-up described in this paragraph (c)(2) (and disregarding the 
special section 457 catch-up described in paragraph (c)(3) of this 
section) or
    (B) The plan ceiling under paragraph (c)(1) of this section and the 
special section 457 catch-up described in paragraph (c)(3) of this 
section (and disregarding the age 50 catch-up described in this 
paragraph (c)(2)).
    (iii) Examples. The provisions of this paragraph (c)(2) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant C, who is 55, is eligible to 
participate in an eligible governmental plan in 2006. The plan provides 
a normal retirement age of 65. The plan provides limitations on annual 
deferrals up to the maximum permitted under paragraphs (c)(1) and (3) of 
this section and the age 50 catch-up described in this paragraph (c)(2). 
For 2006, C will receive compensation of $40,000 from the eligible 
employer. C desires to defer the maximum amount possible in 2006. The 
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section 
is $15,000 for 2006 and the additional dollar amount permitted under the 
age 50 catch-up is $5,000 for 2006.
    (ii) Conclusion. C is eligible for the age 50 catch-up in 2006 
because C is 55 in 2006. However, C is not eligible for the special 
section 457 catch-up under paragraph (c)(3) of this section in 2006 
because 2006 is not one of the last three taxable years ending before C 
attains normal retirement age. Accordingly, the maximum that C may defer 
for 2006 is $20,000.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that, in 2006, C will attain age 62. The maximum amount that C can elect 
under the special section 457 catch-up under paragraph (c)(3) of this 
section is $2,000 for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is $20,000. 
This is the sum of the basic plan ceiling under paragraph (c)(1) of this 
section equal to $15,000 and the age 50 catch-up equal to $5,000. The 
special section 457 catch-up under paragraph (c)(3) of this section is 
not applicable since it provides a smaller plan ceiling.
    Example 3. (i) Facts. The facts are the same as in Example 2, except 
that the maximum additional amount that C can elect under the special 
section 457 catch-up under paragraph (c)(3) of this section is $7,000 
for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is $22,000. 
This is the sum of the basic plan ceiling under paragraph (c)(1) of this 
section equal to $15,000, plus the additional special section 457 catch-
up under paragraph (c)(3) of this section equal to $7,000. The 
additional dollar amount permitted under the age 50 catch-up is not 
applicable to C for 2006 because it provides a smaller plan ceiling.

    (3) Special section 457 catch-up--(i) In general. Except as provided 
in paragraph (c)(2)(ii) of this section, an eligible plan may provide 
that, for one or more of the participant's last three taxable years 
ending before the participant attains normal retirement age, the plan 
ceiling is an amount not in excess of the lesser of--
    (A) Twice the dollar amount in effect under paragraph (c)(1)(i)(A) 
of this section; or
    (B) The underutilized limitation determined under paragraph 
(c)(3)(ii) of this section.
    (ii) Underutilized limitation. The underutilized amount determined 
under this paragraph (c)(3)(ii) is the sum of--
    (A) The plan ceiling established under paragraph (c)(1) of this 
section for the taxable year; plus
    (B) The plan ceiling established under paragraph (c)(1) of this 
section (or under section 457(b)(2) for any year before the 
applicability date of this section) for any prior taxable year or years, 
less the amount of annual deferrals under the plan for such prior 
taxable year or years (disregarding any annual deferrals under the plan 
permitted under the age 50 catch-up under paragraph (c)(2) of this 
section).
    (iii) Determining underutilized limitation under paragraph 
(c)(3)(ii)(B) of this section. A prior taxable year is taken into 
account under paragraph (c)(3)(ii)(B) of this section only if it is a 
year beginning after December 31, 1978, in which the participant was 
eligible to participate in the plan, and in which compensation deferred 
(if any) under the plan during the year was subject to a plan ceiling 
established under paragraph (c)(1) of this section. This paragraph 
(c)(3)(iii) is subject to

[[Page 210]]

the special rules in paragraph (c)(3)(iv) of this section.
    (iv) Special rules concerning application of the coordination limit 
for years prior to 2002 for purposes of determining the underutilized 
limitation--(A) General rule. For purposes of determining the 
underutilized limitation for years prior to 2002, participants remain 
subject to the rules in effect prior to the repeal of the coordination 
limitation under section 457(c)(2). Thus, the applicable basic annual 
limitation under paragraph (c)(1) of this section and the special 
section 457 catch-up under this paragraph (c)(3) for years in effect 
prior to 2002 are reduced, for purposes of determining a participant's 
underutilized amount under a plan, by amounts excluded from the 
participant's income for any prior taxable year by reason of a 
nonelective employer contribution, salary reduction or elective 
contribution under any other eligible section 457(b) plan, or a salary 
reduction or elective contribution under any 401(k) qualified cash or 
deferred arrangement, section 402(h)(1)(B) simplified employee pension 
(SARSEP), section 403(b) annuity contract, and section 408(p) simple 
retirement account, or under any plan for which a deduction is allowed 
because of a contribution to an organization described in section 
501(c)(18) (pre-2002 coordination plans). Similarly, in applying the 
section 457(b)(2)(B) limitation for includible compensation for years 
prior to 2002, the limitation is 33\1/3\ percent of the participant's 
compensation includible in gross income.
    (B) Coordination limitation applied to participant. For purposes of 
determining the underutilized limitation for years prior to 2002, the 
coordination limitation applies to pre-2002 coordination plans of all 
employers for whom a participant has performed services, whether or not 
those are plans of the participant's current eligible employer. Thus, 
for purposes of determining the amount excluded from a participant's 
gross income in any prior taxable year under paragraph (c)(3)(ii)(B) of 
this section, the participant's annual deferrals under an eligible plan, 
and salary reduction or elective deferrals under all other pre-2002 
coordination plans, must be determined on an aggregate basis. To the 
extent that the combined deferrals for years prior to 2002 exceeded the 
maximum deferral limitations, the amount is treated as an excess 
deferral under paragraph (e) of this section for those prior years.
    (C) Special rule where no annual deferrals under the eligible plan. 
A participant who, although eligible, did not defer any compensation 
under the eligible plan in any year before 2002 is not subject to the 
coordinated deferral limit, even though the participant may have 
deferred compensation under one of the other pre-2002 coordination 
plans. An individual is treated as not having deferred compensation 
under an eligible plan for a prior taxable year if all annual deferrals 
under the plan are distributed in accordance with paragraph (e) of this 
section. Thus, to the extent that a participant participated solely in 
one or more of the other pre-2002 coordination plans during a prior 
taxable year (and not the eligible plan), the participant is not subject 
to the coordinated limitation for that prior taxable year. However, the 
participant is treated as having deferred an amount in a prior taxable 
year, for purposes of determining the underutilized limitation for that 
prior taxable year under this paragraph (c)(3)(iv)(C), to the extent of 
the participant's aggregate salary reduction contributions and elective 
deferrals under all pre-2002 coordination plans up to the maximum 
deferral limitations in effect under section 457(b) for that prior 
taxable year. To the extent an employer did not offer an eligible plan 
to an individual in a prior given year, no underutilized limitation is 
available to the individual for that prior year, even if the employee 
subsequently becomes eligible to participate in an eligible plan of the 
employer.
    (D) Examples. The provisions of this paragraph (c)(3)(iv) are 
illustrated by the following examples:

    Example 1. (i) Facts. In 2001 and in years prior to 2001, 
Participant D earned $50,000 a year and was eligible to participate in 
both an eligible plan and a section 401(k) plan. However, D had always 
participated only in the section 401(k) plan and had always deferred the 
maximum amount possible. For each year before 2002, the maximum amount 
permitted under section 401(k) exceeded the

[[Page 211]]

limitation of paragraph (c)(3)(i) of this section. In 2002, D is in the 
3-year period prior to D's attainment of the eligible plan's normal 
retirement age of 65, and D now wants to participate in the eligible 
plan and make annual deferrals of up to $30,000 under the plan's special 
section 457 catch-up provisions.
    (ii) Conclusion. Participant D is treated as having no underutilized 
amount under paragraph (c)(3)(ii)(B) of this section for 2002 for 
purposes of the catch-up limitation under section 457(b)(3) and 
paragraph (c)(3) of this section because, in each of the years before 
2002, D has deferred an amount equal to or in excess of the limitation 
of paragraph (c)(3)(i) of this section under all of D's coordinated 
plans.
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
that D only deferred $2,500 per year under the section 401(k) plan for 
one year before 2002.
    (ii) Conclusion. D is treated as having an underutilized amount 
under paragraph (c)(3)(ii)(B) of this section for 2002 for purposes of 
the special section 457 catch-up limitation. This is because D has 
deferred an amount for prior years that is less than the limitation of 
paragraph (c)(1)(i) of this section under all of D's coordinated plans.
    Example 3. (i) Facts. Participant E, who earned $15,000 for 2000, 
entered into a salary reduction agreement in 2000 with E's eligible 
employer and elected to defer $3,000 for that year under E's eligible 
plan. For 2000, E's eligible employer provided an immediately vested, 
matching employer contribution under the plan for participants who make 
salary reduction deferrals under E's eligible plan. The matching 
contribution was equal to 67 percent of elective contributions, but not 
in excess of 10 percent of compensation before salary reduction 
deferrals (in E's case, $1,000). For 2000, E was not eligible for any 
catch-up contribution, participated in no other retirement plan, and had 
no other income exclusions taken into account in computing taxable 
compensation.
    (ii) Conclusion. Participant E's annual deferral equaled the maximum 
limitation of section 457(b) for 2000. E's maximum deferral limitation 
in 2000 was $4,000 because E's includible compensation was $12,000 
($15,000 minus the deferral of $3,000) and the applicable limitation for 
2000 was one third of the individual's includible compensation (one-
third of $12,000 equals $4,000). E's salary reduction deferral of $3,000 
combined with E's eligible employer's matching contribution of $1,000 
equals the limitation of section 457(b) for 2000 because E's annual 
deferrals totaled $4,000. E's underutilized amount for 2000 is zero.

    (v) Normal retirement age--(A) General rule. For purposes of the 
special section 457 catch-up in this paragraph (c)(3), a plan must 
specify the normal retirement age under the plan. A plan may define 
normal retirement age as any age that is on or after the earlier of age 
65 or the age at which participants have the right to retire and 
receive, under the basic defined benefit pension plan of the State or 
tax-exempt entity (or a money purchase pension plan in which the 
participant also participates if the participant is not eligible to 
participate in a defined benefit plan), immediate retirement benefits 
without actuarial or similar reduction because of retirement before some 
later specified age, and that is not later than age 70\1/2\. 
Alternatively, a plan may provide that a participant is allowed to 
designate a normal retirement age within these ages. For purposes of the 
special section 457 catch-up in this paragraph (c)(3), an entity 
sponsoring more than one eligible plan may not permit a participant to 
have more than one normal retirement age under the eligible plans it 
sponsors.
    (B) Special rule for eligible plans of qualified police or 
firefighters. An eligible plan with participants that include qualified 
police or firefighters as defined under section 415(b)(2)(H)(ii)(I) may 
designate a normal retirement age for such qualified police or 
firefighters that is earlier than the earliest normal retirement age 
designated under the general rule of paragraph (c)(3)(i)(A) of this 
section, but in no event may the normal retirement age be earlier than 
age 40. Alternatively, a plan may allow a qualified police or 
firefighter participant to designate a normal retirement age that is 
between age 40 and age 70\1/2\.
    (vi) Examples. The provisions of this paragraph (c)(3) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant F, who will turn 61 on April 1, 
2006, becomes eligible to participate in an eligible plan on January 1, 
2006. The plan provides a normal retirement age of 65. The plan provides 
limitations on annual deferrals up to the maximum permitted under 
paragraphs (c)(1) through (3) of this section. For 2006, F will receive 
compensation of $40,000 from the eligible employer. F desires to defer 
the maximum amount possible in 2006. The applicable basic dollar limit 
of paragraph (c)(1)(i)(A) of this section is $15,000 for 2006 and the 
additional dollar amount permitted under the age 50 catch-up in 
paragraph (c)(2) of this section

[[Page 212]]

for an individual who is at least age 50 is $5,000 for 2006.
    (ii) Conclusion. F is not eligible for the special section 457 
catch-up under paragraph (c)(3) of this section in 2006 because 2006 is 
not one of the last three taxable years ending before F attains normal 
retirement age. Accordingly, the maximum that F may defer for 2006 is 
$20,000. See also paragraph (c)(2)(iii) Example 1 of this section.
    Example 2. (i) Facts. The facts are the same as in Example 1 except 
that, in 2006, F elects to defer only $2,000 under the plan (rather than 
the maximum permitted amount of $20,000). In addition, assume that the 
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section 
continues to be $15,000 for 2007 and the additional dollar amount 
permitted under the age 50 catch-up in paragraph (c)(2) of this section 
for an individual who is at least age 50 continues to be $5,000 for 
2007. In F's taxable year 2007, which is one of the last three taxable 
years ending before F attains the plan's normal retirement age of 65, F 
again receives a salary of $40,000 and elects to defer the maximum 
amount permissible under the plan's catch-up provisions prescribed under 
paragraph (c) of this section.
    (ii) Conclusion. For 2007, which is one of the last three taxable 
years ending before F attains the plan's normal retirement age of 65, 
the applicable limit on deferrals for F is the larger of the amount 
under the special section 457 catch-up or $20,000, which is the basic 
annual limitation ($15,000) and the age 50 catch-up limit of section 
414(v) ($5,000). For 2007, F's special section 457 catch-up amount is 
the lesser of two times the basic annual limitation ($30,000) or the sum 
of the basic annual limitation ($15,000) plus the $13,000 underutilized 
limitation under paragraph (c)(3)(ii) of this section (the $15,000 plan 
ceiling in 2006, minus the $2,000 contributed for F in 2006), or 
$28,000. Thus, the maximum amount that F may defer in 2007 is $28,000.
    Example 3. (i) Facts. The facts are the same as in Examples 1 and 2, 
except that F does not make any contributions to the plan before 2010. 
In addition, assume that the applicable basic dollar limitation of 
paragraph (c)(1)(i)(A) of this section continues to be $15,000 for 2010 
and the additional dollar amount permitted under the age 50 catch-up in 
paragraph (c)(2) of this section for an individual who is at least age 
50 continues to be $5,000 for 2010. In F's taxable year 2010, the year 
in which F attains age 65 (which is the normal retirement age under the 
plan), F desires to defer the maximum amount possible under the plan. 
F's compensation for 2010 is again $40,000.
    (ii) Conclusion. For 2010, the maximum amount that F may defer is 
$20,000. The special section 457 catch-up provisions under paragraph 
(c)(3) of this section are not applicable because 2010 is not a taxable 
year ending before the year in which F attains normal retirement age.

    (4) Cost-of-living adjustment. For years beginning after December 
31, 2006, the $15,000 dollar limitation in paragraph (c)(1)(i)(A) of 
this section will be adjusted to take into account increases in the 
cost-of-living. The adjustment in the dollar limitation is made at the 
same time and in the same manner as under section 415(d) (relating to 
qualified plans under section 401(a)), except that the base period is 
the calendar quarter beginning July 1, 2005 and any increase which is 
not a multiple of $500 will be rounded to the next lowest multiple of 
$500.
    (d) Deferrals after severance from employment, including sick, 
vacation, and back pay under an eligible plan--(1) In general. An 
eligible plan may provide that a participant who has not had a severance 
from employment may elect to defer accumulated sick pay, accumulated 
vacation pay, and back pay under an eligible plan if the requirements of 
section 457(b) are satisfied. For example, the plan must provide, in 
accordance with paragraph (b) of this section, that these amounts may be 
deferred for any calendar month only if an agreement providing for the 
deferral is entered into before the beginning of the month in which the 
amounts would otherwise be paid or made available and the participant is 
an employee on the date the amounts would otherwise be paid or made 
available. For purposes of section 457, compensation that would 
otherwise be paid for a payroll period that begins before severance from 
employment is treated as an amount that would otherwise be paid or made 
available before an employee has a severance from employment. In 
addition, deferrals may be made for former employees with respect to 
compensation described in Sec.  1.415(c)-2(e)(3)(i) (relating to certain 
compensation paid by the later of 2\1/2\ months after severance from 
employment or the end of the limitation year that includes the date of 
severance from employment). For this purpose, the calendar year is 
substituted for the limitation year. In addition, compensation described 
in Sec.  1.415(c)-2(e)(4), (g)(4), or (g)(7) (relating to compensation 
paid to participants who are permanently and

[[Page 213]]

totally disabled or compensation relating to qualified military service 
under section 414(u)), provided those amounts represent compensation 
described in Sec.  1.415(c)-2(e)(3)(i).
    (2) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant G, who is age 62 in year 2007, is 
an employee who participates in an eligible plan providing a normal 
retirement age of 65 and a bona fide sick leave and vacation pay program 
of the eligible employer. Under the terms of G's employer's eligible 
plan and the sick leave and vacation pay program, G is permitted to make 
a one-time election to contribute amounts representing accumulated sick 
pay to the eligible plan. G has a severance from employment on January 
12, 2008, at which time G's accumulated sick and vacation pay that is 
payable on March 15, 2008, totals $12,000. G elects, on February 4, 
2008, to have the $12,000 of accumulated sick and vacation pay 
contributed to the eligible plan.
    (ii) Conclusion. Under the terms of the eligible plan and the sick 
and vacation pay program, G may elect before March 1, 2008, to defer the 
accumulated sick and vacation pay because the agreement providing for 
the deferral is entered into before the beginning of the month in which 
the amount is currently available and the amount is bona fide 
accumulated sick and vacation pay, as described in Sec.  1.415(c)-
2(e)(3)(ii), and that is payable by the later of 2\1/2\ months after 
severance from employment or the end of the calendar year that includes 
the date of severance from employment by G. Thus, under this section and 
Sec.  1.415(c)-2(e)(3)(ii), the $12,000 is included in G's includible 
compensation for purposes of determining G's includible compensation in 
year 2008.
    Example 2. (i) Facts. Same facts as in Example 1, except that G's 
severance from employment is on May 31, 2008, G's $12,000 of accumulated 
sick and vacation pay is payable on September 15, 2008 (which is by the 
later of 2\1/2\ months after severance from employment or the end of the 
calendar year that includes the date of severance from employment by G), 
and G's election to defer the accumulated sick and vacation pay is made 
before May 1, 2008.
    (ii) Conclusion. Under this section and Sec.  1.415(c)-2(e)(3)(ii), 
the $12,000 is included in G's includible compensation for purposes of 
determining G's includible compensation in year 2008.
    Example 3. (i) Facts. Employer X maintains an eligible plan and a 
vacation leave plan. Under the terms of the vacation leave plan, 
employees generally accrue three weeks of vacation per year. Up to one 
week's unused vacation may be carried over from one year to the next, so 
that in any single year an employee may have a maximum of four weeks' 
vacation time. At the beginning of each calendar year, under the terms 
of the eligible plan (which constitutes an agreement providing for the 
deferral), the value of any unused vacation time from the prior year in 
excess of one week is automatically contributed to the eligible plan, to 
the extent of the employee's maximum deferral limitations. Amounts in 
excess of the maximum deferral limitations are forfeited.
    (ii) Conclusion. The value of the unused vacation pay contributed to 
X's eligible plan pursuant to the terms of the plan and the terms of the 
vacation leave plan is treated as an annual deferral to the eligible 
plan for January of the calendar year. No amounts contributed to the 
eligible plan will be considered made available to a participant in X's 
eligible plan.

    (e) Excess deferrals under an eligible plan--(1) In general. Any 
amount deferred under an eligible plan for the taxable year of a 
participant that exceeds the maximum deferral limitations set forth in 
paragraphs (c)(1) through (3) of this section, and any amount that 
exceeds the individual limitation under Sec.  1.457-5, constitutes an 
excess deferral that is taxable in accordance with Sec.  1.457-11 for 
that taxable year. Thus, an excess deferral is includible in gross 
income in the taxable year deferred or, if later, the first taxable year 
in which there is no substantial risk of forfeiture.
    (2) Excess deferrals under an eligible governmental plan other than 
as a result of the individual limitation. In order to be an eligible 
governmental plan, the plan must provide that any excess deferral 
resulting from a failure of a plan to apply the limitations of 
paragraphs (c)(1) through (3) of this section to amounts deferred under 
the eligible plan (computed without regard to the individual limitation 
under Sec.  1.457-5) will be distributed to the participant, with 
allocable net income, as soon as administratively practicable after the 
plan determines that the amount is an excess deferral. For purposes of 
determining whether there is an excess deferral resulting from a failure 
of a plan to apply the limitations of paragraphs (c)(1) through (3) of 
this section, all plans under which an individual participates by virtue 
of his or her relationship with a single employer are treated as a 
single plan (without regard

[[Page 214]]

to any differences in funding). An eligible governmental plan does not 
fail to satisfy the requirements of paragraphs (a) through (d) of this 
section or Sec. Sec.  1.457-6 through 1.457-10 (including the 
distribution rules under Sec.  1.457-6 and the funding rules under Sec.  
1.457-8) solely by reason of a distribution made under this paragraph 
(e)(2). If such excess deferrals are not corrected by distribution under 
this paragraph (e)(2), the plan will be an ineligible plan under which 
benefits are taxable in accordance with Sec.  1.457-11.
    (3) Excess deferrals under an eligible plan of a tax-exempt employer 
other than as a result of the individual limitation. If a plan of a tax-
exempt employer fails to comply with the limitations of paragraphs 
(c)(1) through (3) of this section, the plan will be an ineligible plan 
under which benefits are taxable in accordance with Sec.  1.457-11. 
However, a plan may distribute to a participant any excess deferrals 
(and any income allocable to such amount) not later than the first April 
15 following the close of the taxable year of the excess deferrals. In 
such a case, the plan will continue to be treated as an eligible plan. 
However, any excess deferral is included in the gross income of a 
participant for the taxable year of the excess deferral. If the excess 
deferrals are not corrected by distribution under this paragraph (e)(3), 
the plan is an ineligible plan under which benefits are taxable in 
accordance with Sec.  1.457-11. For purposes of determining whether 
there is an excess deferral resulting from a failure of a plan to apply 
the limitations of paragraphs (c)(1) through (3) of this section, all 
eligible plans under which an individual participates by virtue of his 
or her relationship with a single employer are treated as a single plan.
    (4) Excess deferrals arising from application of the individual 
limitation. An eligible plan may provide that an excess deferral that is 
a result solely of a failure to comply with the individual limitation 
under Sec.  1.457-5 for a taxable year may be distributed to the 
participant, with allocable net income, as soon as administratively 
practicable after the plan determines that the amount is an excess 
deferral. An eligible plan does not fail to satisfy the requirements of 
paragraphs (a) through (d) of this section or Sec. Sec.  1.457-6 through 
1.457-10 (including the distribution rules under Sec.  1.457-6 and the 
funding rules under Sec.  1.457-8) solely by reason of a distribution 
made under this paragraph (e)(4). Although a plan will still maintain 
eligible status if excess deferrals are not distributed under this 
paragraph (e)(4), a participant must include the excess amounts in 
income as provided in paragraph (e)(1) of this section.
    (5) Examples. The provisions of this paragraph (e) are illustrated 
by the following examples:

    Example 1. (i) Facts. In 2006, the eligible plan of State Employer X 
in which Participant H participates permits a maximum deferral of the 
lesser of $15,000 or 100 percent of includible compensation. In 2006, H, 
who has compensation of $28,000, nevertheless defers $16,000 under the 
eligible plan. Participant H is age 45 and normal retirement age under 
the plan is age 65. For 2006, the applicable dollar limit under 
paragraph (c)(1)(i)(A) of this section is $15,000. Employer X discovers 
the error in January of 2007 when it completes H's 2006 Form W-2 and 
promptly distributes $1,022 to H (which is the sum of the $1,000 excess 
and $22 of allocable net income).
    (ii) Conclusion. Participant H has deferred $1,000 in excess of the 
$15,000 limitation provided for under the plan for 2006. The $1,000 
excess must be included by H in H's income for 2006. In order to correct 
the failure and still be an eligible plan, the plan must distribute the 
excess deferral, with allocable net income, as soon as administratively 
practicable after determining that the amount exceeds the plan deferral 
limitations. In this case, $22 of the distribution of $1,022 is included 
in H's gross income for 2007 (and is not an eligible rollover 
distribution). If the excess deferral were not distributed, the plan 
would be an ineligible plan with respect to which benefits are taxable 
in accordance with Sec.  1.457-11.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that X uses a number of separate arrangements with different trustees 
and annuity insurers to permit employees to defer and H elects deferrals 
under several of the funding arrangements none of which exceeds $15,000 
for any individual funding arrangement, but which total $16,000.
    (ii) Conclusion. The conclusion is the same as in Example 1.
    Example 3. (i) Facts. The facts are the same as in Example 1, except 
that H's deferral under the eligible plan is limited to $11,000 and H 
also makes a salary reduction contribution of $5,000 to an annuity 
contract under section 403(b) with the same Employer X.

[[Page 215]]

    (ii) Conclusion. H's deferrals are within the plan deferral 
limitations of Employer X. Because of the repeal of the application of 
the coordination limitation under former paragraph (2) of section 
457(c), H's salary reduction deferrals under the annuity contract are no 
longer considered in determining H's applicable deferral limits under 
paragraphs (c)(1) through (3) of this section.
    Example 4. (i) Facts. The facts are the same as in Example 1, except 
that H's deferral under the eligible governmental plan is limited to 
$14,000 and H also makes a deferral of $4,000 to an eligible 
governmental plan of a different employer. Participant H is age 45 and 
normal retirement age under both eligible plans is age 65.
    (ii) Conclusion. Because of the application of the individual 
limitation under Sec.  1.457-5, H has an excess deferral of $3,000 (the 
sum of $14,000 plus $4,000 equals $18,000, which is $3,000 in excess of 
the dollar limitation of $15,000). The $3,000 excess deferral, with 
allocable net income, may be distributed from either plan as soon as 
administratively practicable after determining that the combined amount 
exceeds the deferral limitations. If the $3,000 excess deferral is not 
distributed to H, each plan will continue to be an eligible plan, but 
the $3,000 must be included by H in H's income for 2006.
    Example 5. (i) Facts. Assume the same facts as in Example 3, except 
that H's deferral under the eligible governmental plan is limited to 
$14,000 and H also makes a deferral of $4,000 to an eligible plan of 
Employer Y, a tax-exempt entity.
    (ii) Conclusion. The results are the same as in Example 3, namely, 
because of the application of the individual limitation under Sec.  
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess 
deferral is not distributed to H, each plan will continue to be an 
eligible plan, but the $3,000 must be included by H in H's income for 
2006.
    Example 6. (i) Facts. Assume the same facts as in Example 5, except 
that X is a tax-exempt entity and thus its plan is an eligible plan of a 
tax-exempt entity.
    (ii) Conclusion. The results are the same as in Example 5, namely, 
because of the application of the individual limitation under Sec.  
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess 
deferral is not distributed to H, each plan will continue to be an 
eligible plan, but the $3,000 must be included by H into H's income for 
2006.

[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003; T.D. 
9319, 72 FR 16930, Apr. 5, 2007]



Sec.  1.457-5  Individual limitation for combined annual deferrals 
under multiple eligible plans

    (a) General rule. The individual limitation under section 457(c) and 
this section equals the basic annual deferral limitation under Sec.  
1.457-4(c)(1)(i)(A), plus either the age 50 catch-up amount under Sec.  
1.457-4(c)(2), or the special section 457 catch-up amount under Sec.  
1.457-4(c)(3), applied by taking into account the combined annual 
deferral for the participant for any taxable year under all eligible 
plans. While an eligible plan may include provisions under which it will 
limit deferrals to meet the individual limitation under section 457(c) 
and this section, annual deferrals by a participant that exceed the 
individual limit under section 457(c) and this section (but do not 
exceed the limits under Sec.  1.457-4(c)) will not cause a plan to lose 
its eligible status. However, to the extent the combined annual 
deferrals for a participant for any taxable year exceed the individual 
limitation under section 457(c) and this section for that year, the 
amounts are treated as excess deferrals as described in Sec.  1.457-
4(e).
    (b) Limitation applied to participant. The individual limitation in 
this section applies to eligible plans of all employers for whom a 
participant has performed services, including both eligible governmental 
plans and eligible plans of a tax-exempt entity and both eligible plans 
of the employer and eligible plans of other employers. Thus, for 
purposes of determining the amount excluded from a participant's gross 
income in any taxable year (including the underutilized limitation under 
Sec.  1.457-4 (c)(3)(ii)(B)), the participant's annual deferral under an 
eligible plan, and the participant's annual deferrals under all other 
eligible plans, must be determined on an aggregate basis. To the extent 
that the combined annual deferral amount exceeds the maximum deferral 
limitation applicable under Sec.  1.457-4 (c)(1)(i)(A), (c)(2), or 
(c)(3), the amount is treated as an excess deferral under Sec.  1.457-
4(e).
    (c) Special rules for catch-up amounts under multiple eligible 
plans. For purposes of applying section 457(c) and this section, the 
special section 457 catch-up under Sec.  1.457-4 (c)(3) is taken into 
account only to the extent that an annual deferral is made for a 
participant under an eligible plan as a result of plan provisions 
permitted under Sec.  1.457-4 (c)(3). In addition, if a participant has

[[Page 216]]

annual deferrals under more than one eligible plan and the applicable 
catch-up amount under Sec.  1.457-4 (c)(2) or (3) is not the same for 
each such eligible plan for the taxable year, section 457(c) and this 
section are applied using the catch-up amount under whichever plan has 
the largest catch-up amount applicable to the participant.
    (d) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant F is age 62 in 2006 and 
participates in two eligible plans during 2006, Plans J and K, which are 
each eligible plans of two different governmental entities. Each plan 
includes provisions allowing the maximum annual deferral permitted under 
Sec.  1.457-4(c)(1) through (3). For 2006, the underutilized amount 
under Sec.  1.457-4 (c)(3)(ii)(B) is $20,000 under Plan J and is $40,000 
under Plan K. Normal retirement age is age 65 under both plans. 
Participant F defers $15,000 under each plan. Participant F's includible 
compensation is in each case in excess of the deferral. Neither plan 
designates the $15,000 contribution as a catch-up permitted under each 
plan's special section 457 catch-up provisions.
    (ii) Conclusion. For purposes of applying this section to 
Participant F for 2006, the maximum exclusion is $20,000. This is equal 
to the sum of $15,000 plus $5,000, which is the age 50 catch-up amount. 
Thus, F has an excess amount of $10,000 which is treated as an excess 
deferral for Participant F for 2006 under Sec.  1.457-4(e).
    Example 2. (i) Facts. Participant E, who will turn 63 on April 1, 
2006, participates in four eligible plans during year 2006: Plan W which 
is an eligible governmental plan; and Plans X, Y, and Z which are each 
eligible plans of three different tax-exempt entities. For year 2006, 
the limitation that applies to Participant E under all four plans under 
Sec.  1.457-4(c)(1)(i)(A) is $15,000. For year 2006, the additional age 
50 catch-up limitation that applies to Participant E under all four 
plans under Sec.  1.457-4(c)(2) is $5,000. Further, for year 2006, 
different limitations under Sec.  1.457-4(c)(3) and (c)(3)(ii)(B) apply 
to Participant E under each of these plans, as follows: under Plan W, 
the underutilized limitation under Sec.  1.457-4(c)(3)(ii)(B) is $7,000; 
under Plan X, the underutilized limitation under Sec.  1.457-
4(c)(3)(ii)(B) is $2,000; under Plan Y, the underutilized limitation 
under Sec.  1.457-4(c)(3)(ii)(B) is $8,000; and under Plan Z, Sec.  
1.457-4(c)(3) is not applicable since normal retirement age is 62 under 
Plan Z. Participant E's includible compensation is in each case in 
excess of any applicable deferral.
    (ii) Conclusion. For purposes of applying this section to 
Participant E for year 2006, Participant E could elect to defer $23,000 
under Plan Y, which is the maximum deferral limitation under Sec.  
1.457-4(c)(1) through (3), and to defer no amount under Plans W, X, and 
Z. The $23,000 maximum amount is equal to the sum of $15,000 plus 
$8,000, which is the catch-up amount applicable to Participant E under 
Plan Y and which is the largest catch-up amount applicable to 
Participant E under any of the four plans for year 2006. Alternatively, 
Participant E could instead elect to defer the following combination of 
amounts: An aggregate total of $15,000 to Plans X, Y, and Z, if no 
contribution is made to Plan W; an aggregate total of $20,000 to any of 
the four plans, assuming at least $5,000 is contributed to Plan W; or 
$22,000 to Plan W and none to any of the other three plans.
    (iii) If the underutilized amount under Plans W, X, and Y for year 
2006 were in each case zero (because E had always contributed the 
maximum amount or E was a new participant) or an amount not in excess of 
$5,000, the maximum exclusion under this section would be $20,000 for 
Participant E for year 2006 ($15,000 plus the $5,000 age 50 catch-up 
amount), which Participant E could contribute to any of the plans 
assuming at least $5,000 is contributed to Plan W.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 26, 2003; T.D. 
9319, 72 FR 16930, Apr. 5, 2007; 72 FR 28854, May 23, 2007]



Sec.  1.457-6  Timing of distributions under eligible plans.

    (a) In general. Except as provided in paragraph (c) of this section 
(relating to distributions on account of an unforeseeable emergency), 
paragraph (e) of this section (relating to distributions of small 
accounts), Sec.  1.457-10(a) (relating to plan terminations), or Sec.  
1.457-10(c) (relating to domestic relations orders), amounts deferred 
under an eligible plan may not be paid to a participant or beneficiary 
before the participant has a severance from employment with the eligible 
employer or when the participant attains age 70\1/2\, if earlier. For 
rules relating to loans, see paragraph (f) of this section. This section 
does not apply to distributions of excess amounts under Sec.  1.457-
4(e). However, except to the extent set forth by the Commissioner in 
revenue rulings, notices, and other guidance published in the Internal 
Revenue Bulletin (see Sec.  601.601(d) of this chapter), this section 
applies to amounts held in a separate account for eligible rollover 
distributions maintained by an eligible

[[Page 217]]

governmental plan as described in Sec.  1.457-10(e)(2).
    (b) Severance from employment--(1) Employees. An employee has a 
severance from employment with the eligible employer if the employee 
dies, retires, or otherwise has a severance from employment with the 
eligible employer. See regulations under section 401(k) for additional 
guidance concerning severance from employment.
    (2) Independent contractors--(i) In general. An independent 
contractor is considered to have a severance from employment with the 
eligible employer upon the expiration of the contract (or in the case of 
more than one contract, all contracts) under which services are 
performed for the eligible employer if the expiration constitutes a 
good-faith and complete termination of the contractual relationship. An 
expiration does not constitute a good faith and complete termination of 
the contractual relationship if the eligible employer anticipates a 
renewal of a contractual relationship or the independent contractor 
becoming an employee. For this purpose, an eligible employer is 
considered to anticipate the renewal of the contractual relationship 
with an independent contractor if it intends to contract again for the 
services provided under the expired contract, and neither the eligible 
employer nor the independent contractor has eliminated the independent 
contractor as a possible provider of services under any such new 
contract. Further, an eligible employer is considered to intend to 
contract again for the services provided under an expired contract if 
the eligible employer's doing so is conditioned only upon incurring a 
need for the services, the availability of funds, or both.
    (ii) Special rule. Notwithstanding paragraph (b)(2)(i) of this 
section, the plan is considered to satisfy the requirement described in 
paragraph (a) of this section that no amounts deferred under the plan be 
paid or made available to the participant before the participant has a 
severance from employment with the eligible employer if, with respect to 
amounts payable to a participant who is an independent contractor, an 
eligible plan provides that--
    (A) No amount will be paid to the participant before a date at least 
12 months after the day on which the contract expires under which 
services are performed for the eligible employer (or, in the case of 
more than one contract, all such contracts expire); and
    (B) No amount payable to the participant on that date will be paid 
to the participant if, after the expiration of the contract (or 
contracts) and before that date, the participant performs services for 
the eligible employer as an independent contractor or an employee.
    (c) Rules applicable to distributions for unforeseeable 
emergencies--(1) In general. An eligible plan may permit a distribution 
to a participant or beneficiary for an unforeseeable emergency. The 
distribution must satisfy the requirements of paragraph (c)(2) of this 
section.
    (2) Requirements--(i) Unforeseeable emergency defined. An 
unforeseeable emergency must be defined in the plan as a severe 
financial hardship of the participant or beneficiary resulting from an 
illness or accident of the participant or beneficiary, the participant's 
or beneficiary's spouse, or the participant's or beneficiary's dependent 
(as defined in section 152, and, for taxable years beginning on or after 
January 1, 2005, without regard to section 152(b)(1), (b)(2), and 
(d)(1)(B)); loss of the participant's or beneficiary's property due to 
casualty (including the need to rebuild a home following damage to a 
home not otherwise covered by homeowner's insurance, such as damage that 
is the result of a natural disaster); or other similar extraordinary and 
unforeseeable circumstances arising as a result of events beyond the 
control of the participant or the beneficiary. For example, the imminent 
foreclosure of or eviction from the participant's or beneficiary's 
primary residence may constitute an unforeseeable emergency. In 
addition, the need to pay for medical expenses, including non-refundable 
deductibles, as well as for the cost of prescription drug medication, 
may constitute an unforeseeable emergency. Finally, the need to pay for 
the funeral expenses of a spouse or a dependent (as defined in section 
152, and, for taxable years beginning on

[[Page 218]]

or after January 1, 2005, without regard to section 152(b)(1), (b)(2), 
and (d)(1)(B)) of a participant or beneficiary may also constitute an 
unforeseeable emergency. Except as otherwise specifically provided in 
this paragraph (c)(2)(i), the purchase of a home and the payment of 
college tuition are not unforeseeable emergencies under this paragraph 
(c)(2)(i).
    (ii) Unforeseeable emergency distribution standard. Whether a 
participant or beneficiary is faced with an unforeseeable emergency 
permitting a distribution under this paragraph (c) is to be determined 
based on the relevant facts and circumstances of each case, but, in any 
case, a distribution on account of unforeseeable emergency may not be 
made to the extent that such emergency is or may be relieved through 
reimbursement or compensation from insurance or otherwise, by 
liquidation of the participant's assets, to the extent the liquidation 
of such assets would not itself cause severe financial hardship, or by 
cessation of deferrals under the plan.
    (iii) Distribution necessary to satisfy emergency need. 
Distributions because of an unforeseeable emergency must be limited to 
the amount reasonably necessary to satisfy the emergency need (which may 
include any amounts necessary to pay for any federal, state, or local 
income taxes or penalties reasonably anticipated to result from the 
distribution).
    (d) Minimum required distributions for eligible plans. In order to 
be an eligible plan, a plan must meet the distribution requirements of 
section 457(d)(1) and (2). Under section 457(d)(2), a plan must meet the 
minimum distribution requirements of section 401(a)(9). See section 
401(a)(9) and the regulations thereunder for these requirements. Section 
401(a)(9) requires that a plan begin lifetime distributions to a 
participant no later than April 1 of the calendar year following the 
later of the calendar year in which the participant attains age 70\1/2\ 
or the calendar year in which the participant retires.
    (e) Distributions of smaller accounts--(1) In general. An eligible 
plan may provide for a distribution of all or a portion of a 
participant's benefit if this paragraph (e)(1) is satisfied. This 
paragraph (e)(1) is satisfied if the participant's total amount deferred 
(the participant's total account balance) which is not attributable to 
rollover contributions (as defined in section 411(a)(11)(D)) is not in 
excess of the dollar limit under section 411(a)(11)(A), no amount has 
been deferred under the plan by or for the participant during the two-
year period ending on the date of the distribution, and there has been 
no prior distribution under the plan to the participant under this 
paragraph (e). An eligible plan is not required to permit distributions 
under this paragraph (e).
    (2) Alternative provisions possible. Consistent with the provisions 
of paragraph (e)(1) of this section, a plan may provide that the total 
amount deferred for a participant or beneficiary will be distributed 
automatically to the participant or beneficiary if the requirements of 
paragraph (e)(1) of this section are met. Alternatively, if the 
requirements of paragraph (e)(1) of this section are met, the plan may 
provide for the total amount deferred for a participant or beneficiary 
to be distributed to the participant or beneficiary only if the 
participant or beneficiary so elects. The plan is permitted to 
substitute a specified dollar amount that is less than the total amount 
deferred. In addition, these two alternatives can be combined; for 
example, a plan could provide for automatic distributions for up to 
$500, but allow a participant or beneficiary to elect a distribution if 
the total account balance is above $500.
    (f) Loans from eligible plans--(1) Eligible plans of tax-exempt 
entities. If a participant or beneficiary receives (directly or 
indirectly) any amount deferred as a loan from an eligible plan of a 
tax-exempt entity, that amount will be treated as having been paid or 
made available to the individual as a distribution under the plan, in 
violation of the distribution requirements of section 457(d).
    (2) Eligible governmental plans. The determination of whether the 
availability of a loan, the making of a loan, or a failure to repay a 
loan made from a trustee (or a person treated as a trustee under section 
457(g)) of an eligible governmental plan to a participant or beneficiary 
is treated as a distribution

[[Page 219]]

(directly or indirectly) for purposes of this section, and the 
determination of whether the availability of the loan, the making of the 
loan, or a failure to repay the loan is in any other respect a violation 
of the requirements of section 457(b) and the regulations, depends on 
the facts and circumstances. Among the facts and circumstances are 
whether the loan has a fixed repayment schedule and bears a reasonable 
rate of interest, and whether there are repayment safeguards to which a 
prudent lender would adhere. Thus, for example, a loan must bear a 
reasonable rate of interest in order to satisfy the exclusive benefit 
requirement of section 457(g)(1) and Sec.  1.457-8(a)(1). See also Sec.  
1.457-7(b)(3) relating to the application of section 72(p) with respect 
to the taxation of a loan made under an eligible governmental plan, and 
Sec.  1.72(p)-1 relating to section 72(p)(2).
    (3) Example. The provisions of paragraph (f)(2) of this section are 
illustrated by the following example:

    Example. (i) Facts. Eligible Plan X of State Y is funded through 
Trust Z. Plan X permits an employee's account balance under Plan X to be 
paid in a single sum at severance from employment with State Y. Plan X 
includes a loan program under which any active employee with a vested 
account balance may receive a loan from Trust Z. Loans are made pursuant 
to plan provisions regarding loans that are set forth in the plan under 
which loans bear a reasonable rate of interest and are secured by the 
employee's account balance. In order to avoid taxation under Sec.  
1.457-7(b)(3) and section 72(p)(1), the plan provisions limit the amount 
of loans and require loans to be repaid in level installments as 
required under section 72(p)(2). Participant J's vested account balance 
under Plan X is $50,000. J receives a loan from Trust Z in the amount of 
$5,000 on December 1, 2003, to be repaid in level installments made 
quarterly over the 5-year period ending on November 30, 2008. 
Participant J makes the required repayments until J has a severance from 
employment from State Y in 2005 and subsequently fails to repay the 
outstanding loan balance of $2,250. The $2,250 loan balance is offset 
against J's $80,000 account balance benefit under Plan X, and J elects 
to be paid the remaining $77,750 in 2005.
    (ii) Conclusion. The making of the loan to J will not be treated as 
a violation of the requirements of section 457(b) or the regulations. 
The cancellation of the loan at severance from employment does not cause 
Plan X to fail to satisfy the requirements for plan eligibility under 
section 457. In addition, because the loan satisfies the maximum amount 
and repayment requirements of section 72(p)(2), J is not required to 
include any amount in income as a result of the loan until 2005, when J 
has income of $2,250 as a result of the offset (which is a permissible 
distribution under this section) and income of $77,750 as a result of 
the distribution made in 2005.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 27, 2003; T.D. 
9319, 72 FR 16930, Apr. 5, 2007]



Sec.  1.457-7  Taxation of Distributions Under Eligible Plans.

    (a) General rules for when amounts are included in gross income. The 
rules for determining when an amount deferred under an eligible plan is 
includible in the gross income of a participant or beneficiary depend on 
whether the plan is an eligible governmental plan or an eligible plan of 
a tax-exempt entity. Paragraph (b) of this section sets forth the rules 
for an eligible governmental plan. Paragraph (c) of this section sets 
forth the rules for an eligible plan of a tax-exempt entity.
    (b) Amounts included in gross income under an eligible governmental 
plan--(1) Amounts included in gross income in year paid under an 
eligible governmental plan. Except as provided in paragraphs (b)(2) and 
(3) of this section (or in Sec.  1.457-10(c) relating to payments to a 
spouse or former spouse pursuant to a qualified domestic relations 
order), amounts deferred under an eligible governmental plan are 
includible in the gross income of a participant or beneficiary for the 
taxable year in which paid to the participant or beneficiary under the 
plan.
    (2) Rollovers to individual retirement arrangements and other 
eligible retirement plans. A trustee-to-trustee transfer in accordance 
with section 401(a)(31) (generally referred to as a direct rollover) 
from an eligible government plan is not includible in gross income of a 
participant or beneficiary in the year transferred. In addition, any 
payment made from an eligible government plan in the form of an eligible 
rollover distribution (as defined in section 402(c)(4)) is not 
includible in gross income in the year paid to the extent the payment is 
transferred to an eligible retirement plan (as defined in section 
402(c)(8)(B)) within 60 days, including the transfer to the eligible 
retirement

[[Page 220]]

plan of any property distributed from the eligible governmental plan. 
For this purpose, the rules of section 402(c)(2) through (7) and (9) 
apply. Any trustee-to-trustee transfer under this paragraph (b)(2) from 
an eligible government plan is a distribution that is subject to the 
distribution requirements of Sec.  1.457-6.
    (3) Amounts taxable under section 72(p)(1). In accordance with 
section 72(p), the amount of any loan from an eligible governmental plan 
to a participant or beneficiary (including any pledge or assignment 
treated as a loan under section 72(p)(1)(B)) is treated as having been 
received as a distribution from the plan under section 72(p)(1), except 
to the extent set forth in section 72(p)(2) (relating to loans that do 
not exceed a maximum amount and that are repayable in accordance with 
certain terms) and Sec.  1.72(p)-1. Thus, except to the extent a loan 
satisfies section 72(p)(2), any amount loaned from an eligible 
governmental plan to a participant or beneficiary (including any pledge 
or assignment treated as a loan under section 72(p)(1)(B)) is includible 
in the gross income of the participant or beneficiary for the taxable 
year in which the loan is made. See generally Sec.  1.72(p)-1.
    (4) Examples. The provisions of this paragraph (b) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan G of a governmental entity 
permits distribution of benefits in a single sum or in installments of 
up to 20 years, with such benefits to commence at any date that is after 
severance from employment (up to the later of severance from employment 
or the plan's normal retirement age of 65). Effective for participants 
who have a severance from employment after December 31, 2001, Plan X 
allows an election--as to both the date on which payments are to begin 
and the form in which payments are to be made--to be made by the 
participant at any time that is before the commencement date selected. 
However, Plan X chooses to require elections to be filed at least 30 
days before the commencement date selected in order for Plan X to have 
enough time to be able to effectuate the election.
    (ii) Conclusion. No amounts are included in gross income before 
actual payments begin. If installment payments begin (and the 
installment payments are payable over at least 10 years so as not to be 
eligible rollover distributions), the amount included in gross income 
for any year is equal to the amount of the installment payment paid 
during the year.
    Example 2. (i) Facts. Same facts as in Example 1, except that the 
same rules are extended to participants who had a severance from 
employment before January 1, 2002.
    (ii) Conclusion. For all participants (that is, both those who have 
a severance from employment after December 31, 2001, and those who have 
a severance from employment before January 1, 2002, including those 
whose benefit payments have commenced before January 1, 2002), no 
amounts are included in gross income before actual payments begin. If 
installment payments begin (and the installment payments are payable 
over at least 10 years so as not to be eligible rollover distributions), 
the amount included in gross income for any year is equal to the amount 
of the installment payment paid during the year.

    (c) Amounts included in gross income under an eligible plan of a 
tax-exempt entity--(1) Amounts included in gross income in year paid or 
made available under an eligible plan of a tax-exempt entity. Amounts 
deferred under an eligible plan of a tax-exempt entity are includible in 
the gross income of a participant or beneficiary for the taxable year in 
which paid or otherwise made available to the participant or beneficiary 
under the plan. Thus, amounts deferred under an eligible plan of a tax-
exempt entity are includible in the gross income of the participant or 
beneficiary in the year the amounts are first made available under the 
terms of the plan, even if the plan has not distributed the amounts 
deferred. Amounts deferred under an eligible plan of a tax-exempt entity 
are not considered made available to the participant or beneficiary 
solely because the participant or beneficiary is permitted to choose 
among various investments under the plan.
    (2) When amounts deferred are considered to be made available under 
an eligible plan of a tax-exempt entity--(i) General rule. Except as 
provided in paragraphs (c)(2)(ii) through (iv) of this section, amounts 
deferred under an eligible plan of a tax-exempt entity are considered 
made available (and, thus, are includible in the gross income of the 
participant or beneficiary under this paragraph (c)) at the earliest 
date, on or after severance from employment, on which the plan allows 
distributions to commence, but in no event later than the date on which 
distributions

[[Page 221]]

must commence pursuant to section 401(a)(9). For example, in the case of 
a plan that permits distribution to commence on the date that is 60 days 
after the close of the plan year in which the participant has a 
severance from employment with the eligible employer, amounts deferred 
are considered to be made available on that date. However, distributions 
deferred in accordance with paragraphs (c)(2)(ii) through (iv) of this 
section are not considered made available prior to the applicable date 
under paragraphs (c)(2)(ii) through (iv) of this section. In addition, 
no portion of a participant or beneficiary's account is treated as made 
available (and thus currently includible in income) under an eligible 
plan of a tax-exempt entity merely because the participant or 
beneficiary under the plan may elect to receive a distribution in any of 
the following circumstances:
    (A) A distribution in the event of an unforeseeable emergency to the 
extent the distribution is permitted under Sec.  1.457-6(c).
    (B) A distribution from an account for which the total amount 
deferred is not in excess of the dollar limit under section 
411(a)(11)(A) to the extent the distribution is permitted under Sec.  
1.457-6(e).
    (ii) Initial election to defer commencement of distributions--(A) In 
general. An eligible plan of a tax-exempt entity may provide a period 
for making an initial election during which the participant or 
beneficiary may elect, in accordance with the terms of the plan, to 
defer the payment of some or all of the amounts deferred to a fixed or 
determinable future time. The period for making this initial election 
must expire prior to the first time that any such amounts would be 
considered made available under the plan under paragraph (c)(2)(i) of 
this section.
    (B) Failure to make initial election to defer commencement of 
distributions. Generally, if no initial election is made by a 
participant or beneficiary under this paragraph (c)(2)(ii), then the 
amounts deferred under an eligible plan of a tax-exempt entity are 
considered made available and taxable to the participant or beneficiary 
in accordance with paragraph (c)(2)(i) of this section at the earliest 
time, on or after severance from employment (but in no event later than 
the date on which distributions must commence pursuant to section 
401(a)(9)), that distribution is permitted to commence under the terms 
of the plan. However, the plan may provide for a default payment 
schedule that applies if no election is made. If the plan provides for a 
default payment schedule, the amounts deferred are includible in the 
gross income of the participant or beneficiary in the year the amounts 
deferred are first made available under the terms of the default payment 
schedule.
    (iii) Additional election to defer commencement of distribution. An 
eligible plan of a tax-exempt entity is permitted to provide that a 
participant or beneficiary who has made an initial election under 
paragraph (c)(2)(ii)(A) of this section may make one additional election 
to defer (but not accelerate) commencement of distributions under the 
plan before distributions have commenced in accordance with the initial 
deferral election under paragraph (c)(2)(ii)(A) of this section. Amounts 
payable to a participant or beneficiary under an eligible plan of a tax-
exempt entity are not treated as made available merely because the plan 
allows the participant to make an additional election under this 
paragraph (c)(2)(iii). A participant or beneficiary is not precluded 
from making an additional election to defer commencement of 
distributions merely because the participant or beneficiary has 
previously received a distribution under Sec.  1.457-6(c) because of an 
unforeseeable emergency, has received a distribution of smaller amounts 
under Sec.  1.457-6(e), has made (and revoked) other deferral or method 
of payment elections within the initial election period, or is subject 
to a default payment schedule under which the commencement of benefits 
is deferred (for example, until a participant is age 65).
    (iv) Election as to method of payment. An eligible plan of a tax-
exempt entity may provide that an election as to the method of payment 
under the plan may be made at any time prior to the time the amounts are 
distributed in accordance with the participant or beneficiary's initial 
or additional election

[[Page 222]]

to defer commencement of distributions under paragraph (c)(2)(ii) or 
(iii) of this section. Where no method of payment is elected, the entire 
amount deferred will be includible in the gross income of the 
participant or beneficiary when the amounts first become made available 
in accordance with a participant's initial or additional elections to 
defer under paragraphs (c)(2)(ii) and (iii) of this section, unless the 
eligible plan provides for a default method of payment (in which case 
amounts are considered made available and taxable when paid under the 
terms of the default payment schedule). A method of payment means a 
distribution or a series of periodic distributions commencing on a date 
determined in accordance with paragraph (c)(2)(ii) or (iii) of this 
section.
    (3) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan X of a tax-exempt entity 
provides that a participant's total account balance, representing all 
amounts deferred under the plan, is payable to a participant in a single 
sum 60 days after severance from employment throughout these examples, 
unless, during a 30-day period immediately following the severance, the 
participant elects to receive the single sum payment at a later date 
(that is not later than the plan's normal retirement age of 65) or 
elects to receive distribution in 10 annual installments to begin 60 
days after severance from employment (or at a later date, if so elected, 
that is not later than the plan's normal retirement age of 65). On 
November 13, 2004, K, a calendar year taxpayer, has a severance from 
employment with the eligible employer. K does not, within the 30-day 
window period, elect to postpone distributions to a later date or to 
receive payment in 10 fixed annual installments.
    (ii) Conclusion. The single sum payment is payable to K 60 days 
after the date K has a severance from employment (January 12, 2005), and 
is includible in the gross income of K in 2005 under section 457(a).
    Example 2. (i) Facts. The terms of eligible Plan X are the same as 
described in Example 1. Participant L participates in eligible Plan X. 
On November 11, 2003, L has a severance from the employment of the 
eligible employer. On November 24, 2003, L makes an initial deferral 
election not to receive the single-sum payment payable 60 days after the 
severance, and instead elects to receive the amounts in 10 annual 
installments to begin 60 days after severance from employment.
    (ii) Conclusion. No portion of L's account is considered made 
available in 2003 or 2004 before a payment is made and no amount is 
includible in the gross income of L until distributions commence. The 
annual installment payable in 2004 will be includible in L's gross 
income in 2004.
    Example 3. (i) Facts. The facts are the same as in Example 1, except 
that eligible Plan X also provides that those participants who are 
receiving distributions in 10 annual installments may, at any time and 
without restriction, elect to receive a cash out of all remaining 
installments. Participant M elects to receive a distribution in 10 
annual installments commencing in 2004.
    (ii) Conclusion. M's total account balance, representing the total 
of the amounts deferred under the plan, is considered made available and 
is includible in M's gross income in 2004.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that, instead of providing for an unrestricted cashout of remaining 
payments, the plan provides that participants or beneficiaries who are 
receiving distributions in 10 annual installments may accelerate the 
payment of the amount remaining payable to the participant upon the 
occurrence of an unforeseeable emergency as described in Sec.  1.457-
6(c)(1) in an amount not exceeding that described in Sec.  1.457-
6(c)(2).
    (ii) Conclusion. No amount is considered made available to 
participant M on account of M's right to accelerate payments upon the 
occurrence of an unforeseeable emergency.
    Example 5. (i) Facts. Eligible Plan Y of a tax-exempt entity 
provides that distributions will commence 60 days after a participant's 
severance from employment unless the participant elects, within a 30-day 
window period following severance from employment, to defer 
distributions to a later date (but no later than the year following the 
calendar year the participant attains age 70\1/2\). The plan provides 
that a participant who has elected to defer distributions to a later 
date may make an election as to form of distribution at any time prior 
to the 30th day before distributions are to commence.
    (ii) Conclusion. No amount is considered made available prior to the 
date distributions are to commence by reason of a participant's right to 
defer or make an election as to the form of distribution.
    Example 6. (i) Facts. The facts are the same as in Example 1, except 
that the plan also permits participants who have made an initial 
election to defer distribution to make one additional deferral election 
at any time prior to the date distributions are scheduled to commence. 
Participant N has a severance from employment at age 50. The next day, 
during the 30-day period provided in the plan, N elects to receive 
distribution in the form of 10 annual installment payments beginning at 
age 55. Two weeks later, within

[[Page 223]]

the 30-day window period, N makes a new election permitted under the 
plan to receive 10 annual installment payments beginning at age 60 
(instead of age 55). When N is age 59, N elects under the additional 
deferral election provisions, to defer distributions until age 65.
    (ii) Conclusion. In this example, N's election to defer 
distributions until age 65 is a valid election. The two elections N 
makes during the 30-day window period are not additional deferral 
elections described in paragraph (c)(2)(iii) of this section because 
they are made before the first permissible payout date under the plan. 
Therefore, the plan is not precluded from allowing N to make the 
additional deferral election. However, N can make no further election to 
defer distributions beyond age 65 (or accelerate distribution before age 
65) because this additional deferral election can only be made once.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec.  1.457-8  Funding rules for eligible plans.

    (a) Eligible governmental plans--(1) In general. In order to be an 
eligible governmental plan, all amounts deferred under the plan, all 
property and rights purchased with such amounts, and all income 
attributable to such amounts, property, or rights, must be held in trust 
for the exclusive benefit of participants and their beneficiaries. A 
trust described in this paragraph (a) that also meets the requirements 
of Sec. Sec.  1.457-3 through 1.457-10 is treated as an organization 
exempt from tax under section 501(a), and a participant's or 
beneficiary's interest in amounts in the trust is includible in the 
gross income of the participants and beneficiaries only to the extent, 
and at the time, provided for in section 457(a) and Sec. Sec.  1.457-4 
through 1.457-10.
    (2) Trust requirement. (i) A trust described in this paragraph (a) 
must be established pursuant to a written agreement that constitutes a 
valid trust under State law. The terms of the trust must make it 
impossible, prior to the satisfaction of all liabilities with respect to 
participants and their beneficiaries, for any part of the assets and 
income of the trust to be used for, or diverted to, purposes other than 
for the exclusive benefit of participants and their beneficiaries.
    (ii) Amounts deferred under an eligible governmental plan must be 
transferred to a trust within a period that is not longer than is 
reasonable for the proper administration of the participant accounts (if 
any). For purposes of this requirement, the plan may provide for amounts 
deferred for a participant under the plan to be transferred to the trust 
within a specified period after the date the amounts would otherwise 
have been paid to the participant. For example, the plan could provide 
for amounts deferred under the plan at the election of the participant 
to be contributed to the trust within 15 business days following the 
month in which these amounts would otherwise have been paid to the 
participant.
    (3) Custodial accounts and annuity contracts treated as trusts--(i) 
In general. For purposes of the trust requirement of this paragraph (a), 
custodial accounts and annuity contracts described in section 401(f) 
that satisfy the requirements of this paragraph (a)(3) are treated as 
trusts under rules similar to the rules of section 401(f). Therefore, 
the provisions of Sec.  1.401(f)-1(b) will generally apply to determine 
whether a custodial account or an annuity contract is treated as a 
trust. The use of a custodial account or annuity contract as part of an 
eligible governmental plan does not preclude the use of a trust or 
another custodial account or annuity contract as part of the same plan, 
provided that all such vehicles satisfy the requirements of section 
457(g)(1) and (3) and paragraphs (a)(1) and (2) of this section and that 
all assets and income of the plan are held in such vehicles.
    (ii) Custodial accounts--(A) In general. A custodial account is 
treated as a trust, for purposes of section 457(g)(1) and paragraphs 
(a)(1) and (2) of this section, if the custodian is a bank, as described 
in section 408(n), or a person who meets the nonbank trustee 
requirements of paragraph (a)(3)(ii)(B) of this section, and the account 
meets the requirements of paragraphs (a)(1) and (2) of this section, 
other than the requirement that it be a trust.
    (B) Nonbank trustee status. The custodian of a custodial account may 
be a person other than a bank only if the person demonstrates to the 
satisfaction of the Commissioner that the

[[Page 224]]

manner in which the person will administer the custodial account will be 
consistent with the requirements of section 457(g)(1) and (3). To do so, 
the person must demonstrate that the requirements of Sec.  1.408-2(e)(2) 
through (6) (relating to nonbank trustees) are met. The written 
application must be sent to the address prescribed by the Commissioner 
in the same manner as prescribed under Sec.  1.408-2(e). To the extent 
that a person has already demonstrated to the satisfaction of the 
Commissioner that the person satisfies the requirements of Sec.  1.408-
2(e) in connection with a qualified trust (or custodial account or 
annuity contract) under section 401(a), that person is deemed to satisfy 
the requirements of this paragraph (a)(3)(ii)(B).
    (iii) Annuity contracts. An annuity contract is treated as a trust 
for purposes of section 457(g)(1) and paragraph (a)(1) of this section 
if the contract is an annuity contract, as defined in section 401(g), 
that has been issued by an insurance company qualified to do business in 
the State, and the contract meets the requirements of paragraphs (a)(1) 
and (2) of this section, other than the requirement that it be a trust. 
An annuity contract does not include a life, health or accident, 
property, casualty, or liability insurance contract.
    (4) Combining assets. [Reserved]
    (b) Eligible plans maintained by tax-exempt entity--(1) General 
rule. In order to be an eligible plan of a tax-exempt entity, the plan 
must be unfunded and plan assets must not be set aside for participants 
or their beneficiaries. Under section 457(b)(6) and this paragraph (b), 
an eligible plan of a tax-exempt entity must provide that all amounts 
deferred under the plan, all property and rights to property (including 
rights as a beneficiary of a contract providing life insurance 
protection) purchased with such amounts, and all income attributable to 
such amounts, property, or rights, must remain (until paid or made 
available to the participant or beneficiary) solely the property and 
rights of the eligible employer (without being restricted to the 
provision of benefits under the plan), subject only to the claims of the 
eligible employer's general creditors.
    (2) Additional requirements. For purposes of paragraph (b)(1) of 
this section, the plan must be unfunded regardless of whether or not the 
amounts were deferred pursuant to a salary reduction agreement between 
the eligible employer and the participant. Any funding arrangement under 
an eligible plan of a tax-exempt entity that sets aside assets for the 
exclusive benefit of participants violates this requirement, and amounts 
deferred are generally immediately includible in the gross income of 
plan participants and beneficiaries. Nothing in this paragraph (b) 
prohibits an eligible plan from permitting participants and their 
beneficiaries to make an election among different investment options 
available under the plan, such as an election affecting the investment 
of the amounts described in paragraph (b)(1) of this section.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec.  1.457-9  Effect on eligible plans when not administered 
in accordance with eligibility requirements.

    (a) Eligible governmental plans. A plan of a State ceases to be an 
eligible governmental plan on the first day of the first plan year 
beginning more than 180 days after the date on which the Commissioner 
notifies the State in writing that the plan is being administered in a 
manner that is inconsistent with one or more of the requirements of 
Sec. Sec.  1.457-3 through 1.457-8 or 1.447-10. However, the plan may 
correct the plan inconsistencies specified in the written notification 
before the first day of that plan year and continue to maintain plan 
eligibility. If a plan ceases to be an eligible governmental plan, 
amounts subsequently deferred by participants will be includible in 
income when deferred, or, if later, when the amounts deferred cease to 
be subject to a substantial risk of forfeiture, as provided at Sec.  
1.457-11. Amounts deferred before the date on which the plan ceases to 
be an eligible governmental plan, and any earnings thereon, will be 
treated as if the plan continues to be an eligible governmental plan and 
will not be includible in participant's or beneficiary's gross income 
until paid to the participant or beneficiary.

[[Page 225]]

    (b) Eligible plans of tax-exempt entities. A plan of a tax-exempt 
entity ceases to be an eligible plan on the first day that the plan 
fails to satisfy one or more of the requirements of Sec. Sec.  1.457-3 
through 1.457-8, or Sec.  1.457-10. See Sec.  1.457-11 for rules 
regarding the treatment of an ineligible plan.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec.  1.457-10  Miscellaneous provisions.

    (a) Plan terminations and frozen plans--(1) In general. An eligible 
employer may amend its plan to eliminate future deferrals for existing 
participants or to limit participation to existing participants and 
employees. An eligible plan may also contain provisions that permit plan 
termination and permit amounts deferred to be distributed on 
termination. In order for a plan to be considered terminated, amounts 
deferred under an eligible plan must be distributed to all plan 
participants and beneficiaries as soon as administratively practicable 
after termination of the eligible plan. The mere provision for, and 
making of, distributions to participants or beneficiaries upon a plan 
termination will not cause an eligible plan to cease to satisfy the 
requirements of section 457(b) or the regulations.
    (2) Employers that cease to be eligible employers--(i) Plan not 
terminated. An eligible employer that ceases to be an eligible employer 
may no longer maintain an eligible plan. If the employer was a tax-
exempt entity and the plan is not terminated as permitted under 
paragraph (a)(2)(ii) of this section, the tax consequences to 
participants and beneficiaries in the previously eligible (unfunded) 
plan of an ineligible employer are determined in accordance with either 
section 451 if the employer becomes an entity other than a State or 
Sec.  1.457-11 if the employer becomes a State. If the employer was a 
State and the plan is neither terminated as permitted under paragraph 
(a)(2)(ii) of this section nor transferred to another eligible plan of 
that State as permitted under paragraph (b) of this section, the tax 
consequences to participants in the previously eligible governmental 
plan of an ineligible employer, the assets of which are held in trust 
pursuant to Sec.  1.457-8(a), are determined in accordance with section 
402(b) (section 403(c) in the case of an annuity contract) and the trust 
is no longer to be treated as a trust that is exempt from tax under 
section 501(a).
    (ii) Plan termination. As an alternative to determining the tax 
consequences to the plan and participants under paragraph (a)(2)(i) of 
this section, the employer may terminate the plan and distribute the 
amounts deferred (and all plan assets) to all plan participants as soon 
as administratively practicable in accordance with paragraph (a)(1) of 
this section. Such distribution may include eligible rollover 
distributions in the case of a plan that was an eligible governmental 
plan. In addition, if the employer is a State, another alternative to 
determining the tax consequences under paragraph (a)(2)(i) of this 
section is to transfer the assets of the eligible governmental plan to 
an eligible governmental plan of another eligible employer within the 
same State under the plan-to-plan transfer rules of paragraph (b) of 
this section.
    (3) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples:

    Example 1. (i) Facts. Employer Y, a corporation that owns a State 
hospital, sponsors an eligible governmental plan funded through a trust. 
Employer Y is acquired by a for-profit hospital and Employer Y ceases to 
be an eligible employer under section 457(e)(1) or Sec.  1.457-2(e). 
Employer Y terminates the plan and, during the next 6 months, 
distributes to participants and beneficiaries all amounts deferred that 
were under the plan.
    (ii) Conclusion. The termination and distribution does not cause the 
plan to fail to be an eligible governmental plan. Amounts that are 
distributed as eligible rollover distributions may be rolled over to an 
eligible retirement plan described in section 402(c)(8)(B).
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that Employer Y decides to continue to maintain the plan.
    (ii) Conclusion. If Employer Y continues to maintain the plan, the 
tax consequences to participants and beneficiaries will be determined in 
accordance with either section 402(b) if the compensation deferred is 
funded through a trust, section 403(c) if the compensation deferred is 
funded through annuity contracts, or Sec.  1.457-11 if the compensation 
deferred is not funded through a trust or annuity contract. In addition, 
if Employer Y

[[Page 226]]

continues to maintain the plan, the trust will no longer be treated as 
exempt from tax under section 501(a).
    Example 3. (i) Facts. Employer Z, a corporation that owns a tax-
exempt hospital, sponsors an unfunded eligible plan. Employer Z is 
acquired by a for-profit hospital and is no longer an eligible employer 
under section 457(e)(1) or Sec.  1.457-2(e). Employer Z terminates the 
plan and distributes all amounts deferred under the eligible plan to 
participants and beneficiaries within a one-year period.
    (ii) Conclusion. Distributions under the plan are treated as made 
under an eligible plan of a tax-exempt entity and the distributions of 
the amounts deferred are includible in the gross income of the 
participant or beneficiary in the year distributed.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that Employer Z decides to maintain instead of terminate the plan.
    (ii) Conclusion. If Employer Z maintains the plan, the tax 
consequences to participants and beneficiaries in the plan will 
thereafter be determined in accordance with section 451.

    (b) Plan-to-plan transfers--(1) General rule. An eligible 
governmental plan may provide for the transfer of amounts deferred by a 
participant or beneficiary to another eligible governmental plan if the 
conditions in paragraphs (b)(2), (3), or (4) of this section are met. An 
eligible plan of a tax-exempt entity may provide for transfers of 
amounts deferred by a participant to another eligible plan of a tax-
exempt entity if the conditions in paragraph (b)(5) of this section are 
met. In addition, an eligible governmental plan may accept transfers 
from another eligible governmental plan as described in the first 
sentence of this paragraph (b)(1), and an eligible plan of a tax-exempt 
entity may accept transfers from another eligible plan of a tax-exempt 
entity as described in the preceding sentence. However, a State may not 
transfer the assets of its eligible governmental plan to a tax-exempt 
entity's eligible plan and the plan of a tax-exempt entity may not 
accept such a transfer. Similarly, a tax-exempt entity may not transfer 
the assets of its eligible plan to an eligible governmental plan and an 
eligible governmental plan may not accept such a transfer. In addition, 
if the conditions in paragraph (b)(4) of this section (relating to 
permissive past service credit and repayments under section 415) are 
met, an eligible governmental plan of a State may provide for the 
transfer of amounts deferred by a participant or beneficiary to a 
qualified plan (under section 401(a)) maintained by a State. However, a 
qualified plan may not transfer assets to an eligible governmental plan 
or to an eligible plan of a tax-exempt entity, and an eligible 
governmental plan or the plan of a tax-exempt entity may not accept such 
a transfer.
    (2) Requirements for post-severance plan-to-plan transfers among 
eligible governmental plans. A transfer under paragraph (b)(1) of this 
section from an eligible governmental plan to another eligible 
governmental plan is permitted if the following conditions are met--
    (i) The transferor plan provides for transfers;
    (ii) The receiving plan provides for the receipt of transfers;
    (iii) The participant or beneficiary whose amounts deferred are 
being transferred will have an amount deferred immediately after the 
transfer at least equal to the amount deferred with respect to that 
participant or beneficiary immediately before the transfer; and
    (iv) In the case of a transfer for a participant, the participant 
has had a severance from employment with the transferring employer and 
is performing services for the entity maintaining the receiving plan.
    (3) Requirements for plan-to-plan transfers of all plan assets of 
eligible governmental plan. A transfer under paragraph (b)(1) of this 
section from an eligible governmental plan to another eligible 
governmental plan is permitted if the following conditions are met--
    (i) The transfer is from an eligible governmental plan to another 
eligible governmental plan within the same State;
    (ii) All of the assets held by the transferor plan are transferred;
    (iii) The transferor plan provides for transfers;
    (iv) The receiving plan provides for the receipt of transfers;
    (v) The participant or beneficiary whose amounts deferred are being 
transferred will have an amount deferred immediately after the transfer

[[Page 227]]

at least equal to the amount deferred with respect to that participant 
or beneficiary immediately before the transfer; and
    (vi) The participants or beneficiaries whose deferred amounts are 
being transferred are not eligible for additional annual deferrals in 
the receiving plan unless they are performing services for the entity 
maintaining the receiving plan.
    (4) Requirements for plan-to-plan transfers among eligible 
governmental plans of the same employer. A transfer under paragraph 
(b)(1) of this section from an eligible governmental plan to another 
eligible governmental plan is permitted if the following conditions are 
met--
    (i) The transfer is from an eligible governmental plan to another 
eligible governmental plan of the same employer (and, for this purpose, 
the employer is not treated as the same employer if the participant's 
compensation is paid by a different entity);
    (ii) The transferor plan provides for transfers;
    (iii) The receiving plan provides for the receipt of transfers;
    (iv) The participant or beneficiary whose amounts deferred are being 
transferred will have an amount deferred immediately after the transfer 
at least equal to the amount deferred with respect to that participant 
or beneficiary immediately before the transfer; and
    (v) The participant or beneficiary whose deferred amounts are being 
transferred is not eligible for additional annual deferrals in the 
receiving plan unless the participant or beneficiary is performing 
services for the entity maintaining the receiving plan.
    (5) Requirements for post-severance plan-to-plan transfers among 
eligible plans of tax-exempt entities. A transfer under paragraph (b)(1) 
of this section from an eligible plan of a tax-exempt employer to 
another eligible plan of a tax-exempt employer is permitted if the 
following conditions are met--
    (i) The transferor plan provides for transfers;
    (ii) The receiving plan provides for the receipt of transfers;
    (iii) The participant or beneficiary whose amounts deferred are 
being transferred will have an amount deferred immediately after the 
transfer at least equal to the amount deferred with respect to that 
participant or beneficiary immediately before the transfer; and
    (iv) In the case of a transfer for a participant, the participant 
has had a severance from employment with the transferring employer and 
is performing services for the entity maintaining the receiving plan.
    (6) Treatment of amount transferred following a plan-to-plan 
transfer between eligible plans. Following a transfer of any amount 
between eligible plans under paragraphs (b)(1) through (b)(5) of this 
section--
    (i) The transferred amount is subject to the restrictions of Sec.  
1.457-6 (relating to when distributions are permitted to be made to a 
participant under an eligible plan) in the receiving plan in the same 
manner as if the transferred amount had been originally been deferred 
under the receiving plan if the participant is performing services for 
the entity maintaining the receiving plan, and
    (ii) In the case of a transfer between eligible plans of tax-exempt 
entities, except as otherwise determined by the Commissioner, the 
transferred amount is subject to Sec.  1.457-7(c)(2) (relating to when 
amounts are considered to be made available under an eligible plan of a 
tax-exempt entity) in the same manner as if the elections made by the 
participant or beneficiary under the transferor plan had been made under 
the receiving plan.
    (7) Examples. The provisions of paragraphs (b)(1) through (6) of 
this section are illustrated by the following examples:

    Example 1. (i) Facts. Participant A, the president of City X's 
hospital, has accepted a position with another hospital which is a tax-
exempt entity. A participates in the eligible governmental plan of City 
X. A would like to transfer the amounts deferred under City X's eligible 
governmental plan to the eligible plan of the tax-exempt hospital.
    (ii) Conclusion. City X's plan may not transfer A's amounts deferred 
to the tax-exempt employer's eligible plan. In addition, because the 
amounts deferred would no longer be held in trust for the exclusive 
benefit of participants and their beneficiaries,

[[Page 228]]

the transfer would violate the exclusive benefit rule of section 457(g) 
and Sec.  1.457-8(a).
    Example 2. (i) Facts. County M, located in State S, operates several 
health clinics and maintains an eligible governmental plan for employees 
of those clinics. One of the clinics operated by County M is being 
acquired by a hospital operated by State S, and employees of that clinic 
will become employees of State S. County M permits those employees to 
transfer their balances under County M's eligible governmental plan to 
the eligible governmental plan of State S.
    (ii) Conclusion. If the eligible governmental plans of County M and 
State S provide for the transfer and acceptance of the transfer (and the 
other requirements of paragraph (b)(1) of this section are satisfied), 
then the requirements of paragraph (b)(2) of this section are satisfied 
and, thus, the transfer will not cause either plan to violate the 
requirements of section 457 or these regulations.
    Example 3. (i) Facts. City Employer Z, a hospital, sponsors an 
eligible governmental plan. City Employer Z is located in State B. All 
of the assets of City Employer Z are being acquired by a tax-exempt 
hospital. City Employer Z, in accordance with the plan-to-plan transfer 
rules of paragraph (b) of this section, would like to transfer the total 
amount of assets deferred under City Employer Z's eligible governmental 
plan to the acquiring tax-exempt entity's eligible plan.
    (ii) Conclusion. City Employer Z may not permit participants to 
transfer the amounts to the eligible plan of the tax-exempt entity. In 
addition, because the amounts deferred would no longer be held in trust 
for the exclusive benefit of participants and their beneficiaries, the 
transfer would violate the exclusive benefit rule of section 457(g) and 
Sec.  1.457-8(a).
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that City Employer Z, instead of transferring all of its assets to the 
eligible plan of the tax-exempt entity, decides to transfer all of the 
amounts deferred under City Z's eligible governmental plan to the 
eligible governmental plan of County B in which City Z is located. 
County B's eligible plan does not cover employees of City Z, but is 
willing to allow the assets of City Z's plan to be transferred to County 
B's plan, a related state government entity, also located in State B.
    (ii) Conclusion. If City Employer Z's (transferor) eligible 
governmental plan provides for such transfer and the eligible 
governmental plan of County B permits the acceptance of such a transfer 
(and the other requirements of paragraph (b)(1) of this section are 
satisfied), then the requirements of paragraph (b)(3) of this section 
are satisfied and, thus, City Employer Z may transfer the total amounts 
deferred under its eligible governmental plan, prior to termination of 
that plan, to the eligible governmental plan maintained by County B. 
However, the participants of City Employer Z whose deferred amounts are 
being transferred are not eligible to participate in the eligible 
governmental plan of County B, the receiving plan, unless they are 
performing services for County B.
    Example 5. (i) Facts. State C has an eligible governmental plan. 
Employees of City U in State C are among the eligible employees for 
State C's plan and City U decides to adopt another eligible governmental 
plan only for its employees. State C decides to allow employees to elect 
to transfer all of the amounts deferred for an employee under State C's 
eligible governmental plan to City U's eligible governmental plan.
    (ii) Conclusion. If State C's (transferor) eligible governmental 
plan provides for such transfer and the eligible governmental plan of 
City U permits the acceptance of such a transfer (and the other 
requirements of paragraph (b)(1) of this section are satisfied), then 
the requirements of paragraph (b)(4) of this section are satisfied and, 
thus, State C may transfer the total amounts deferred under its eligible 
governmental plan to the eligible governmental plan maintained by City 
U.

    (8) Purchase of permissive service credit by plan-to-plan transfers 
from an eligible governmental plan to a qualified plan--(i) General 
rule. An eligible governmental plan of a State may provide for the 
transfer of amounts deferred by a participant or beneficiary to a 
defined benefit governmental plan (as defined in section 414(d)), and no 
amount shall be includible in gross income by reason of the transfer, if 
the conditions in paragraph (b)(8)(ii) of this section are met. A 
transfer under this paragraph (b)(8) is not treated as a distribution 
for purposes of Sec.  1.457-6. Therefore, such a transfer may be made 
before severance from employment.
    (ii) Conditions for plan-to-plan transfers from an eligible 
governmental plan to a qualified plan. A transfer may be made under this 
paragraph (b)(8) only if the transfer is either--
    (A) For the purchase of permissive service credit (as defined in 
section 415(n)(3)(A)) under the receiving defined benefit governmental 
plan; or
    (B) A repayment to which section 415 does not apply by reason of 
section 415(k)(3).
    (iii) Example. The provisions of this paragraph (b)(8) are 
illustrated by the following example:


[[Page 229]]


    Example. (i) Facts. Plan X is an eligible governmental plan 
maintained by County Y for its employees. Plan X provides for 
distributions only in the event of death, an unforeseeable emergency, or 
severance from employment with County Y (including retirement from 
County Y). Plan S is a qualified defined benefit plan maintained by 
State T for its employees. County Y is within State T. Employee A is an 
employee of County Y and is a participant in Plan X. Employee A 
previously was an employee of State T and is still entitled to benefits 
under Plan S. Plan S includes provisions allowing participants in 
certain plans, including Plan X, to transfer assets to Plan S for the 
purchase of service credit under Plan S and does not permit the amount 
transferred to exceed the amount necessary to fund the benefit resulting 
from the service credit. Although not required to do so, Plan X allows 
Employee A to transfer assets to Plan S to provide a service benefit 
under Plan S.
    (ii) Conclusion. The transfer is permitted under this paragraph 
(b)(8).

    (c) Qualified domestic relations orders under eligible plans--(1) 
General rule. An eligible plan does not become an ineligible plan 
described in section 457(f) solely because its administrator or sponsor 
complies with a qualified domestic relations order as defined in section 
414(p), including an order requiring the distribution of the benefits of 
a participant to an alternate payee in advance of the general rules for 
eligible plan distributions under Sec.  1.457-6. If a distribution or 
payment is made from an eligible plan to an alternate payee pursuant to 
a qualified domestic relations order, rules similar to the rules of 
section 402(e)(1)(A) shall apply to the distribution or payment.
    (2) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant C and C's spouse D are divorcing. 
C is employed by State S and is a participant in an eligible plan 
maintained by State S. C has an account valued at $100,000 under the 
plan. Pursuant to the divorce, a court issues a qualified domestic 
relations order on September 1, 2003 that allocates 50 percent of C's 
$100,000 plan account to D and specifically provides for an immediate 
distribution to D of D's share within 6 months of the order. Payment is 
made to D in January of 2004.
    (ii) Conclusion. State S's eligible plan does not become an 
ineligible plan described in section 457(f) and Sec.  1.457-11 solely 
because its administrator or sponsor complies with the qualified 
domestic relations order requiring the immediate distribution to D in 
advance of the general rules for eligible plan distributions under Sec.  
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include 
the distribution in gross income. The distribution is includible in D's 
gross income in 2004. If the qualified domestic relations order were to 
provide for distribution to D at a future date, amounts deferred 
attributable to D's share will be includible in D's gross income when 
paid to D.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that S is a tax-exempt entity, instead of a State.
    (ii) Conclusion. State S's eligible plan does not become an 
ineligible plan described in section 457(f) and Sec.  1.457-11 solely 
because its administrator or sponsor complies with the qualified 
domestic relations order requiring the immediate distribution to D in 
advance of the general rules for eligible plan distributions under Sec.  
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include 
the distribution in gross income. The distribution is includible in D's 
gross income in 2004, assuming that the plan did not make the 
distribution available to D in 2003. If the qualified domestic relations 
order were to provide for distribution to D at a future date, amounts 
deferred attributable to D's share would be includible in D's gross 
income when paid or made available to D.

    (d) Death benefits and life insurance proceeds. A death benefit plan 
under section 457(e)(11) is not an eligible plan. In addition, no amount 
paid or made available under an eligible plan as death benefits or life 
insurance proceeds is excludable from gross income under section 101.
    (e) Rollovers to eligible governmental plans--(1) General rule. An 
eligible governmental plan may accept contributions that are eligible 
rollover distributions (as defined in section 402(c)(4)) made from 
another eligible retirement plan (as defined in section 402(c)(8)(B)) if 
the conditions in paragraph (e)(2) of this section are met. Amounts 
contributed to an eligible governmental plan as eligible rollover 
distributions are not taken into account for purposes of the annual 
limit on annual deferrals by a participant in Sec.  1.457-4(c) or Sec.  
1.457-5, but are otherwise treated in the same manner as amounts 
deferred under section 457 for purposes of Sec. Sec.  1.457-3 through 
1.457-9 and this section.

[[Page 230]]

    (2) Conditions for rollovers to an eligible governmental plan. An 
eligible governmental plan that permits eligible rollover distributions 
made from another eligible retirement plan to be paid into the eligible 
governmental plan is required under this paragraph (e)(2) to provide 
that it will separately account for any eligible rollover distributions 
it receives. A plan does not fail to satisfy this requirement if it 
separately accounts for particular types of eligible rollover 
distributions (for example, if it maintains a separate account for 
eligible rollover distributions attributable to annual deferrals that 
were made under other eligible governmental plans and a separate account 
for amounts attributable to other eligible rollover distributions), but 
this requirement is not satisfied if any such separate account includes 
any amount that is not attributable to an eligible rollover 
distribution.
    (3) Example. The provisions of this paragraph (e) are illustrated by 
the following example:

    Example. (i) Facts. Plan T is an eligible governmental plan that 
provides that employees who are eligible to participate in Plan T may 
make rollover contributions to Plan T from amounts distributed to an 
employee from an eligible retirement plan. An eligible retirement plan 
is defined in Plan T as another eligible governmental plan, a qualified 
section 401(a) or 403(a) plan, or a section 403(b) contract, or an 
individual retirement arrangement (IRA) that holds such amounts. Plan T 
requires rollover contributions to be paid by the eligible retirement 
plan directly to Plan T (a direct rollover) or to be paid by the 
participant within 60 days after the date on which the participant 
received the amount from the other eligible retirement plan. Plan T does 
not take rollover contributions into account for purposes of the plan's 
limits on amounts deferred that conform to Sec.  1.457-4(c). Rollover 
contributions paid to Plan T are invested in the trust in the same 
manner as amounts deferred under Plan T and rollover contributions (and 
earnings thereon) are available for distribution to the participant at 
the same time and in the same manner as amounts deferred under Plan T. 
In addition, Plan T provides that, for each participant who makes a 
rollover contribution to Plan T, the Plan T record-keeper is to 
establish a separate account for the participant's rollover 
contributions. The record-keeper calculates earnings and losses for 
investments held in the rollover account separately from earnings and 
losses on other amounts held under the plan and calculates disbursements 
from and payments made to the rollover account separately from 
disbursements from and payments made to other amounts held under the 
plan.
    (ii) Conclusion. Plan T does not lose its status as an eligible 
governmental plan as a result of the receipt of rollover contributions. 
The conclusion would not be different if the Plan T record-keeper were 
to establish two separate accounts, one of which is for the 
participant's rollover contributions attributable to annual deferrals 
that were made under an eligible governmental plan and the other of 
which is for other rollover contributions.

    (f) Deemed IRAs under eligible governmental plans. See regulations 
under section 408(q) for guidance regarding the treatment of separate 
accounts or annuities as individual retirement plans (IRAs).

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003; T.D. 
9319, 72 FR 16931, Apr. 5, 2007]



Sec.  1.457-11  Tax treatment of participants if plan is not an eligible plan.

    (a) In general. Under section 457(f), if an eligible employer 
provides for a deferral of compensation under any agreement or 
arrangement that is an ineligible plan--
    (1) Compensation deferred under the agreement or arrangement is 
includible in the gross income of the participant or beneficiary for the 
first taxable year in which there is no substantial risk of forfeiture 
(within the meaning of section 457(f)(3)(B)) of the rights to such 
compensation;
    (2) If the compensation deferred is subject to a substantial risk of 
forfeiture, the amount includible in gross income for the first taxable 
year in which there is no substantial risk of forfeiture includes 
earnings thereon to the date on which there is no substantial risk of 
forfeiture;
    (3) Earnings credited on the compensation deferred under the 
agreement or arrangement that are not includible in gross income under 
paragraph (a)(2) of this section are includible in the gross income of 
the participant or beneficiary only when paid or made available to the 
participant or beneficiary, provided that the interest of the 
participant or beneficiary in any assets (including amounts deferred

[[Page 231]]

under the plan) of the entity sponsoring the agreement or arrangement is 
not senior to the entity's general creditors; and
    (4) Amounts paid or made available to a participant or beneficiary 
under the agreement or arrangement are includible in the gross income of 
the participant or beneficiary under section 72, relating to annuities.
    (b) Exceptions. Paragraph (a) of this section does not apply with 
respect to--
    (1) A plan described in section 401(a) which includes a trust exempt 
from tax under section 501(a);
    (2) An annuity plan or contract described in section 403;
    (3) That portion of any plan which consists of a transfer of 
property described in section 83;
    (4) That portion of any plan which consists of a trust to which 
section 402(b) applies; or
    (5) A qualified governmental excess benefit arrangement described in 
section 415(m).
    (c) Amount included in income. The amount included in gross income 
on the applicable date under paragraphs (a)(1) and (a)(2) of this 
section is equal to the present value of the compensation (including 
earnings to the extent provided in paragraph (a)(2) of this section) on 
that date. For purposes of applying section 72 on the applicable date 
under paragraphs (a)(3) and (4) of this section, the participant is 
treated as having paid investment in the contract (or basis) to the 
extent that the deferred compensation has been taken into account by the 
participant in accordance with paragraphs (a)(1) and (a)(2) of this 
section.
    (d) Coordination of section 457(f) with section 83--(1) General 
rules. Under paragraph (b)(3) of this section, section 457(f) and 
paragraph (a) of this section do not apply to that portion of any plan 
which consists of a transfer of property described in section 83. For 
this purpose, a transfer of property described in section 83 means a 
transfer of property to which section 83 applies. Section 457(f) and 
paragraph (a) of this section do not apply if the date on which there is 
no substantial risk of forfeiture with respect to compensation deferred 
under an agreement or arrangement that is not an eligible plan is on or 
after the date on which there is a transfer of property to which section 
83 applies. However, section 457(f) and paragraph (a) of this section 
apply if the date on which there is no substantial risk of forfeiture 
with respect to compensation deferred under an agreement or arrangement 
that is not an eligible plan precedes the date on which there is a 
transfer of property to which section 83 applies. If deferred 
compensation payable in property is includible in gross income under 
section 457(f), then, as provided in section 72, the amount includible 
in gross income when that property is later transferred or made 
available to the service provider is the excess of the value of the 
property at that time over the amount previously included in gross 
income under section 457(f).
    (2) Examples. The provisions of this paragraph (d) are illustrated 
in the following examples:

    Example 1. (i) Facts. As part of an arrangement for the deferral of 
compensation, an eligible employer agrees on December 1, 2002 to pay an 
individual rendering services for the eligible employer a specified 
dollar amount on January 15, 2005. The arrangement provides for the 
payment to be made in the form of property having a fair market value 
equal to the specified dollar amount. The individual's rights to the 
payment are not subject to a substantial risk of forfeiture (within the 
meaning of section 457(f)(3)(B)).
    (ii) Conclusion. In this Example 1, because there is no substantial 
risk of forfeiture with respect to the agreement to transfer property in 
2005, the present value (as of December 1, 2002) of the payment is 
includible in the individual's gross income for 2002. Under paragraph 
(a)(4) of this section, when the payment is made on January 15, 2005, 
the amount includible in the individual's gross income is equal to the 
excess of the fair market value of the property when paid, over the 
amount that was includible in gross income for 2002 (which is the basis 
allocable to that payment).
    Example 2. (i) Facts. As part of an arrangement for the deferral of 
compensation, individuals A and B rendering services for a tax-exempt 
entity each receive in 2010 property that is subject to a substantial 
risk of forfeiture (within the meaning of section 457(f)(3)(B) and 
within the meaning of section 83(c)(1)). Individual A makes an election 
to include the fair market value of the property in gross income under 
section 83(b) and individual B does not make this election. The 
substantial risk of forfeiture for the property

[[Page 232]]

transferred to individual A lapses in 2012 and the substantial risk of 
forfeiture for the property transferred to individual B also lapses in 
2012. Thus, the property transferred to individual A is included in A's 
gross income for 2010 when A makes a section 83(b) election and the 
property transferred to individual B is included in B's gross income for 
2012 when the substantial risk of forfeiture for the property lapses.
    (ii) Conclusion. In this Example 2, in each case, the compensation 
deferred is not subject to section 457(f) or this section because 
section 83 applies to the transfer of property on or before the date on 
which there is no substantial risk of forfeiture with respect to 
compensation deferred under the arrangement.
    Example 3. (i) Facts. In 2004, Z, a tax-exempt entity, grants an 
option to acquire property to employee C. The option lacks a readily 
ascertainable fair market value, within the meaning of section 83(e)(3), 
has a value on the date of grant equal to $100,000, and is not subject 
to a substantial risk of forfeiture (within the meaning of section 
457(f)(3)(B) and within the meaning of section 83(c)(1)). Z exercises 
the option in 2012 by paying an exercise price of $75,000 and receives 
property that has a fair market value (for purposes of section 83) equal 
to $300,000.
    (ii) Conclusion. In this Example 3, under section 83(e)(3), section 
83 does not apply to the grant of the option. Accordingly, C has income 
of $100,000 in 2004 under section 457(f). In 2012, C has income of 
$125,000, which is the value of the property transferred in 2012, minus 
the allocable portion of the basis that results from the $100,000 of 
income in 2004 and the $75,000 exercise price.
    Example 4. (i) Facts. In 2010, X, a tax-exempt entity, agrees to pay 
deferred compensation to employee D. The amount payable is $100,000 to 
be paid 10 years later in 2020. The commitment to make the $100,000 
payment is not subject to a substantial risk of forfeiture. In 2010, the 
present value of the $100,000 is $50,000. In 2018, X transfers to D 
property having a fair market value (for purposes of section 83) equal 
to $70,000. The transfer is in partial settlement of the commitment made 
in 2010 and, at the time of the transfer in 2018, the present value of 
the commitment is $80,000. In 2020, X pays D the $12,500 that remains 
due.
    (ii) Conclusion. In this Example 4, D has income of $50,000 in 2010. 
In 2018, D has income of $30,000, which is the amount transferred in 
2018, minus the allocable portion of the basis that results from the 
$50,000 of income in 2010. (Under section 72(e)(2)(B), income is 
allocated first. The income is equal to $30,000 ($80,000 minus the 
$50,000 basis), with the result that the allocable portion of the basis 
is equal to $40,000 ($70,000 minus the $30,000 of income).) In 2020, D 
has income of $2,500 ($12,500 minus $10,000, which is the excess of the 
original $50,000 basis over the $40,000 basis allocated to the transfer 
made in 2018).

[T.D. 9075, 68 FR 41240, July 11, 2003]



Sec.  1.457-12  Effective dates.

    (a) General effective date. Except as otherwise provided in this 
section, Sec. Sec.  1.457-1 through 1.457-11 apply for taxable years 
beginning after December 31, 2001.
    (b) Transition period for eligible plans to comply with EGTRRA. For 
taxable years beginning after December 31, 2001, and before January 1, 
2004, a plan does not fail to be an eligible plan as a result of 
requirements imposed by the Economic Growth and Tax Relief 
Reconciliation Act of 2001 (115 Stat. 385) (EGTRRA) (Public Law 107-16) 
June 7, 2001, if it is operated in accordance with a reasonable, good 
faith interpretation of EGTRRA.
    (c) Special rule for distributions from rollover accounts. The last 
sentence of Sec.  1.457-6(a) (relating to distributions of amounts held 
in a separate account for eligible rollover distributions) applies for 
taxable years beginning after December 31, 2003.
    (d) Special rule for options. Section 1.457-11(d) does not apply 
with respect to an option without a readily ascertainable fair market 
value (within the meaning of section 83(e)(3)) that was granted on or 
before May 8, 2002.
    (e) Special rule for qualified domestic relations orders. Section 
1.457-10(c) (relating to qualified domestic relations orders) applies 
for transfers, distributions, and payments made after December 31, 2001.

[T.D. 9075, 68 FR 41240, July 11, 2003]



Sec.  1.458-1  Exclusion for certain returned magazines, paperbacks, 
or records.

    (a) In general--(1) Introduction. For taxable years beginning after 
September 30, 1979, section 458 allows accrual basis taxpayers to elect 
to use a method of accounting that excludes from gross income some or 
all of the income attributable to qualified sales during the taxable 
year of magazines, paperbacks, or records, that are returned before the 
close of the applicable merchandise return period for that taxable year. 
Any amount so excluded cannot be excluded or deducted from

[[Page 233]]

gross income for the taxable year in which the merchandise is returned 
to the taxpayer. For the taxable year in which the taxpayer first uses 
this method of accounting, the taxpayer is not allowed to exclude from 
gross income amounts attributable to merchandise returns received during 
the taxable year that would have been excluded from gross income for the 
prior taxable year had the taxpayer used this method of accounting for 
that prior year. (See paragraph (e) of this section for rules describing 
how this amount should be taken into account.) The election to use this 
method of accounting shall be made in accordance with the rules 
contained in section 458(c) and in Sec.  1.458-2 and this section. A 
taxpayer that does not elect to use this method of accounting can reduce 
income for returned merchandise only for the taxable year in which the 
merchandise is actually returned unsold by the purchaser.
    (2) Effective date. While this section is generally effective only 
for taxable years beginning after August 31, 1984, taxpayers may rely on 
the provisions of paragraphs (a) through (f) of this section in taxable 
years beginning after September 30, 1979.
    (b) Definitions--(1) Magazine. ``Magazine'' means a publication, 
usually paper-backed and sometimes illustrated, that is issued at 
regular intervals and contains stories, poems, articles, features, etc. 
This term includes periodicals, but does not include newspapers or 
volumes of a single publication issued at various intervals. However, 
volumes of a single publication that are issued at least annually, are 
related by title or subject matter to a magazine, and would otherwise 
qualify as a magazine, will be treated as a magazine.
    (2) Paperback. ``Paperback'' means a paperback book other than a 
magazine. Unlike a hardback book, which usually has stiff front and back 
covers that enclose pages bound to a separate spine, a paperback book is 
characterized by a flexible outer cover to which the pages of the book 
are directly affixed.
    (3) Record. ``Record'' means a disc, tape, or similar item on which 
music, spoken or other sounds are recorded. However, the term does not 
include blank records, tapes, etc., on which it is expected the ultimate 
purchaser will record. The following items, provided they carry pre-
recorded sound, are examples of ``records'': audio and video cassettes, 
eight-track tapes, reel-to-reel tapes, cylinders, and flat, compact, and 
laser discs.
    (4) Qualified sale. In order for a sale to be considered a qualified 
sale, both of the following conditions must be met:
    (i) The taxpayer must be under a legal obligation (as determined by 
applicable State law), at the time of sale, to adjust the sales price of 
the magazine, paperback, or record on account of the purchaser's failure 
to resell it; and
    (ii) The taxpayer must actually adjust the sales price of the 
magazine, paperback, or record to reflect the purchaser's failure to 
resell the merchandise. The following are examples of adjustments to the 
sales price of unsold merchandise: Cash refunds, credits to the account 
of the purchaser, and repurchases of the merchandise. The adjustment 
need not be equal to the full amount of the sales price of the item. 
However, a markdown of the sales price under an agreement whereby the 
purchaser continues to hold the merchandise for sale or other 
disposition (other than solely for scrap) does not constitute an 
adjustment resulting from a failure to resell.
    (5) Merchandise return period--(i) In general. Unless the taxpayer 
elects a shorter period, the ``merchandise return period'' is the period 
that ends 2 months and 15 days after the close of the taxable year for 
sales of magazines and 4 months and 15 days after the close of the 
taxable year for sales of paperbacks and records.
    (ii) Election to use shorter period. The taxpayer may select a 
shorter merchandise return period than the applicable period set forth 
in paragraph (b)(5)(i) of this section.
    (iii) Change in merchandise return period. Any change in the 
merchandise return period after its initial establishment will be 
treated as a change in method of accounting.
    (c) Amount of the exclusion--(1) In general. Except as otherwise 
provided in paragraph (g) of this section, the

[[Page 234]]

amount of the gross income exclusion with respect to any qualified sale 
is equal to the lesser of--
    (i) The amount covered by the legal obligation referred to in 
paragraph (b)(4)(i) of this section; or
    (ii) The amount of the adjustment agreed to by the taxpayer before 
the close of the merchandise return period.
    (2) Price adjustment in excess of legal obligation. The excess, if 
any, of the amount described in paragraph (c)(1)(ii) of this section 
over the amount described in paragraph (c)(1)(i) of this section should 
be excluded in the taxable year in which it is properly accruable under 
section 461.
    (d) Return of the merchandise--(1) In general. (i) The exclusion 
from gross income allowed by section 458 applies with respect to a 
qualified sale of merchandise only if the seller receives, before the 
close of the merchandise return period, either--
    (A) The physical return of the merchandise; or
    (B) Satisfactory evidence that the merchandise has not been and will 
not be resold (as defined in paragraph (d)(2) of this section).
    (ii) For purposes of this paragraph (d), evidence of a return 
received by an agent of the seller (other than the purchaser who 
purchased the merchandise from the seller) will be considered to be 
received by the seller at the time the agent receives the merchandise or 
evidence.
    (2) Satisfactory evidence. Evidence that merchandise has not been 
and will not be resold is satisfactory only if the seller receives--
    (i) Physical return of some portion of the merchandise (e.g., 
covers) provided under either the agreement between the seller and the 
purchaser or industry practice (such return evidencing the fact that the 
purchaser has not and will not resell the merchandise); or
    (ii) A written statement from the purchaser specifying the 
quantities of each title not resold, provided either--
    (A) The statement contains a representation that the items specified 
will not be resold by the purchaser; or
    (B) The past dealings, if any, between the parties and industry 
practice indicate that such statement constitutes a promise by the 
purchaser not to resell the items.
    (3) Retention of evidence. In the case of a return of merchandise 
(described in paragraph (d)(1)(i)(A) of this section) or portion thereof 
(described in paragraph (d)(2)(i) of this section), the seller has no 
obligation to retain physical evidence of the returned merchandise or 
portion thereof, provided the seller maintains documentary evidence that 
describes the quantity of physical items returned to the seller and 
indicates that the items were returned before the close of the 
merchandise return period.
    (e) Transitional adjustment--(1) In general. An election to change 
from some other method of accounting for the return of magazines, 
paperbacks, or records to the method of accounting described in section 
458 is a change in method of accounting that requires a transitional 
adjustment. Section 458 provides special rules for transitional 
adjustments that must be taken into account as a result of this change. 
See paragraph (e)(2) of this section for special rules applicable to 
magazines and paragraphs (e) (3) and (4) of this section for special 
rules applicable to paperbacks and records.
    (2) Magazines: 5-year spread of decrease in taxable income. For 
taxpayers who have elected to use the method of accounting described in 
section 458 to account for returned magazines for a taxable year, 
section 458(d) and this paragraph (e)(2) provide a special rule for 
taking into account any decrease in taxable income resulting from the 
adjustment required by section 481(a)(2). Under these provisions, one-
fifth of the transitional adjustment must be taken into account in the 
taxable year of the change and in each of the 4 succeeding taxable 
years. For example, if the application of section 481(a)(2) would 
produce a decrease in taxable income of $50 for 1980, the year of 
change, then $10 (one-fifth of $50) must be taken into account as a 
decrease in taxable income for 1980, 1981, 1982, 1983, and 1984.
    (3) Suspense account for paperbacks and records--(i) In general. For 
taxpayers who have elected to use the method of accounting described in 
section 458 to account for returned paperbacks and records for a taxable 
year,

[[Page 235]]

section 458(e) provides that, in lieu of applying section 481, an 
electing taxpayer must establish a separate suspense account for its 
paperback business and its record business. The initial opening balance 
of the suspense account is described in paragraph (e)(3)(ii)(A) of this 
section. An initial adjustment to gross income for the year of election 
is described in paragraph (e)(3)(ii)(B) of this section. Annual 
adjustments to the suspense account are described in paragraph 
(e)(3)(iii)(A) of this section. Gross income adjustments are described 
in paragraph (e)(3)(iii)(B) of this section. Examples are provided in 
paragraph (e)(4) of this section. The effect of the suspense account is 
to defer all, or some part, of the deduction of the transitional 
adjustment until the taxpayer is no longer engaged in the trade or 
business of selling paperbacks or records, whichever is applicable.
    (ii) Establishing a suspense account--(A) Initial opening balance. 
To compute the initial opening balance of the suspense account for the 
first taxable year for which an election is effective, the taxpayer must 
determine the section 458 amount (as defined in paragraph (e)(3)(ii)(C) 
of this section) for each of the three preceding taxable years. The 
initial opening balance of the account is the largest of the section 458 
amounts.
    (B) Initial year adjustment. If the initial opening balance in the 
suspense account exceeds the section 458 amount (as defined in paragraph 
(e)(3)(ii)(C) of this section) for the taxable year immediately 
preceding the year of election, the excess is included in the taxpayer's 
gross income for the first taxable year for which the election was made.
    (C) Section 458 amount. For purposes of paragraph (e)(3)(ii) of this 
section, the section 458 amount for a taxable year is the dollar amount 
of merchandise returns that would have been excluded from gross income 
under section 458(a) for that taxable year if the section 458 election 
had been in effect for that taxable year.
    (iii) Annual adjustments--(A) Adjustment to the suspense account. 
Adjustments are made to the suspense account each year to account for 
fluctuations in merchandise returns. To compute the annual adjustment, 
the taxpayer must determine the amount to be excluded under the election 
from gross income under section 458(a) for the taxable year. If the 
amount is less than the opening balance in the suspense account for the 
taxable year, the balance in the suspense account is reduced by the 
difference. Conversely, if the amount is greater than the opening 
balance in the suspense account for the taxable year, the account is 
increased by the difference, but not to an amount in excess of the 
initial opening balance described in paragraph (e)(3)(ii)(A) of this 
section. Therefore, the balance in the suspense account will never be 
greater than the initial opening balance in the suspense account 
determined in paragraph (e)(3)(ii)(A) of this section. However, the 
balance in the suspense account after adjustments may be less than this 
initial opening balance in the suspense account.
    (B) Gross income adjustments. Adjustments to the suspense account 
for years subsequent to the year of election also produce adjustments in 
the taxpayer's gross income. Adjustments which reduce the balance in the 
suspense account reduce gross income for the year in which the 
adjustment to the suspense account is made. Adjustments which increase 
the balance in the suspense account increase gross income for the year 
in which the adjustment to the suspense account is made.
    (4) Example. The provisions of paragraph (e)(3) of this section may 
be illustrated by the following example:

    Example: (i) X corporation, a paperback distributor, makes a timely 
section 458 election for its taxable year ending December 31, 1980. If 
the election had been in effect for the taxable years ending on December 
31, 1977, 1978, and 1979, the dollar amounts of the qualifying returns 
would have been $5, $8, and $6, respectively. The initial opening 
balance of X's suspense account on January 1, 1980, is $8, the largest 
of these amounts. Since the initial opening balance ($8), is larger than 
the qualifying returns for 1979 ($6), the initial adjustment to gross 
income for 1980 is $2 ($8-$6).
    (ii) X has $5 in qualifying returns for its taxable year ending 
December 31, 1980. X must reduce its suspense account by $3, which is 
the excess of the opening balance ($8) over the amount of qualifying 
returns for the 1980 taxable year ($5). X also reduces

[[Page 236]]

its gross income for 1980 by $3. Thus, the net amount excludable from 
gross income for the 1980 taxable year after taking into account the 
qualifying returns, the gross income adjustment, and the initial year 
adjustment is $6 ($3 + $5-$2).
    (iii) X has qualifying returns of $7 for its taxable year ending 
December 31, 1981. X must increase its suspense account balance by $2, 
which is the excess of the amount of qualifying returns for 1981 ($7) 
over X's opening balance in the suspense account ($5). X must also 
increase its gross income by $2. Thus, the net income excludable from 
gross income for the 1981 taxable year after taking into account the 
qualifying returns and the gross income adjustment is $5 ($7-$2).
    (iv) X has qualifying returns of $10 for its taxable year ending 
December 31, 1982. The opening balance in X's suspense account of $7 
will not be increased in excess of the initial opening balance ($8). X 
must also increase gross income by $1. Thus, the net amount excludable 
from gross income for the 1982 taxable year is $9 ($10-$1).
    (v) This example is summarized by the following table:

----------------------------------------------------------------------------------------------------------------
                                                              Years Ending December 31
                                   -----------------------------------------------------------------------------
                                        1977         1978         1979       1980 \1\       1981         1982
----------------------------------------------------------------------------------------------------------------
Facts:
    Qualifying returns during                $5           $8           $6           $5           $7          $10
     merchandise return period for
     the taxable year.............
                                   =============================================================================
Adjustment to suspense account:
    Opening balance...............  ...........  ...........  ...........           $8           $5           $7
    Addition to account \2\.......  ...........  ...........  ...........  ...........            2            1
    Reduction to account \3\......  ...........  ...........  ...........          (3)
                                   -----------------------------------------------------------------------------
      Opening balance for next      ...........  ...........  ...........           $5           $7           $8
       year.......................
                                   =============================================================================
Amount excludable from income:
    Initial year adjustment.......  ...........  ...........  ...........         $(2)
    Amount excludable as            ...........  ...........  ...........            5           $7          $10
     qualifying returns in
     merchandise return period....
    Adjustment for increase in      ...........  ...........  ...........  ...........          (2)          (1)
     suspense account.............
    Adjustment for decrease in      ...........  ...........  ...........            3
     suspense account.............
                                   -----------------------------------------------------------------------------
      Net amount excludable for     ...........  ...........  ...........           $6           $5           $9
       the year...................
----------------------------------------------------------------------------------------------------------------
\1\ Year of Change.
\2\ Applies when qualifying returns during the merchandise return period exceed the opening balance; the
  addition is not to cause the suspense account to exceed the initial opening balance.
\3\ Applies when qualifying returns during the merchandise return period are less than the opening balance.

    (f) Subchapter C transactions--(1) General rule. If a transfer of 
substantially all the assets of a trade or business in which paperbacks 
or records are sold is made to an acquiring corporation, and if the 
acquiring corporation determines its basis in these assets, in whole or 
part, with reference to the basis of these assets in the hands of the 
transferor, then for the purposes of section 458(e) the principles of 
section 381 and Sec.  1.381(c)(4)-1 will apply. The application of this 
rule is not limited to the transactions described in section 381(a). 
Thus, the rule also applies, for example, to transactions described in 
section 351.
    (2) Special rules. If, in the case of a transaction described in 
paragraph (f)(1) of this section, an acquiring corporation acquires 
assets that were used in a trade or business that was not subject to a 
section 458 election from a transferor that is owned or controlled 
directly (or indirectly through a chain of corporations) by the same 
interests, and if the acquiring corporation uses the acquired assets in 
a trade or business for which the acquiring corporation later makes an 
election to use section 458, then the acquiring corporation must 
establish a suspense account by taking into account not only its own 
experience but also the transferor's experience when the transferor

[[Page 237]]

held the assets in its trade or business. Furthermore, the transferor is 
not allowed a deduction or exclusion for merchandise returned after the 
date of the transfer attributable to sales made by the transferor before 
the date of the transfer. Such returns shall be considered to be 
received by the acquiring corporation.
    (3) Example. The provisions of paragraph (f)(2) of this section may 
be illustrated by the following example.

    Example. Corporation S, a calendar year taxpayer, is a wholly owned 
subsidiary of Corporation P, a calendar year taxpayer. On December 31, 
1982, S acquires from P substantially all of the assets used in a trade 
or business in which records are sold. P had not made an election under 
section 458 with respect to the qualified sale of records made in 
connection with that trade or business. S makes an election to use 
section 458 for its taxable year ending December 31, 1983, for the trade 
or business in which the acquired assets are used. P's qualified record 
returns within the 4 month and 15 day merchandise return period 
following the 1980 and 1981 taxable years were $150 and $170, 
respectively. S's qualified record returns during the merchandise return 
period following 1982 were $160. S must establish a suspense account by 
taking into account both P's and S's experience for the 3 immediately 
preceding taxable years. Thus, the initial opening balance of S's 
suspense account is $170. S must also make an initial year adjustment of 
$10 ($170--$160), which S must include in income for S's taxable year 
ending December 31, 1983. P is not entitled to a deduction or exclusion 
for merchandise received after the date of the transfer (December 31, 
1982) attributable to sales made by the transferor before the date of 
transfer. Thus, P is not entitled to a deduction or exclusion for the 
$160 of merchandise received by S during the first 4 months and 15 days 
of 1983.

    (g) Adjustment to inventory and cost of goods sold. (1) If a 
taxpayer makes adjustments to gross receipts for a taxable year under 
the method of accounting described in section 458, the taxpayer, in 
determining excludable gross income, is also required to make 
appropriate correlative adjustments to purchases or closing inventory 
and to cost of goods sold for the same taxable year. Adjustments are 
appropriate, for example, where the taxpayer holds the merchandise 
returned for resale or where the taxpayer is entitled to receive a price 
adjustment from the person or entity that sold the merchandise to the 
taxpayer. Cost of goods sold must be properly adjusted in accordance 
with the provisions of Sec.  1.61-3 which provides, in pertinent part, 
that gross income derived from a manufacturing or merchandising business 
equals total sales less cost of goods sold.
    (2) The provisions of this paragraph (g) may be illustrated by the 
following examples. These examples do not, however, reflect any required 
adjustments under paragraph (e)(3) of this section.

    Example 1. (i) In 1986, P, a publisher, properly elects under 
section 458 of the Code not to include in its gross income in the year 
of sale, income attributable to qualified sales of paperback books 
returned within the specified statutory merchandise return period of 4 
months and 15 days. P and D, a distributor, agree that P shall provide D 
with a full refund for paperback books that D purchases from P and is 
unable to resell, provided the merchandise is returned to P within four 
months following the original sale. The agreement constitutes a legal 
obligation. The agreement provides that D's return of the covers of 
paperback books within the first four months following their sale 
constitutes satisfactory evidence that D has not resold and will not 
resell the paperback books. During P's 1989 taxable year, pursuant to 
the agreement, P sells D 500 paperback books for $1 each. In 1990, 
during the merchandise return period, D returns covers from 100 unsold 
paperback books representing $100 of P's 1989 sales of paperback books. 
P's cost attributable to the returned books is $25. No adjustment to 
cost of goods sold is required under paragraph (g)(1) of this section 
because P is not holding returned merchandise for resale. P's proper 
amount excluded from its 1989 gross income under section 458 is $100.
    (ii) If D returns the paperback books, rather than the covers, to P 
and these same books are then held by P for resale to other customers, 
paragraph (g)(1) of this section applies. Under paragraph (g)(1), P is 
required to decrease its cost of goods sold by $25, the amount of P's 
cost attributable to the returned merchandise. The proper amount 
excluded from P's 1989 gross income under section 458 is $75, resulting 
from adjustments to sales and cost of sales [(100 x $1)--$25].
    Example 2. (i) In 1986, D, a distributor, properly elects under 
section 458 of the Code not to include in its gross income in the year 
of sale, income attributable to qualified sales of paperback books 
returned within the specified statutory merchandise return period of 
four months and 15 days. D and R, a retailer, agree that D shall provide 
a full refund for paperback books that R purchases from it and is unable 
to resell. D and R also have

[[Page 238]]

agreed that the merchandise must be returned to D within four months 
following the original sale. The agreement constitutes a legal 
obligation. D is similarly entitled to a full refund from P, the 
publisher, for the same paperback books. In 1990, during the merchandise 
return period, R returns paperback books to D representing $100 of 1989 
sales. D's cost relating to these sales is $50. Under paragraph (g)(1) 
of this section, D must decrease its costs of goods sold by $50. D's 
proper amount excluded from its 1989 gross income under section 458 is 
$50 resulting from adjustments to sales and costs of sales ($100--$50).
    (ii) If D is instead only entitled to a 50 percent refund from P, D 
is required under paragraph (g)(1) of this section to decrease its costs 
of goods sold by $25, the amount of refund from P. D's proper amount 
excluded from its 1989 gross income under section 458 is $75, resulting 
from adjustments to sales and cost of sales ($100--$25).

[T.D. 8426, 57 FR 38596, Aug. 26, 1992; 57 FR 45879, Oct. 5, 1992]



Sec.  1.458-2  Manner of and time for making election.

    (a) Scope. For taxable years beginning after September 30, 1979, 
section 458 provides a special method of accounting for taxpayers who 
account for sales of magazines, paperbacks, or records using an accrual 
method of accounting. In order to use the special method of accounting 
under section 458, a taxpayer must make an election in the manner 
prescribed in this section. The election does not require the prior 
consent of the Internal Revenue Service. The election is effective for 
the taxable year for which it is made and for all subsequent taxable 
years, unless the taxpayer secures the prior consent of the Internal 
Revenue Service to revoke such election.
    (b) Separate election for each trade or business. An election is 
made with respect to each trade or business of a taxpayer in connection 
with which qualified sales (as defined in section 458(b)(5)) of a 
category of merchandise were made. Magazines, paperbacks, and records 
are each treated as a separate category of merchandise. If qualified 
sales of two or more categories of merchandise are made in connection 
with the same trade or business, then solely for purposes of section 
458, each category is treated as a separate trade or business. For 
example, if a taxpayer makes qualified sales of both magazines and 
paperbacks in the same trade or business, then solely for purposes of 
section 458, the qualified sales relating to magazines are considered 
one trade or business and the qualified sales relating to paperbacks are 
considered a separate trade or business. Thus, if the taxpayer wishes to 
account under section 458 for the qualified sales of both magazines and 
paperbacks, such taxpayer must make a separate election for each 
category.
    (c) Manner of, and time for, making election. An election is made 
under section 458 and this section by filing a statement of election 
containing the information described in paragraph (d) of this section 
with the taxpayer's income tax return for first taxable year for which 
the election is made. The election must be made no later than the time 
prescribed by law (including extensions) for filing the income tax 
return for the first taxable year for which the election is made. Thus, 
the election may not be filed with an amended income tax return after 
the prescribed date (including extensions) for filing the original 
return for such year.
    (d) Required information. The statement of election required by 
paragraph (c) of this section must indicate that an election is being 
made under section 458(c) and must set forth the following information:
    (1) The taxpayer's name, address, and identification number;
    (2) A description of each trade or business for which an election is 
made;
    (3) The first taxable year for which an election is made for each 
trade or business;
    (4) The merchandise return period (as defined in section 458(b)(7)) 
for each trade or business for which an election is made;
    (5) With respect to an election that applies to magazines, the 
amount of the adjustment computed under section 481(a) resulting from 
the change to the method of accounting described in section 458; and
    (6) With respect to an election that applies to paperbacks or 
records, the initial opening balance (computed in accordance with 
section 458(e)) in the suspense account for each trade or business for 
which an election is made.

[[Page 239]]


The statement of election should be made on a Form 3115 which need 
contain no information other than that required by this paragraph.

[T.D. 7628, 44 FR 33398, June 11, 1979. Redesignated by T.D. 8426, 57 FR 
38599, Aug. 26, 1992]



Sec.  1.460-0  Outline of regulations under section 460.

    This section lists the paragraphs contained in Sec.  1.460-1 through 
Sec.  1.460-6.

                   Sec.  1.460-1 Long-term contracts.

    (a) Overview.
    (1) In general.
    (2) Exceptions to required use of PCM.
    (i) Exempt construction contract.
    (ii) Qualified ship or residential construction contract.
    (b) Terms.
    (1) Long-term contract.
    (2) Contract for the manufacture, building, installation, or 
construction of property.
    (i) In general.
    (ii) De minimis construction activities.
    (3) Allocable contract costs.
    (4) Related party.
    (5) Contracting year.
    (6) Completion year.
    (7) Contract commencement date.
    (8) Incurred.
    (9) Independent research and development expenses.
    (10) Long-term contract methods of accounting.
    (c) Entering into and completing long-term contracts.
    (1) In general.
    (2) Date contract entered into.
    (i) In general.
    (ii) Options and change orders.
    (3) Date contract completed.
    (i) In general.
    (ii) Secondary items.
    (iii) Subcontracts.
    (iv) Final completion and acceptance.
    (A) In general.
    (B) Contingent compensation.
    (C) Assembly or installation.
    (D) Disputes.
    (d) Allocation among activities.
    (1) In general.
    (2) Non-long-term contract activity.
    (e) Severing and aggregating contracts.
    (1) In general.
    (2) Facts and circumstances.
    (i) Pricing.
    (ii) Separate delivery or acceptance.
    (iii) Reasonable businessperson.
    (3) Exceptions.
    (i) Severance for PCM.
    (ii) Options and change orders.
    (4) Statement with return.
    (f) Classifying contracts.
    (1) In general.
    (2) Hybrid contracts.
    (i) In general.
    (ii) Elections.
    (3) Method of accounting.
    (4) Use of estimates.
    (i) Estimating length of contract.
    (ii) Estimating allocable contract costs.
    (g) Special rules for activities benefitting long-term contracts of 
a related party.
    (1) Related party use of PCM.
    (i) In general.
    (ii) Exception for components and subassemblies.
    (2) Total contract price.
    (3) Completion factor.
    (h) Effective date.
    (1) In general.
    (2) Change in method of accounting.
    (3) Changes made by Tax Cuts and Jobs Act (Pub. L. 115-97).
    (i) [Reserved]
    (j) Examples.

            Sec.  1.460-2 Long-term manufacturing contracts.

    (a) In general.
    (b) Unique.
    (1) In general.
    (2) Safe harbors.
    (i) Short production period.
    (ii) Customized item.
    (iii) Inventoried item.
    (c) Normal time to complete.
    (1) In general.
    (2) Production by related parties.
    (d) Qualified ship contracts.
    (e) Examples.

             Sec.  1.460-3 Long-term construction contracts.

    (a) In general.
    (b) Exempt construction contracts.
    (1) In general.
    (2) Home construction contract.
    (i) In general.
    (ii) Townhouses and rowhouses.
    (iii) Common improvements.
    (iv) Mixed use costs.
    (3) Gross receipts test.
    (i) In general
    (ii) Application of gross receipts test
    (A) In general
    (B) Gross receipts of individuals, etc.
    (C) Partners and S corporation shareholders
    (D) Examples
    (1) Example 1.
    (2) Example 2.
    (iii) Method of accounting.
    (c) Residential construction contracts.
    (d) Applicability dates.

      Sec.  1.460-4 Methods of accounting for long-term contracts.

    (a) Overview.
    (b) Percentage-of-completion method.
    (1) In general.
    (2) Computations.

[[Page 240]]

    (3) Post-completion-year income.
    (4) Total contract price.
    (i) In general.
    (A) Definition.
    (B) Contingent compensation.
    (C) Non-long-term contract activities.
    (ii) Estimating total contract price.
    (5) Completion factor.
    (i) Allocable contract costs.
    (ii) Cumulative allocable contract costs.
    (iii) Estimating total allocable contract costs.
    (iv) Pre-contracting-year costs.
    (v) Post-completion-year costs.
    (6) 10-percent method.
    (i) In general.
    (ii) Election.
    (7) Terminated contract.
    (i) Reversal of income.
    (ii) Adjusted basis.
    (iii) Look-back method.
    (c) Exempt contract methods.
    (1) In general.
    (2) Exempt-contract percentage-of-completion method.
    (i) In general.
    (ii) Determination of work performed.
    (d) Completed-contract method.
    (1) In general.
    (2) Post-completion-year income and costs.
    (3) Gross contract price.
    (4) Contracts with disputed claims.
    (i) In general.
    (ii) Taxpayer assured of profit or loss.
    (iii) Taxpayer unable to determine profit or loss.
    (iv) Dispute resolved.
    (e) Percentage-of-completion/capitalized-cost method.
    (f) Alternative minimum taxable income.
    (1) In general.
    (2) Election to use regular completion factors.
    (g) Method of accounting.
    (h) Examples.
    (i) Applicability date.
    (j) Consolidated groups and controlled groups.
    (1) Intercompany transactions.
    (i) In general.
    (ii) Definitions and nomenclature.
    (2) Example.
    (3) Effective dates.
    (i) In general.
    (ii) Prior law.
    (4) Consent to change method of accounting.
    (k) Mid-contract change in taxpayer.
    (1) In general.
    (2) Constructive completion transactions.
    (i) Scope.
    (ii) Old taxpayer.
    (iii) New taxpayer.
    (iv) Special rules relating to distributions of certain contracts by 
a partnership.
    (A) In general.
    (B) Old taxpayer.
    (C) New taxpayer.
    (D) Basis rules.
    (E) Section 751.
    (1) In general.
    (2) Ordering rules.
    (3) Step-in-the-shoes transactions.
    (i) Scope.
    (ii) Old taxpayer.
    (A) In general.
    (B) Gain realized on the transaction.
    (iii) New taxpayer.
    (A) Method of accounting.
    (B) Contract price.
    (C) Contract costs.
    (iv) Special rules related to certain corporate and partnership 
transactions.
    (A) Old taxpayer--basis adjustment.
    (1) In general.
    (2) Basis adjustment in excess of stock or partnership interest 
basis.
    (3) Subsequent dispositions of certain contracts.
    (B) New taxpayer.
    (1) Contract price adjustment.
    (2) Basis in contract.
    (C) Definition of old taxpayer and new taxpayer for certain 
partnership transactions.
    (D) Exceptions to step-in-the-shoes rules for S corporations.
    (v) Special rules relating to certain partnership transactions.
    (A) Section 704(c).
    (1) Contributions of contracts.
    (2) Revaluations of partnership property.
    (3) Allocation methods.
    (B) Basis adjustments under sections 743(b) and 734(b).
    (C) Cross reference.
    (D) Exceptions to step-in-the-shoes rules.
    (4) Anti-abuse rule.
    (5) Examples.
    (6) Effective date.

                  Sec.  1.460-5 Cost allocation rules.

    (a) Overview.
    (b) Cost allocation method for contracts subject to PCM.
    (1) In general.
    (2) Special rules.
    (i) Direct material costs.
    (ii) Components and subassemblies.
    (iii) Simplified production methods.
    (iv) Costs identified under cost-plus long-term contracts and 
federal long-term contracts.
    (v) Interest.
    (A) In general.
    (B) Production period.
    (C) Application of section 263A(f).
    (vi) Research and experimental expenses.
    (vii) Service costs.
    (A) Simplified service cost method.
    (1) In general.
    (2) Example.
    (B) Jobsite costs.
    (C) Limitation on other reasonable cost allocation methods.

[[Page 241]]

    (c) Simplified cost-to-cost method for contracts subject to the PCM.
    (1) In general.
    (2) Election.
    (d) Cost allocation rules for exempt construction contracts reported 
using CCM.
    (1) In general.
    (2) Indirect costs.
    (i) Indirect costs allocable to exempt construction contracts.
    (ii) Indirect costs not allocable to exempt construction contracts.
    (3) Large homebuilders.
    (e) Cost allocation rules for contracts subject to the PCCM.
    (f) Special rules applicable to costs allocated under this section.
    (1) Nondeductible costs.
    (2) Costs incurred for non-long-term contract activities.
    (g) Method of accounting.

                     Sec.  1.460-6 Look-back method.

    (a) In general.
    (1) Introduction.
    (2) Overview.
    (b) Scope of look-back method.
    (1) In general.
    (2) Exceptions from section 460.
    (3) De minimis exception.
    (4) Alternative minimum tax.
    (5) Effective date.
    (c) Operation of the look-back method.
    (1) Overview.
    (i) In general.
    (ii) Post-completion revenue and expenses.
    (A) In general.
    (B) Completion.
    (C) Discounting of contract price and contract cost adjustments 
subsequent to completion; election not to discount.
    (1) General rule.
    (2) Election not to discount.
    (3) Year-end discounting convention.
    (D) Revenue acceleration rule.
    (2) Look-back Step One.
    (i) Hypothetical reallocation of income among prior tax years.
    (ii) Treatment of estimated future costs in year of completion.
    (iii) Interim reestimates not considered.
    (iv) Tax years in which income is affected.
    (v) Costs incurred prior to contract execution; 10-percent method.
    (A) General rule.
    (B) Example.
    (vi) Amount treated as contract price.
    (A) General rule.
    (B) Contingencies.
    (C) Change orders.
    (3) Look-back Step Two: Computation of hypothetical overpayment or 
underpayment of tax.
    (i) In general.
    (ii) Redetermination of tax liability.
    (iii) Hypothetical underpayment or overpayment.
    (iv) Cumulative determination of tax liability.
    (v) Years affected by look-back only.
    (vi) Definition of tax liability.
    (4) Look-back Step Three: Calculation of interest on underpayment or 
overpayment.
    (i) In general.
    (ii) Changes in the amount of a loss or credit carryback or 
carryover.
    (iii) Changes in the amount of tax liability that generated a 
subsequent refund.
    (d) Simplified marginal impact method.
    (1) Introduction.
    (2) Operation.
    (i) In general.
    (ii) Applicable tax rate.
    (iii) Overpayment ceiling.
    (iv) Example.
    (3) Anti-abuse rule.
    (4) Application.
    (i) Required use by certain pass-through entities.
    (A) General rule.
    (B) Closely held.
    (C) Examples.
    (D) Domestic contracts.
    (1) General rule.
    (2) Portion of contract income sourced.
    (E) Application to foreign contracts.
    (F) Effective date.
    (ii) Elective use.
    (A) General rule.
    (B) Election requirements.
    (C) Consolidated group consistency rule.
    (e) Delayed reapplication method.
    (1) In general.
    (2) Time and manner of making election.
    (3) Examples.
    (f) Look-back reporting.
    (1) Procedure.
    (2) Treatment of interest on return.
    (i) General rule.
    (ii) Timing of look-back interest.
    (3) Statutes of limitations and compounding of interest on look-back 
interest.
    (g) Mid-contract change in taxpayer.
    (1) In general.
    (2) Constructive completion transactions.
    (3) Step-in-the-shoes transactions.
    (i) General rules.
    (ii) Application of look-back method to pre-transaction period.
    (A) Contract price
    (B) Method.
    (C) Interest accrual period.
    (D) Information old taxpayer must provide.
    (1) In general.
    (2) Special rules for certain pass-through entity transactions.
    (iii) Application of look-back method to post-transaction years.
    (iv) S corporation elections.
    (4) Effective date.
    (h) Examples.
    (1) Overview.
    (2) Step One.

[[Page 242]]

    (3) Step Two.
    (4) Post-completion adjustments.
    (5) Alternative minimum tax.
    (6) Credit carryovers.
    (7) Net operating losses.
    (8) Alternative minimum tax credit.
    (9) Period for interest.
    (i) [Reserved]
    (j) Election not to apply look-back method in de minimis cases.
    (k) Applicability date.

[T.D. 9315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8597, 60 FR 
36683, July 18, 1995; T.D. 8756, 63 FR 1918, Jan. 13, 1998; T.D. 8775, 
63 FR 36181, July 2, 1998; T.D. 8929, 66 FR 2224, Jan. 11, 2001; T.D. 
8995, 67 FR 34605, May 15, 2002; T.D. 9137, 69 FR 42553, July 16, 2004; 
T.D. 9942, 86 FR 272, Jan. 5, 2021; 86 FR 32186, June 17, 2021]



Sec.  1.460-1  Long-term contracts.

    (a) Overview--(1) In general. This section provides rules for 
determining whether a contract for the manufacture, building, 
installation, or construction of property is a long-term contract under 
section 460 and what activities must be accounted for as a single long-
term contract. Specific rules for long-term manufacturing and 
construction contracts are provided in Sec. Sec.  1.460-2 and 1.460-3, 
respectively. A taxpayer generally must determine the income from a 
long-term contract using the percentage-of-completion method described 
in Sec.  1.460-4(b) (PCM) and the cost allocation rules described in 
Sec.  1.460-5(b) or (c). In addition, after a contract subject to the 
PCM is completed, a taxpayer generally must apply the look-back method 
described in Sec.  1.460-6 to determine the amount of interest owed on 
any hypothetical underpayment of tax, or earned on any hypothetical 
overpayment of tax, attributable to accounting for the long-term 
contract under the PCM.
    (2) Exceptions to required use of PCM--(i) Exempt construction 
contract. The requirement to use the PCM does not apply to any exempt 
construction contract described in Sec.  1.460-3(b). Thus, a taxpayer 
may determine the income from an exempt construction contract using any 
accounting method permitted by Sec.  1.460-4(c) and, for contracts 
accounted for using the completed-contract method (CCM), any cost 
allocation method permitted by Sec.  1.460-5(d). Exempt construction 
contracts that are not subject to the PCM or CCM are not subject to the 
cost allocation rules of Sec.  1.460-5 except for the production-period 
interest rules of Sec.  1.460-5(b)(2)(v). Exempt construction 
contractors that are large homebuilders described in Sec.  1.460-5(d)(3) 
must capitalize costs under section 263A. All other exempt construction 
contractors must account for the cost of construction using the 
appropriate rules contained in other sections of the Internal Revenue 
Code or regulations.
    (ii) Qualified ship or residential construction contract. The 
requirement to use the PCM applies only to a portion of a qualified ship 
contract described in Sec.  1.460-2(d) or residential construction 
contract described in Sec.  1.460-3(c). A taxpayer generally may 
determine the income from a qualified ship contract or residential 
construction contract using the percentage-of-completion/capitalized-
cost method (PCCM) described in Sec.  1.460-4(e), but must use a cost 
allocation method described in Sec.  1.460-5(b) for the entire contract.
    (b) Terms--(1) Long-term contract. A long-term contract generally is 
any contract for the manufacture, building, installation, or 
construction of property if the contract is not completed within the 
contracting year, as defined in paragraph (b)(5) of this section. 
However, a contract for the manufacture of property is a long-term 
contract only if it also satisfies either the unique item or 12-month 
requirements described in Sec.  1.460-2. A contract for the manufacture 
of personal property is a manufacturing contract. In contrast, a 
contract for the building, installation, or construction of real 
property is a construction contract.
    (2) Contract for the manufacture, building, installation, or 
construction of property--(i) In general. A contract is a contract for 
the manufacture, building, installation, or construction of property if 
the manufacture, building, installation, or construction of property is 
necessary for the taxpayer's contractual obligations to be fulfilled and 
if the manufacture, building, installation, or construction of that 
property has not been completed when the parties enter into the 
contract. If a taxpayer has to manufacture or construct an item to 
fulfill its obligations under

[[Page 243]]

the contract, the fact that the taxpayer is not required to deliver that 
item to the customer is not relevant. Whether the customer has title to, 
control over, or bears the risk of loss from, the property manufactured 
or constructed by the taxpayer also is not relevant. Furthermore, how 
the parties characterize their agreement (e.g., as a contract for the 
sale of property) is not relevant.
    (ii) De minimis construction activities. Notwithstanding paragraph 
(b)(2)(i) of this section, a contract is not a construction contract 
under section 460 if the contract includes the provision of land by the 
taxpayer and the estimated total allocable contract costs, as defined in 
paragraph (b)(3) of this section, attributable to the taxpayer's 
construction activities are less than 10 percent of the contract's total 
contract price, as defined in Sec.  1.460-4(b)(4)(i). For the purposes 
of this paragraph (b)(2)(ii), the allocable contract costs attributable 
to the taxpayer's construction activities do not include the cost of the 
land provided to the customer. In addition, a contract's estimated total 
allocable contract costs include a proportionate share of the estimated 
cost of any common improvement that benefits the subject matter of the 
contract if the taxpayer is contractually obligated, or required by law, 
to construct the common improvement.
    (3) Allocable contract costs. Allocable contract costs are costs 
that are allocable to a long-term contract under Sec.  1.460-5.
    (4) Related party. A related party is a person whose relationship to 
a taxpayer is described in section 707(b) or 267(b), determined without 
regard to section 267(f)(1)(A) and determined by replacing ``at least 80 
percent'' with ``more than 50 percent'' for the purposes of determining 
the ownership of the stock of a corporation in sections 267(b)(2), (8), 
(10)(A), and (12).
    (5) Contracting year. The contracting year is the taxable year in 
which a taxpayer enters into a contract as described in paragraph (c)(2) 
of this section.
    (6) Completion year. The completion year is the taxable year in 
which a taxpayer completes a contract as described in paragraph (c)(3) 
of this section.
    (7) Contract commencement date. The contract commencement date is 
the date that a taxpayer or related party first incurs any allocable 
contract costs, such as design and engineering costs, other than 
expenses attributable to bidding and negotiating activities. Generally, 
the contract commencement date is relevant in applying Sec.  1.460-
6(b)(3) (concerning the de minimis exception to the look-back method 
under section 460(b)(3)(B)); Sec.  1.460-5(b)(2)(v)(B)(1)(i) (concerning 
the production period subject to interest allocation); Sec.  1.460-2(d) 
(concerning qualified ship contracts); and Sec.  1.460-3(b)(1)(ii) 
(concerning the construction period for exempt construction contracts).
    (8) Incurred. Incurred has the meaning given in Sec.  1.461-1(a)(2) 
(concerning the taxable year a liability is incurred under the accrual 
method of accounting), regardless of a taxpayer's overall method of 
accounting. See Sec.  1.461-4(d)(2)(ii) for economic performance rules 
concerning the PCM.
    (9) Independent research and development expenses. Independent 
research and development expenses are any expenses incurred in the 
performance of research or development, except that this term does not 
include any expenses that are directly attributable to a particular 
long-term contract in existence when the expenses are incurred and this 
term does not include any expenses under an agreement to perform 
research or development.
    (10) Long-term contract methods of accounting. Long-term contract 
methods of accounting, which include the PCM, the CCM, the PCCM, and the 
exempt-contract percentage-of-completion method (EPCM), are methods of 
accounting that may be used only for long-term contracts.
    (c) Entering into and completing long-term contracts--(1) In 
general. To determine when a contract is entered into under paragraph 
(c)(2) of this section and completed under paragraph (c)(3) of this 
section, a taxpayer must consider all relevant allocable contract costs 
incurred and activities performed

[[Page 244]]

by itself, by related parties on its behalf, and by the customer, that 
are incident to or necessary for the long-term contract. In addition, to 
determine whether a contract is completed in the contracting year, the 
taxpayer may not consider when it expects to complete the contract.
    (2) Date contract entered into--(i) In general. A taxpayer enters 
into a contract on the date that the contract binds both the taxpayer 
and the customer under applicable law, even if the contract is subject 
to unsatisfied conditions not within the taxpayer's control (such as 
obtaining financing). If a taxpayer delays entering into a contract for 
a principal purpose of avoiding section 460, however, the taxpayer will 
be treated as having entered into a contract not later than the contract 
commencement date.
    (ii) Options and change orders. A taxpayer enters into a new 
contract on the date that the customer exercises an option or similar 
provision in a contract if that option or similar provision must be 
severed from the contract under paragraph (e) of this section. 
Similarly, a taxpayer enters into a new contract on the date that it 
accepts a change order or other similar agreement if the change order or 
other similar agreement must be severed from the contract under 
paragraph (e) of this section.
    (3) Date contract completed--(i) In general. A taxpayer's contract 
is completed upon the earlier of--
    (A) Use of the subject matter of the contract by the customer for 
its intended purpose (other than for testing) and at least 95 percent of 
the total allocable contract costs attributable to the subject matter 
have been incurred by the taxpayer; or
    (B) Final completion and acceptance of the subject matter of the 
contract.
    (ii) Secondary items. The date a contract accounted for using the 
CCM is completed is determined without regard to whether one or more 
secondary items have been used or finally completed and accepted. If any 
secondary items are incomplete at the end of the taxable year in which 
the primary subject matter of a contract is completed, the taxpayer must 
separate the portion of the gross contract price and the allocable 
contract costs attributable to the incomplete secondary item(s) from the 
completed contract and account for them using a permissible method of 
accounting. A permissible method of accounting includes a long-term 
contract method of accounting only if a separate contract for the 
secondary item(s) would be a long-term contract, as defined in paragraph 
(b)(1) of this section.
    (iii) Subcontracts. In the case of a subcontract, a subcontractor's 
customer is the general contractor. Thus, the subject matter of the 
subcontract is the relevant subject matter under paragraph (c)(3)(i) of 
this section.
    (iv) Final completion and acceptance--(A) In general. Except as 
otherwise provided in this paragraph (c)(3)(iv), to determine whether 
final completion and acceptance of the subject matter of a contract have 
occurred, a taxpayer must consider all relevant facts and circumstances. 
Nevertheless, a taxpayer may not delay the completion of a contract for 
the principal purpose of deferring federal income tax.
    (B) Contingent compensation. Final completion and acceptance is 
determined without regard to any contractual term that provides for 
additional compensation that is contingent on the successful performance 
of the subject matter of the contract. A taxpayer must account for all 
contingent compensation that is not includible in total contract price 
under Sec.  1.460-4(b)(4)(i), or in gross contract price under Sec.  
1.460-4(d)(3), using a permissible method of accounting. For application 
of the look-back method for contracts accounted for using the PCM, see 
Sec.  1.460-6(c)(1)(ii) and (2)(vi).
    (C) Assembly or installation. Final completion and acceptance is 
determined without regard to whether the taxpayer has an obligation to 
assist or supervise assembly or installation of the subject matter of 
the contract where the assembly or installation is not performed by the 
taxpayer or a related party. A taxpayer must account for the gross 
receipts and costs attributable to such an obligation using a 
permissible method of accounting, other than a long-term contract 
method.

[[Page 245]]

    (D) Disputes. Final completion and acceptance is determined without 
regard to whether a dispute exists at the time the taxpayer tenders the 
subject matter of the contract to the customer. For contracts accounted 
for using the CCM, see Sec.  1.460-4(d)(4). For application of the look-
back method for contracts accounted for using the PCM, see Sec.  1.460-
6(c)(1)(ii) and (2)(vi).
    (d) Allocation among activities--(1) In general. Long-term contract 
methods of accounting apply only to the gross receipts and costs 
attributable to long-term contract activities. Gross receipts and costs 
attributable to long-term contract activities means amounts included in 
total contract price or gross contract price, whichever is applicable, 
as determined under Sec.  1.460-4, and costs allocable to the contract, 
as determined under Sec.  1.460-5. Gross receipts and costs attributable 
to non-long-term contract activities (as defined in paragraph (d)(2) of 
this section) generally must be taken into account using a permissible 
method of accounting other than a long-term contract method. See section 
446(c) and Sec.  1.446-1(c). However, if the performance of a non-long-
term contract activity is incident to or necessary for the manufacture, 
building, installation, or construction of the subject matter of one or 
more of the taxpayer's long-term contracts, the gross receipts and costs 
attributable to that activity must be allocated to the long-term 
contract(s) benefitted as provided in Sec. Sec.  1.460-4(b)(4)(i) and 
1.460-5(f)(2), respectively. Similarly, if a single long-term contract 
requires a taxpayer to perform a non-long-term contract activity that is 
not incident to or necessary for the manufacture, building, 
installation, or construction of the subject matter of the long-term 
contract, the gross receipts and costs attributable to that non-long-
term contract activity must be separated from the contract and accounted 
for using a permissible method of accounting other than a long-term 
contract method. But see paragraph (g) of this section for related party 
rules.
    (2) Non-long-term contract activity. Non-long-term contract activity 
means the performance of an activity other than manufacturing, building, 
installation, or construction, such as the provision of architectural, 
design, engineering, and construction management services, and the 
development or implementation of computer software. In addition, 
performance under a guaranty, warranty, or maintenance agreement is a 
non-long-term contract activity that is never incident to or necessary 
for the manufacture or construction of property under a long-term 
contract.
    (e) Severing and aggregating contracts--(1) In general. After 
application of the allocation rules of paragraph (d) of this section, 
the severing and aggregating rules of this paragraph (e) may be applied 
by the Commissioner or the taxpayer as necessary to clearly reflect 
income (e.g., to prevent the unreasonable deferral (or acceleration) of 
income or the premature recognition (or deferral) of loss). Under the 
severing and aggregating rules, one agreement may be treated as two or 
more contracts, and two or more agreements may be treated as one 
contract. Except as provided in paragraph (e)(3)(ii) of this section, a 
taxpayer must determine whether to sever an agreement or to aggregate 
two or more agreements based on the facts and circumstances known at the 
end of the contracting year.
    (2) Facts and circumstances. Whether an agreement should be severed, 
or two or more agreements should be aggregated, depends on the following 
factors:
    (i) Pricing. Independent pricing of items in an agreement is 
necessary for the agreement to be severed into two or more contracts. In 
the case of an agreement for similar items, if the price to be paid for 
the items is determined under different terms or formulas (e.g., if some 
items are priced under a cost-plus incentive fee arrangement and later 
items are to be priced under a fixed-price arrangement), then the 
difference in the pricing terms or formulas indicates that the items are 
independently priced. Similarly, interdependent pricing of items in 
separate agreements is necessary for two or more agreements to be 
aggregated into one contract. A single price negotiation for similar 
items ordered under one or more agreements indicates that the items are 
interdependently priced.

[[Page 246]]

    (ii) Separate delivery or acceptance. An agreement may not be 
severed into two or more contracts unless it provides for separate 
delivery or separate acceptance of items that are the subject matter of 
the agreement. However, the separate delivery or separate acceptance of 
items by itself does not necessarily require an agreement to be severed.
    (iii) Reasonable businessperson. Two or more agreements to perform 
manufacturing or construction activities may not be aggregated into one 
contract unless a reasonable businessperson would not have entered into 
one of the agreements for the terms agreed upon without also entering 
into the other agreement(s). Similarly, an agreement to perform 
manufacturing or construction activities may not be severed into two or 
more contracts if a reasonable businessperson would not have entered 
into separate agreements containing terms allocable to each severed 
contract. Analyzing the reasonable businessperson standard requires an 
analysis of all the facts and circumstances of the business arrangement 
between the taxpayer and the customer. For purposes of this paragraph 
(e)(2)(iii), a taxpayer's expectation that the parties would enter into 
another agreement, when agreeing to the terms contained in the first 
agreement, is not relevant.
    (3) Exceptions--(i) Severance for PCM. A taxpayer may not sever 
under this paragraph (e) a long-term contract that would be subject to 
the PCM without obtaining the Commissioner's prior written consent.
    (ii) Options and change orders. Except as provided in paragraph 
(e)(3)(i) of this section, a taxpayer must sever an agreement that 
increases the number of units to be supplied to the customer, such as 
through the exercise of an option or the acceptance of a change order, 
if the agreement provides for separate delivery or separate acceptance 
of the additional units.
    (4) Statement with return. If a taxpayer severs an agreement or 
aggregates two or more agreements under this paragraph (e) during the 
taxable year, the taxpayer must attach a statement to its original 
federal income tax return for that year. This statement must contain the 
following information--
    (i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC. 
1.460-1(e);
    (ii) The taxpayer's name; and
    (iii) The taxpayer's employer identification number or social 
security number.
    (f) Classifying contracts--(1) In general. After applying the 
severing and aggregating rules of paragraph (e) of this section, a 
taxpayer must determine the classification of a contract (e.g., as a 
long-term manufacturing contract, long-term construction contract, non-
long-term contract) based on all the facts and circumstances known no 
later than the end of the contracting year. Classification is determined 
on a contract-by-contract basis. Consequently, a requirement to 
manufacture a single unique item under a long-term contract will subject 
all other items in that contract to section 460.
    (2) Hybrid contracts--(i) In general. A long-term contract that 
requires a taxpayer to perform both manufacturing and construction 
activities (hybrid contract) generally must be classified as two 
contracts, a manufacturing contract and a construction contract. A 
taxpayer may elect, on a contract-by-contract basis, to classify a 
hybrid contract as a long-term construction contract if at least 95 
percent of the estimated total allocable contract costs are reasonably 
allocable to construction activities. In addition, a taxpayer may elect, 
on a contract-by-contract basis, to classify a hybrid contract as a 
long-term manufacturing contract subject to the PCM.
    (ii) Elections. A taxpayer makes an election under this paragraph 
(f)(2) by using its method of accounting for similar construction 
contracts or for manufacturing contracts, whichever is applicable, to 
account for a hybrid contract entered into during the taxable year of 
the election on its original federal income tax return for the election 
year. If an electing taxpayer's method is the PCM, the taxpayer also 
must use the PCM to apply the look-back method under Sec.  1.460-6 and 
to determine alternative minimum taxable income under Sec.  1.460-4(f).

[[Page 247]]

    (3) Method of accounting. Except as provided in paragraph (f)(2)(ii) 
of this section, a taxpayer's method of classifying contracts is a 
method of accounting under section 446 and, thus, may not be changed 
without the Commissioner's consent. If a taxpayer's method of 
classifying contracts is unreasonable, that classification method is an 
impermissible accounting method. A taxpayer may adopt any permissible 
method of accounting for each classification of contract. Such adoption 
is not a change in method of accounting under section 446 and the 
accompanying regulations. For example, a taxpayer that has had only 
contracts classified as nonexempt long-term contracts and has used the 
PCM for these contracts may adopt an exempt contract method in the 
taxable year it first enters into an exempt long-term contract.
    (4) Use of estimates--(i) Estimating length of contract. A taxpayer 
must use a reasonable estimate of the time required to complete a 
contract when necessary to classify the contract (e.g., to determine 
whether the five-year completion rule for qualified ship contracts under 
Sec.  1.460-2(d), or the two-year completion rule for exempt 
construction contracts under Sec.  1.460-3(b), is satisfied, but not to 
determine whether a contract is completed within the contracting year 
under paragraph (b)(1) of this section). To be considered reasonable, an 
estimate of the time required to complete the contract must include 
anticipated time for delay, rework, change orders, technology or design 
problems, or other problems that reasonably can be anticipated 
considering the nature of the contract and prior experience. A contract 
term that specifies an expected completion or delivery date may be 
considered evidence that the taxpayer reasonably expects to complete or 
deliver the subject matter of the contract on or about the date 
specified, especially if the contract provides bona fide penalties for 
failing to meet the specified date. If a taxpayer classifies a contract 
based on a reasonable estimate of completion time, the contract will not 
be reclassified based on the actual (or another reasonable estimate of) 
completion time. A taxpayer's estimate of completion time will not be 
considered unreasonable if a contract is not completed within the 
estimated time primarily because of unforeseeable factors not within the 
taxpayer's control, such as third-party litigation, extreme weather 
conditions, strikes, or delays in securing permits or licenses.
    (ii) Estimating allocable contract costs. A taxpayer must use a 
reasonable estimate of total allocable contract costs when necessary to 
classify the contract (e.g., to determine whether a contract is a home 
construction contract under Sec.  1.460-(3)(b)(2)). If a taxpayer 
classifies a contract based on a reasonable estimate of total allocable 
contract costs, the contract will not be reclassified based on the 
actual (or another reasonable estimate of) total allocable contract 
costs.
    (g) Special rules for activities benefitting long-term contracts of 
a related party--(1) Related party use of PCM--(i) In general. Except as 
provided in paragraph (g)(1)(ii) of this section, if a related party and 
its customer enter into a long-term contract subject to the PCM, and a 
taxpayer performs any activity that is incident to or necessary for the 
related party's long-term contract, the taxpayer must account for the 
gross receipts and costs attributable to this activity using the PCM, 
even if this activity is not otherwise subject to section 460(a). This 
type of activity may include, for example, the performance of 
engineering and design services, and the production of components and 
subassemblies that are reasonably expected to be used in the production 
of the subject matter of the related party's contract.
    (ii) Exception for components and subassemblies. A taxpayer is not 
required to use the PCM under this paragraph (g) to account for a 
component or subassembly that benefits a related party's long-term 
contract if more than 50 percent of the average annual gross receipts 
attributable to the sale of this item for the 3-taxable-year-period 
ending with the contracting year comes from unrelated parties.
    (2) Total contract price. If a taxpayer is required to use the PCM 
under paragraph (g)(1)(i) of this section, the total contract price (as 
defined in Sec.  1.460-4(b)(4)(i)) is the fair market value of

[[Page 248]]

the taxpayer's activity that is incident to or necessary for the 
performance of the related party's long-term contract. The related party 
also must use the fair market value of the taxpayer's activity as the 
cost it incurs for the activity. The fair market value of the taxpayer's 
activity may or may not be the same as the amount the related party pays 
the taxpayer for that activity.
    (3) Completion factor. To compute a contract's completion factor (as 
described in Sec.  1.460-4(b)(5)), the related party must take into 
account the fair market value of the taxpayer's activity that is 
incident to or necessary for the performance of the related party's 
long-term contract when the related party incurs the liability to the 
taxpayer for the activity, rather than when the taxpayer incurs the 
costs to perform the activity.
    (h) Effective date--(1) In general. Except as otherwise provided, 
this section and Sec. Sec.  1.460-2 through 1.460-5 are applicable for 
contracts entered into on or after January 11, 2001.
    (2) Change in method of accounting. Any change in a taxpayer's 
method of accounting necessary to comply with this section and 
Sec. Sec.  1.460-2 through 1.460-5 is a change in method of accounting 
to which the provisions of section 446 and the regulations thereunder 
apply. For the first taxable year that includes January 11, 2001, a 
taxpayer is granted the consent of the Commissioner to change its method 
of accounting to comply with the provisions of this section and 
Sec. Sec.  1.460-2 through 1.460-5 for long-term contracts entered into 
on or after January 11, 2001. A taxpayer that wants to change its method 
of accounting under this paragraph (h)(2) must follow the automatic 
consent procedures in Rev. Proc. 99-49 (1999-52 I.R.B. 725) (see Sec.  
601.601(d)(2) of this chapter), except that the scope limitations in 
section 4.02 of Rev. Proc. 99-49 do not apply. Because a change under 
this paragraph (h)(2) is made on a cut-off basis, a section 481(a) 
adjustment is not permitted or required. Moreover, the taxpayer does not 
receive audit protection under section 7 of Rev. Proc. 99-49 for a 
change in method of accounting under this paragraph (h)(2). A taxpayer 
that wants to change its exempt-contract method of accounting is not 
granted the consent of the Commissioner under this paragraph (h)(2) and 
must file a Form 3115, ``Application for Change in Accounting Method,'' 
to obtain consent. See Rev. Proc. 97-27 (1997-1 C.B. 680) (see Sec.  
601.601(d)(2) of this chapter).
    (3) Changes made by Tax Cuts and Jobs Act (Pub. L. 115-97). 
Paragraph (f)(3) of this section, and Sec.  1.460-5(d)(1) and (d)(3), 
apply for contracts entered into in taxable years beginning on or after 
January 5, 2021. However, for contracts entered into after December 31, 
2017, in a taxable year ending after December 31, 2017, and before 
January 5, 2021, a taxpayer may apply paragraph (f)(3) of this section, 
and Sec.  1.460-5(d)(1) and (d)(3), provided that the taxpayer also 
applies the applicable rules contained in the regulations under section 
460 for such taxable year and all subsequent taxable years.
    (i) [Reserved]
    (j) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Contract for manufacture of property. B notifies C, an 
aircraft manufacturer, that it wants to purchase an aircraft of a 
particular type. At the time C receives the order, C has on hand several 
partially completed aircraft of this type; however, C does not have any 
completed aircraft of this type on hand. C and B agree that B will 
purchase one of these aircraft after it has been completed. C retains 
title to and risk of loss with respect to the aircraft until the sale 
takes place. The agreement between C and B is a contract for the 
manufacture of property under paragraph (b)(2)(i) of this section, even 
if labeled as a contract for the sale of property, because the 
manufacture of the aircraft is necessary for C's obligations under the 
agreement to be fulfilled and the manufacturing was not complete when B 
and C entered into the agreement.
    Example 2. De minimis construction activity. C, a master developer 
whose taxable year ends December 31, owns 5,000 acres of undeveloped 
land with a cost basis of $5,000,000 and a fair market value of 
$50,000,000. To obtain permission from the local county government to 
improve this land, a service road must be constructed on this land to 
benefit all 5,000 acres. In 2001, C enters into a contract to sell a 
1,000-acre parcel of undeveloped land to B, a residential developer, for 
its fair market value, $10,000,000. In this contract, C agrees to 
construct a service road running through the land that C is selling to B 
and through the 4,000 adjacent acres of undeveloped land that C has sold 
or will sell to

[[Page 249]]

other residential developers for its fair market value, $40,000,000. C 
reasonably estimates that it will incur allocable contract costs of 
$50,000 (excluding the cost of the land) to construct this service road, 
which will be owned and maintained by the county. C must reasonably 
allocate the cost of the service road among the benefitted parcels. The 
portion of the estimated total allocable contract costs that C allocates 
to the 1,000-acre parcel being sold to B (based upon its fair market 
value) is $10,000 ($50,000 x ($10,000,000 / $50,000,000)). Construction 
of the service road is finished in 2002. Because the estimated total 
allocable contract costs attributable to C's construction activities, 
$10,000, are less than 10 percent of the contract's total contract 
price, $10,000,000, C's contract with B is not a construction contract 
under paragraph (b)(2)(ii) of this section. Thus, C's contract with B is 
not a long-term contract under paragraph (b)(2)(i) of this section, 
notwithstanding that construction of the service road is not completed 
in 2001.
    Example 3. Completion--customer use. In 2002, C, whose taxable year 
ends December 31, enters into a contract to construct a building for B. 
In November of 2003, the building is completed in every respect 
necessary for its intended use, and B occupies the building. In early 
December of 2003, B notifies C of some minor deficiencies that need to 
be corrected, and C agrees to correct them in January 2004. C reasonably 
estimates that the cost of correcting these deficiencies will be less 
than five percent of the total allocable contract costs. C's contract is 
complete under paragraph (c)(3)(i)(A) of this section in 2003 because in 
that year, B used the building and C had incurred at least 95 percent of 
the total allocable contract costs attributable to the building. C must 
use a permissible method of accounting for any deficiency-related costs 
incurred after 2003.
    Example 4. Completion--customer use. In 2001, C, whose taxable year 
ends December 31, agrees to construct a shopping center, which includes 
an adjoining parking lot, for B. By October 2002, C has finished 
constructing the retail portion of the shopping center. By December 
2002, C has graded the entire parking lot, but has paved only one-fourth 
of it because inclement weather conditions prevented C from laying 
asphalt on the remaining three-fourths. In December 2002, B opens the 
retail portion of the shopping center and the paved portion of the 
parking lot to the general public. C reasonably estimates that the cost 
of paving the remaining three-fourths of the parking lot when weather 
permits will exceed five percent of C's total allocable contract costs. 
Even though B is using the subject matter of the contract, C's contract 
is not completed in December 2002 under paragraph (c)(3)(i)(A) of this 
section because C has not incurred at least 95 percent of the total 
allocable contract costs attributable to the subject matter.
    Example 5. Completion--customer use. In 2001, C, whose taxable year 
ends December 31, agrees to manufacture 100 machines for B. By December 
31, 2002, C has delivered 99 of the machines to B. C reasonably 
estimates that the cost of finishing the related work on the contract 
will be less than five percent of the total allocable contract costs. 
C's contract is not complete under paragraph (c)(3)(i)(A) of this 
section in 2002 because in that year, B is not using the subject matter 
of the contract (all 100 machines) for its intended purpose.
    Example 6. Non-long-term contract activity. On January 1, 2001, C, 
whose taxable year ends December 31, enters into a single long-term 
contract to design and manufacture a satellite and to develop computer 
software enabling B to operate the satellite. At the end of 2001, C has 
not finished manufacturing the satellite. Designing the satellite and 
developing the computer software are non-long-term contract activities 
that are incident to and necessary for the taxpayer's manufacturing of 
the subject matter of a long-term contract because the satellite could 
not be manufactured without the design and would not operate without the 
software. Thus, under paragraph (d)(1) of this section, C must allocate 
these non-long-term contract activities to the long-term contract and 
account for the gross receipts and costs attributable to designing the 
satellite and developing computer software using the PCM.
    Example 7. Non-long-term contract activity. C agrees to manufacture 
equipment for B under a long-term contract. In a separate contract, C 
agrees to design the equipment being manufactured for B under the long-
term contract. Under paragraph (d)(1) of this section, C must allocate 
the gross receipts and costs related to the design to the long-term 
contract because designing the equipment is a non-long-term contract 
activity that is incident to and necessary for the manufacture of the 
subject matter of the long-term contract.
    Example 8. Severance. On January 1, 2001, C, a construction 
contractor, and B, a real estate investor, enter into an agreement 
requiring C to build two office buildings in different areas of a large 
city. The agreement provides that the two office buildings will be 
completed by C and accepted by B in 2002 and 2003, respectively, and 
that C will be paid $1,000,000 and $1,500,000 for the two office 
buildings, respectively. The agreement will provide C with a reasonable 
profit from the construction of each building. Unless C is required to 
use the PCM to account for the contract, C is required to sever this 
contract under paragraph (e)(2) of this section because the buildings 
are independently priced, the agreement provides for separate delivery 
and

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acceptance of the buildings, and, as each building will generate a 
reasonable profit, a reasonable businessperson would have entered into 
separate agreements for the terms agreed upon for each building.
    Example 9. Severance. C, a large construction contractor whose 
taxable year ends December 31, accounts for its construction contracts 
using the PCM and has elected to use the 10-percent method described in 
Sec.  1.460-4(b)(6). In September 2001, C enters into an agreement to 
construct four buildings in four different cities. The buildings are 
independently priced and the contract provides a reasonable profit for 
each of the buildings. In addition, the agreement requires C to complete 
one building per year in 2002, 2003, 2004, and 2005. As of December 31, 
2001, C has incurred 25 percent of the estimated total allocable 
contract costs attributable to one of the buildings, but only five 
percent of the estimated total allocable contract costs attributable to 
all four buildings included in the agreement. C does not request the 
Commissioner's consent to sever this contract. Using the 10-percent 
method, C does not take into account any portion of the total contract 
price or any incurred allocable contract costs attributable to this 
agreement in 2001. Upon examination of C's 2001 tax return, the 
Commissioner determines that C entered into one agreement for four 
buildings rather than four separate agreements each for one building 
solely to take advantage of the deferral obtained under the 10-percent 
method. Consequently, to clearly reflect the taxpayer's income, the 
Commissioner may require C to sever the agreement into four separate 
contracts under paragraph (e)(2) of this section because the buildings 
are independently priced, the agreement provides for separate delivery 
and acceptance of the buildings, and a reasonable businessperson would 
have entered into separate agreements for these buildings.
    Example 10. Aggregation. In 2001, C, a shipbuilder, enters into two 
agreements with the Department of the Navy as the result of a single 
negotiation. Each agreement obligates C to manufacture a submarine. 
Because the submarines are of the same class, their specifications are 
similar. Because C has never manufactured submarines of this class, 
however, C anticipates that it will incur substantially higher costs to 
manufacture the first submarine, to be delivered in 2007, than to 
manufacture the second submarine, to be delivered in 2010. If the 
agreements are treated as separate contracts, the first contract 
probably will produce a substantial loss, while the second contract 
probably will produce substantial profit. Based upon these facts, 
aggregation is required under paragraph (e)(2) of this section because 
the submarines are interdependently priced and a reasonable 
businessperson would not have entered the first agreement without also 
entering into the second.
    Example 11. Aggregation. In 2001, C, a manufacturer of aircraft and 
related equipment, agrees to manufacture 10 military aircraft for 
foreign government B and to deliver the aircraft by the end of 2003. 
When entering into the agreement, C anticipates that it might receive 
production orders from B over the next 20 years for as many as 300 more 
of these aircraft. The negotiated contract price reflects C's and B's 
consideration of the expected total cost of manufacturing the 10 
aircraft, the risks and opportunities associated with the agreement, and 
the additional factors the parties considered relevant. The negotiated 
price provides a profit on the sale of the 10 aircraft even if C does 
not receive any additional production orders from B. It is unlikely, 
however, that C actually would have wanted to manufacture the 10 
aircraft but for the expectation that it would receive additional 
production orders from B. In 2003, B accepts delivery of the 10 
aircraft. At that time, B orders an additional 20 aircraft of the same 
type for delivery in 2007. When negotiating the price for the additional 
20 aircraft, C and B consider the fact that the expected unit cost for 
this production run of 20 aircraft will be lower than the unit cost of 
the 10 aircraft completed and accepted in 2003, but substantially higher 
than the expected unit cost of future production runs. Based upon these 
facts, aggregation is not permitted under paragraph (e)(2) of this 
section. Because the parties negotiated the prices of both agreements 
considering only the expected production costs and risks for each 
agreement standing alone, the terms and conditions agreed upon for the 
first agreement are independent of the terms and conditions agreed upon 
for the second agreement. The fact that the agreement to manufacture 10 
aircraft provides a profit for C indicates that a reasonable 
businessperson would have entered into that agreement without entering 
into the agreement to manufacture the additional 20 aircraft.
    Example 12. Classification and completion. In 2001, C, whose taxable 
year ends December 31, agrees to manufacture and install an industrial 
machine for B. C elects under paragraph (f) of this section to classify 
the agreement as a long-term manufacturing contract and to account for 
it using the PCM. The agreement requires C to deliver the machine in 
August 2003 and to install and test the machine in B's factory. In 
addition, the agreement requires B to accept the machine when the tests 
prove that the machine's performance will satisfy the environmental 
standards set by the Environmental Protection Agency (EPA), even if B 
has not obtained the

[[Page 251]]

required operating permit. Because of technical difficulties, C cannot 
deliver the machine until December 2003, when B conditionally accepts 
delivery. C installs the machine in December 2003 and then tests it 
through February 2004. B accepts the machine in February 2004, but does 
not obtain the operating permit from the EPA until January 2005. Under 
paragraph (c)(3)(i)(B) of this section, C's contract is finally 
completed and accepted in February 2004, even though B does not obtain 
the operating permit until January 2005, because C completed all its 
obligations under the contract and B accepted the machine in February 
2004.

[T.D. 8929, 66 FR 2225, Jan. 11, 2001; 66 FR 18357, Apr. 6, 2001; T.D. 
9942, 86 FR 272, Jan. 5, 2021]



Sec.  1.460-2  Long-term manufacturing contracts.

    (a) In general. Section 460 generally requires a taxpayer to 
determine the income from a long-term manufacturing contract using the 
percentage-of-completion method described in Sec.  1.460-4(b) (PCM). A 
contract not completed in the contracting year is a long-term 
manufacturing contract if it involves the manufacture of personal 
property that is--
    (1) A unique item of a type that is not normally carried in the 
finished goods inventory of the taxpayer; or
    (2) An item that normally requires more than 12 calendar months to 
complete (regardless of the duration of the contract or the time to 
complete a deliverable quantity of the item).
    (b) Unique--(1) In general. Unique means designed for the needs of a 
specific customer. To determine whether an item is designed for the 
needs of a specific customer, a taxpayer must consider the extent to 
which research, development, design, engineering, retooling, and similar 
activities (customizing activities) are required to manufacture the item 
and whether the item could be sold to other customers with little or no 
modification. A contract may require the taxpayer to manufacture more 
than one unit of a unique item. If a contract requires a taxpayer to 
manufacture more than one unit of the same item, the taxpayer must 
determine whether that item is unique by considering the customizing 
activities that would be needed to produce only the first unit. For the 
purposes of this paragraph (b), a taxpayer must consider the activities 
performed on its behalf by a subcontractor.
    (2) Safe harbors. Notwithstanding paragraph (b)(1) of this section, 
an item is not unique if it satisfies one or more of the safe harbors in 
this paragraph (b)(2). If an item does not satisfy one or more safe 
harbors, the determination of uniqueness will depend on the facts and 
circumstances. The safe harbors are:
    (i) Short production period. An item is not unique if it normally 
requires 90 days or less to complete. In the case of a contract for 
multiple units of an item, the item is not unique only if it normally 
requires 90 days or less to complete each unit of the item in the 
contract.
    (ii) Customized item. An item is not unique if the total allocable 
contract costs attributable to customizing activities that are incident 
to or necessary for the manufacture of the item do not exceed 10 percent 
of the estimated total allocable contract costs allocable to the item. 
In the case of a contract for multiple units of an item, this comparison 
must be performed on the first unit of the item, and the total allocable 
contract costs attributable to customizing activities that are incident 
to or necessary for the manufacture of the first unit of the item must 
be allocated to that first unit.
    (iii) Inventoried item. A unique item ceases to be unique no later 
than when the taxpayer normally includes similar items in its finished 
goods inventory.
    (c) Normal time to complete--(1) In general. The amount of time 
normally required to complete an item is the item's reasonably expected 
production period, as described in Sec.  1.263A-12, determined at the 
end of the contracting year. Thus, in general, the expected production 
period for an item begins when a taxpayer incurs at least five percent 
of the costs that would be allocable to the item under Sec.  1.460-5 and 
ends when the item is ready to be held for sale and all reasonably 
expected production activities are complete. In the case of components 
that are assembled or reassembled into an item or unit at the customer's 
facility by the taxpayer's employees or agents, the production period 
ends when the components are assembled or reassembled

[[Page 252]]

into an operable item or unit. To the extent that several distinct 
activities related to the production of the item are expected to occur 
simultaneously, the period during which these distinct activities occur 
is not counted more than once. Furthermore, when determining the normal 
time to complete an item, a taxpayer is not required to consider 
activities performed or costs incurred that would not be allocable 
contract costs under section 460 (e.g., independent research and 
development expenses (as defined in Sec.  1.460-1(b)(9)) and marketing 
expenses). Moreover, the time normally required to design and 
manufacture the first unit of an item for which the taxpayer intends to 
produce multiple units generally does not indicate the normal time to 
complete the item.
    (2) Production by related parties. To determine the time normally 
required to complete an item, a taxpayer must consider all relevant 
production activities performed and costs incurred by itself and by 
related parties, as defined in Sec.  1.460-1(b)(4). For example, if a 
taxpayer's item requires a component or subassembly manufactured by a 
related party, the taxpayer must consider the time the related party 
takes to complete the component or subassembly and, for purposes of 
determining the beginning of an item's production period, the costs 
incurred by the related party that are allocable to the component or 
subassembly. However, if both requirements of the exception for 
components and subassemblies under Sec.  1.460-1(g)(1)(ii) are 
satisfied, a taxpayer does not consider the activities performed or the 
costs incurred by a related party when determining the normal time to 
complete an item.
    (d) Qualified ship contracts. A taxpayer may determine the income 
from a long-term manufacturing contract that is a qualified ship 
contract using either the PCM or the percentage-of-completion/
capitalized-cost method (PCCM) of accounting described in Sec.  1.460-
4(e). A qualified ship contract is any contract entered into after 
February 28, 1986, to manufacture in the United States not more than 5 
seagoing vessels if the vessels will not be manufactured directly or 
indirectly for the United States Government and if the taxpayer 
reasonably expects to complete the contract within 5 years of the 
contract commencement date. Under Sec.  1.460-1(e)(3)(i), a contract to 
produce more than 5 vessels for which the PCM would be required cannot 
be severed in order to be classified as a qualified ship contract.
    (e) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Unique item and classification. In December 2001, C 
enters into a contract with B to design and manufacture a new type of 
industrial equipment. C reasonably expects the normal production period 
for this type of equipment to be eight months. Because the new type of 
industrial equipment requires a substantial amount of research, design, 
and engineering to produce, C determines that the equipment is a unique 
item and its contract with B is a long-term contract. After delivering 
the equipment to B in September 2002, C contracts with B to produce five 
additional units of that industrial equipment with certain different 
specifications. These additional units, which also are expected to take 
eight months to produce, will be delivered to B in 2003. C determines 
that the research, design, engineering, retooling, and similar 
customizing costs necessary to produce the five additional units of 
equipment does not exceed 10 percent of the first unit's share of 
estimated total allocable contract costs. Consequently, the additional 
units of equipment satisfy the safe harbor in paragraph (b)(2)(ii) of 
this section and are not unique items. Although C's contract with B to 
produce the five additional units is not completed within the 
contracting year, the contract is not a long-term contract since the 
additional units of equipment are not unique items and do not normally 
require more than 12 months to produce. C must classify its second 
contract with B as a non-long term contract, notwithstanding that it 
classified the previous contract with B for a similar item as a long-
term contract, because the determination of whether a contract is a 
long-term contract is made on a contract-by-contract basis. A change in 
classification is not a change in method of accounting because the 
change in classification results from a change in underlying facts.
    Example 2. 12-month rule--related party. C manufactures cranes. C 
purchases one of the crane's components from R, a related party under 
Sec.  1.460-1(b)(4). Less than 50 percent of R's gross receipts 
attributable to the sale of this component comes from sales to unrelated 
parties; thus, the exception for components and subassemblies under 
Sec.  1.460-1(g)(1)(ii) is not satisfied. Consequently, C must consider 
the activities of R as R incurs costs and performs the activities rather 
than

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as C incurs a liability to R. The normal time period between the time 
that both C and R incur five percent of the costs allocable to the crane 
and the time that R completes the component is five months. C normally 
requires an additional eight months to complete production of the crane 
after receiving the integral component from R. C's crane is an item of a 
type that normally requires more than 12 months to complete under 
paragraph (c) of this section because the production period from the 
time that both C and R incur five percent of the costs allocable to the 
crane until the time that production of the crane is complete is 
normally 13 months.
    Example 3. 12-month rule--duration of contract. The facts are the 
same as in Example 2, except that C enters into a sales contract with B 
on December 31, 2001 (the last day of C's taxable year), and delivers a 
completed crane to B on February 1, 2002. C's contract with B is a long-
term contract under paragraph (a)(2) of this section because the 
contract is not completed in the contracting year, 2001, and the crane 
is an item that normally requires more than 12 calendar months to 
complete (regardless of the duration of the contract).
    Example 4. 12-month rule--normal time to complete. The facts are the 
same as in Example 2, except that C (and R) actually complete B's crane 
in only 10 calendar months. The contract is a long-term contract because 
the normal time to complete a crane, not the actual time to complete a 
crane, is the relevant criterion for determining whether an item is 
subject to paragraph (a)(2) of this section.
    Example 5. Normal time to complete. C enters into a multi-unit 
contract to produce four units of an item. C does not anticipate 
producing any additional units of the item. C expects to perform the 
research, design, and development that are directly allocable to the 
particular item and to produce the first unit in the first 24 months. C 
reasonably expects the production period for each of the three remaining 
units will be 3 months. This contract is not a contract that involves 
the manufacture of an item that normally requires more than 12 months to 
complete because the normal time to complete the item is 3 months. 
However, the contract does not satisfy the 90-day safe harbor for unique 
items because the normal time to complete the first unit of this item 
exceeds 90 days. Thus, the contract might involve the manufacture of a 
unique item depending on the facts and circumstances.

[T.D. 8929, 66 FR 2230, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001]



Sec.  1.460-3  Long-term construction contracts.

    (a) In general. Section 460 generally requires a taxpayer to 
determine the income from a long-term construction contract using the 
percentage-of-completion method described in Sec.  1.460-4(b) (PCM). A 
contract not completed in the contracting year is a long-term 
construction contract if it involves the building, construction, 
reconstruction, or rehabilitation of real property; the installation of 
an integral component to real property; or the improvement of real 
property (collectively referred to as construction). Real property means 
land, buildings, and inherently permanent structures, as defined in 
Sec.  1.263A-8(c)(3), such as roadways, dams, and bridges. Real property 
does not include vessels, offshore drilling platforms, or unsevered 
natural products of land. An integral component to real property 
includes property not produced at the site of the real property but 
intended to be permanently affixed to the real property, such as 
elevators and central heating and cooling systems. Thus, for example, a 
contract to install an elevator in a building is a construction contract 
because a building is real property, but a contract to install an 
elevator in a ship is not a construction contract because a ship is not 
real property.
    (b) Exempt construction contracts--(1) In general. The general 
requirement to use the PCM and the cost allocation rules described in 
Sec.  1.460-5(b) or (c) does not apply to any long-term construction 
contract described in this paragraph (b) (exempt construction contract). 
Exempt construction contract means any--
    (i) Home construction contract; and
    (ii) Other construction contract, entered into after December 31, 
2017, in a taxable year ending after December 31, 2017, by a taxpayer, 
other than a tax shelter prohibited from using the cash receipts and 
disbursements method of accounting (cash method) under section 
448(a)(3), who estimates at the time such contract is entered into that 
such contract will be completed within the 2-year period beginning on 
the contract commencement date, and who meets the gross receipts test 
described in paragraph (b)(3) of this section for the taxable year in 
which such contract is entered into.

[[Page 254]]

    (2) Home construction contract--(i) In general. A long-term 
construction contract is a home construction contract if a taxpayer 
(including a subcontractor working for a general contractor) reasonably 
expects to attribute 80 percent or more of the estimated total allocable 
contract costs (including the cost of land, materials, and services), 
determined as of the close of the contracting year, to the construction 
of--
    (A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), 
contained in buildings containing 4 or fewer dwelling units (including 
buildings with 4 or fewer dwelling units that also have commercial 
units); and
    (B) Improvements to real property directly related to, and located 
at the site of, the dwelling units.
    (ii) Townhouses and rowhouses. Each townhouse or rowhouse is a 
separate building.
    (iii) Common improvements. A taxpayer includes in the cost of the 
dwelling units their allocable share of the cost that the taxpayer 
reasonably expects to incur for any common improvements (e.g., sewers, 
roads, clubhouses) that benefit the dwelling units and that the taxpayer 
is contractually obligated, or required by law, to construct within the 
tract or tracts of land that contain the dwelling units.
    (iv) Mixed use costs. If a contract involves the construction of 
both commercial units and dwelling units within the same building, a 
taxpayer must allocate the costs among the commercial units and dwelling 
units using a reasonable method or combination of reasonable methods, 
such as specific identification, square footage, or fair market value.
    (3) Gross receipts test--(i) In general. A taxpayer, other than a 
tax shelter prohibited from using the cash method under section 
448(a)(3), meets the gross receipts test of this paragraph (b)(3) if it 
meets the gross receipts test of section 448(c) and Sec.  1.448-2(c)(2). 
This gross receipts test applies even if the taxpayer is not otherwise 
subject to section 448(a).
    (ii) Application of gross receipts test--(A) In general. In the case 
of any taxpayer that is not a corporation or a partnership, and except 
as provided in paragraphs (b)(3)(ii)(B) and (C) of this section, the 
gross receipts test of section 448(c) and the accompanying regulations 
are applied in the same manner as if each trade or business of such 
taxpayer were a corporation or partnership.
    (B) Gross receipts of individuals, etc. Except when the aggregation 
rules of section 448(c)(2) apply, the gross receipts of a taxpayer other 
than a corporation or partnership are the amount derived from all trades 
or businesses of such taxpayer. Amounts not related to a trade or 
business are excluded from the gross receipts of the taxpayer. For 
example, an individual taxpayer's gross receipts do not include 
inherently personal amounts, such as personal injury awards or 
settlements with respect to an injury of the individual taxpayer, 
disability benefits, Social Security benefits received by the taxpayer 
during the taxable year, and wages received as an employee that are 
reported on Form W-2.
    (C) Partners and S corporation shareholders. Except when the 
aggregation rules of section 448(c)(2) apply, each partner in a 
partnership includes a share of partnership gross receipts in proportion 
to such partner's distributive share (as determined under section 704) 
of items of gross income that were taken into account by the partnership 
under section 703. Similarly, a shareholder includes the pro rata share 
of S corporation gross receipts taken into account by the S corporation 
under section 1363(b).
    (D) Examples. The operation of this paragraph (b)(3) is illustrated 
by the following examples:
    (1) Example 1. Taxpayer A is an individual who operates two separate 
and distinct trades or business that are reported on Schedule C, Profit 
or Loss from Business, of A's Federal income tax return. For 2020, one 
trade or business has annual average gross receipts of $5 million, and 
the other trade or business has average annual gross receipts of $35 
million. Under paragraph (b)(3)(ii)(B) of this section, for 2020, 
neither of A's trades or businesses meets the gross receipts test of 
paragraph (b)(3) of this section ($5 million + $35 million = $40 
million, which is greater

[[Page 255]]

than the inflation-adjusted gross receipts test amount for 2020, which 
is $26 million).
    (2) Example 2. Taxpayer B is an individual who operates three 
separate and distinct trades or business that are reported on Schedule C 
of B's Federal income tax return. For 2020, Business X is a retail store 
with average annual gross receipts of $15 million, Business Y is a dance 
studio with average annual gross receipts of $6 million, and Business Z 
is a car repair shop with average annual gross receipts of $12 million. 
Under paragraph (b)(3)(ii)(B) of this section, B's gross receipts are 
the combined amount derived from all three of B's trades or businesses. 
Therefore, for 2020, X, Y and Z do not meet the gross receipts test of 
paragraph (b)(3)(i) of this section ($15 million + $6 million + $12 
million = $33 million, which is greater than the inflation-adjusted 
gross receipts test amount for 2020, which is $26 million).
    (iii) Method of accounting. A change in the method of accounting 
used for exempt construction contracts described in paragraph (b)(1)(ii) 
of this section is a change in method of accounting under section 446 
and the accompanying regulations. For rules distinguishing a change in 
method from adoption of a method, see Sec.  1.460-1(f)(3). A taxpayer 
changing its method of accounting must obtain the consent of the 
Commissioner in accordance with Sec.  1.446-1(e)(3). For rules relating 
to the clear reflection of income and the pattern of consistent 
treatment of an item, see section 446 and Sec.  1.446-1. A change in 
method of accounting shall be implemented pursuant to the applicable 
administrative procedures to obtain the consent of the Commissioner to 
change a method of accounting under section 446(e) as published in the 
Internal Revenue Bulletin (IRB) (see Revenue Procedure 2015-13 (2015-5 
IRB 419) (or successor) (see Sec.  601.601(d)(2) of this chapter)). A 
taxpayer that uses the percentage of completion method for exempt 
contracts described in paragraph (b)(1)(ii) of this section that wants 
to change to another exempt contract method is to use the applicable 
administrative procedures to obtain the automatic consent of the 
Commissioner to change such method under section 446(e) as published in 
the IRB. A taxpayer-initiated change in method of accounting will be 
permitted only on a cut-off basis, and thus, a section 481(a) adjustment 
will not be permitted or required. See Sec.  1.460-4(g).
    (c) Residential construction contracts. A taxpayer may determine the 
income from a long-term construction contract that is a residential 
construction contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in 
Sec.  1.460-4(e). A residential construction contract is a home 
construction contract, as defined in paragraph (b)(2) of this section, 
except that the building or buildings being constructed contain more 
than 4 dwelling units.
    (d) Applicability Dates. Paragraphs (b)(1)(ii) and (b)(3) of this 
section apply, for contracts entered into in taxable years beginning on 
or after January 5, 2021. However, for contracts entered into after 
December 31, 2017, in a taxable year ending after December 31, 2017, and 
before January 5, 2021, a taxpayer may apply the paragraphs described in 
the first sentence of this paragraph (d), provided that the taxpayer 
follows all the applicable rules contained in the regulations under 
section 460 for such taxable year and all subsequent taxable years.

[T.D. 8929, 66 FR 2231, Jan. 11, 2001, as amended by T.D. 9942, 86 FR 
272, Jan. 5, 2021; 86 FR 32186, June 17, 2021]



Sec.  1.460-4  Methods of accounting for long-term contracts.

    (a) Overview. This section prescribes permissible methods of 
accounting for long-term contracts. Paragraph (b) of this section 
describes the percentage-of-completion method under section 460(b) (PCM) 
that a taxpayer generally must use to determine the income from a long-
term contract. Paragraph (c) of this section lists permissible methods 
of accounting for exempt construction contracts described in Sec.  
1.460-3(b)(1) and describes the exempt-contract percentage-of-completion 
method (EPCM). Paragraph (d) of this section describes the completed-
contract method (CCM), which is one of the permissible methods of 
accounting for exempt construction contracts. Paragraph (e) of this 
section describes the percentage-of-

[[Page 256]]

completion/capitalized-cost method (PCCM), which is a permissible method 
of accounting for qualified ship contracts described in Sec.  1.460-2(d) 
and residential construction contracts described in Sec.  1.460-3(c). 
Paragraph (f) of this section provides rules for determining the 
alternative minimum taxable income (AMTI) from long-term contracts that 
are not exempted under section 56. Paragraph (g) of this section 
provides rules concerning consistency in methods of accounting for long-
term contracts. Paragraph (h) of this section provides examples 
illustrating the principles of this section. Paragraph (j) of this 
section provides rules for taxpayers that file consolidated tax returns. 
Finally, paragraph (k) of this section provides rules relating to a mid-
contract change in taxpayer of a contract accounted for using a long-
term contract method of accounting.
    (b) Percentage-of-completion method--(1) In general. Under the PCM, 
a taxpayer generally must include in income the portion of the total 
contract price, as defined in paragraph (b)(4)(i) of this section, that 
corresponds to the percentage of the entire contract that the taxpayer 
has completed during the taxable year. The percentage of completion must 
be determined by comparing allocable contract costs incurred with 
estimated total allocable contract costs. Thus, the taxpayer includes a 
portion of the total contract price in gross income as the taxpayer 
incurs allocable contract costs.
    (2) Computations. To determine the income from a long-term contract, 
a taxpayer--
    (i) Computes the completion factor for the contract, which is the 
ratio of the cumulative allocable contract costs that the taxpayer has 
incurred through the end of the taxable year to the estimated total 
allocable contract costs that the taxpayer reasonably expects to incur 
under the contract;
    (ii) Computes the amount of cumulative gross receipts from the 
contract by multiplying the completion factor by the total contract 
price;
    (iii) Computes the amount of current-year gross receipts, which is 
the difference between the amount of cumulative gross receipts for the 
current taxable year and the amount of cumulative gross receipts for the 
immediately preceding taxable year (the difference can be a positive or 
negative number); and
    (iv) Takes both the current-year gross receipts and the allocable 
contract costs incurred during the current year into account in 
computing taxable income.
    (3) Post-completion-year income. If a taxpayer has not included the 
total contract price in gross income by the completion year, as defined 
in Sec.  1.460-1(b)(6), the taxpayer must include the remaining portion 
of the total contract price in gross income for the taxable year 
following the completion year. For the treatment of post-completion-year 
costs, see paragraph (b)(5)(v) of this section. See Sec.  1.460-
6(c)(1)(ii) for application of the look-back method as a result of 
adjustments to total contract price.
    (4) Total contract price--(i) In general--(A) Definition. Total 
contract price means the amount that a taxpayer reasonably expects to 
receive under a long-term contract, including holdbacks, retainages, and 
cost reimbursements. See Sec.  1.460-6(c)(1)(ii) and (2)(vi) for 
application of the look-back method as a result of changes in total 
contract price.
    (B) Contingent compensation. Any amount related to a contingent 
right under a contract, such as a bonus, award, incentive payment, and 
amount in dispute, is included in total contract price as soon as the 
taxpayer can reasonably predict that the amount will be earned, even if 
the all events test has not yet been met. For example, if a bonus is 
payable to a taxpayer for meeting an early completion date, the bonus is 
includible in total contract price at the time and to the extent that 
the taxpayer can reasonably predict the achievement of the corresponding 
objective. Similarly, a portion of the contract price that is in dispute 
is includible in total contract price at the time and to the extent that 
the taxpayer can reasonably predict that the dispute will be resolved in 
the taxpayer's favor (regardless of when the taxpayer actually receives 
payment or when the dispute is finally resolved). Total contract price 
does not include compensation that might be

[[Page 257]]

earned under any other agreement that the taxpayer expects to obtain 
from the same customer (e.g., exercised option or follow-on contract) if 
that other agreement is not aggregated under Sec.  1.460-1(e). For the 
purposes of this paragraph (b)(4)(i)(B), a taxpayer can reasonably 
predict that an amount of contingent income will be earned not later 
than when the taxpayer includes that amount in income for financial 
reporting purposes under generally accepted accounting principles. If a 
taxpayer has not included an amount of contingent compensation in total 
contract price under this paragraph (b)(4)(i) by the taxable year 
following the completion year, the taxpayer must account for that amount 
of contingent compensation using a permissible method of accounting. If 
it is determined after the taxable year following the completion year 
that an amount included in total contract price will not be earned, the 
taxpayer should deduct that amount in the year of the determination.
    (C) Non-long-term contract activities. Total contract price includes 
an allocable share of the gross receipts attributable to a non-long-term 
contract activity, as defined in Sec.  1.460-1(d)(2), if the activity is 
incident to or necessary for the manufacture, building, installation, or 
construction of the subject matter of the long-term contract. Total 
contract price also includes amounts reimbursed for independent research 
and development expenses (as defined in Sec.  1.460-1(b)(9)), or for 
bidding and proposal costs, under a federal or cost-plus long-term 
contract (as defined in section 460(d)), regardless of whether the 
research and development, or bidding and proposal, activities are 
incident to or necessary for the performance of that long-term contract.
    (ii) Estimating total contract price. A taxpayer must estimate the 
total contract price based upon all the facts and circumstances known as 
of the last day of the taxable year. For this purpose, an event that 
occurs after the end of the taxable year must be taken into account if 
its occurrence was reasonably predictable and its income was subject to 
reasonable estimation as of the last day of that taxable year.
    (5) Completion factor--(i) Allocable contract costs. A taxpayer must 
use a cost allocation method permitted under either Sec.  1.460-5(b) or 
(c) to determine the amount of cumulative allocable contract costs and 
estimated total allocable contract costs that are used to determine a 
contract's completion factor. Allocable contract costs include a 
reimbursable cost that is allocable to the contract.
    (ii) Cumulative allocable contract costs. To determine a contract's 
completion factor for a taxable year, a taxpayer must take into account 
the cumulative allocable contract costs that have been incurred, as 
defined in Sec.  1.460-1(b)(8), through the end of the taxable year.
    (iii) Estimating total allocable contract costs. A taxpayer must 
estimate total allocable contract costs for each long-term contract 
based upon all the facts and circumstances known as of the last day of 
the taxable year. For this purpose, an event that occurs after the end 
of the taxable year must be taken into account if its occurrence was 
reasonably predictable and its cost was subject to reasonable estimation 
as of the last day of that taxable year. To be considered reasonable, an 
estimate of total allocable contract costs must include costs 
attributable to delay, rework, change orders, technology or design 
problems, or other problems that reasonably can be predicted considering 
the nature of the contract and prior experience. However, estimated 
total allocable contract costs do not include any contingency allowance 
for costs that, as of the end of the taxable year, are not reasonably 
predicted to be incurred in the performance of the contract. For 
example, estimated total allocable contract costs do not include any 
costs attributable to factors not reasonably predictable at the end of 
the taxable year, such as third-party litigation, extreme weather 
conditions, strikes, and delays in securing required permits and 
licenses. In addition, the estimated costs of performing other 
agreements that are not aggregated with the contract under Sec.  1.460-
1(e) that the taxpayer expects to incur with the same customer (e.g., 
follow-on contracts) are not included in estimated total allocable 
contract costs for the initial contract.

[[Page 258]]

    (iv) Pre-contracting-year costs. If a taxpayer reasonably expects to 
enter into a long-term contract in a future taxable year, the taxpayer 
must capitalize all costs incurred prior to entering into the contract 
that will be allocable to that contract (e.g., bidding and proposal 
costs). A taxpayer is not required to compute a completion factor, or to 
include in gross income any amount, related to allocable contract costs 
for any taxable year ending before the contracting year or, if 
applicable, the 10-percent year defined in paragraph (b)(6)(i) of this 
section. In that year, the taxpayer is required to compute a completion 
factor that includes all allocable contract costs that have been 
incurred as of the end of that taxable year (whether previously 
capitalized or deducted) and to take into account in computing taxable 
income the related gross receipts and the previously capitalized 
allocable contract costs. If, however, a taxpayer determines in a 
subsequent year that it will not enter into the long-term contract, the 
taxpayer must account for these pre-contracting-year costs in that year 
(e.g., as a deduction or an inventoriable cost) using the appropriate 
rules contained in other sections of the Code or regulations.
    (v) Post-completion-year costs. If a taxpayer incurs an allocable 
contract cost after the completion year, the taxpayer must account for 
that cost using a permissible method of accounting. See Sec.  1.460-
6(c)(1)(ii) for application of the look-back method as a result of 
adjustments to allocable contract costs.
    (6) 10-percent method--(i) In general. Instead of determining the 
income from a long-term contract beginning with the contracting year, a 
taxpayer may elect to use the 10-percent method under section 460(b)(5). 
Under the 10-percent method, a taxpayer does not include in gross income 
any amount related to allocable contract costs until the taxable year in 
which the taxpayer has incurred at least 10 percent of the estimated 
total allocable contract costs (10-percent year). A taxpayer must treat 
costs incurred before the 10-percent year as pre-contracting-year costs 
described in paragraph (b)(5)(iv) of this section.
    (ii) Election. A taxpayer makes an election under this paragraph 
(b)(6) by using the 10-percent method for all long-term contracts 
entered into during the taxable year of the election on its original 
federal income tax return for the election year. This election is a 
method of accounting and, thus, applies to all long-term contracts 
entered into during and after the taxable year of the election. An 
electing taxpayer must use the 10-percent method to apply the look-back 
method under Sec.  1.460-6 and to determine alternative minimum taxable 
income under paragraph (f) of this section. This election is not 
available if a taxpayer uses the simplified cost-to-cost method 
described in Sec.  1.460-5(c) to compute the completion factor of a 
long-term contract.
    (7) Terminated contract--(i) Reversal of income. If a long-term 
contract is terminated before completion and, as a result, the taxpayer 
retains ownership of the property that is the subject matter of that 
contract, the taxpayer must reverse the transaction in the taxable year 
of termination. To reverse the transaction, the taxpayer reports a loss 
(or gain) equal to the cumulative allocable contract costs reported 
under the contract in all prior taxable years less the cumulative gross 
receipts reported under the contract in all prior taxable years.
    (ii) Adjusted basis. As a result of reversing the transaction under 
paragraph (b)(7)(i) of this section, a taxpayer will have an adjusted 
basis in the retained property equal to the cumulative allocable 
contract costs reported under the contract in all prior taxable years. 
However, if the taxpayer received and retains any consideration or 
compensation from the customer, the taxpayer must reduce the adjusted 
basis in the retained property (but not below zero) by the fair market 
value of that consideration or compensation. To the extent that the 
amount of the consideration or compensation described in the preceding 
sentence exceeds the adjusted basis in the retained property, the 
taxpayer must include the excess in gross income for the taxable year of 
termination.
    (iii) Look-back method. The look-back method does not apply to a 
terminated

[[Page 259]]

contract that is subject to this paragraph (b)(7).
    (c) Exempt contract methods--(1) In general. An exempt contract 
method means the method of accounting that a taxpayer must use to 
account for all its long-term contracts (and any portion of a long-term 
contract) that are exempt from the requirements of section 460(a). Thus, 
an exempt contract method applies to exempt construction contracts, as 
defined in Sec.  1.460-3(b); the non-PCM portion of a qualified ship 
contract, as defined in Sec.  1.460-2(d); and the non-PCM portion of a 
residential construction contract, as defined in Sec.  1.460-3(c). 
Permissible exempt contract methods include the PCM, the EPCM described 
in paragraph (c)(2) of this section, the CCM described in paragraph (d) 
of this section, or any other permissible method. See section 446.
    (2) Exempt-contract percentage-of-completion method--(i) In general. 
Similar to the PCM described in paragraph (b) of this section, a 
taxpayer using the EPCM generally must include in income the portion of 
the total contract price, as described in paragraph (b)(4) of this 
section, that corresponds to the percentage of the entire contract that 
the taxpayer has completed during the taxable year. However, under the 
EPCM, the percentage of completion may be determined as of the end of 
the taxable year by using any method of cost comparison (such as 
comparing direct labor costs incurred to date to estimated total direct 
labor costs) or by comparing the work performed on the contract with the 
estimated total work to be performed, rather than by using the cost-to-
cost comparison required by paragraphs (b)(2)(i) and (5) of this 
section, provided such method is used consistently and clearly reflects 
income. In addition, paragraph (b)(3) of this section (regarding post-
completion-year income), paragraph (b)(6) of this section (regarding the 
10-percent method) and Sec.  1.460-6 (regarding the look-back method) do 
not apply to the EPCM.
    (ii) Determination of work performed. For purposes of the EPCM, the 
criteria used to compare the work performed on a contract as of the end 
of the taxable year with the estimated total work to be performed must 
clearly reflect the earning of income with respect to the contract. For 
example, in the case of a roadbuilder, a standard of completion solely 
based on miles of roadway completed in a case where the terrain is 
substantially different may not clearly reflect the earning of income 
with respect to the contract.
    (d) Completed-contract method--(1) In general. Except as otherwise 
provided in paragraph (d)(4) of this section, a taxpayer using the CCM 
to account for a long-term contract must take into account in the 
contract's completion year, as defined in Sec.  1.460-1(b)(6), the gross 
contract price and all allocable contract costs incurred by the 
completion year. A taxpayer may not treat the cost of any materials and 
supplies that are allocated to a contract, but actually remain on hand 
when the contract is completed, as an allocable contract cost.
    (2) Post-completion-year income and costs. If a taxpayer has not 
included an item of contingent compensation (i.e., amounts for which the 
all events test has not been satisfied) in gross contract price under 
paragraph (d)(3) of this section by the completion year, the taxpayer 
must account for this item of contingent compensation using a 
permissible method of accounting. If a taxpayer incurs an allocable 
contract cost after the completion year, the taxpayer must account for 
that cost using a permissible method of accounting.
    (3) Gross contract price. Gross contract price includes all amounts 
(including holdbacks, retainages, and reimbursements) that a taxpayer is 
entitled by law or contract to receive, whether or not the amounts are 
due or have been paid. In addition, gross contract price includes all 
bonuses, awards, and incentive payments, such as a bonus for meeting an 
early completion date, to the extent the all events test is satisfied. 
If a taxpayer performs a non-long-term contract activity, as defined in 
Sec.  1.460-1(d)(2), that is incident to or necessary for the 
manufacture, building, installation, or construction of the subject 
matter of one or more of the taxpayer's long-term contracts, the 
taxpayer must include an allocable share of the gross receipts 
attributable to that activity in the gross contract

[[Page 260]]

price of the contract(s) benefitted by that activity. Gross contract 
price also includes amounts reimbursed for independent research and 
development expenses (as defined in Sec.  1.460-1(b)(9)), or bidding and 
proposal costs, under a federal or cost-plus long-term contract (as 
defined in section 460(d)), regardless of whether the research and 
development, or bidding and proposal, activities are incident to or 
necessary for the performance of that long-term contract.
    (4) Contracts with disputed claims--(i) In general. The special 
rules in this paragraph (d)(4) apply to a long-term contract accounted 
for using the CCM with a dispute caused by a customer's requesting a 
reduction of the gross contract price or the performance of additional 
work under the contract or by a taxpayer's requesting an increase in 
gross contract price, or both, on or after the date a taxpayer has 
tendered the subject matter of the contract to the customer.
    (ii) Taxpayer assured of profit or loss. If the disputed amount 
relates to a customer's claim for either a reduction in price or 
additional work and the taxpayer is assured of either a profit or a loss 
on a long-term contract regardless of the outcome of the dispute, the 
gross contract price, reduced (but not below zero) by the amount 
reasonably in dispute, must be taken into account in the completion 
year. If the disputed amount relates to a taxpayer's claim for an 
increase in price and the taxpayer is assured of either a profit or a 
loss on a long-term contract regardless of the outcome of the dispute, 
the gross contract price must be taken into account in the completion 
year. If the taxpayer is assured a profit on the contract, all allocable 
contract costs incurred by the end of the completion year are taken into 
account in that year. If the taxpayer is assured a loss on the contract, 
all allocable contract costs incurred by the end of the completion year, 
reduced by the amount reasonably in dispute, are taken into account in 
the completion year.
    (iii) Taxpayer unable to determine profit or loss. If the amount 
reasonably in dispute affects so much of the gross contract price or 
allocable contract costs that a taxpayer cannot determine whether a 
profit or loss ultimately will be realized from a long-term contract, 
the taxpayer may not take any of the gross contract price or allocable 
contract costs into account in the completion year.
    (iv) Dispute resolved. Any part of the gross contract price and any 
allocable contract costs that have not been taken into account because 
of the principles described in paragraph (d)(4)(i), (ii), or (iii) of 
this section must be taken into account in the taxable year in which the 
dispute is resolved. If a taxpayer performs additional work under the 
contract because of the dispute, the term taxable year in which the 
dispute is resolved means the taxable year the additional work is 
completed, rather than the taxable year in which the outcome of the 
dispute is determined by agreement, decision, or otherwise.
    (e) Percentage-of-completion/capitalized-cost method. Under the 
PCCM, a taxpayer must determine the income from a long-term contract 
using the PCM for the applicable percentage of the contract and its 
exempt contract method, as defined in paragraph (c) of this section, for 
the remaining percentage of the contract. For residential construction 
contracts described in Sec.  1.460-3(c), the applicable percentage is 70 
percent, and the remaining percentage is 30 percent. For qualified ship 
contracts described in Sec.  1.460-2(d), the applicable percentage is 40 
percent, and the remaining percentage is 60 percent.
    (f) Alternative minimum taxable income--(1) In general. Under 
section 56(a)(3), a taxpayer subject to the AMT must use the PCM to 
determine its AMTI from any long-term contract entered into on or after 
March 1, 1986, that is not a home construction contract, as defined in 
Sec.  1.460-3(b)(2). For AMTI purposes, the PCM must include any 
election under paragraph (b)(6) of this section (concerning the 10-
percent method) or under Sec.  1.460-5(c) (concerning the simplified 
cost-to-cost method) that the taxpayer has made for regular tax 
purposes. For exempt construction contracts described in Sec.  1.460-
3(b)(1)(ii), a taxpayer must use the simplified cost-to-cost method to 
determine the completion factor for AMTI purposes. Except as provided in

[[Page 261]]

paragraph (f)(2) of this section, a taxpayer must use AMTI costs and 
AMTI methods, such as the depreciation method described in section 
56(a)(1), to determine the completion factor of a long-term contract 
(except a home construction contract) for AMTI purposes.
    (2) Election to use regular completion factors. Under this paragraph 
(f)(2), a taxpayer may elect for AMTI purposes to determine the 
completion factors of all of its long-term contracts using the methods 
of accounting and allocable contract costs used for regular federal 
income tax purposes. A taxpayer makes this election by using regular 
methods and regular costs to compute the completion factors of all long-
term contracts entered into during the taxable year of the election for 
AMTI purposes on its original federal income tax return for the election 
year. This election is a method of accounting and, thus, applies to all 
long-term contracts entered into during and after the taxable year of 
the election. Although a taxpayer may elect to compute the completion 
factor of its long-term contracts using regular methods and regular 
costs, an election under this paragraph (f)(2) does not eliminate a 
taxpayer's obligation to comply with the requirements of section 55 when 
computing AMTI. For example, although a taxpayer may elect to use the 
depreciation methods used for regular tax purposes to compute the 
completion factor of its long-term contracts for AMTI purposes, the 
taxpayer must use the depreciation methods permitted by section 56 to 
compute AMTI.
    (g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM, 
or PCCM, or elects the 10-percent method or special AMTI method (or 
changes to another method of accounting with the Commissioner's consent) 
must apply the method(s) consistently for all similarly classified long-
term contracts, until the taxpayer obtains the Commissioner's consent 
under section 446(e) to change to another method of accounting. A 
taxpayer-initiated change in method of accounting will be permitted only 
on a cut-off basis (i.e., for contracts entered into on or after the 
year of change), and thus, a section 481(a) adjustment will not be 
permitted or required.
    (h) Examples. The following examples illustrate the rules of this 
section:

    Example 1. PCM--estimating total contract price. C, whose taxable 
year ends December 31, determines the income from long-term contracts 
using the PCM. On January 1, 2001, C enters into a contract to design 
and manufacture a satellite (a unique item). The contract provides that 
C will be paid $10,000,000 for delivering the completed satellite by 
December 1, 2002. The contract also provides that C will receive a 
$3,000,000 bonus for delivering the satellite by July 1, 2002, and an 
additional $4,000,000 bonus if the satellite successfully performs its 
mission for five years. C is unable to reasonably predict if the 
satellite will successfully perform its mission for five years. If on 
December 31, 2001, C should reasonably expect to deliver the satellite 
by July 1, 2002, the estimated total contract price is $13,000,000 
($10,000,000 unit price + $3,000,000 production-related bonus). 
Otherwise, the estimated total contract price is $10,000,000. In either 
event, the $4,000,000 bonus is not includible in the estimated total 
contract price as of December 31, 2001, because C is unable to 
reasonably predict that the satellite will successfully perform its 
mission for five years.
    Example 2. PCM--computing income. (i) C, whose taxable year ends 
December 31, determines the income from long-term contracts using the 
PCM. During 2001, C agrees to manufacture for the customer, B, a unique 
item for a total contract price of $1,000,000. Under C's contract, B is 
entitled to retain 10 percent of the total contract price until it 
accepts the item. By the end of 2001, C has incurred $200,000 of 
allocable contract costs and estimates that the total allocable contract 
costs will be $800,000. By the end of 2002, C has incurred $600,000 of 
allocable contract costs and estimates that the total allocable contract 
costs will be $900,000. In 2003, after completing the contract, C 
determines that the actual cost to manufacture the item was $750,000.
    (ii) For each of the taxable years, C's income from the contract is 
computed as follows:

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.     $200,000      $600,000      $750,000
(B) Estimated total costs.....      800,000       900,000       750,000
                               -----------------------------------------

[[Page 262]]

 
(C) Completion factor: (A) /         25.00%        66.67%       100.00%
 (B)..........................
                               -----------------------------------------
(D) Total contract price......    1,000,000     1,000,000     1,000,000
                               -----------------------------------------
(E) Cumulative gross receipts:      250,000       666,667     1,000,000
 (C) x (D)....................
(F) Cumulative gross receipts            (0)     (250,000)     (666,667)
 (prior year).................
                               -----------------------------------------
(G) Current-year gross              250,000       416,667       333,333
 receipts.....................
                               -----------------------------------------
(H) Cumulative incurred costs.      200,000       600,000       750,000
(I) Cumulative incurred costs            (0)     (200,000)     (600,000)
 (prior year).................
                               -----------------------------------------
(J) Current-year costs........      200,000       400,000       150,000
                               -----------------------------------------
(K) Gross income: (G) - (J)...      $50,000       $16,667      $183,333
------------------------------------------------------------------------

    Example 3. PCM--computing income with cost sharing. (i) C, whose 
taxable year ends December 31, determines the income from long-term 
contracts using the PCM. During 2001, C enters into a contract to 
manufacture a unique item. The contract specifies a target price of 
$1,000,000, a target cost of $600,000, and a target profit of $400,000. 
C and B will share the savings of any cost underrun (actual total 
incurred cost is less than target cost) and the additional cost of any 
cost overrun (actual total incurred cost is greater than target cost) as 
follows: 30 percent to C and 70 percent to B. By the end of 2001, C has 
incurred $200,000 of allocable contract costs and estimates that the 
total allocable contract costs will be $600,000. By the end of 2002, C 
has incurred $300,000 of allocable contract costs and estimates that the 
total allocable contract costs will be $400,000. In 2003, after 
completing the contract, C determines that the actual cost to 
manufacture the item was $700,000.
    (ii) For each of the taxable years, C's income from the contract is 
computed as follows (note that the sharing of any cost underrun or cost 
overrun is reflected as an adjustment to C's target price under 
paragraph (b)(4)(i) of this section):

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.     $200,000      $300,000      $700,000
(B) Estimated total costs.....      600,000       400,000       700,000
                               -----------------------------------------
(C) Completion factor: (A) /         33.33%        75.00%       100.00%
 (B)..........................
                               =========================================
(D) Target price..............   $1,000,000    $1,000,000    $1,000,000
                               -----------------------------------------
(E) Estimated total costs.....      600,000       400,000       700,000
(F) Target costs..............      600,000       600,000       600,000
                               -----------------------------------------
(G) Cost (underrun)/overrun:              0      (200,000)      100,000
 (E) - (F)....................
(H) Adjustment rate...........          70%           70%           70%
                               -----------------------------------------
(I) Target price adjustment...            0      (140,000)       70,000
                               -----------------------------------------
(J) Total contract price: (D)    $1,000,000      $860,000    $1,070,000
 + (I)........................
                               =========================================
(K) Cumulative gross receipts:     $333,333      $645,000    $1,070,000
 (C) x (J)....................
(L) Cumulative gross receipts            (0)     (333,333)     (645,000)
 (prior year):................
                               -----------------------------------------
(M) Current-year gross              333,333       311,667       425,000
 receipts.....................
                               -----------------------------------------
(N) Cumulative incurred costs.      200,000       300,000       700,000
(O) Cumulative incurred costs            (0)     (200,000)     (300,000)
 (prior year):................
                               -----------------------------------------
(P) Current-year costs........      200,000       100,000       400,000
                               -----------------------------------------
(Q) Gross income: (M) - (P)...     $133,333      $211,667       $25,000
------------------------------------------------------------------------


[[Page 263]]

    Example 4. PCM--10 percent method. (i) C, whose taxable year ends 
December 31, determines the income from long-term contracts using the 
PCM. In November 2001, C agrees to manufacture a unique item for 
$1,000,000. C reasonably estimates that the total allocable contract 
costs will be $600,000. By December 31, 2001, C has received $50,000 in 
progress payments and incurred $40,000 of costs. C elects to use the 10 
percent method effective for 2001 and all subsequent taxable years. 
During 2002, C receives $500,000 in progress payments and incurs 
$260,000 of costs. In 2003, C incurs an additional $300,000 of costs, C 
finishes manufacturing the item, and receives the final $450,000 
payment.
    (ii) For each of the taxable years, C's income from the contract is 
computed as follows:

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.      $40,000      $300,000      $600,000
(B) Estimated total costs.....      600,000       600,000       600,000
                               -----------------------------------------
(C) Completion factor (A) /           6.67%        50.00%       100.00%
 (B)..........................
                               -----------------------------------------
(D) Total contract price......    1,000,000     1,000,000     1,000,000
                               -----------------------------------------
(E) Cumulative gross receipts:            0       500,000     1,000,000
 (C) x (D)*...................
(F) Cumulative gross receipts            (0)           (0)     (500,000)
 (prior year):................
                               -----------------------------------------
(G) Current-year gross                    0       500,000       500,000
 receipts.....................
                               -----------------------------------------
(H) Cumulative incurred costs.            0       300,000       600,000
(I) Cumulative incurred costs            (0)           (0)     (300,000)
 (prior year):................
                               -----------------------------------------
(J) Current-year costs........            0       300,000       300,000
                               -----------------------------------------
(K) Gross income: (G) - (J)...           $0      $200,000     $200,000
------------------------------------------------------------------------
*Unless (C) <10 percent.

    Example 5. PCM--contract terminated. C, whose taxable year ends 
December 31, determines the income from long-term contracts using the 
PCM. During 2001, C buys land and begins constructing a building that 
will contain 50 condominium units on that land. C enters into a contract 
to sell one unit in this condominium to B for $240,000. B gives C a 
$5,000 deposit toward the purchase price. By the end of 2001, C has 
incurred $50,000 of allocable contract costs on B's unit and estimates 
that the total allocable contract costs on B's unit will be $150,000. 
Thus, for 2001, C reports gross receipts of $80,000 ($50,000 / $150,000 
x $240,000), current-year costs of $50,000, and gross income of $30,000 
($80,000 - $50,000). In 2002, after C has incurred an additional $25,000 
of allocable contract costs on B's unit, B files for bankruptcy 
protection and defaults on the contract with C, who is permitted to keep 
B's $5,000 deposit as liquidated damages. In 2002, C reverses the 
transaction with B under paragraph (b)(7) of this section and reports a 
loss of $30,000 ($50,000-$80,000). In addition, C obtains an adjusted 
basis in the unit sold to B of $70,000 ($50,000 (current-year costs 
deducted in 2001)- $5,000 (B's forfeited deposit) + $25,000 (current-
year costs incurred in 2002). C may not apply the look-back method to 
this contract in 2002.
    Example 6. CCM--contracts with disputes from customer claims. In 
2001, C, whose taxable year ends December 31, uses the CCM to account 
for exempt construction contracts. C enters into a contract to construct 
a bridge for B. The terms of the contract provide for a $1,000,000 gross 
contract price. C finishes the bridge in 2002 at a cost of $950,000. 
When B examines the bridge, B insists that C either repaint several 
girders or reduce the contract price. The amount reasonably in dispute 
is $10,000. In 2003, C and B resolve their dispute, C repaints the 
girders at a cost of $6,000, and C and B agree that the contract price 
is not to be reduced. Because C is assured a profit of $40,000 
($1,000,000 - $10,000 - $950,000) in 2002 even if the dispute is 
resolved in B's favor, C must take this $40,000 into account in 2002. In 
2003, C will earn an additional $4,000 profit ($1,000,000 - $956,000 - 
$40,000) from the contract with B. Thus, C must take into account an 
additional $10,000 of gross contract price and $6,000 of additional 
contract costs in 2003.
    Example 7. CCM--contracts with disputes from taxpayer claims. In 
2003, C, whose taxable year ends December 31, uses the CCM to account 
for exempt construction contracts. C enters into a contract to construct 
a building for B. The terms of the contract provide for a $1,000,000 
gross contract price. C finishes the building in 2004 at a cost of 
$1,005,000. B examines the building in 2004 and agrees that it meets the 
contract's specifications; however, at the end of 2004, C and

[[Page 264]]

B are unable to agree on the merits of C's claim for an additional 
$10,000 for items that C alleges are changes in contract specifications 
and B alleges are within the scope of the contract's original 
specifications. In 2005, B agrees to pay C an additional $2,000 to 
satisfy C's claims under the contract. Because the amount in dispute 
affects so much of the gross contract price that C cannot determine in 
2004 whether a profit or loss will ultimately be realized, C may not 
taken any of the gross contract price or allocable contract costs into 
account in 2004. C must take into account $1,002,000 of gross contract 
price and $1,005,000 of allocable contract costs in 2005.
    Example 8. CCM--contracts with disputes from taxpayer and customer 
claims. C, whose taxable year ends December 31, uses the CCM to account 
for exempt construction contracts. C constructs a factory for B pursuant 
to a long-term contract. Under the terms of the contract, B agrees to 
pay C a total of $1,000,000 for construction of the factory. C finishes 
construction of the factory in 2002 at a cost of $1,020,000. When B 
takes possession of the factory and begins operations in December 2002, 
B is dissatisfied with the location and workmanship of certain heating 
ducts. As of the end of 2002, C contends that the heating ducts are 
constructed in accordance with contract specifications. The amount of 
the gross contract price reasonably in dispute with respect to the 
heating ducts is $6,000. As of this time, C is claiming $14,000 in 
addition to the original contract price for certain changes in contract 
specifications which C alleges have increased his costs. B denies that 
these changes have increased C's costs. In 2003, the disputes between C 
and B are resolved by performance of additional work by C at a cost of 
$1,000 and by an agreement that the contract price would be revised 
downward to $996,000. Under these circumstances, C must include in his 
gross income for 2002, $994,000 (the gross contract price less the 
amount reasonably in dispute because of B's claim, or $1,000,000 - 
$6,000). In 2002, C must also take into account $1,000,000 of allocable 
contract costs (costs incurred less the amounts in dispute attributable 
to both B's and C's claims, or $1,020,000 - $6,000 - $14,000). In 2003, 
C must take into account an additional $2,000 of gross contract price 
($996,000 - $994,000) and $21,000 of allocable contract costs 
($1,021,000 - $1,000,000).

    (i) Applicability date. Paragraph (f)(1) of this section applies to 
taxable years beginning on or after January 5, 2021. However, for a 
taxable year beginning after December 31, 2017, and before January 5, 
2021, a taxpayer may apply the paragraph described in the first sentence 
of this paragraph (i), provided that the taxpayer follows all the 
applicable rules contained in the regulations under section 460 for such 
taxable year and all subsequent taxable years.
    (j) Consolidated groups and controlled groups--(1) Intercompany 
transactions--(i) In general. Section 1.1502-13 does not apply to the 
income, gain, deduction, or loss from an intercompany transaction 
between members of a consolidated group, and section 267(f) does not 
apply to these items from an intercompany sale between members of a 
controlled group, to the extent--
    (A) The transaction or sale directly or indirectly benefits, or is 
intended to benefit, another member's long-term contract with a 
nonmember;
    (B) The selling member is required under section 460 to determine 
any part of its gross income from the transaction or sale under the 
percentage-of-completion method (PCM); and
    (C) The member with the long-term contract is required under section 
460 to determine any part of its gross income from the long-term 
contract under the PCM.
    (ii) Definitions and nomenclature. The definitions and nomenclature 
under Sec.  1.1502-13 and Sec.  1.267(f)-1 apply for purposes of this 
paragraph (j).
    (2) Example. The following example illustrates the principles of 
paragraph (j)(1) of this section.

    Example. Corporations P, S, and B file consolidated returns on a 
calendar-year basis. In 1996, B enters into a long-term contract with X, 
a nonmember, to manufacture 5 airplanes for $500 million, with delivery 
scheduled for 1999. Section 460 requires B to determine the gross income 
from its contract with X under the PCM. S enters into a contract with B 
to manufacture for $50 million the engines that B will install on X's 
airplanes. Section 460 requires S to determine the gross income from its 
contract with B under the PCM. S estimates that it will incur $40 
million of total contract costs during 1997 and 1998 to manufacture the 
engines. S incurs $10 million of contract costs in 1997 and $30 million 
in 1998. Under paragraph (j) of this section, S determines its gross 
income from the long-term contract under the PCM rather than taking its 
income or loss into account under section 267(f) or Sec.  1.1502-13. 
Thus, S includes $12.5 million of gross receipts and $10 million of 
contract costs in gross income in 1997 and includes $37.5 million of 
gross receipts and $30 million of contract costs in gross income in 
1998.


[[Page 265]]


    (3) Effective dates--(i) In general. This paragraph (j) applies with 
respect to transactions and sales occurring pursuant to contracts 
entered into in years beginning on or after July 12, 1995.
    (ii) Prior law. For transactions and sales occurring pursuant to 
contracts entered into in years beginning before July 12, 1995, see the 
applicable regulations issued under sections 267(f) and 1502, including 
Sec. Sec.  1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in 
the 26 CFR part 1 edition revised as of April 1, 1995).
    (4) Consent to change method of accounting. For transactions and 
sales to which this paragraph (j) applies, the Commissioner's consent 
under section 446(e) is hereby granted to the extent any changes in 
method of accounting are necessary solely to comply with this section, 
provided the changes are made in the first taxable year of the taxpayer 
to which the rules of this paragraph (j) apply. Changes in method of 
accounting for these transactions are to be effected on a cut-off basis.
    (k) Mid-contract change in taxpayer--(1) In general. The rules in 
this paragraph (k) apply if prior to the completion of a long-term 
contract accounted for using a long-term contract method by a taxpayer 
(old taxpayer), there is a transaction that makes another taxpayer (new 
taxpayer) responsible for accounting for income from the same contract. 
For purposes of this paragraph (k) and Sec.  1.460-6(g), an old taxpayer 
also includes any old taxpayer(s) (e.g., predecessors) of the old 
taxpayer. In addition, a change in status from taxable to tax exempt or 
from domestic to foreign, or vice versa, will be considered a change in 
taxpayer. Finally, a contract will be treated as the same contract if 
the terms of the contract are not substantially changed in connection 
with the transaction, whether or not the customer agrees to release the 
old taxpayer from any or all of its obligations under the contract. The 
rules governing constructive completion transactions are provided in 
paragraph (k)(2) of this section, while the rules governing step-in-the-
shoes transactions are provided in paragraph (k)(3) of this section. 
Special rules relating to the treatment of certain partnership 
transactions are provided in paragraphs (k)(2)(iv) and (k)(3)(v) of this 
section. For application of the look-back method to mid-contract changes 
in taxpayers for contracts accounted for using the PCM, see Sec.  1.460-
6(g).
    (2) Constructive completion transactions--(i) Scope. The 
constructive completion rules in this paragraph (k)(2) apply to 
transactions (constructive completion transactions) that result in a 
change in the taxpayer responsible for reporting income from a contract 
and that are not described in paragraph (k)(3)(i) of this section. 
Constructive completion transactions generally include, for example, 
taxable sales under section 1001 and deemed asset sales under section 
338.
    (ii) Old taxpayer. The old taxpayer is treated as completing the 
contract on the date of the transaction. The total contract price (or, 
gross contract price in the case of a long-term contract accounted for 
under the CCM) for the old taxpayer is the sum of any amounts realized 
from the transaction that are allocable to the contract and any amounts 
the old taxpayer has received or reasonably expects to receive under the 
contract. Total contract price (or gross contract price) is reduced by 
any amount paid by the old taxpayer to the new taxpayer, and by any 
transaction costs, that are allocable to the contract. Thus, the old 
taxpayer's allocable contract costs determined under paragraph (b)(5) of 
this section do not include any consideration paid, or costs incurred, 
as a result of the transaction that are allocable to the contract. In 
the case of a transaction subject to section 338 or 1060, the amount 
realized from the transaction allocable to the contract is determined by 
using the residual method under Sec. Sec.  1.338-6 and 1.338-7.
    (iii) New taxpayer. The new taxpayer is treated as entering into a 
new contract on the date of the transaction. The new taxpayer must 
evaluate whether the new contract should be classified as a long-term 
contract within the meaning of Sec.  1.460-1(b) and account for the 
contract under a permissible method of accounting. For a new taxpayer 
who accounts for a contract using the PCM, the total contract price

[[Page 266]]

is any amount the new taxpayer reasonably expects to receive under the 
contract consistent with paragraph (b)(4) of this section. Total 
contract price is reduced by the amount of any consideration paid by the 
new taxpayer as a result of the transaction, and by any transaction 
costs, that are allocable to the contract and is increased by the amount 
of any consideration received by the new taxpayer as a result of the 
transaction that is allocable to the contract. Similarly, the gross 
contract price for a contract accounted for using the CCM is all amounts 
the new taxpayer is entitled by law or contract to receive consistent 
with paragraph (d)(3) of this section, adjusted for any consideration 
paid (or received) by the new taxpayer as a result of the transaction, 
and for any transaction costs, that are allocable to the contract. Thus, 
the new taxpayer's allocable contract costs determined under paragraph 
(b)(5) of this section do not include any consideration paid, or costs 
incurred, as a result of the transaction that are allocable to the 
contract. In the case of a transaction subject to sections 338 or 1060, 
the amount of consideration paid that is allocable to the contract is 
determined by using the residual method under Sec. Sec.  1.338-6 and 
1.338-7.
    (iv) Special rules relating to distributions of certain contracts by 
a partnership--(A) In general. The constructive completion rules of 
paragraph (k)(2) of this section apply both to the distribution of a 
contract accounted for under a long-term contract method of accounting 
by a partnership to a partner and to the distribution of an interest in 
a partnership (lower-tier partnership) holding (either directly or 
through other partnerships) one or more contracts accounted for under a 
long-term contract method of accounting by another partnership (upper-
tier partnership). Notwithstanding the previous sentence, the 
constructive completion rules of paragraph (k)(2) of this section do not 
apply to a transfer by a partnership (transferor partnership) of all of 
its assets and liabilities to a second partnership (transferee 
partnership) in an exchange described in section 721, followed by a 
distribution of the interest in the transferee partnership in 
liquidation of the transferor partnership, under Sec.  1.708-1(b)(4) 
(relating to terminations under section 708(b)(1)(B)) or Sec.  1.708-
1(c)(3)(i) (relating to certain partnership mergers). If a partnership 
that holds a contract accounted for under a long-term contract method of 
accounting terminates under section 708(b)(1)(A) because the number of 
its owners is reduced to one, the entire contract will be treated as 
being distributed from the partnership for purposes of the constructive 
completion rules, and the partnership must apply paragraph (k)(2) of 
this section immediately prior to the transaction or transactions 
resulting in the termination of the partnership.
    (B) Old taxpayer. The partnership that distributes the contract is 
treated as the old taxpayer for purposes of paragraph (k)(2)(ii) of this 
section. For purposes of determining the total contract price (or gross 
contract price) under paragraph (k)(2)(ii) of this section, the fair 
market value of the contract is treated as the amount realized from the 
transaction. For purposes of determining each partner's distributive 
share of partnership items, any income or loss resulting from the 
constructive completion must be allocated among the partners of the old 
taxpayer as though the partnership closed its books on the date of the 
distribution.
    (C) New taxpayer. The partner receiving the distributed contract is 
treated as the new taxpayer for purposes of paragraph (k)(2)(iii) of 
this section. For purposes of determining the total contract price (or 
gross contract price) under paragraph (k)(2)(iii) of this section, the 
new taxpayer's basis in the contract (including the uncompleted 
property, if applicable) after the distribution (as determined under 
section 732) is treated as consideration paid by the new taxpayer that 
is allocable to the contract. Thus, the total contract price (or gross 
contract price) of the new contract is reduced by the partner's basis in 
the contract (including the uncompleted property, if applicable) 
immediately after the distribution.
    (D) Basis rules. For purposes of determining the new taxpayer's 
basis in the contract (including the uncompleted property, if 
applicable) under section

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732, and the amount of any basis adjustment under section 734(b), the 
partnership's basis in the contract (including the uncompleted property, 
if applicable) immediately prior to the distribution is equal to--
    (1) The partnership's allocable contract costs (including 
transaction costs);
    (2) Increased (or decreased) by the amount of cumulative taxable 
income (or loss) recognized by the partnership on the contract through 
the date of the distribution (including amounts recognized as a result 
of the constructive completion); and
    (3) Decreased by the amounts that the partnership has received or 
reasonably expects to receive under the contract.
    (E) Section 751--(1) In general. Contracts accounted for under a 
long-term contract method of accounting are unrealized receivables 
within the meaning of section 751(c). For purposes of section 751, the 
amount of ordinary income or loss attributable to a contract accounted 
for under a long-term contract method of accounting is the amount of 
income or loss that the partnership would take into account under the 
constructive completion rules of paragraph (k)(2) of this section if the 
contract were disposed of for its fair market value in a constructive 
completion transaction, adjusted to account for any income or loss from 
the contract that is allocated under section 706 to that portion of the 
taxable year of the partnership ending on the date of the distribution, 
sale, or exchange.
    (2) Ordering rules. Because the distribution of a contract accounted 
for under a long-term contract method of accounting is the distribution 
of an unrealized receivable, section 751(b) may apply to the 
distribution. A partnership that distributes a contract accounted for 
under a long-term contract method of accounting must apply paragraph 
(k)(2)(ii) of this section before applying the rules of section 751(b) 
to the distribution.
    (3) Step-in-the-shoes transactions--(i) Scope. Except as otherwise 
provided in paragraph (k)(3)(v)(D) of this section, the step-in-the-
shoes rules in this paragraph (k)(3) apply to the following transactions 
that result in a change in the taxpayer responsible for reporting income 
from a contract accounted for using a long-term contract method of 
accounting (step-in-the-shoes transactions)--
    (A) Transfers to which section 361 applies if the transfer is in 
connection with a reorganization described in section 368(a)(1)(A), (C) 
or (F);
    (B) Transfers to which section 361 applies if the transfer is in 
connection with a reorganization described in section 368(a)(1)(D) or 
(G), provided the requirements of section 354(b)(1)(A) and (B) are met;
    (C) Distributions to which section 332 applies, provided the 
contract is transferred to an 80-percent distributee;
    (D) Transfers described in section 351;
    (E) Transfers to which section 361 applies if the transfer is in 
connection with a reorganization described in section 368(a)(1)(D) with 
respect to which the requirements of section 355 (or so much of section 
356 as relates to section 355) are met;
    (F) Transfers (e.g., sales) of S corporation stock;
    (G) Conversion to or from an S corporation;
    (H) Members joining or leaving a consolidated group;
    (I) Contributions of contracts accounted for under a long-term 
contract method of accounting to which section 721(a) applies;
    (J) Contributions of property (other than contracts accounted for 
under a long-term contract method of accounting) to a partnership that 
holds a contract accounted for under a long-term contract method of 
accounting;
    (K) Transfers of partnership interests (other than transfers which 
cause the partnership to terminate under section 708(b)(1)(A));
    (L) Distributions to which section 731 applies (other than the 
distribution of the contract); and
    (M) Any other transaction designated in the Internal Revenue 
Bulletin by the Internal Revenue Service. See Sec.  601.601(d)(2)(ii) of 
this chapter.
    (ii) Old taxpayer--(A) In general. The new taxpayer will ``step into 
the shoes'' of the old taxpayer with respect to the contract. Thus, the 
old taxpayer's obligation to account for the contract terminates on the 
date of the

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transaction and is assumed by the new taxpayer, as set forth in 
paragraph (k)(3)(iii) of this section. As a result, an old taxpayer 
using the PCM is required to recognize income from the contract based on 
the cumulative allocable contract costs incurred as of the date of the 
transaction. Similarly, an old taxpayer using the CCM is not required to 
recognize any revenue and may not deduct allocable contract costs 
incurred with respect to the contract.
    (B) Gain realized on the transaction. The amount of gain the old 
taxpayer realizes on the transfer of a contract in a step-in-the-shoes 
transaction must be determined after application of paragraph 
(k)(3)(ii)(A) of this section using the rules of paragraph (k)(2) of 
this section that apply to constructive completion transactions. (The 
amount of gain realized on a transfer of a contract is relevant, for 
example, in determining the amount of gain recognized with respect to 
the contract in a section 351 transaction in which the old taxpayer 
receives from the new taxpayer money or property other than stock of the 
transferee.)
    (iii) New taxpayer--(A) Method of accounting. Beginning on the date 
of the transaction, the new taxpayer must account for the long-term 
contract by using the same method of accounting used by the old taxpayer 
prior to the transaction. The same method of accounting must be used for 
such contract regardless of whether the old taxpayer's method is the new 
taxpayer's principal method of accounting under Sec.  1.381(c)(4)-
1(b)(3) or whether the new taxpayer is otherwise eligible to use the old 
taxpayer's method. Thus, if the old taxpayer uses the PCM to account for 
the contract, the new taxpayer steps into the shoes of the old taxpayer 
with respect to its completion factor and percentage of completion 
methods (such as the 10-percent method), even if the new taxpayer has 
not elected such methods for similarly classified contracts. Similarly, 
if the old taxpayer uses the CCM, the new taxpayer steps into the shoes 
of the old taxpayer with respect to the CCM, even if the new taxpayer is 
not otherwise eligible to use the CCM. However, the new taxpayer is not 
necessarily bound by the old taxpayer's method for similarly classified 
contracts entered into by the new taxpayer subsequent to the transaction 
and must apply general tax principles, including section 381, to 
determine the appropriate method to account for these subsequent 
contracts. To the extent that general tax principles allow the taxpayer 
to account for similarly classified contracts using a method other than 
the old taxpayer's method, the taxpayer is not required to obtain the 
consent of the Commissioner to begin using such other method.
    (B) Contract price. In the case of a long-term contract that has 
been accounted for under PCM, the total contract price for the new 
taxpayer is the sum of any amounts the old taxpayer or the new taxpayer 
has received or reasonably expects to receive under the contract 
consistent with paragraph (b)(4) of this section. Similarly, the gross 
contract price in the case of a long-term contract accounted for under 
the CCM includes all amounts the old taxpayer or the new taxpayer is 
entitled by law or by contract to receive consistent with paragraph 
(d)(3) of this section.
    (C) Contract costs. Total allocable contract costs for the new 
taxpayer are the allocable contract costs as defined under paragraph 
(b)(5) of this section incurred by either the old taxpayer prior to, or 
the new taxpayer after, the transaction. Thus, any payments between the 
old taxpayer and the new taxpayer with respect to the contract in 
connection with the transaction are not treated as allocable contract 
costs.
    (iv) Special rules related to certain corporate and partnership 
transactions--(A) Old taxpayer--basis adjustment--(1) In general. Except 
as provided in paragraph (k)(3)(iv)(A)(2) of this section, in the case 
of a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of 
this section, the old taxpayer must adjust its basis in the stock or 
partnership interest of the new taxpayer by--
    (i) Increasing such basis by the amount of gross receipts the old 
taxpayer has recognized under the contract; and

[[Page 269]]

    (ii) Reducing such basis by the amount of gross receipts the old 
taxpayer has received or reasonably expects to receive under the 
contract (except to the extent such gross receipts give rise to a 
liability other than a liability described in section 357(c)(3)).
    (2) Basis adjustment in excess of stock or partnership interest 
basis. If the old and new taxpayer do not join in the filing of a 
consolidated Federal income tax return, the old taxpayer may not adjust 
its basis in the stock or partnership interest of the new taxpayer under 
paragraph (k)(3)(iv)(A)(1) of this section below zero and the old 
taxpayer must recognize ordinary income to the extent the basis in the 
stock or partnership interest of the new taxpayer otherwise would be 
adjusted below zero. If the old and new taxpayer join in the filing of a 
consolidated Federal income tax return, the old taxpayer must create an 
(or increase an existing) excess loss account to the extent the basis in 
the stock of the new taxpayer otherwise would be adjusted below zero 
under paragraph (k)(3)(iv)(A)(1) of this section. See Sec.  1.1502-19 
and 1.1502-32(a)(3)(ii).
    (3) Subsequent dispositions of certain contracts. If the old 
taxpayer disposes of a contract in a transaction described in paragraph 
(k)(3)(i)(D), (E), or (I) of this section that the old taxpayer acquired 
in a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of 
this section, the basis adjustment rule of this paragraph (k)(3)(iv)(A) 
is applied by treating the old taxpayer as having recognized the amount 
of gross receipts recognized by the previous old taxpayer under the 
contract and any amount recognized by the previous old taxpayer with 
respect to the contract in connection with the transaction in which the 
old taxpayer acquired the contract. In addition, the old taxpayer is 
treated as having received or as reasonably expecting to receive under 
the contract any amount the previous old taxpayer received or reasonably 
expects to receive under the contract. Similar principles will apply in 
the case of multiple successive transfers described in paragraph 
(k)(3)(i)(D), (E), or (I) of this section involving the contract.
    (B) New taxpayer--(1) Contract price adjustment. Generally, payments 
between the old taxpayer and the new taxpayer with respect to the 
contract in connection with the transaction do not affect the contract 
price. Notwithstanding the preceding sentence and paragraph 
(k)(3)(iii)(B) of this section, however, in the case of transactions 
described in paragraph (k)(3)(i)(B), (D), (E), or (I) of this section, 
the total contract price (or gross contract price) must be reduced to 
the extent of any amount recognized by the old taxpayer with respect to 
the contract in connection with the transaction (e.g., any amount 
recognized under section 351(b) or section 357 that is attributable to 
the contract and any income recognized by the old taxpayer pursuant to 
the basis adjustment rule of paragraph (k)(3)(iv)(A) of this section).
    (2) Basis in contract. The new taxpayer's basis in a contract 
(including the uncompleted property, if applicable) acquired in a 
transaction described in paragraphs (k)(3)(i)(A) through (E) or 
paragraph (k)(3)(i)(I) of this section will be computed under section 
362, section 334, or section 723, as applicable. Upon a new taxpayer's 
completion (actual or constructive) of a CCM or a PCM contract acquired 
in a transaction described in paragraphs (k)(3)(i)(A) through (E) or 
paragraph (k)(3)(i)(I) of this section, the new taxpayer's basis in the 
contract (including the uncompleted property, if applicable) is reduced 
to zero. The new taxpayer is not entitled to a deduction or loss in 
connection with any basis reduction pursuant to this paragraph 
(k)(3)(iv)(B)(2).
    (C) Definition of old taxpayer and new taxpayer for certain 
partnership transactions. For purposes of paragraphs (k)(3)(ii), (iii) 
and (iv) of this section, in the case of a transaction described in 
paragraph (k)(3)(i)(I) of this section, the partner contributing the 
contract to the partnership is treated as the old taxpayer, and the 
partnership receiving the contract from the partner is treated as the 
new taxpayer.
    (D) Exceptions to step-in-the-shoes rules for S corporations. Upon a 
transfer described in paragraph (k)(3)(i)(F) of this section or a 
conversion described in paragraph (k)(3)(i)(G) of this section,

[[Page 270]]

paragraphs (k)(3)(ii) and (iii) of this section apply to a contract 
accounted for under a long-term contract method of accounting only if 
the S corporation's books are closed under section 1362(e)(3), section 
1362(e)(6)(C), section 1362(e)(6)(D), section 1377(a)(2), or Sec.  
1.1502-76 on the date of the transfer or conversion. In these cases, the 
corporation is treated as both the old taxpayer and the new taxpayer for 
purposes of paragraphs (k)(3)(ii) and (iii) of this section. In all 
other cases involving these transfers, the corporation shall compute its 
income or loss from each contract accounted for under a long-term 
contract method of accounting for the period that includes the date of 
the transaction as though no change in taxpayer had occurred with 
respect to the contract, and must allocate the income or loss from the 
contract for that period in accordance with the rules generally 
applicable to transfers of S corporation stock and conversions to or 
from S corporation status. This paragraph (k)(3)(iv)(D) is applicable 
for transactions on or after July 16, 2004. In addition, this paragraph 
(k)(3)(iv)(D) may be relied upon for transactions on or after May 15, 
2002.
    (v) Special rules relating to certain partnership transactions--(A) 
Section 704(c)--(1) Contributions of contracts. The principles of 
section 704(c)(1)(A), section 737, and the regulations thereunder apply 
to income or loss with respect to a contract accounted for under a long-
term contract method of accounting that is contributed to a partnership. 
The amount of built-in income or built-in loss attributable to a 
contributed contract that is subject to section 704(c)(1)(A) is 
determined as follows. First, the contributing partner must take into 
account any income or loss required under paragraph (k)(3)(ii)(A) of 
this section for the period ending on the date of the contribution. 
Second, the partnership must determine the amount of income or loss that 
the contributing partner would take into account if the contract were 
disposed of for its fair market value in a constructive completion 
transaction. This calculation is treated as occurring immediately after 
the partner has applied paragraph (k)(3)(ii)(A) of this section, but 
before the contribution to the partnership. Finally, this amount is 
reduced by the amount of income, if any, that the contributing partner 
is required to recognize as a result of the contribution.
    (2) Revaluations of partnership property. The principles of section 
704(c) and Sec.  1.704-3 apply to allocations of income or loss with 
respect to a long-term contract that is revalued by a partnership under 
Sec.  1.704-1(b)(2)(iv)(f). The amount of built-in income or built-in 
loss attributable to such a contract is equal to the amount of income or 
loss that would be taken into account if, at the time of the 
revaluation, the contract were disposed of for its fair market value in 
a constructive completion transaction.
    (3) Allocation methods. In the case of a contract accounted for 
under the CCM, any built-in income or loss under section 704(c) is taken 
into account in the year the contract is completed. In the case of a 
contract accounted for under a long-term contract method of accounting 
other than the CCM, any built-in income or loss under section 704(c) 
must be taken into account in a manner that reasonably accounts for the 
section 704(c) income or loss over the remaining term of the contract.
    (B) Basis adjustments under sections 743(b) and 734(b). For purposes 
of Sec. Sec.  1.743-1(d), 1.755-1(b), and 1.755-1(c), the amount of 
ordinary income or loss attributable to a contract accounted for under a 
long-term contract method of accounting is the amount of income or loss 
that the partnership would take into account under the constructive 
completion rules of paragraph (k)(2) of this section if, at the time of 
the sale of a partnership interest or the distribution to a partner, the 
partnership disposed of the contract for its fair market value in a 
constructive completion transaction. If all or part of the transferee's 
basis adjustment under section 743(b) or the partnership's basis 
adjustment under section 734(b) is allocated to a contract accounted for 
under a long-term contract method of accounting, the basis adjustment 
shall reduce or increase, as the case may be, the affected party's 
income or loss from the contract. In the case of a contract accounted 
for under the CCM, the basis adjustment is taken into account

[[Page 271]]

in the year in which the contract is completed. In the case of a 
contract accounted for under a long-term contract method of accounting 
other than the CCM, the portion of that basis adjustment that is 
recovered in each taxable year of the partnership must be determined by 
the partnership in a manner that reasonably accounts for the adjustment 
over the remaining term of the contract.
    (C) Cross reference. See paragraph (k)(2)(iv)(E) of this section for 
rules relating to the application of section 751 to the transfer of an 
interest in a partnership holding a contract accounted for under a long-
term contract method of accounting.
    (D) Exceptions to step-in-the-shoes rules. Upon a contribution 
described in paragraph (k)(3)(i)(J) of this section, a transfer 
described in paragraph (k)(3)(i)(K) of this section, or a distribution 
described in paragraph (k)(3)(i)(L) of this section, paragraphs 
(k)(3)(ii) and (iii) of this section apply to a contract accounted for 
under a long-term contract method of accounting only if the 
partnership's books are properly closed with respect to that contract 
under section 706. In these cases, the partnership is treated as both 
the old taxpayer and the new taxpayer for purposes of paragraphs 
(k)(3)(ii) and (iii) of this section. In all other cases involving these 
transactions, the partnership shall compute its income or loss from each 
contract accounted for under a long-term contract method of accounting 
for the period that includes the date of the transaction as though no 
change in taxpayer had occurred with respect to the contract, and must 
allocate the income or loss from the contract for that period under a 
reasonable method complying with section 706.
    (4) Anti-abuse rule. Notwithstanding this paragraph (k), in the case 
of a transaction entered into with a principal purpose of shifting the 
tax consequences associated with a long-term contract in a manner that 
substantially reduces the aggregate U.S. Federal income tax liability of 
the parties with respect to that contract, the Commissioner may allocate 
to the old (or new) taxpayer the income from that contract properly 
allocable to the old (or new) taxpayer. For example, the Commissioner 
may reallocate income from a long-term contract in a transaction in 
which a contract accounted for using the CCM, or using the PCM where the 
old taxpayer has received advance payments in excess of its contribution 
to the contract, is transferred to a tax indifferent party (e.g., a 
foreign person not subject to U.S. Federal income tax).
    (5) Examples. The following examples illustrate the rules of this 
paragraph (k). For purposes of these examples, it is assumed that the 
contract is a long-term construction contract accounted for using the 
PCM prior to the transaction unless stated otherwise and the contract is 
not transferred with a principal purpose of shifting the tax 
consequences associated with a long-term contract in a manner that 
substantially reduces the aggregate U.S. Federal income tax liability of 
the parties with respect to that contract. The examples are as follows:

    Example 1. Constructive completion--PCM. (i) Facts. In Year 1, X 
enters into a contract. The total contract price is $1,000,000 and the 
estimated total allocable contract costs are $800,000. In Year 1, X 
incurs costs of $200,000. In Year 2, X incurs additional costs of 
$400,000 before selling the contract as part of a taxable sale of its 
business in Year 2 to Y, an unrelated party. At the time of sale, X has 
received $650,000 in progress payments under the contract. The 
consideration allocable to the contract under section 1060 is $150,000. 
Pursuant to the sale, the new taxpayer Y immediately assumes X's 
contract obligations and rights. Y is required to account for the 
contract using the PCM. In Year 2, Y incurs additional allocable 
contract costs of $50,000. Y correctly estimates at the end of Year 2 
that it will have to incur an additional $75,000 of allocable contract 
costs in Year 3 to complete the contract.
    (ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the 
completion factor multiplied by total contract price ($200,000/$800,000 
x $1,000,000)) and costs of $200,000, for a profit of $50,000. X is 
treated as completing the contract in Year 2 because it sold the 
contract. For purposes of applying the PCM in Year 2, the total contract 
price is $800,000 (the sum of the amounts received under the contract 
and the amount realized in the sale ($650,000 + $150,000)) and the total 
allocable contract costs are $600,000 (the sum of the costs incurred in 
Year 1 and Year 2 ($200,000 + $400,000)). Thus, in Year 2, X reports 
receipts of $550,000 (total contract price minus receipts already 
reported ($800,000 -

[[Page 272]]

$250,000)) and costs incurred in year 2 of $400,000, for a profit of 
$150,000.
    (iii) New taxpayer. Y is treated as entering into a new contract in 
Year 2. The total contract price is $200,000 (the amount remaining to be 
paid under the terms of the contract less the consideration paid 
allocable to the contract ($1,000,000 - $650,000 - $150,000)). The 
estimated total allocable contract costs at the end of Year 2 are 
$125,000 (the allocable contract costs that Y reasonably expects to 
incur to complete the contract ($50,000 + $75,000)). In Year 2, Y 
reports receipts of $80,000 (the completion factor multiplied by the 
total contract price [($50,000/$125,000) x $200,000] and costs of 
$50,000 (the costs incurred after the purchase), for a profit of 
$30,000. For Year 3, Y reports receipts of $120,000 (total contract 
price minus receipts already reported ($200,000 - $80,000)) and costs of 
$75,000, for a profit of $45,000.
    Example 2. Constructive completion--CCM. (i) Facts. The facts are 
the same as in Example 1, except that X and Y properly account for the 
contract under the CCM.
    (ii) Old taxpayer. X does not report any income or costs from the 
contract in Year 1. In Year 2, the contract is deemed complete for X, 
and X reports its gross contract price of $800,000 (the sum of the 
amounts received under the contract and the amount realized in the sale 
($650,000 + $150,000)) and its total allocable contract costs of 
$600,000 (the sum of the costs incurred in Year 1 and Year 2 ($200,000 + 
$400,000)) in that year, for a profit of $200,000.
    (iii) New taxpayer. Y is treated as entering into a new contract in 
Year 2. Under the CCM, Y reports no gross receipts or costs in Year 2. Y 
reports its gross contract price of $200,000 (the amount remaining to be 
paid under the terms of the contract less the consideration paid 
allocable to the contract ($1,000,000 - $650,000 - $150,000)) and its 
total allocable contract costs of $125,000 (the allocable contract costs 
that Y incurred to complete the contract ($50,000 + $75,000)) in Year 3, 
the completion year, for a profit of $75,000.
    Example 3. Step-in-the-shoes--PCM. (i) Facts. The facts are the same 
as in Example 1, except that X transfers the contract (including the 
uncompleted property) to Y in exchange for stock of Y in a transaction 
that qualifies as a statutory merger described in section 368(a)(1)(A) 
and does not result in gain or loss to X under section 361(a).
    (ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the 
completion factor multiplied by total contract price ($200,000/$800,000 
x $1,000,000)) and costs of $200,000, for a profit of $50,000. Because 
the mid-contract change in taxpayer results from a transaction described 
in paragraph (k)(3)(i) of this section, X is not treated as completing 
the contract in Year 2. In Year 2, X reports receipts of $500,000 (the 
completion factor multiplied by the total contract price and minus the 
Year 1 gross receipts [($600,000/$800,000 x $1,000,000)-$250,000]) and 
costs of $400,000, for a profit of $100,000.
    (iii) New taxpayer. Because the mid-contract change in taxpayer 
results from a step-in-the-shoes transaction, Y must account for the 
contract using the same methods of accounting used by X prior to the 
transaction. Total contract price is the sum of any amounts that X and Y 
have received or reasonably expect to receive under the contract, and 
total allocable contract costs are the allocable contract costs of X and 
Y. Thus, the estimated total allocable contract costs at the end of Year 
2 are $725,000 (the cumulative allocable contract costs of X and the 
estimated total allocable contract costs of Y ($200,000 + $400,000 + 
$50,000 + $75,000)). In Year 2, Y reports receipts of $146,552 (the 
completion factor multiplied by the total contract price minus receipts 
reported by the old taxpayer ([($650,000/$725,000) x $1,000,000]-
$750,000) and costs of $50,000, for a profit of $96,552. For Year 3, Y 
reports receipts of $103,448 (the total contract price minus prior year 
receipts ($1,000,000-$896,552)) and costs of $75,000, for a profit of 
$28,448.
    Example 4. Step-in-the-shoes--CCM (i) Facts. The facts are the same 
as in Example 3, except that X properly accounts for the contract under 
the CCM.
    (ii) Old taxpayer. X reports no income or costs from the contract in 
Years 1, 2 or 3.
    (iii) New taxpayer. Because the mid-contract change in taxpayer 
results from a step-in-the-shoes transaction, Y must account for the 
contract using the same method of accounting used by X prior to the 
transaction. Thus, in Year 3, the completion year, Y reports receipts of 
$1,000,000 and total contract costs of $725,000, for a profit of 
$275,000.
    Example 5. Step in the shoes--PCM--basis adjustment. The facts are 
the same as in Example 3, except that X transfers the contract 
(including the uncompleted property) with a basis of $0 and $125,000 of 
cash to a new corporation, Z, in exchange for all of the stock of Z in a 
section 351 transaction. Thus, under section 358(a), X's basis in the Z 
stock is $125,000. Pursuant to paragraph (k)(3)(iv)(A)(1) of this 
section, X must increase its basis in the Z stock by the amount of gross 
receipts X recognized under the contract, $750,000 ($250,000 receipts in 
Year 1 + $500,000 receipts in Year 2), and reduce its basis by the 
amount of gross receipts X received under the contract, the $650,000 in 
progress payments. Accordingly, X's basis in the Z stock is $225,000. 
All other results are the same.
    Example 6. Step in the shoes--CCM--basis adjustment. (i) Facts. The 
facts are the same as in Example 4, except that X receives progress 
payments of $800,000 (rather than $650,000) and transfers the contract 
(including the uncompleted property) with a basis of

[[Page 273]]

$600,000 and $125,000 of cash to a new corporation, Z, in exchange for 
all of the stock of Z in a section 351 transaction. X and Z do not join 
in filing a consolidated Federal income tax return.
    (ii) Old taxpayer. X reports no income or costs under the contract 
in Years 1, 2, or 3. Under section 358(a), X's basis in Z is $725,000. 
Pursuant to paragraph (k)(3)(iv)(A)(1), X must reduce its basis in the 
stock of Z by $800,000, the progress payments received by X. However, X 
may not reduce its basis in the Z stock below zero pursuant paragraph 
(k)(3)(iv)(A)(2) of this section. Accordingly, X's basis in the Z stock 
is reduced by $725,000 to zero and X must recognize ordinary income of 
$75,000.
    (iii) New taxpayer. Upon completion of the contract in Year 3, Z 
reports gross receipts of $925,000 ($1,000,000 original contract price--
$75,000 income recognized by the old taxpayer pursuant to the basis 
adjustment rule of paragraph (k)(3)(iv)(A)) and total contract costs of 
$725,000, for a profit of $200,000.
    Example 7. Step in the shoes--PCM--gain recognized in transaction. 
(i) Facts. The facts are the same as in Example 3, except that X 
transfers the contract (including the uncompleted property) with a basis 
of $0 and an unrelated capital asset with a value of $100,000 and a 
basis of $0 to a new corporation, Z, in exchange for stock of Z with a 
value of $200,000 and $50,000 of cash in a section 351 transaction.
    (ii) Old taxpayer. For year 1, X reports receipts of $250,000 
($200,000/$800,000 x $1,000,000) and costs of $200,000, for a profit of 
$50,000. X is not treated as completing the contract in Year 2. In Year 
2, X reports receipts of $500,000 (($600,000/$800,000 x $1,000,000 = 
$750,000 cumulative gross receipts)--$250,000 prior year cumulative 
gross receipts) and costs of $400,000, for a profit of $100,000. Under 
paragraph (k)(3)(ii)(B) of this section, X determines that the gain 
realized on the transfer of the contract to Z under the constructive 
completion rules of paragraph (k)(2)(ii) of this section is $50,000 
(total contract price of $800,000 ($150,000 value allocable to the 
contract + $650,000 progress payments)--$750,000 previously recognized 
cumulative gross receipts--$0 costs incurred but not recognized). The 
gain realized on the transfer of the unrelated capital asset to Z is 
$100,000. The amount of gain X must recognize due to the receipt of 
$50,000 cash in the exchange is $50,000, of which $30,000 is allocated 
to the contract ($150,000 value of contract/$250,000 total value of 
property transferred to Z x $50,000) and is treated as ordinary income, 
and $20,000 is allocated to the unrelated capital asset ($100,000 value 
of capital asset/$250,000 total value of property transferred to Z x 
$50,000). Under section 358(a), X's basis in the Z stock is $0. However, 
pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X must increase 
its basis in the Z stock by $750,000, the amount of gross receipts 
recognized under the contract, and must reduce its basis in the Z stock 
by $650,000, the amount of gross receipts X received under the contract. 
Therefore, X's basis in the Z stock is $100,000.
    (iii) New taxpayer. Z must account for the contract using the same 
PCM method used by X prior to the transaction. Pursuant to paragraph 
(k)(3)(iv)(B)(1) of this section, the total contract price is $970,000 
($1,000,000 amount X and Z have received or reasonably expect to receive 
under the contract--$30,000 income recognized by X with respect to the 
contract as a result of the receipt of $50,000 cash in the transaction). 
In Year 2, Z reports gross receipts of $119,655 ($650,000/$725,000 x 
$970,000 = $869,655 current year cumulative gross receipts--$750,000 
cumulative gross receipts reported by the old taxpayer) and costs of 
$50,000, for a profit of $69,655. In Year 3, Z reports gross receipts of 
$100,345 ($970,000-$869,655) and costs of $75,000, for a profit of 
$25,345.
    Example 8. Step in the shoes--CCM--gain recognized in transaction. 
(i) Facts. The facts are the same as in Example 4, except that X 
transfers the contract (including the uncompleted property) with a basis 
of $600,000 and an unrelated capital asset with a value of $125,000 and 
a basis of $0 to a new corporation, Z, in exchange for all the stock of 
Z with a value of $175,000 and $100,000 of cash in a section 351 
transaction. X and Z do not join in filing a consolidated Federal income 
tax return.
    (ii) Old taxpayer. X reports no income or costs under the contract 
in Years 1, 2, or 3. Under paragraph (k)(3)(ii)(B), X determines that 
the gain realized on the transfer of the contract to Z under the 
constructive completion rules of paragraph (k)(2)(ii) of this section is 
$200,000 ($800,000 total contract price ($150,000 value allocable to the 
contract + $650,000 progress payments)--$600,000 costs incurred but not 
recognized). The gain realized on the transfer of the unrelated capital 
asset to Z is $125,000. The amount of gain X must recognize due to the 
receipt of $100,000 of cash in the exchange is $100,000, of which 
$54,545 is allocated to the contract ($150,000 value of the contract/
$275,000 total value of property transferred to Z x $100,000) and is 
treated as ordinary income, and $45,455 is allocated to the unrelated 
capital asset ($125,000 value of capital asset/$275,000 total value of 
property transferred to Z x $100,000). Under section 358(a), X's basis 
in the Z stock is $600,000 ($600,000 basis in the contract and unrelated 
capital asset transferred--$100,000 cash received + $100,000 gain 
recognized). Pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X 
must reduce its basis in the stock of Z by $650,000, the progress 
payments received under the contract. However, X may not reduce its 
basis in the Z stock below zero pursuant to paragraph (k)(3)(iv)(A)(2) 
of this section. Accordingly, X's basis in the Z stock

[[Page 274]]

is reduced by $600,000 to zero and X must recognize income of $50,000.
    (iii) New taxpayer. Z must account for the contract using the same 
CCM used by X prior to the transaction. Pursuant to paragraph 
(k)(3)(iv)(B)(1) of this section, the total contract price is $895,455 
($1,000,000 original contract price--$54,545 income recognized by old 
taxpayer with respect to the contract as a result of the receipt of cash 
in the transaction--$50,000 income recognized by the old taxpayer 
pursuant to the basis adjustment rule of paragraph (k)(3)(iv)(A)). 
Accordingly, upon completion of the contract in Year 3, Z reports gross 
receipts of $895,455 and total contract costs of $725,000, for a profit 
of $170,455.
    Example 9. Constructive completion--PCM--distribution of contract by 
partnership. (i) Facts. In Year 1, W, X, Y, and Z each contribute 
$100,000 to form equal partnership PRS. In Year 1, PRS enters into a 
contract. The total contract price is $1,000,000 and the estimated total 
allocable contract costs are $800,000. In Year 1, PRS incurs costs of 
$600,000 and receives $650,000 in progress payments under the contract. 
Under the contract, PRS performed all of the services required in order 
to be entitled to receive the progress payments, and there was no 
obligation to return the payments or perform any additional services in 
order to retain the payments. PRS properly accounts for the contract 
under the PCM. In Year 2, PRS distributes the contract to X in 
liquidation of X's interest. PRS incurs no costs and receives no 
progress payments in Year 2 prior to the distribution. At the time of 
the distribution, PRS's only asset other than the long-term contract and 
the partially constructed property is $450,000 cash ($400,000 initially 
contributed and $50,000 in excess progress payments). The fair market 
value of the contract is $150,000. Pursuant to the distribution, X 
assumes PRS's contract obligations and rights. In Year 2, X incurs 
additional allocable contract costs of $50,000. X correctly estimates at 
the end of Year 2 that X will have to incur an additional $75,000 of 
allocable contract costs in Year 3 to complete the contract (rather than 
$150,000 as originally estimated by PRS). Assume that X properly 
accounts for the contract under the PCM, that PRS has no income or loss 
other than income or loss from the contract, and that PRS has an 
election under section 754 in effect in Year 2.
    (ii) Tax consequences to PRS. For Year 1, PRS reports receipts of 
$750,000 (the completion factor multiplied by total contract price 
($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of 
$150,000, which is allocated equally among W, X, Y, and Z ($37,500 
each). Immediately prior to the distribution of the contract to X in 
Year 2, the contract is deemed completed. Under paragraph (k)(2)(iv)(B) 
of this section, the fair market value of the contract ($150,000) is 
treated as the amount realized from the transaction. For purposes of 
applying the PCM in Year 2, the total contract price is $800,000 (the 
sum of the amounts received under the contract and the amount treated as 
realized from the transaction ($650,000 + $150,000)) and the total 
allocable contract costs are $600,000. Thus, in Year 2 PRS reports 
receipts of $50,000 (total contract price minus receipts already 
reported ($800,000 - $750,000)), and costs incurred in Year 2 of $0, for 
a profit of $50,000. Under paragraph (k)(2)(iv)(B) of this section, this 
profit must be allocated among W, X, Y, and Z as though the partnership 
closed its books on the date of the distribution. Accordingly, each 
partner's distributive share of this income is $12,500.
    (iii) Tax consequences to X. X's basis in its interest in PRS 
immediately prior to the distribution is $150,000 (X's $100,000 initial 
contribution, increased by $37,500, X's distributive share of Year 1 
income, and $12,500, X's distributive share of Year 2 income). Under 
paragraph (k)(2)(iv)(D) of this section, PRS's basis in the contract 
(including the uncompleted property, if applicable) immediately prior to 
the distribution is equal to $150,000 (the partnership's allocable 
contract costs, $600,000, increased by the amount of income recognized 
by PRS on the contract through the date of the distribution (including 
amounts recognized as a result of the constructive completion), 
$200,000, decreased by the amounts that the partnership has received or 
reasonably expects to receive under the contract, $650,000). Under 
section 732, X's basis in the contract (including the uncompleted 
property) after the distribution is $150,000. Under paragraph 
(k)(2)(iv)(C) of this section, X's basis in the contract (including the 
uncompleted property) is treated as consideration paid by X that is 
allocable to the contract. X's total contract price is $200,000 (the 
amount remaining to be paid under the terms of the contract less the 
consideration allocable to the contract ($350,000-$150,000)). For Year 
2, X reports receipts of $80,000 (the completion factor multiplied by 
the total contract price [($50,000/$125,000) x $200,000]) and costs of 
$50,000 (the costs incurred after the distribution of the contract), for 
a profit of $30,000. For Year 3, X reports receipts of $120,000 (the 
total contract price minus receipts already reported ($200,000 - 
$80,000)) and costs of $75,000, for a profit of $45,000.
    (iv) Section 734(b). Because X's basis in the contract (including 
the uncompleted property) immediately after the distribution, $150,000, 
is equal to PRS's basis in the contract (including the uncompleted 
property) immediately prior to the distribution, there is no basis 
adjustment under section 734(b).
    Example 10. Constructive completion--CCM--distribution of contract 
by partnership. (i) Facts. The facts are the same as in Example

[[Page 275]]

9, except that PRS and X properly account for the contract under the 
CCM.
    (ii) Tax consequences to PRS. PRS reports no income or costs from 
the contract in Year 1. Immediately prior to the distribution of the 
contract to X in Year 2, the contract is deemed completed. Under 
paragraph (k)(2)(iv)(B) of this section, the fair market value of the 
contract ($150,000) is treated as the amount realized from the 
transaction. For purposes of applying the CCM in Year 2, the gross 
contract price is $800,000 (the sum of the amounts received under the 
contract and the amount treated as realized from the transaction 
($650,000 + $150,000)) and the total allocable contract costs are 
$600,000. Thus, in Year 2 PRS reports profits of $200,000 ($800,000 - 
$600,000). This profit must be allocated among W, X, Y, and Z as though 
the partnership closed its books on the date of the distribution. 
Accordingly, each partner's distributive share of this income is 
$50,000.
    (iii) Tax consequences to X. X's basis in its interest in PRS 
immediately prior to the distribution is $150,000 ($100,000 initial 
contribution, increased by $50,000, X's distributive share of Year 2 
income). Under paragraph (k)(2)(iv)(D) of this section, PRS's basis in 
the contract (including the uncompleted property, if applicable) 
immediately prior to the distribution is equal to $150,000 (the 
partnership's allocable contract costs, $600,000, increased by the 
amount of cumulative taxable income recognized by PRS on the contract 
through the date of the distribution (including amounts recognized as a 
result of the constructive completion), $200,000, decreased by the 
amounts that the partnership has received or reasonably expects to 
receive under the contract, $650,000). Under section 732, X's basis in 
the contract (including the uncompleted property) after the distribution 
is $150,000. Under paragraph (k)(2)(iv)(C) of this section, X's basis in 
the contract is treated as consideration paid by X that is allocable to 
the contract. Under the CCM, X reports no gross receipts or costs in 
Year 2. For Year 3, the completion year, X reports its gross contract 
price of $200,000 (the amount remaining to be paid under the terms of 
the contract less the consideration allocable to the contract ($350,000 
- $150,000)) and its total allocable contract costs of $125,000 (the 
allocable contract costs that X incurred to complete the contract 
($50,000 + $75,000)), for a profit of $75,000.
    (iv) Section 734(b). The results under section 734(b) are the same 
as in Example 9.
    Example 11. Step-in-the-shoes--PCM--contribution of contract to 
partnership. (i) Facts. In Year 1, X enters into a contract that X 
properly accounts for under the PCM. The total contract price is 
$1,000,000 and the estimated total allocable contract costs are 
$800,000. In Year 1, X incurs costs of $600,000 and receives $650,000 in 
progress payments under the contract. Under the contract, X performed 
all of the services required in order to be entitled to receive the 
progress payments, and there was no obligation to return the payments or 
perform any additional services in order to retain the payments. In Year 
2, X contributes the contract (including the uncompleted property) with 
a basis of $0 and $125,000 of cash to partnership PRS in exchange for a 
one-fourth partnership interest. X incurs costs of $10,000, and receives 
no progress payments in Year 2 prior to the contribution of the 
contract. X and the other three partners of PRS share equally in its 
capital, profits, and losses. The parties determine that, at the time of 
the contribution, the fair market value of the contract is $160,000. 
Following the contribution in Year 2, PRS incurs additional allocable 
contract costs of $40,000. PRS correctly estimates at the end of Year 2 
that it will have to incur an additional $75,000 of allocable contract 
costs in Year 3 to complete the contract (rather than $150,000 as 
originally estimated by PRS).
    (ii) Tax consequences to X. For Year 1, X reports receipts of 
$750,000 (the completion factor multiplied by the total contract price 
($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of 
$150,000. Because the mid-contract change in taxpayer results from a 
transaction described in paragraph (k)(3)(i)(I) of this section, X is 
not treated as completing the contract in Year 2. Under paragraph 
(k)(3)(ii)(A) of this section, for Year 2, X reports receipts of $12,500 
(the completion factor multiplied by the total contract price ($610,000/
$800,000 x $1,000,000, or $762,500), decreased by receipts already 
reported, $750,000) and costs of $10,000, for a profit of $2,500. Under 
section 722, X's initial basis in its interest in PRS is $125,000. 
Pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X must increase 
its basis in its interest in PRS by the amount of gross receipts X 
recognized under the contract, $762,500, and reduce its basis by the 
amount of gross receipts X received under the contract, the $650,000 in 
progress payments. Accordingly, X's basis in its interest in PRS is 
$237,500.
    (iii) Tax consequences to PRS. Because the mid-contract change in 
taxpayer results from a step-in-the-shoes transaction, PRS must account 
for the contract using the same methods of accounting used by X prior to 
the transaction. The total contract price is the sum of any amounts that 
X and PRS have received or reasonably expect to receive under the 
contract, and total allocable contract costs are the allocable contract 
costs of X and PRS. For Year 2, PRS reports receipts of $134,052 (the 
completion factor multiplied by the total contract price [($650,000/
$725,000) - $1,000,000], $896,552, decreased by receipts reported by X, 
$762,500) and costs of $40,000, for a profit of $94,052. For Year 3, PRS 
reports receipts of $103,448 (the total contract price minus prior year 
receipts

[[Page 276]]

($1,000,000 x $896,552)) and costs of $75,000, for a profit of $28,448.
    (iv) Section 704(c). The principles of section 704(c) and Sec.  
1.704-3 apply to allocations of income or loss with respect to the 
contract contributed by X. In this case, the amount of built-in income 
that is subject to section 704(c) is the amount of income or loss that 
the contributing partner would take into account if the contract were 
disposed of for its fair market value in a constructive completion 
transaction. This calculation is treated as occurring immediately after 
the partner has applied paragraph (k)(3)(ii)(A) of this section, but 
before the contribution to the partnership. In a constructive completion 
transaction, the total contract price would be $810,000 (the sum of the 
amounts received under the contract and the amount realized in the 
deemed sale ($650,000 + $160,000)). X would report receipts of $47,500 
(total contract price minus receipts already reported ($810,000 - 
$762,500)) and costs of $0, for a profit of $47,500. Thus, the amount of 
built-in income that is subject to section 704(c) is $47,500. The 
partnership must apply section 704(c) to this income in a manner that 
reasonably accounts for the income over the remaining term of the 
contract. For example, in Year 2, PRS could allocate $26,810 to X under 
section 704(c) (the amount of built-in income, $47,500, multiplied by a 
fraction, the numerator of which is the completion factor for the year, 
$650,000/725,000, less the completion factor for the prior year, 
$610,000/$800,000, and the denominator of which is 100 percent reduced 
by the completion factor for the taxable year preceding the event 
creating the section 704(c) income or loss, $610,000/$800,000). The 
remaining $67,242 would be allocated equally among all of the partners. 
In Year 3, the completion year, PRS could allocate $20,690 to X under 
section 704(c) ($47,500 x [($725,000/$725,000 -$650,000/$725,000) / (100 
percent - $610,000/$800,000)]). The remaining $7,758 would be allocated 
equally among all the partners.
    Example 12. Step-in-the-shoes--CCM--contribution of contract to 
partnership. (i) Facts. The facts are the same as in Example 11, except 
that X and PRS properly account for the contract under the CCM, and X 
has a basis of $610,000 in the contract (including the uncompleted 
property).
    (ii) Tax consequences to X. X reports no income or costs from the 
contract in Years 1 or 2. X is not treated as completing the contract in 
Year 2. Under section 722, X's initial basis in its interest in PRS is 
$735,000 (the sum of $125,000 cash and X's basis of $610,000 in the 
contract (including the uncompleted property)). Pursuant to paragraph 
(k)(3)(iv)(A)(1)(ii) of this section, X must reduce its basis in its 
interest in PRS by the amount of gross receipts X received under the 
contract, or $650,000. Accordingly, X's basis in its interest in PRS is 
$85,000.
    (iii) Tax consequences to PRS. PRS must account for the contract 
using the same methods of accounting used by X prior to the transaction. 
Under the CCM, PRS reports no gross receipts or costs in Year 2. For 
Year 3, the completion year, PRS reports its gross contract price of 
$1,000,000 (the sum of any amounts that X and PRS have received or 
reasonably expect to receive under the contract), and total allocable 
contract costs of $725,000 (the allocable contract costs of X and PRS), 
for a profit of $275,000.
    (iv) Section 704(c). In this case, the amount of built-in income 
that is subject to section 704(c) is the amount of income or loss that 
the contributing partner would take into account if the contract were 
disposed of for its fair market value in a constructive completion 
transaction. This calculation is treated as occurring immediately after 
the partner has applied paragraph (k)(3)(ii)(A) of this section, but 
before the contribution to the partnership. In a constructive completion 
transaction, X would report its gross contract price of $810,000 (the 
sum of the amounts received under the contract and the amount realized 
in the deemed sale ($650,000 + $160,000)) and its total allocable 
contract costs of $610,000, for a profit of $200,000. Thus, the amount 
of built-in income that is subject to section 704(c) is $200,000. Out of 
PRS's income of $275,000, in Year 3, $200,000 must be allocated to X 
under section 704(c), and the remaining $75,000 is allocated equally 
among all of the partners.
    Example 13. Step-in-the-shoes--PCM--transfer of a partnership 
interest. (i) Facts. In Year 1, W, X, Y, and Z each contribute $100,000 
to form equal partnership PRS. In Year 1, PRS enters into a contract. 
The total contract price is $1,000,000 and the estimated total allocable 
contract costs are $800,000. In Year 1, PRS incurs costs of $600,000 and 
receives $650,000 in progress payments under the contract. Under the 
contract, PRS performed all of the services required in order to be 
entitled to receive the progress payments, and there was no obligation 
to return the payment or perform any additional services in order to 
retain the payments. PRS properly accounts for the contract under the 
PCM. In Year 2, W transfers W's interest in PRS to T for $150,000. 
Assume that $10,000 of PRS's Year 2 costs are incurred prior to the 
transfer, $40,000 are incurred after the transfer; and that PRS receives 
no progress payments in Year 2. Also assume that the fair market value 
of the contract on the date of the transfer is $160,000, that PRS closes 
its books with respect to the contract under section 706 on the date of 
the transfer, and that PRS correctly estimates at the end of Year 2 that 
it will have to incur an additional $75,000 of allocable contract costs 
in Year 3 to complete the contract (rather than $150,000 as originally 
estimated by PRS).

[[Page 277]]

    (ii) Income reporting for period ending on date of transfer. For 
Year 1, PRS reports receipts of $750,000 (the completion factor 
multiplied by total contract price ($600,000/$800,000 x $1,000,000)) and 
costs of $600,000, for a profit of $150,000. This profit is allocated 
equally among W, X, Y, and Z ($37,500 each). Under paragraph 
(k)(3)(ii)(A) of this section, for the part of Year 2 ending on the date 
of the transfer of W's interest, PRS reports receipts of $12,500 (the 
completion factor multiplied by the total contract price ($610,000/
$800,000 x $1,000,000) minus receipts already reported ($750,000)) and 
costs of $10,000 for a profit of $2,500. This profit is allocated 
equally among W, X, Y, and Z ($625 each).
    (iii) Income reporting for period after transfer. PRS must continue 
to use the PCM. For the part of Year 2 beginning on the day after the 
transfer, PRS reports receipts of $134,052 (the completion factor 
multiplied by the total contract price decreased by receipts reported by 
PRS for the period ending on the date of the transfer [($650,000/
$725,000 x $1,000,000)--$762,500]) and costs of $40,000, for a profit of 
$94,052. This profit is shared equally among T, X, Y, and Z ($23,513 
each). For Year 3, PRS reports receipts of $103,448 (the total contract 
price minus prior year receipts ($1,000,000 - $896,552)) and costs of 
$75,000, for a profit of $28,448. The profit for Year 3 is shared 
equally among T, X, Y, and Z ($7,112 each).
    (iv) Tax Consequences to W. W's amount realized is $150,000. W's 
adjusted basis in its interest in PRS is $138,125 ($100,000 originally 
contributed, plus $37,500, W's distributive share of PRS's Year 1 
income, and $625, W's distributive share of PRS's Year 2 income prior to 
the transfer). Accordingly, W's income from the sale of W's interest in 
PRS is $11,875. Under paragraph (k)(2)(iv)(E) of this section, for 
purposes of section 751(a), the amount of ordinary income attributable 
to the contract is determined as follows. First, the partnership must 
determine the amount of income or loss from the contract that is 
allocated under section 706 to the period ending on the date of the sale 
($625). Second, the partnership must determine the amount of income or 
loss that the partnership would take into account under the constructive 
completion rules of paragraph (k)(2) of this section if the contract 
were disposed of for its fair market value in a constructive completion 
transaction. Because PRS closed its books under section 706 with respect 
to the contract on the date of the sale, this calculation is treated as 
occurring immediately after the partnership has applied paragraph 
(k)(3)(ii)(A) of this section on the date of the sale. In a constructive 
completion transaction, the total contract price would be $810,000 (the 
sum of the amounts received under the contract and the amount realized 
in the deemed sale ($650,000 + $160,000)). PRS would report receipts of 
$47,500 (total contract price minus receipts already reported ($810,000 
- $762,500)) and costs of $0, for a profit of $47,500. Thus, the amount 
of ordinary income attributable to the contract is $47,500, and W's 
share of that income is $11,875. Thus, under Sec.  1.751-1(a), all of 
W's $11,875 of income from the sale of W's interest in PRS is ordinary 
income.
    (v) Tax Consequences to T. T's adjusted basis for its interest in 
PRS is $150,000. Under Sec.  1.743-1(d)(2), the amount of income that 
would be allocated to T if the contract were disposed of for its fair 
market value (adjusted to account for income from the contract for the 
portion of PRS's taxable year that ends on the date of the transfer) is 
$11,875. Under Sec.  1.743-1(b), the amount of T's basis adjustment 
under section 743(b) is $11,875. Under paragraph (k)(3)(v)(B) of this 
section, the portion of T's basis adjustment that is recovered in Year 2 
and Year 3 must be determined by PRS in a manner that reasonably 
accounts for the adjustment over the remaining term of the contract. For 
example, PRS could recover $6,703 of the adjustment in Year 2 (the 
amount of the basis adjustment, $11,875, multiplied by a fraction, the 
numerator of which is the excess of the completion factor for the year, 
$650,000/$725,000, less the completion factor for the prior year, 
$610,000/$800,000, and the denominator of which is 100 percent reduced 
by the completion factor for the taxable year preceding the transfer, 
$610,000/$800,000). T's distributive share of income in Year 2 from the 
contract would be adjusted from $23,513 to $16,810 as a result of the 
basis adjustment. In Year 3, the completion year, PRS could recover 
$5,172 of the adjustment ($11,875 x [($725,000/$725,000 -$650,000/
$725,000) / (100 percent - $610,000/$800,000)]). T's distributive share 
of income in Year 3, the completion year, from the contract would be 
adjusted from $7,112 to $1,940 as a result of the basis adjustment.

    (6) Effective date. Except as provided in paragraph (k)(3)(iv)(D) of 
this section, this paragraph (k) is applicable for transactions on or 
after May 15, 2002. Application of the rules of this paragraph (k) to a 
transaction that occurs on or after May 15, 2002 is not a change in 
method of accounting.

[T.D. 8597, 60 FR 36684, July 18, 1995, as amended by T.D. 8929, 66 FR 
2232, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001; T.D. 8995, 67 FR 34605, 
May 15, 2002; T.D. 9137, 69 FR 42553, July 16, 2004; T.D. 9942, 86 FR 
273, Jan. 5, 2021]



Sec.  1.460-5  Cost allocation rules.

    (a) Overview. This section prescribes methods of allocating costs to 
long-term contracts accounted for using the

[[Page 278]]

percentage-of-completion method described in Sec.  1.460-4(b) (PCM), the 
completed-contract method described in Sec.  1.460-4(d) (CCM), or the 
percentage-of-completion/capitalized-cost method described in Sec.  
1.460-4(e) (PCCM). Exempt construction contracts described in Sec.  
1.460-3(b) accounted for using a method other than the PCM or CCM are 
not subject to the cost allocation rules of this section (other than the 
requirement to allocate production-period interest under paragraph 
(b)(2)(v) of this section). Paragraph (b) of this section describes the 
regular cost allocation methods for contracts subject to the PCM. 
Paragraph (c) of this section describes an elective simplified cost 
allocation method for contracts subject to the PCM. Paragraph (d) of 
this section describes the cost allocation methods for exempt 
construction contracts reported using the CCM. Paragraph (e) of this 
section describes the cost allocation rules for contracts subject to the 
PCCM. Paragraph (f) of this section describes additional rules 
applicable to the cost allocation methods described in this section. 
Paragraph (g) of this section provides rules concerning consistency in 
method of allocating costs to long-term contracts.
    (b) Cost allocation method for contracts subject to PCM--(1) In 
general. Except as otherwise provided in paragraph (b)(2) of this 
section, a taxpayer must allocate costs to each long-term contract 
subject to the PCM in the same manner that direct and indirect costs are 
capitalized to property produced by a taxpayer under Sec.  1.263A-1(e) 
through (h). Thus, a taxpayer must allocate to each long-term contract 
subject to the PCM all direct costs and certain indirect costs properly 
allocable to the long-term contract (i.e., all costs that directly 
benefit or are incurred by reason of the performance of the long-term 
contract). However, see paragraph (c) of this section concerning an 
election to allocate contract costs using the simplified cost-to-cost 
method. As in section 263A, the use of the practical capacity concept is 
not permitted. See Sec.  1.263A-2(a)(4).
    (2) Special rules--(i) Direct material costs. The costs of direct 
materials must be allocated to a long-term contract when dedicated to 
the contract under principles similar to those in Sec.  1.263A-11(b)(2). 
Thus, a taxpayer dedicates direct materials by associating them with a 
specific contract, including by purchase order, entry on books and 
records, or shipping instructions. A taxpayer maintaining inventories 
under Sec.  1.471-1 must determine allocable contract costs attributable 
to direct materials using its method of accounting for those inventories 
(e.g., FIFO, LIFO, specific identification).
    (ii) Components and subassemblies. The costs of a component or 
subassembly (component) produced by the taxpayer must be allocated to a 
long-term contract as the taxpayer incurs costs to produce the component 
if the taxpayer reasonably expects to incorporate the component into the 
subject matter of the contract. Similarly, the cost of a purchased 
component (including a component purchased from a related party) must be 
allocated to a long-term contract as the taxpayer incurs the cost to 
purchase the component if the taxpayer reasonably expects to incorporate 
the component into the subject matter of the contract. In all other 
cases, the cost of a component must be allocated to a long-term contract 
when the component is dedicated, under principles similar to those in 
Sec.  1.263A-11(b)(2). A taxpayer maintaining inventories under Sec.  
1.471-1 must determine allocable contract costs attributable to 
components using its method of accounting for those inventories (e.g., 
FIFO, LIFO, specific identification).
    (iii) Simplified production methods. A taxpayer may not determine 
allocable contract costs using the simplified production methods 
described in Sec.  1.263A-2(b) and (c).
    (iv) Costs identified under cost-plus long-term contracts and 
federal long-term contracts. To the extent not otherwise allocated to 
the contract under this paragraph (b), a taxpayer must allocate any 
identified costs to a cost-plus long-term contract or federal long-term 
contract (as defined in section 460(d)). Identified cost means any cost, 
including a charge representing the time-value of money, identified by 
the taxpayer or related person as being attributable to the taxpayer's 
cost-plus long-term contract or federal long-term

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contract under the terms of the contract itself or under federal, state, 
or local law or regulation.
    (v) Interest--(A) In general. If property produced under a long-term 
contract is designated property, as defined in Sec.  1.263A-8(b) 
(without regard to the exclusion for long-term contracts under Sec.  
1.263A-8(d)(2)(v)), a taxpayer must allocate interest incurred during 
the production period to the long-term contract in the same manner as 
interest is allocated to property produced by a taxpayer under section 
263A(f). See Sec. Sec.  1.263A-8 to 1.263A-12 generally.
    (B) Production period. Notwithstanding Sec.  1.263A-12(c) and (d), 
for purposes of this paragraph (b)(2)(v), the production period of a 
long-term contract--
    (1) Begins on the later of--
    (i) The contract commencement date, as defined in Sec.  1.460-
1(b)(7); or
    (ii) For a taxpayer using the accrual method of accounting for long-
term contracts, the date by which 5 percent or more of the total 
estimated costs, including design and planning costs, under the contract 
have been incurred; and
    (2) Ends on the date that the contract is completed, as defined in 
Sec.  1.460-1(c)(3).
    (C) Application of section 263A(f). For purposes of this paragraph 
(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated production 
period exceeding 1 year and a cost exceeding $1,000,000) must be applied 
on a contract-by-contract basis; except that, in the case of a taxpayer 
using an accrual method of accounting, that section must be applied on a 
property-by-property basis.
    (vi) Research and experimental expenses. Notwithstanding Sec.  
1.263A-1(e)(3)(ii)(P) and (iii)(B), a taxpayer must allocate research 
and experimental expenses, other than independent research and 
development expenses (as defined in Sec.  1.460-1(b)(9)), to its long-
term contracts.
    (vii) Service costs--(A) Simplified service cost method--(1) In 
general. To use the simplified service cost method under Sec.  1.263A-
1(h), a taxpayer must allocate the otherwise capitalizable mixed service 
costs among its long-term contracts using a reasonable method. For 
example, otherwise capitalizable mixed service costs may be allocated to 
each long-term contract based on labor hours or contract costs allocable 
to the contract. To be considered reasonable, an allocation method must 
be applied consistently and must not disproportionately allocate service 
costs to contracts expected to be completed in the near future.
    (2) Example. The following example illustrates the rule of this 
paragraph (b)(2)(vii)(A):

    Example. Simplified service cost method. During 2001, C, whose 
taxable year ends December 31, produces electronic equipment for 
inventory and enters into long-term contracts to manufacture specialized 
electronic equipment. C's method of allocating mixed service costs to 
the property it produces is the labor-based, simplified service cost 
method described in Sec.  1.263A-1(h)(4). For 2001, C's total mixed 
service costs are $100,000, C's section 263A labor costs are $500,000, 
C's section 460 labor costs (i.e., labor costs allocable to C's long-
term contracts) are $250,000, and C's total labor costs are $1,000,000. 
To determine the amount of mixed service costs capitalizable under 
section 263A for 2001, C multiplies its total mixed service costs by its 
section 263A allocation ratio (section 263A labor costs / total labor 
costs). Thus, C's capitalizable mixed service costs for 2001 are $50,000 
($100,000 x $500,000 / $1,000,000). Thereafter, C allocates its 
capitalizable mixed service costs to produced property remaining in 
ending inventory using its 263A allocation method (e.g., burden rate, 
simplified production). Similarly, to determine the amount of mixed 
service costs that are allocable to C's long-term contracts for 2001, C 
multiplies its total mixed service costs by its section 460 allocation 
ratio (section 460 labor / total labor costs). Thus, C's allocable mixed 
service contract costs for 2001 are $25,000 ($100,000 x $250,000 / 
$1,000,000). Thereafter, C allocates its allocable mixed service costs 
to its long-term contracts proportionately based on its section 460 
labor costs allocable to each long-term contract.

    (B) Jobsite costs. If an administrative, service, or support 
function is performed solely at the jobsite for a specific long-term 
contract, the taxpayer may allocate all the direct and indirect costs of 
that administrative, service, or support function to that long-term 
contract. Similarly, if an administrative, service, or support function 
is performed at the jobsite solely for the taxpayer's long-term contract 
activities,

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the taxpayer may allocate all the direct and indirect costs of that 
administrative, service, or support function among all the long-term 
contracts performed at that jobsite. For this purpose, jobsite means a 
production plant or a construction site.
    (C) Limitation on other reasonable cost allocation methods. A 
taxpayer may use any other reasonable method of allocating service 
costs, as provided in Sec.  1.263A-1(f)(4), if, for the taxpayer's long-
term contracts considered as a whole, the--
    (1) Total amount of service costs allocated to the contracts does 
not differ significantly from the total amount of service costs that 
would have been allocated to the contracts under Sec.  1.263A-1(f)(2) or 
(3);
    (2) Service costs are not allocated disproportionately to contracts 
expected to be completed in the near future because of the taxpayer's 
cost allocation method; and
    (3) Taxpayer's cost allocation method is applied consistently.
    (c) Simplified cost-to-cost method for contracts subject to the 
PCM--(1) In general. Instead of using the cost allocation method 
prescribed in paragraph (b) of this section, a taxpayer may elect to use 
the simplified cost-to-cost method, which is authorized under section 
460(b)(3)(A), to allocate costs to a long-term contract subject to the 
PCM. Under the simplified cost-to-cost method, a taxpayer determines a 
contract's completion factor based upon only direct material costs; 
direct labor costs; and depreciation, amortization, and cost recovery 
allowances on equipment and facilities directly used to manufacture or 
construct the subject matter of the contract. For this purpose, the 
costs associated with any manufacturing or construction activities 
performed by a subcontractor are considered either direct material or 
direct labor costs, as appropriate, and therefore must be allocated to 
the contract under the simplified cost-to-cost method. An electing 
taxpayer must use the simplified cost-to-cost method to apply the look-
back method under Sec.  1.460-6 and to determine alternative minimum 
taxable income under Sec.  1.460-4(f).
    (2) Election. A taxpayer makes an election under this paragraph (c) 
by using the simplified cost-to-cost method for all long-term contracts 
entered into during the taxable year of the election on its original 
federal income tax return for the election year. This election is a 
method of accounting and, thus, applies to all long-term contracts 
entered into during and after the taxable year of the election. This 
election is not available if a taxpayer does not use the PCM to account 
for all long-term contracts or if a taxpayer elects to use the 10-
percent method described in Sec.  1.460-4(b)(6).
    (d) Cost allocation rules for exempt construction contracts reported 
using the CCM--(1) In general. For exempt construction contracts 
reported using the CCM, other than contracts described in paragraph 
(d)(3) of this section, a taxpayer must annually allocate the cost of 
any activity that is incident to or necessary for the taxpayer's 
performance under a long-term contract. A taxpayer must allocate to each 
exempt construction contract all direct costs as defined in Sec.  
1.263A-1(e)(2)(i) and all indirect costs either as provided in Sec.  
1.263A-1(e)(3) or as provided in paragraph (d)(2) of this section.
    (2) Indirect costs--(i) Indirect costs allocable to exempt 
construction contracts. A taxpayer allocating costs under this paragraph 
(d)(2) must allocate the following costs to an exempt construction 
contract, other than a contract described in paragraph (d)(3) of this 
section, to the extent incurred in the performance of that contract--
    (A) Repair of equipment or facilities;
    (B) Maintenance of equipment or facilities;
    (C) Utilities, such as heat, light, and power, allocable to 
equipment or facilities;
    (D) Rent of equipment or facilities;
    (E) Indirect labor and contract supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983), shift differential, 
payroll taxes, and contributions to a supplemental unemployment benefits 
plan;
    (F) Indirect materials and supplies;
    (G) Noncapitalized tools and equipment;

[[Page 281]]

    (H) Quality control and inspection;
    (I) Taxes otherwise allowable as a deduction under section 164, 
other than state, local, and foreign income taxes, to the extent 
attributable to labor, materials, supplies, equipment, or facilities;
    (J) Depreciation, amortization, and cost-recovery allowances 
reported for the taxable year for financial purposes on equipment and 
facilities to the extent allowable as deductions under chapter 1 of the 
Internal Revenue Code;
    (K) Cost depletion;
    (L) Administrative costs other than the cost of selling or any 
return on capital;
    (M) Compensation paid to officers other than for incidental or 
occasional services;
    (N) Insurance, such as liability insurance on machinery and 
equipment; and
    (O) Interest, as required under paragraph (b)(2)(v) of this section.
    (ii) Indirect costs not allocable to exempt construction contracts. 
A taxpayer allocating costs under this paragraph (d)(2) is not required 
to allocate the following costs to an exempt construction contract 
reported using the CCM--
    (A) Marketing and selling expenses, including bidding expenses;
    (B) Advertising expenses;
    (C) Other distribution expenses;
    (D) General and administrative expenses attributable to the 
performance of services that benefit the taxpayer's activities as a 
whole (e.g., payroll expenses, legal and accounting expenses);
    (E) Research and experimental expenses (described in section 174 and 
the regulations thereunder);
    (F) Losses under section 165 and the regulations thereunder;
    (G) Percentage of depletion in excess of cost depletion;
    (H) Depreciation, amortization, and cost recovery allowances on 
equipment and facilities that have been placed in service but are 
temporarily idle (for this purpose, an asset is not considered to be 
temporarily idle on non-working days, and an asset used in construction 
is considered to be idle when it is neither en route to nor located at a 
job-site), and depreciation, amortization and cost recovery allowances 
under chapter 1 of the Internal Revenue Code in excess of depreciation, 
amortization, and cost recovery allowances reported by the taxpayer in 
the taxpayer's financial reports;
    (I) Income taxes attributable to income received from long-term 
contracts;
    (J) Contributions paid to or under a stock bonus, pension, profit-
sharing, or annuity plan or other plan deferring the receipt of 
compensation whether or not the plan qualifies under section 401(a), and 
other employee benefit expenses paid or accrued on behalf of labor, to 
the extent the contributions or expenses are otherwise allowable as 
deductions under chapter 1 of the Internal Revenue Code. Other employee 
benefit expenses include (but are not limited to): Worker's 
compensation; amounts deductible or for whose payment reduction in 
earnings and profits is allowed under section 404A and the regulations 
thereunder; payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983; amounts includible in 
the gross income of employees under a method or arrangement of employer 
contributions or compensation which has the effect of a stock bonus, 
pension, profit-sharing, or annuity plan, or other plan deferring the 
receipt of compensation or providing deferred benefits; premiums on life 
and health insurance; and miscellaneous benefits provided for employees 
such as safety, medical treatment, recreational and eating facilities, 
membership dues, etc.;
    (K) Cost attributable to strikes, rework labor, scrap and spoilage; 
and
    (L) Compensation paid to officers attributable to the performance of 
services that benefit the taxpayer's activities as a whole.
    (3) Large homebuilders. A taxpayer must capitalize the costs of home 
construction contracts under section 263A, unless the taxpayer 
estimates, when entering into the contract, that it will be completed 
within two years of the contract commencement date, and the taxpayer 
satisfies the gross receipts test of section 448(c) described in Sec.  
1.460-3(b)(3) for the taxable year in which the contract is entered 
into.
    (e) Cost allocation rules for contracts subject to the PCCM. A 
taxpayer must use the cost allocation rules described

[[Page 282]]

in paragraph (b) of this section to determine the costs allocable to the 
entire qualified ship contract or residential construction contract 
accounted for using the PCCM and may not use the simplified cost-to-cost 
method described in paragraph (c) of this section.
    (f) Special rules applicable to costs allocated under this section--
(1) Nondeductible costs. A taxpayer may not allocate any otherwise 
allocable contract cost to a long-term contract if any section of the 
Internal Revenue Code disallows a deduction for that type of payment or 
expenditure (e.g., an illegal bribe described in section 162(c)).
    (2) Costs incurred for non-long-term contract activities. If a 
taxpayer performs a non-long-term contract activity, as defined in Sec.  
1.460-1(d)(2), that is incident to or necessary for the manufacture, 
building, installation, or construction of the subject matter of one or 
more of the taxpayer's long-term contracts, the taxpayer must allocate 
the costs attributable to that activity to such contract(s).
    (g) Method of accounting. A taxpayer that adopts or elects a cost 
allocation method of accounting (or changes to another cost allocation 
method of accounting with the Commissioner's consent) must apply that 
method consistently for all similarly classified contracts, until the 
taxpayer obtains the Commissioner's consent under section 446(e) to 
change to another cost allocation method. A taxpayer-initiated change in 
cost allocation method will be permitted only on a cut-off basis (i.e., 
for contracts entered into on or after the year of change) and thus, a 
section 481(a) adjustment will not be permitted or required.

[T.D. 8929, 66 FR 2237, Jan. 11, 2001, as amended by T.D. 9942, 86 FR 
273, Jan. 5, 2021]



Sec.  1.460-6  Look-back method.

    (a) In general--(1) Introduction. With respect to income from any 
long-term contract reported under the percentage of completion method, a 
taxpayer is required to pay or is entitled to receive interest under 
section 460(b) on the amount of tax liability that is deferred or 
accelerated as a result of overestimating or underestimating total 
contract price or contract costs. Under this look-back method, taxpayers 
are required to pay interest for any deferral of tax liability resulting 
from the underestimation of the total contract price or the 
overestimation of total contract costs. Conversely, if the total 
contract price is overestimated or the total contract costs are 
underestimated, taxpayers are entitled to receive interest for any 
resulting acceleration of tax liability. The computation of the amount 
of deferred or accelerated tax liability under the look-back method is 
hypothetical; application of the look-back method does not result in an 
adjustment to the taxpayer's tax liability as originally reported, as 
reported on an amended return, or as adjusted on examination. Thus, the 
look-back method does not correct for differences in tax liability that 
result from over- or under-estimation of contract price and costs and 
that are permanent because, for example, tax rates change during the 
term of the contract.
    (2) Overview. Paragraph (b) explains which situations require 
application of the look-back method to income from a long-term contract. 
Paragraph (c) explains the operation of the three computational steps 
for applying the look-back method. Paragraph (d) provides guidance 
concerning the simplified marginal impact method. Paragraph (e) provides 
an elective method to minimize the number of times the look-back method 
must be reapplied to a single long-term contract. Paragraph (f) 
describes the reporting requirements for the look-back method and the 
tax treatment of look-back interest. Paragraph (g) provides rules for 
applying the look-back method when there is a transaction that changes 
the taxpayer that reports income from a long-term contract prior to the 
completion of a contract. Paragraph (h) provides examples illustrating 
the three computational steps for applying the look-back method. 
Paragraph (j) of this section provides guidance concerning the election 
not to apply the look-back method in de minimis cases.
    (b) Scope of look-back method--(1) In general. The look-back method 
applies to any income from a long-term contract within the meaning of 
section 460(f) that is required to be reported under the percentage of 
completion

[[Page 283]]

method (as modified by section 460) for regular income tax purposes or 
for alternative minimum tax purposes. If a taxpayer uses the percentage 
of completion-capitalized cost method for long-term contracts, the look-
back method applies for regular tax purposes only to the portion (40, 
70, or 90 percent, whichever applies) of the income from the contract 
that is reported under the percentage of completion method. To the 
extent that the percentage-of-completion method is required to be used 
under Sec.  1.460-1(g) with respect to income and expenses that are 
attributable to activities that benefit a related party's long-term 
contract, the look-back method also applies to these amounts, even if 
those activities are not performed under a contract entered into 
directly by the taxpayer.
    (2) Exceptions from section 460. The look-back method generally does 
not apply to the regular taxable income from any long-term construction 
contract within the meaning of section 460(e)(3) that:
    (i) Is a home construction contract within the meaning of section 
460(e)(1)(A), or
    (ii) Is not a home construction contract but is estimated to be 
completed within a 2-year period by a taxpayer, other than a tax shelter 
prohibited from using the cash receipts and disbursements method of 
accounting under section 448(a)(3), who meets the gross receipts test of 
section 448(c) and Sec.  1.460-3(b)(3) for the taxable year in which 
such contract is entered into. These contracts are not subject to the 
look-back method for regular tax purposes, even if the taxpayer uses a 
version of the percentage of completion method permitted under Sec.  
1.451-3, unless the taxpayer has properly changed its method of 
accounting for these contracts to the percentage of completion method as 
modified by section 460(b). The look-back method, however, applies to 
the alternative minimum taxable income from a contract of this type, for 
those taxpayers subject to the AMT in taxable years prior to the filing 
taxable year in which the look-back method is required, unless the 
contract is exempt from required use of the percentage of completion 
method under section 56(a)(3).
    (3) De minimis exception. Notwithstanding that the percentage of 
completion method is otherwise required to be used, the look-back method 
does not apply to any long-term contract that:
    (i) Is completed within 2 years of the contract commencement date, 
and
    (ii) Has a gross contract price (as of the completion of the 
contract) that does not exceed the lesser of $1,000,000 or 1 percent of 
the average annual gross receipts of the taxpayer for the 3 tax years 
preceding the tax year in which the contract is completed.
    (iii) This de minimis exception is mandatory and, therefore, 
precludes application of the look-back method to any contract that meets 
the requirements of the exception. The de minimis exception applies for 
purposes of computing both regular taxable income and alternative 
minimum taxable income. Solely for this purpose, the determination of 
whether a long-term contract meets the gross receipts test for both 
alternative minimum tax and regular tax purposes is made based only on 
the taxpayer's regular taxable income. For contracts entered into after 
December 31, 2017, in a taxable year ending after December 31, 2017, a 
taxpayer's gross receipts are determined in the manner required by 
regulations under section 448(c).
    (4) Alternative minimum tax. For purposes of computing alternative 
minimum taxable income, section 56(a)(3) generally requires long-term 
contracts within the meaning of section 460(f) (generally without regard 
to the exceptions in section 460(e)) to be accounted for using only the 
percentage of completion method as defined in section 460(b), including 
the look-back method of section 460(b), with respect to tax years 
beginning after December 31, 1986. However, section 56(a)(3) (and thus 
the look-back method) does not apply to any long-term contract entered 
into after June 20, 1988, and before the beginning of the first tax year 
that begins after September 30, 1990, that meets the conditions of both 
section 460(e)(1)(A) and clauses (i) and (ii) of section 460(e)(1)(B), 
and does not apply to any long-term contract entered into

[[Page 284]]

in a tax year that begins after September 30, 1990, that meets the 
conditions of section 460(e)(1)(A). A taxpayer that applies the 
percentage of completion method (and thus the look-back method) to 
income from a long-term contract only for purposes of determining 
alternative minimum taxable income, and not regular taxable income, must 
apply the look-back method to the alternative minimum taxable income in 
the year of contract completion and other filing years whether or not 
the taxpayer was liable for the alternative minimum tax for the filing 
year or for any prior year. Interest is computed under the look-back 
method to the extent that the taxpayer's total tax liability (including 
the alternative minimum tax liability) would have differed if the 
percentage of completion method had been applied using actual, rather 
than estimated, contract price and contract costs.
    (5) Effective date. The look-back method, including the de minimis 
exception, applies to long-term contracts entered into after February 
28, 1986. With respect to activities that are subject to section 460 
solely because they benefit a long-term contract of a related party, the 
look-back method generally applies only if the related party's long-term 
contract was entered into after June 20, 1988, unless a principal 
purpose of the related-party arrangement is to avoid the requirements of 
section 460.
    (c) Operation of the look-back method--(1) Overview--(i) In general. 
The amount of interest charged or credited to a taxpayer under the look-
back method is computed in three steps. This paragraph (c) describes the 
three steps for applying the look-back method. These steps are 
illustrated by the examples in paragraph (h). The first step is to 
hypothetically reapply the percentage of completion method to all long-
term contracts that are completed or adjusted in the current year (the 
``filing year''), using the actual, rather than estimated, total 
contract price and contract costs. Based on this reapplication, the 
taxpayer determines the amount of taxable income (and, when applicable, 
alternative minimum taxable income and modified taxable income under 
section 59A(c)) that would have been reported for each year prior to the 
filing year that is affected by contracts completed or adjusted in the 
filing year if the actual, rather than estimated, total contract price 
and costs had been used in applying the percentage of completion method 
to these contracts, and to any other contracts completed or adjusted in 
a year preceding the filing year. If the percentage of completion method 
only applies to alternative minimum taxable income for contracts 
completed or adjusted in the filing year, only alternative minimum 
taxable income is recomputed in the first step. The second step is to 
compare what the tax liability would have been under the percentage of 
completion method (as reapplied in the first step) for each tax year for 
which the tax liability is affected by income from contracts completed 
or adjusted in the filing year (a ``redetermination year'') with the 
most recent determination of tax liability for that year to produce a 
hypothetical underpayments or overpayment of tax. The third step is to 
apply the rate of interest on overpayments designated under section 6621 
of the Code, compounded daily, to the hypothetical underpayment or 
overpayment of tax for each redetermination year to compute interest 
that runs, generally, from the due date (determined without regard to 
extensions) of the return for the redetermination year to the due date 
(determined without regard to extensions) of the return for the filing 
year. The net amount of interest computed under the third step is paid 
by or credited to the taxpayer for the filing year. Paragraph (d) 
provides a simplified marginal impact method that simplifies the second 
step--the computation of hypothetical underpayments or overpayments of 
tax liability for redetermination years--and, in some cases, the third 
step--the determination of the time period for computing interest.
    (ii) Post-completion revenue and expenses--(A) In general. Except as 
otherwise provided in section 460(b)(6) (see Sec.  1.460-6(j) for method 
of electing) or Sec.  1.460-6(e), a taxpayer must apply the look-back 
method to a long-term contract in the completion year and in any post-
completion year for which the taxpayer must adjust total contract

[[Page 285]]

price or total allocable contract costs, or both, under the PCM. Any 
year in which the look-back method must be reapplied is treated as a 
filing year. See Example 3 of paragraph (h)(4) for an illustration of 
how the look-back method is applied to post-completion adjustments.
    (B) Completion. A contract is considered to be completed for 
purposes of the look-back method in the year in which final completion 
and acceptance within the meaning of Sec.  1.460-1(c)(3) have occurred.
    (C) Discounting of contract price and contract cost adjustments 
subsequent to completion; election not to discount--(1) General rule. 
The amount of any post-completion adjustment to the total contract price 
or contract costs is discounted, solely for purposes of applying the 
look-back method, from its value at the time the amount is taken into 
account in computing taxable income to its value at the completion of 
the contract. The discount rate for this purpose is the Federal mid-term 
rate under section 1274(d) in effect at the time the amount is properly 
taken into account. For purposes of applying the look-back method for 
the completion year, no amounts are discounted, even if they are 
received after the completion year.
    (2) Election not to discount. Notwithstanding the general 
requirement to discount post-completion adjustments, a taxpayer may 
elect not to discount contract price and contract cost adjustments with 
respect to any contract. The election not to discount is to be made on a 
contract-by-contract basis and is binding with respect to all post-
completion adjustments that arise with respect to a contract for which 
an election has been made. An election not to discount with respect to 
any contract is made by stating that an election is being made on the 
taxpayer's timely filed Federal income tax return (determined with 
regard to extensions) for the first tax year after completion in which 
the taxpayer takes into account (i.e., includes in income or deducts) 
any adjustment to the contract price or contract costs. See Sec.  
301.9100-8 of this chapter.
    (3) Year-end discounting convention. In the absence of an election 
not to discount, any revisions to the contract price and contract costs 
must be discounted to their value as of the completion of the contract 
in reapplying the look-back method. For this purpose, the period of 
discounting is the period between the completion date of the contract 
and the date that any adjustment is taken into account in computing 
taxable income. Although taxpayers may use the period between the months 
in which these two events actually occur, in many cases, these dates may 
not be readily identifiable. Therefore, for administrative convenience, 
taxpayers are permitted to use the period between the end of the tax 
years in which these events occur as the period of discounting provided 
that the convention is used consistently with respect to all post-
completion adjustments for all contracts of the taxpayer the adjustments 
to which are discounted. In that case, the taxpayer must use as the 
discount rate the Federal mid-term rate under section 1274(d) as of the 
end of the tax year in which any revision is taken into account in 
computing taxable income.
    (D) Revenue acceleration rule. Section 460(b)(1) imposes a special 
rule that requires a taxpayer to include in gross income, for the tax 
year immediately following the year of completion, any previously 
unreported portion of the total contract price (including amounts that 
the taxpayer expects to receive in the future) determined as of that 
year, even if the percentage of completion ratio is less than 100 
percent because the taxpayer expects to incur additional allocable 
contract costs in a later year. At the time any remaining portion of the 
contract price is includible in income under this rule, no offset 
against this income is permitted for estimated future contract costs. To 
achieve the requirement to report all remaining contract revenue without 
regard to additional estimated costs, a taxpayer must include only costs 
actually incurred through the end of the tax year in the denominator of 
the percentage of completion ratio in applying the percentage of 
completion method for any tax years after the year of completion. The 
look-back method also must be reapplied for the year immediately 
following the year of

[[Page 286]]

completion if any portion of the contract price is includible in income 
in that year by reason of section 460(b)(1). For purposes of reapplying 
the look-back method as a result of this inclusion in income, the 
taxpayer must only include in the denominator of the percentage of 
completion ratio the actual contract costs incurred as of the end of the 
year, even if the taxpayer reasonably expects to incur additional 
allocable contract costs. To the extent that costs are incurred in a 
subsequent tax year, the look-back method is reapplied in that year (or 
a later year if the delayed reapplication method is used), and the 
taxpayer is entitled to receive interest for the post-completion 
adjustment to contract costs. Because this reapplication occurs 
subsequent to the completion year, only the cumulative costs incurred as 
of the end of the reapplication year are includible in the denominator 
of the percentage of completion ratio.
    (2) Look-back Step One--(i) Hypothetical reallocation of income 
among prior tax years. For each filing year, a taxpayer must allocate 
total contract income among prior tax years, by hypothetically applying 
the percentage of completion method to all contracts that are completed 
or adjusted in the filing year using the rules of this paragraph (c)(2). 
The taxpayer must reallocate income from those contracts among all years 
preceding the filing year that are affected by those contracts using the 
total contract price and contract costs, as determined as of the end of 
the filing year (``actual contract price and costs''), rather than the 
estimated contract price and contract costs. The taxpayer then must 
determine the amount of taxable income (and, when applicable, 
alternative minimum taxable income and modified taxable income under 
section 59A(c)) that would have been reported for each affected tax year 
preceding the filing year if the percentage of completion method had 
been applied on the basis of actual contract price and contract costs in 
reporting income from all contracts completed or adjusted in the filing 
year and in any preceding year. If the percentage of completion method 
only applies to alternative minimum taxable income from the contract, 
only alternative minimum taxable income is recomputed in the first step. 
For purposes of reallocating income (and costs if the 10-percent year 
changes for a taxpayer using the 10-percent method of section 460(b)(5)) 
under the look-back method, the method of computing the percentage of 
completion ratio is the same method used to report income from the 
contract on the taxpayer's return. (Thus, an election to use the 10-
percent method or the simplified cost-to-cost method is taken into 
account). See Example 1 of paragraph (h)(2) for an illustration of Step 
One.
    (ii) Treatment of estimated future costs in year of completion. If a 
taxpayer reasonably expects to incur additional allocable contract costs 
in a tax year subsequent to the year in which the contract is completed, 
the taxpayer includes the actual costs incurred as of the end of the 
completion year plus the additional allocable contract costs that are 
reasonably expected to be incurred (to the extent includible under the 
taxpayer's percentage of completion method) in the denominator of the 
percentage of completion ratio. The completion year is the only filing 
year for which the taxpayer may include additional estimated costs in 
the denominator of the percentage of completion ratio in applying the 
look-back method. If the look-back method is reapplied in any year after 
the completion year, only the cumulative costs incurred as of the end of 
the year of reapplication are includible in the denominator of the 
percentage of completion ratio in reapplying the look-back method.
    (iii) Interim reestimates not considered. The look-back method 
cannot be applied to a contract before it is completed. Accordingly, for 
purposes of applying Step One, the actual total contract price and 
contract costs are substituted for the previous estimates of total 
contract price and contract costs only with respect to contracts that 
have been completed in the filing year and in a tax year preceding the 
filing year. No adjustments are made under Step One for contracts that 
have not been completed prior to the end of the current filing year, 
even if, as of the end of this year, the estimated total contract price 
or contract costs for

[[Page 287]]

these uncompleted contracts is different from the estimated amount that 
was used during any tax year for which taxable income is recomputed with 
respect to completed contracts under the look-back method for the 
current filing year.
    (iv) Tax years in which income is affected. In general, because 
income under the percentage of completion method is generally reported 
as costs are incurred, the taxable income and, when applicable, 
alternative minimum taxable income and modified taxable income under 
section 59A(c), are recomputed only for each year in which allocable 
contract costs were incurred. However, there will be exceptions to this 
general rule. For example, a taxpayer may be required to cumulatively 
adjust the income from a contract in a year in which no allocable 
contract costs are incurred if the estimated total contract price or 
contract costs was revised in that year. However, in applying the look-
back method, no contract income is allocated to that year. Thus, there 
may be a difference between the amount of contract income originally 
reported for that year and the amount of contract income as reallocated. 
Similarly, because of the revenue acceleration rule of section 
460(b)(1), income may be reported in the year immediately following the 
completion year even though no costs were incurred during that year and, 
in applying the look-back method in that year or another year, if 
additional costs are incurred or the contract price is adjusted in a 
later year, no income is allocated to the year immediately following the 
completion year.
    (v) Costs incurred prior to contract execution; 10-percent method--
(A) General rule. The look-back method does not require allocation of 
contract income to tax years before the contract was entered into. Costs 
incurred prior to the year a contract is entered into are first taken 
into account in the numerator of the percentage of completion ratio in 
the year the contract is entered into. A taxpayer using the 10-percent 
method must also use the 10-percent method in applying the look-back 
method, using actual total contract costs to determine the 10-percent 
year. Thus, contract income is never reallocated to a year before the 
10-percent year as determined on the basis of actual contract costs. If 
the 10-percent year is earlier as a result of applying Step One of the 
look-back method, contract costs incurred up to and including the new 
10-percent year (as determined based on actual contract costs), are 
reallocated from the original 10-percent year to the new 10-percent, and 
costs incurred in later years but before the old 10-percent year are 
reallocated to those years. If the 10-percent year is later as a result 
of applying Step One of the look-back method, contract costs incurred up 
to and including the new 10-percent year are reallocated from all prior 
years to the new 10-percent year. This is the only case in which costs 
are reallocated under the look-back method.
    (B) Example. The application of the look-back method by a taxpayer 
using the 10-percent method is illustrated by the following example:

    Example. Z elected to use the 10-percent method of section 460(b)(5) 
for reporting income under the percentage of completion method. Z 
entered into a contract in 1990 for a fixed price of $1,000x. During 
1990, Z incurred allocable contract costs of $80x and estimated that it 
would incur a total of $900x for the entire contract. Since $80x is less 
than 10 percent of total estimated contract costs, Z reported no revenue 
from the contract in 1990 and deferred the $80x of costs incurred. In 
1991, Z incurred an additional $620x of contract costs, and completed 
the contract. Accordingly, in its 1991 return, Z reported the entire 
contract price of $l,000x, and deducted the $620x of costs incurred in 
1991 and the $80x of costs incurred in 1990.
    Under section 460(b)(5), the 10-percent method applies both for 
reporting contract income and the look-back method. Under the look-back 
method, since the costs incurred in 1990 ($80x) exceed 10 percent of the 
actual total contract costs ($700x), Z is required to allocate $114x of 
contract revenue ($80x/$700x x $1,000x) and the $80x of costs incurred 
to 1990. Thus, application of the 1ook-back method results in a net 
increase in taxable income for 1990 of $34x, solely for purposes of the 
look-back method.

    (vi) Amount treated as contract price--(A) General rule. The amount 
that is treated as total contract price for purposes of applying the 
percentage of completion method and reapplying the percentage of 
completion method under the look-back method under

[[Page 288]]

Step One includes all amounts that the taxpayer expects to receive from 
the customer. Thus, amounts are treated as part of the contract price as 
soon as it is reasonably estimated that they will be received, even if 
the all-events test has not yet been met.
    (B) Contingencies. Any amounts related to contingent rights or 
obligations, such as incentive fees or amounts in dispute, are not 
separated from the contract and accounted for under a non-long-term 
contract method of accounting, notwithstanding any provision in Sec.  
1.460-4(b)(4)(i), to the contrary. Instead, those amounts are treated as 
part of the total contract price in applying the look-back method. For 
example, if an incentive fee under a contract to manufacture a satellite 
is payable to the taxpayer after a specified period of successful 
performance, the incentive fee is includible in the total contract price 
at the time and to the extent that it can reasonably be predicted that 
the performance objectives will be met, . A portion of the contract 
price that is in dispute is included in the total contract price at the 
time and to the extent that the taxpayer can reasonably expect the 
dispute will be resolved in the taxpayer's favor (without regard to when 
the taxpayer receives payment for the amount in dispute or when the 
dispute is finally resolved).
    (C) Change orders. In applying the look-back method, a change order 
with respect to a contract is not treated as a separate contract unless 
the change order would be treated as a separate contract under the rules 
for severing and aggregating contracts provided in Sec.  1.460-1(e). 
Thus, if a change order is not treated as a separate contract, the 
contract price and contract costs attributable to the change order must 
be taken into account in allocating contract income to all tax years 
affected by the underlying contract.
    (3) Look-back Step Two: Computation of hypothetical overpayment or 
underpayment of tax--(i) In general. Step Two involves the computation 
of a hypothetical overpayment or underpayment of tax for each year in 
which the tax liability is affected by income from contracts that are 
completed or adjusted in the filing year (a ``redetermination year''). 
The application of Step Two depends on whether the taxpayer uses the 
simplified marginal impact method contained in paragraph (d) or the 
actual method described in this paragraph (c)(3). The remainder of this 
paragraph (c)(3) does not apply if a taxpayer uses the simplified 
marginal impact method.
    (ii) Redetermination of tax liability. Under the method described in 
this paragraph (c)(3) (actual method), a taxpayer first must determine 
what its regular and, when applicable, its alternative minimum tax and 
base erosion minimum tax liability would have been for each 
redetermination year if the amounts of contract income allocated in Step 
One for all contracts completed or adjusted in the filing year and in 
any prior year were substituted for the amounts of contract income 
reported under the percentage of completion method on the taxpayer's 
original return (or as subsequently adjusted on examination, or by 
amended return). See Example 2 of paragraph (h)(3) for an illustration 
of Step Two.
    (iii) Hypothetical underpayment or overpayment. After redetermining 
the income tax liability for each tax year affected by the reallocation 
of contract income, the taxpayer then determines the amount, if any, of 
the hypothetical underpayment or overpayment of tax for each of these 
redetermination years. The hypothetical underpayment or overpayment for 
each affected year is the difference between the tax liability as 
redetermined under the look-back method for that year and the amount of 
tax liability determined as of the latest of the following:
    (A) The original return date;
    (B) The date of a subsequently amended or adjusted return (if, 
however, the amended return is due to a carryback described in section 
6611(f), see paragraph (c)(4)(iii)); or,
    (C) The last previous application of the look-back method (in which 
case, the previous hypothetical tax liability is used).
    (iv) Cumulative determination of tax liability. The redetermination 
of tax liability resulting from previous applications of the look-back 
method is cumulative. Thus, for example, in computing

[[Page 289]]

the amount of a hypothetical overpayment or underpayment of tax for a 
redetermination year, the current hypothetical tax liability is compared 
to the hypothetical tax liability for that year determined as of the 
last previous application of the look-back method.
    (v) Years affected by look-back only. A redetermination of income 
tax liability under Step Two is required for every tax year for which 
the tax liability would have been affected by a change in the amount of 
income or loss for any other year for which a redetermination is 
required. For example, if the allocation of contract income under Step 
One changed the amount of a net operating loss that was carried back to 
a year preceding the year the taxpayer entered into the contract, the 
tax liability for the earlier year must be redetermined.
    (vi) Definition of tax liability. For purposes of Step Two, the 
income tax liability must be redetermined by taking into account all 
applicable additions to tax, credits, and net operating loss carrybacks 
and carryovers. Thus, the taxes, if any, imposed under sections 55 and 
59A (relating to alternative and base erosion minimum tax, respectively) 
must be taken into account. For example, if the taxpayer did not pay 
alternative minimum tax, but would have paid alternative minimum tax for 
that year if actual rather than estimated contract price and costs had 
been used in determining contract income for the year, the amount of any 
hypothetical overpayment or underpayment of tax must be determined by 
comparing the hypothetical total tax liability (including hypothetical 
alternative minimum tax liability) with the actual tax liability for 
that year. The effect of taking these items into account in applying the 
look-back method is illustrated in Examples (4) through (7) of 
paragraphs (h)(5) through (h)(8) below.
    (4) Look-back Step Three: Calculation of interest on underpayment or 
overpayment--(i) In general. After determining a hypothetical 
underpayment or overpayment of tax for each redetermination year, the 
taxpayer must determine the interest charged or credited on each of 
these amounts. Interest on the amount determined under Step Two is 
determined by applying the overpayment rate designated under section 
6621, compounded daily. In general, the time period over which interest 
is charged on hypothetical underpayments or credited on hypothetical 
overpayments begins at the due date (not including extensions) of the 
return for the redetermination year for which the hypothetical 
underpayment or overpayment determined in Step Two is computed. This 
time period generally ends on the earlier of:
    (A) The due date (not including extensions) of the return for the 
filing year, and
    (B) The date both
    (1) The income tax return for the filing year is filed, and
    (2) The tax for that year has been paid in full. If a taxpayer uses 
the simplified marginal impact method contained in paragraph (d), the 
remainder of this paragraph (c)(4) does not apply.
    (ii) Changes in the amount of a loss or credit carryback or 
carryover. The time period for determining interest may be different in 
cases involving loss or credit carrybacks or carryovers in order to 
properly reflect the time period during which the taxpayer (in the case 
of an underpayment) or the Government (in the case of an overpayment) 
had the use of the amount determined to be a hypothetical underpayment 
or overpayment. Thus, if a reallocation of contract income under Step 
One results in an increase or decrease to a net operating loss carryback 
(but not a carryforward), the interest due or to be refunded must be 
computed on the increase or decrease in tax attributable to the change 
to the carryback only from the due date (not including extensions) of 
the return for the redetermination year that generated the carryback and 
not from the due date of the return for the redetermination year in 
which the carryback was absorbed. In the case of a change in the amount 
of a carryover as a result of applying the lookback method, interest is 
computed from the due date of the return for the year in which the 
carryover was absorbed. See Examples (8) and (9) of paragraph (h)(9) for 
an illustration of these rules.

[[Page 290]]

    (iii) Changes in the amount of tax liability that generated a 
subsequent refund. If the amount of tax liability for a redetermination 
year (as reported on the taxpayer's original return, as subsequently 
adjusted on examination, as adjusted by amended return, or as 
redetermined by the last previous application of the look-back method) 
is decreased by the application of the look-back method, and any portion 
of the redetermination year tax liability was absorbed by a loss or 
credit carryback arising in a year subsequent to the redetermination 
year, the look-back method applies as follows to properly reflect the 
time period of the use of the tax overpayment. To the extent the amount 
of tax absorbed because of the carryback exceeds the total hypothetical 
tax liability for the year (as redetermined under the look-back method) 
the taxpayer is entitled to receive interest only until the due date 
(not including extensions) of the return for the year in which the 
carryback arose.

    Example. Upon the completion of a long-term contract in 1990, the 
taxpayer redetermines its tax liability for 1988 under the look-back 
method. This redetermination results in a hypothetical reduction of tax 
liability from $1,500x (actual liability originally reported) to $1,200x 
(hypothetical liability). In addition, the taxpayer had already received 
a refund of some or all of the actual 1988 tax by carrying back a net 
operating loss (NOL) that arose in 1989. The time period over which 
interest would be computed on the hypothetical overpayment of $300x for 
1988 would depend on the amount of the refund generated by the 
carryback, as illustrated by the following three alternative situations:
    (A) If the amount refunded because of the NOL is $1,500x: interest 
is credited to the taxpayer on the entire hypothetical overpayment of 
$300x from the due date of the 1988 return, when the hypothetical 
overpayment occurred, until the due date of the 1989 return, when the 
taxpayer received a refund for the entire amount of the 1988 tax, 
including the hypothetical overpayment.
    (B) If the amount refunded because of the NOL is $1,000x: interest 
is credited to the taxpayer on the entire amount of the hypothetical 
overpayment of $300x from the due date of the 1988 return, when the 
hypothetical overpayment occurred, until the due date of the 1990 
return. In this situation interest is credited until the due date of the 
return for the completion year of the contract, rather than the due date 
of the return for the year in which the carryback arose, because the 
amount refunded was less than the redetermined tax liability. Therefore, 
no portion of the hypothetical overpayment is treated as having been 
refunded to the taxpayer before the filing year.
    (C) If the amount refunded because of the NOL is $1,300x-: interest 
is credited to the taxpayer on $100x ($1,300x-$1,200x) from the due date 
of the 1988 return until the due date of the 1989 return because only 
this portion of the total hypothetical overpayment is treated as having 
been refunded to the taxpayer before the filing year. However, the 
taxpayer did not receive a refund for the remaining $200x of the 
overpayment at that time and, therefore, is credited with interest on 
$200x through the due date of the tax return for 1990, the filing year. 
See Examples (10) and (11) of paragraph (h)(9) for a further 
illustration of this rule.

    (d) Simplified marginal impact method--(1) Introduction. This 
paragraph (d) provides a simplified method for calculating look-back 
interest. Any taxpayer may elect this simplified marginal impact method, 
except that pass-through entities described in paragraph (d)(4) of this 
section are required to apply the simplified marginal impact method at 
the entity level with respect to domestic contracts and the owners of 
those entities do not apply the look-back method to those contracts. 
Under the simplified marginal impact method, a taxpayer calculates the 
hypothetical underpayments or overpayments of tax for a prior year based 
on an assumed marginal tax rate. A taxpayer electing to use the 
simplified marginal impact method must use the method for each long-term 
contract for which it reports income (except with respect to domestic 
contracts if the taxpayer is an owner in a widely held pass-through 
entity that is required to use the simplified marginal impact method at 
the entity level for those contracts).
    (2) Operation--(i) In general. Under the simplified marginal impact 
method, income from those contracts that are completed or adjusted in 
the filing year is first reallocated in accordance with the procedures 
of Step One contained in paragraph (c)(2) of this section. Step Two is 
modified in the following manner. The hypothetical underpayment or 
overpayment of tax for

[[Page 291]]

each year of the contract (a ``redetermination year'') is determined by 
multiplying the applicable regular tax rate (as defined in paragraph 
(d)(2)(iii)) by the increase or decrease in regular taxable income (or, 
if it produces a greater amount, by multiplying the applicable 
alternative minimum tax rate by the increase or decrease in alternative 
minimum taxable income, for taxpayers subject to the alternative minimum 
tax without regard to whether tentative minimum tax exceeds regular tax 
for the redetermination year) that results from reallocating income to 
the tax year under Step One. Generally, the product of the alternative 
minimum tax rate and the increase or decrease in alternative minimum 
taxable income will be the greater of the two amounts described in the 
preceding sentence only with respect to contracts for which a taxpayer 
uses the full percentage of completion method only for alternative 
minimum tax purposes and uses the completed contract method, or the 
percentage of completion-capitalized cost method, for regular tax 
purposes. Step Three is then applied. Interest is credited to the 
taxpayer on the net overpayment and is charged to the taxpayer on the 
net underpayment for each redetermination year from the due date 
(determined without regard to extensions) of the return for the 
redetermination year until the earlier of
    (A) The due date (determined without regard to extensions) of the 
return for the filing year, and
    (B) The first date by which both the return is filed and the tax is 
fully paid.
    (ii) Applicable tax rate. For purposes of determining hypothetical 
underpayments or overpayments of tax under the simplified marginal 
impact method, the applicable regular tax rate is the highest rate of 
tax in effect for the redetermination year under section 1 in the case 
of an individual and under section 11 in the case of a corporation. The 
applicable alternative minimum tax rate is the rate of tax in effect for 
the taxpayer under section 55(b)(1). The highest rate is determined 
without regard to the taxpayer's actual rate bracket and without regard 
to any additional surtax imposed for the purpose of phasing out multiple 
tax brackets or exemptions.
    (iii) Overpayment ceiling. The net hypothetical overpayment of tax 
for any redetermination year is limited to the taxpayer's total federal 
income tax liability for the redetermination year reduced by the 
cumulative amount of net hypothetical overpayments of tax for that 
redetermination year resulting from earlier applications of the look-
back method. If the reallocation of contract income results in a net 
overpayment of tax and this amount exceeds the actual tax liability (as 
of the filing year) for the redetermination year, as adjusted for past 
applications of the look-back method and taking into account net 
operating loss, capital loss, or credit carryovers and carrybacks to 
that year, the actual tax so adjusted is treated as the overpayment for 
the redetermination year. This overpayment ceiling does not apply when 
the simplified marginal impact method is applied at the entity level by 
a widely held pass-through entity in accordance with paragraph (d)(4) of 
this section.
    (iv) Example. The application of the simplified marginal impact 
method is illustrated by the following example:

    Example. Corporation X, a calendar-year taxpayer, reports income 
from long-term contracts and elected the simplified marginal impact 
method when it filed its income tax return for 1989. X uses only the 
percentage of completion method for both regular taxable income and 
alternative minimum taxable income. X completed contracts A, B, and C in 
1989 and, therefore, was required to apply the look-back method in 1989. 
Income was actually reported for these contracts in 1987, 1988, and 
1989. X's applicable tax rate, as determined under section 11, for the 
redetermination years 1987 and 1988 was 40 percent and 34 percent, 
respectively. The amount of contract income originally reported and 
reallocated for contracts A, B, and C, and the net overpayments and 
underpayments for the redetermination years are as follows:

------------------------------------------------------------------------
                                                     1987        1988
------------------------------------------------------------------------
Contract A:
  Originally reported...........................    $5,000x     $4,000x
  Reallocated...................................     3,000x      5,000x
  Increase/(Decrease)...........................    (2,000x)     1,000x
Contract B:
  Originally reported...........................     6,000x      2,000x
  Reallocated...................................     7,000x      1,500x
  Increase/(Decrease)...........................     1,000x       (500x)
Contract C:
  Originally reported...........................     8,000x      5,000x
  Reallocated...................................     4,000x      7,000x
  Increase/(Decrease)...........................    (4,000x)     2,000x

[[Page 292]]

 
Net Increase/(Decrease).........................    (5,000x)     2,500x
Tentative (Underpayment)/Overpayment:
    @ .40.......................................     2,000x   ..........
    @ .34.......................................  ..........      (850x)
Ceiling:
  Actual Tax Liability (After Carryovers and         1,500x        500x
   Carrybacks)..................................
Final (Underpayment)/Overpayment................     1,500x       (850x)
------------------------------------------------------------------------

    Under the simplified marginal impact method, X determined a 
tentative hypothetical net overpayment for 1987 and a net underpayment 
for 1988. X determined these amounts by first aggregating the difference 
for contracts A, B, and C between the amount of contract price 
originally reported and the amount of contract price as reallocated and, 
then, applying the highest regular tax rate to the aggregate decrease in 
income for 1987 and the aggregate increase in income for 1988.
    However, X's overpayment for 1987 is subject to a ceiling based on 
X's total tax liability. Because the tentative net overpayment of tax 
for 1987 exceeds the actual tax liability for that year after taking 
into account carryovers and carrybacks to that year, the final 
overpayment under the simplified marginal impact method is the amount of 
tax liability paid instead of the tentative net overpayment. Since 
application of the look-back method for 1988 results in a tentative 
underpayment of tax, it is not subject to a ceiling. If the look-back 
method is applied in 1991, the ceiling amount for 1987 will be zero and 
the ceiling amount for 1988 will be $1,350.
    X is entitled to receive interest on the hypothetical overpayment 
from March 15, 1988, to March 15, 1990. X is required to pay interest on 
the underpayment from March 15, 1989, to March 15, 1990.

    (3) Anti-abuse rule. If the simplified marginal impact method is 
used with respect to any long-term contract (including a contract of a 
widely held pass-through entity), the district director may recompute 
interest for the contract (including domestic contracts of widely held 
pass-through entities) under the look-back method using the actual 
method (and without regard to the simplified marginal impact method). 
The district director may make such a recomputation only if the amount 
of income originally reported with respect to the contract for any 
redetermination year exceeds the amount of income reallocated under the 
look-back method with respect to that contract for that year (using 
actual contract price and contract costs) by the lesser of $1,000,000 or 
20 percent of the amount of income as reallocated (i.e., based on actual 
contract price and contract costs) under the look-back method with 
respect to that contract for that year. In determining whether to 
exercise this authority upon examination of the Form 8697, the district 
director may take into account whether the taxpayer overreported income 
for a purpose of receiving interest under the look-back method on a 
hypothetical overpayment determined at the applicable tax rate. The 
district director also may take into account whether the taxpayer 
underreported income for the year in question with respect to other 
contracts. Notwithstanding the look-back method, the district director 
may require an adjustment to the tax liability for any open tax year if 
the taxpayer did not apply the percentage of completion method properly 
on its original return.
    (4) Application--(i) Required use by certain pass-through entities-- 
(A) General rule. The simplified marginal impact method is required to 
be used with respect to income reported from domestic contracts by a 
pass-through entity that is either a partnership, an S corporation, or a 
trust, and that is not closely held. With respect to contracts described 
in the preceding sentence, the simplified marginal impact method is 
applied by the pass-through entity at the entity level. The pass-through 
entity determines the amount of any hypothetical underpayment or 
overpayment for a redetermination year using the highest rate of tax in 
effect for corporations under section 11. However, for redetermination 
years beginning before January 1, 2018, the pass-through entity uses the 
highest rates of tax in effect for corporations under section 11 and 
section 55(b)(1). Further, the pass-through entity uses the highest 
rates of tax imposed on individuals under section 1 and section 55(b)(1) 
if, at all times during the redetermination year involved (that is, the 
year in which the hypothetical increase or decrease in income arises), 
more than 50 percent of the interests in the entity were held by 
individuals directly or through 1 or more pass-through entities.

[[Page 293]]

    (B) Closely held. A pass-through entity is closely held if, at any 
time during any redetermination year, 50 percent of more (by value) of 
the beneficial interests in that entity are held (directly or 
indirectly) by or for 5 or fewer persons. For this purpose, the term 
``person'' has the same meaning as in section 7701(a)(1), except that a 
pass-through entity is not treated as a person. In addition, the 
constructive ownership rules of section 1563(e) apply by substituting 
the term ``beneficial interest'' for the term ``stock'' and by 
substituting the term ``pass-through entity'' for the term, 
``corporation'' used in that section, as appropriate, for purposes of 
determining whether a beneficial interest in a pass-through entity is 
indirectly owned by any person.
    (C) Examples. The following examples illustrate the application of 
the rules of paragraph (d)(4)(i):

    Example 1. P, a partnership, began a long-term contract on March 1, 
1986, and completed this contract in its tax year ending December 31, 
1989. P used the percentage of completion method for all contract 
income. Substantially all of the income from the contract arose from 
U.S. sources. At all times during all of the years for which income was 
required to be reported under the contract, exactly 25 percent of the 
value of P's interests was owned by Corporation M. The remaining 75 
percent of the value of P's interests was owned in equal shares by 15 
unrelated individuals, who are also unrelated to Corporation M. M's 
ownership of P represents less than 50 percent of the value of the 
beneficial interests in P, and, therefore, viewed alone, is insufficient 
to make P a closely held partnership. In addition, because no 4 of the 
individual owners together own 25 percent or more of the remaining value 
of P's beneficial interests, there is no group of 5 owners that together 
own, directly or indirectly, 50 percent or more by value of the 
beneficial interests in P. Therefore, P is not closely held pass-through 
entity.
    Because P is not a closely held pass-through entity, and because P 
completed the contract after the effective date of section 460(b)(4), P 
is required to use the simplified marginal impact method. Any interest 
computed under the look-back method will be paid to, or collected from, 
P, rather than its partners, and must be reported to each of the 
partners on Form 1065 as interest income or expense. Further, assume 
that, for the redetermination years, Corporation M is subject to 
alternative minimum tax at the rate of 20 percent and 3 of the 
individuals who own interests in P are subject to the highest marginal 
tax rate of 33 percent in 1988. Regardless of the actual marginal tax 
rates of its partners, P is required to determine the underpayment or 
overpayment of tax for each redetermination year at the entity level by 
applying a single rate to the increase or decrease in income resulting 
from the reallocation of contract income under the look-back method. 
Because more than 50 percent of the interests in P are held by 
individuals, P must use the highest rate specified in section 1 for each 
redetermination year. Thus, the rate applied by P is 50 percent for 
1986, 38.5 percent for 1987, and 28 percent for 1988.
    Example 2. Assume the same facts as in Example 1, except that one of 
the individuals, Individual I, who directly owns 5 percent of the value 
of the interests of P, also owns 100 percent of the stock of Corporation 
M. Section 1563(e)(4) of the Code provides that stock owned directly or 
indirectly by or for a corporation is considered to be owned by any 
person who owns 5 percent or more in value of its stock in that 
proportion which the value of the stock which that person so owns bears 
to the value of all the stock in that corporation. Because section 
460(b)(4)(C)(iii) and this paragraph (d)(4) provide that rules similar 
to the constructive ownership rules of section 1563(e) apply in 
determining whether a pass-through entity is closely held, all of M's 
interest in P is attributed to I because I owns 100 percent of the value 
of the stock in M. Accordingly, because I's direct 5 percent and 
constructive 25 percent ownership of P, plus the interests owned by any 
4 other individual partners, equals 50 percent or more of the value of 
the beneficial interests of P, P is a closely held pass-through entity 
within the meaning of section 460(b)(4)(C)(iii). Therefore, P cannot use 
the simplified marginal impact method at the entity level. Accordingly, 
each of the partners of P must separately apply the look-back method to 
their respective interests in the income and expenses attributable to 
the contract, but each partner may elect to use the simplified marginal 
impact method with respect to the partner's share of income from the 
contract.

    (D) Domestic contracts--(1) General rule. A domestic contract is any 
contract substantially all of the income of which is from sources in the 
United States. For this purpose, ``substantially all'' of the income 
from a long-term contract is considered to be from United States sources 
if 95 percent or more of the gross income from the contract is from 
sources within the United States as determined under the rules in 
sections 861 through 865.
    (2) Portion of contract income sourced. In determining whether 
substantially

[[Page 294]]

all of the gross income from a long-term contract is from United States 
sources, taxpayers must apply the allocation and apportionment 
principles of sections 861 through 865 only to the portion of the 
contract accounted for under the percentage of completion method. Under 
the percentage of completion method, gross income from a long-term 
contract includes all payments to be received under the contract (i.e., 
any amounts treated as contract price). Similarly, all costs taken into 
account in the computation of taxable income under the percentage of 
completion method are deducted from gross income rather than added to a 
cost of goods sold account that reduces gross income. Therefore, 
allocable contract costs are not considered in determining whether a 
long-term contract is a domestic contract or a foreign contract, even 
if, under the taxpayer's facts, the allocation of contract costs to any 
portion of a contract not accounted for under the percentage of 
completion method would affect the relative percentages of United States 
and foreign source gross income from the entire contract if this portion 
of the contract were taken into account in applying the 95-percent test.
    (E) Application to foreign contracts. If a widely held pass-through 
entity has some foreign contracts and some domestic contracts, the 
owners of the pass-through entity each apply the look-back method 
(using, if they elect, the simplified marginal impact method) to their 
respective share of the income and expense from foreign contracts. 
Moreover, in applying the look-back method to foreign contracts at the 
owner level, the owners do not take into account their share of 
increases or decreases in contract income resulting from the application 
of the simplified marginal impact method with respect to domestic 
contracts at the entity level.
    (F) Effective date. The simplified marginal impact method must be 
applied to pass-through entities described in paragraph (d)(4)(i) of 
this section with respect to domestic contracts completed or adjusted in 
tax years for which the due date of the return (determined with regard 
to extensions) of the pass-through entity is after November 9, 1988.
    (ii) Elective use--(A) General rule. As provided in paragraph 
(d)(4)(i) of this section, the simplified marginal impact method must be 
used by certain pass-through entities with respect to domestic 
contracts. C corporations, individuals, and owners of closely held pass-
through entities may elect the simplified marginal impact method. Owners 
of other pass-through entities may also elect the simplified marginal 
impact method with respect to all contracts other than those for which 
the simplified marginal impact method is required to be applied at the 
entity level. This rule applies to foreign contracts of widely held 
pass-through entities. In the case of an electing owner in a pass-
through entity, the simplified marginal impact method is applied at the 
owner level, instead of at the entity level, with respect to the owner's 
share of the long-term contract income and expense reported by the pass-
through entity.
    (B) Election requirements. A taxpayer elects the simplified marginal 
impact method by stating that the election is being made on a timely 
filed income tax return (determined with regard to extensions) for the 
first tax year the election is to apply. An election to use the 
simplified marginal impact method applies to all applications of the 
look-back method to all eligible long-term contracts for the tax year 
for which the election is made and for any subsequent tax year. The 
election may not be revoked without the consent of the Commissioner.
    (C) Consolidated group consistency rule. In the case of a 
consolidated group of corporations as defined in Sec.  1.1502-1(h), an 
election to use the simplified marginal impact method is made by the 
common parent of the group. The election is binding on all other 
affected members of the group (including members that join the group 
after the election is made with respect to all applications of the look-
back method after joining). If a member subsequently leaves the group, 
the election remains binding as to that member unless the Commissioner 
consents to a revocation of the election. If a corporation using the 
simplified marginal impact method

[[Page 295]]

joins a group that does not use the method, the election is 
automatically revoked with respect to all applications of the look-back 
method after it joins the group.
    (e) Delayed reapplication method--(1) In general. For purposes of 
reapplying the look-back method after the year of contract completion, a 
taxpayer may elect the delayed reapplication method to minimize the 
number of required reapplications of the look-back method. Under this 
method, the look-back method is reapplied after the year of completion 
of a contract (or after a subsequent application of the look-back 
method) only when the first one of the following conditions is met with 
respect to the contract:
    (i) The net undiscounted value of increases or decreases in the 
contract price occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (ii) The net undiscounted value of increases or decreases in the 
contract costs occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (iii) The taxpayer goes out of existence,
    (iv) The taxpayer reasonably believes the contract is finally 
settled and closed, or
    (v) Neither condition (e)(1) (i), (ii), (iii), nor (iv) above is met 
by the end of the fifth tax year that begins after the last previous 
application of the look-back method.
    (2) Time and manner of making election. An election to use the 
delayed reapplication method may be made for any filing year for which 
the due date of the return (determined with regard to extensions) is 
after June 12, 1990. The election is made by a statement to that effect 
on the taxpayer's timely filed Federal income tax return (determined 
with regard to extensions) for the first tax year the election is to be 
effective. An election to use the delayed reapplication method is 
binding with respect to all long-term contracts for which the look-back 
method would be reapplied without regard to the election in the year of 
election and any subsequent year unless the Commissioner consents to a 
revocation of the election. In the case of a consolidated group of 
corporations as defined in Sec.  1.1502-1(h), an election to use the 
delayed reapplication method is made by the common parent of the group. 
The election is binding on all other affected members of the group 
(including members that join the group after the election is made with 
respect to contracts adjusted after joining). If a member subsequently 
leaves the group, the election remains binding as to that member unless 
the Commissioner consents to a revocation of the election. If a 
corporation that has made the election joins a consolidated group that 
has not made the election, the election is treated as revoked with 
respect to contracts adjusted after joining.
    (3) Examples. The operation of this delayed reapplication method is 
illustrated by the following examples:

    Example 1. X completes a contract in 1987, and applies the look-back 
method when its return for 1987 is filed. X properly uses $600,000 as 
the actual contract price in applying the look-back method. In 1990, as 
a result of the settlement of a dispute with its customer, X 
redetermines total contract price to be $640,000, and includes $40,000 
in gross income. On its return for 1990, X states it is electing the 
delayed reapplication method. X is not required to reapply the look-back 
method at that time, because $40,000 does not exceed the lesser of 
$1,000,000 or 10 percent of the unadjusted contract price of $600,000, 
and 5 years have not passed since the last application of the look-back 
method.
    Example 2. Assume the same facts as in Example 1, except that at the 
end of 1992, the fifth year after completion of the contract, no other 
adjustments to contract price or contract costs have occurred. X is 
required to reapply the look-back method in 1992 and, accordingly, 
redetermine its tax liability for each redetermination year. After 
redetermining the underpayment of tax for those years, X must compute 
the amount of interest charged on the underpayments. Although 1992 is 
the filing year, interest is due on the amount of each underpayment 
resulting from the adjustment only from the due date of the return for 
each redetermination year to the due date of the return for 1990 because 
the tax liability for the adjustment was fully paid in 1990. However, 
from the due of the 1990 return until the due date of the 1992 return, 
when the look-back method is reapplied for the adjustment, interest is 
due on

[[Page 296]]

the amount of interest attributable to the underpayments.

    (f) Look-back reporting--(1) Procedure. The amount of any interest 
due from, or payable to, a taxpayer as a result of applying the look-
back method is computed on Form 8697 for any filing year. In general, 
the look-back method is applied by the taxpayer that reports income from 
a long-term contract. See paragraph (g) of this section to determine who 
is responsible for applying the look-back method when, prior to the 
completion of a long-term contract, there is a transaction that changes 
the taxpayer that reports income from the contract.
    (2) Treatment of interest on return--(i) General rule. The amount of 
interest required to be paid by a taxpayer is treated as an income tax 
under subtitle A, but only for purposes of subtitle F of the Code (other 
than sections 6654 and 6655), which addresses tax procedures and 
administration. Thus, a taxpayer that fails to pay the amount of 
interest due is subject to any applicable penalties under subtitle F, 
including, for example, an underpayment penalty under section 6651, and 
the taxpayer also is liable for underpayment interest under section 
6601. However, interest required to be paid under the look-back method 
is treated as interest expense for purposes of computing taxable income 
under subtitle A, even though it is treated as income tax liability for 
subtitle F purposes. Interest received under the look-back method is 
treated as taxable interest income for all purposes, and is not treated 
as a reduction in tax liability or a tax refund. The determination of 
whether or not interest computed under the look-back method is treated 
as tax is determined on a ``net'' basis for each filing year. Thus, if a 
taxpayer computes for the current filing year both hypothetical 
overpayments and hypothetical underpayments for prior years, the 
taxpayer has an increase in tax only if the interest computed on the 
underpayments for all those prior years exceeds the interest computed on 
the overpayments for all those prior years, for all contracts completed 
or adjusted for the year.
    (ii) Timing of look-back interest. For purposes of determining 
taxable income under subtitle A of the Code, any amount of interest 
payable to the taxpayer under the look-back method is includible in 
gross income as interest income in the tax year it is properly taken 
into account under the taxpayer's method of accounting for interest 
income. Any amount of interest required to be paid is taken into account 
as interest expense arising from an underpayment of income tax in the 
tax year it is properly taken into account under the taxpayer's method 
of accounting for interest expense. Thus, look-back interest required to 
be paid by an individual, or by a pass-through entity on behalf of an 
individual owner (or beneficiary) under the simplified marginal impact 
method, is personal interest and, therefore, is disallowed in accordance 
with Sec.  1.163-9T(b)(2). Interest determined at the entity level under 
the simplified marginal impact method is allocated among the owners (or 
beneficiaries) for reporting purposes in the same manner that interest 
income and interest expense are allocated to owners (or beneficiaries) 
and subject to the requirements of section 704 and any other applicable 
rules.
    (3) Statute of limitations and compounding of interest on look-back 
interest. For guidance on the statute of limitations applicable to the 
assessment and collection of look-back interest owed by a taxpayer, see 
sections 6501 and 6502. A taxpayer's claim for credit or refund of look-
back interest previously paid by or collected from a taxpayer is a claim 
for credit or refund of an overpayment of tax and is subject to the 
statute of limitations provided in section 6511. A taxpayer's claim for 
look-back interest (or interest payable on look-back interest) that is 
not attributable to an amount previously paid by or collected from a 
taxpayer is a general, non-tax claim against the federal government. For 
guidance on the statute of limitations that applies to general, non-tax 
claims against the federal government, see 28 U.S.C. sections 2401 and 
2501. For guidance applicable to the compounding of interest when the 
look-back interest is not paid, see sections 6601 to 6622.
    (g) Mid-contract change in taxpayer--(1) In general. The rules in 
this paragraph (g) apply if, as described in Sec.  1.460-4(k), prior to 
the completion of a

[[Page 297]]

long-term contract accounted for using the PCM or the PCCM by a taxpayer 
(old taxpayer), there is a transaction that makes another taxpayer (new 
taxpayer) responsible for accounting for income from the same contract. 
The rules governing constructive completion transactions are provided in 
paragraph (g)(2) of this section, while the rules governing step-in-the-
shoes transactions are provided in paragraph (g)(3) of this section. For 
purposes of this paragraph, pre-transaction years are all taxable years 
of the old taxpayer in which the old taxpayer accounted for (or should 
have accounted for) gross receipts from the contract, and post-
transaction years are all taxable years of the new taxpayer in which the 
new taxpayer accounted for (or should have accounted for) gross receipts 
from the contract.
    (2) Constructive completion transactions. In the case of a 
transaction described in Sec.  1.460-4(k)(2)(i) (constructive completion 
transaction), the look-back method is applied by the old taxpayer with 
respect to pre-transaction years upon the date of the transaction and, 
if the new taxpayer uses the PCM or the PCCM to account for the 
contract, by the new taxpayer with respect to post-transaction years 
upon completion of the contract. The contract price and allocable 
contract costs to be taken into account by the old taxpayer or the new 
taxpayer in applying the look-back method are described in Sec.  1.460-
4(k)(2).
    (3) Step-in-the-shoes transactions--(i) General rules. In the case 
of a transaction described in Sec.  1.460-4(k)(3)(i) (step-in-the-shoes 
transaction), the look-back method is not applied at the time of the 
transaction, but is instead applied for the first time when the contract 
is completed by the new taxpayer. Upon completion of the contract, the 
look-back method is applied by the new taxpayer with respect to both 
pre-transaction years and post-transaction years, taking into account 
all amounts reasonably expected to be received by either the old or new 
taxpayer and all allocable contract costs incurred during both periods 
as described in Sec.  1.460-4(k)(3). The new taxpayer is liable for 
filing the Form 8697 and for interest computed on hypothetical 
underpayments of tax, and is entitled to receive interest with respect 
to hypothetical overpayments of tax, for both pre- and post-transaction 
years. The old taxpayer will be secondarily liable for any interest 
required to be paid with respect to pre-transaction years reduced by any 
interest on pre-transaction overpayments.
    (ii) Application of look-back method to pre-transaction period--(A) 
Contract price. The actual contract price for pre-transaction taxable 
years must be determined by the new taxpayer without regard to any 
contract price adjustment described in paragraph (k)(3)(iv)(B)(1) of 
this section.
    (B) Method. The new taxpayer may apply the look-back method to each 
pre-transaction taxable year that is a redetermination year using the 
simplified marginal impact method described in paragraph (d) of this 
section (regardless of whether or not the old taxpayer would have 
actually used that method and without regard to the tax liability 
ceiling). But see paragraph (d)(4) of this section, which requires use 
of the simplified marginal impact method by certain pass-through 
entities.
    (C) Interest accrual period. With respect to any hypothetical 
underpayment or overpayment of tax for a pre-transaction taxable year, 
interest accrues from the due date of the old taxpayer's tax return (not 
including extensions) for the taxable year of the underpayment or 
overpayment until the due date of the new taxpayer's return (not 
including extensions) for the completion year or the year of a post-
completion adjustment, whichever is applicable.
    (D) Information old taxpayer must provide--(1) In general. Except as 
provided in paragraph (g)(3)(ii)(D)(2) of this section, in order to help 
the new taxpayer to apply the look-back method with respect to pre-
transaction taxable years, any old taxpayer that accounted for income 
from a long-term contract under the PCM or PCCM for either regular or 
alternative minimum tax purposes is required to provide the information 
described in this paragraph to the new taxpayer by the due date (not 
including extensions) of the old taxpayer's income tax return for the 
first taxable

[[Page 298]]

year ending on or after a step-in-the-shoes transaction described in 
Sec.  1.460-4(k)(3)(i). The required information is as follows--
    (i) The portion of the contract reported by the old taxpayer under 
PCM for regular and alternative minimum tax purposes (i.e., whether the 
old taxpayer used PCM, the 40/60 PCCM method, or the 70/30 PCCM method);
    (ii) Any submethods used in the application of PCM (e.g., the 
simplified cost-to-cost method or the 10-percent method);
    (iii) The amount of total contract price reported by year;
    (iv) The numerator and the denominator of the completion factor by 
year;
    (v) The due date (not including extensions) of the old taxpayer's 
income tax returns for each taxable year in which income was required to 
be reported;
    (vi) Whether the old taxpayer was a corporate or a noncorporate 
taxpayer by year; and
    (vii) Any other information required by the Commissioner by 
administrative pronouncement.
    (2) Special rules for certain pass-through entity transactions. For 
purposes of paragraph (g)(3)(ii)(D)(1) of this section, in the case of a 
transaction described in Sec.  1.460-4(k)(3)(i)(I), the contributing 
partner is treated as the old taxpayer, and the partnership is treated 
as the new taxpayer. In the case of transactions described in Sec.  
1.460-4(k)(3)(i)(F), (G), (J), (K), or (L), the old taxpayer is not 
required to provide the information described in paragraph 
(g)(3)(ii)(D)(1) of this section, because information necessary for the 
new taxpayer to apply the look-back method is provided by the pass-
through entity. This paragraph (g)(3)(ii)(D) is applicable for 
transactions on or after August 6, 2003.
    (iii) Application of look-back method to post-transaction years. 
With respect to post-transaction taxable years, the new taxpayer must 
use the same look-back method it uses for other contacts (i.e., the 
simplified marginal impact method or the acutal method) to determine the 
amount of any hypothetical overpayment or underpayment of tax and the 
time period for computing interest on these amounts.
    (iv) S corporation elections. Following the conversion of a C 
corporation into an S corporation, the look-back method is applied at 
the entity level with respect to contracts entered into prior to the 
conversion, notwithstanding section 460(b)(4)(B)(i).
    (4) Effective date. Except as provided in paragraph (g)(3)(ii)(D) of 
this section, this paragraph (g) is applicable for transactions on or 
after May 15, 2002.
    (h) Examples--(1) Overview. This paragraph provides computational 
examples of the rules of this section. Except as otherwise noted, the 
examples involve calendar-year taxpayers and involve long-term contracts 
subject to section 460 that are accounted for using the percentage of 
completion method, rather than the percentage of completion-capitalized 
cost method. If the percentage of completion-capitalized cost method 
were used by a taxpayer described in the examples, the amounts of 
contract income and expenses shown in the examples would be reduced, for 
purposes of determining regular taxable income, to the appropriate 
fraction (40, 70, or 90 percent) of contract items accounted for under 
the percentage of completion method. Tens of thousands of dollars ($ 
00,000's) are omitted from the figures in the examples. The contracts 
described in the examples are assumed to be the taxpayers' only 
contracts that are subject to the look-back method of section 460. 
Except as otherwise stated, the examples assume that the taxpayer has no 
adjustments and preferences for purposes of section 55, so that 
alternative minimum taxable income is the same as taxable income, and no 
alternative minimum tax is imposed for the years involved. The examples 
assume that the taxpayer does not elect the 10-percent method, the 
simplified marginal impact method, or the delayed reapplication method.
    (2) Step One. The following example illustrates the application of 
paragraph (c)(2):

    Example 1. In 1989, W completes three long-term contracts, A, B, and 
C, entered into on January 1 of 1986, 1987, and 1988, respectively. For 
Contract A, W used the completed contract method of accounting. For 
Contract B,

[[Page 299]]

W used the percentage of completion-capitalized cost method of 
accounting, taking into account 60 percent of contract income under W's 
normal method of accounting, which was the completed contract method. 
For Contract C, W used the percentage of completion method of 
accounting. The total price for each contract was $1,000. In computing 
alternative minimum taxable income, W is required to use the percentage 
of completion method for Contracts B and C. W used regular tax costs for 
purposes of determining the degree of contract completion under the 
alternative minimum tax.
    Contract A is not taken into account for purposes of applying the 
look-back method, because it is subject to neither section 460 nor 
section 56(a)(3). Thus, even if W had used the percentage of completion 
method as permitted under Sec.  1.451-3, instead of the completed 
contract method, the look-back method would not be applicable because 
the Contract A was entered into before the effective date of section 
460.
    The actual costs allocated to Contracts B and C under section 460(c) 
and incurred in each year of the contract were as follows:

------------------------------------------------------------------------
                 Contract                    1987   1988   1989   Total
------------------------------------------------------------------------
B.........................................   $200   $400   $200     $800
C.........................................    100    300    400      800
------------------------------------------------------------------------

    In applying the look-back method, the first step is to allocate the 
contract price among tax years preceding and including the completion 
year. That allocation would produce the following amounts of gross 
income for purposes of the regular tax. Note that no income from 
Contract C is allocated to 1987, the year before the contract was 
entered into, even though contract costs were incurred in 1987:

----------------------------------------------------------------------------------------------------------------
              Contract                           1987                              1988                    1989
----------------------------------------------------------------------------------------------------------------
B..................................              $100                              $200                     $700
                                            (40%X$200/$800X$1000)          ((40%X$600/$800X$1000)-$100)  .......
C..................................                0                                500                      500
                                     ............................                     ($400/$800X$1000)  .......
----------------------------------------------------------------------------------------------------------------

    Because the percentage of completion-capitalized cost method may not 
be used for alternative minimum tax purposes, the allocation of contract 
income would produce the following amounts of gross income for purposes 
of computing alternative minimum taxable income:

----------------------------------------------------------------------------------------------------------------
                     Contract                               1987                       1988                1989
----------------------------------------------------------------------------------------------------------------
B.................................................          $250                       $500                 $250
                                                       ($200/$800X$1000)       (($600/$800X$1000)-$250)  .......
C.................................................            0                        500                   500
----------------------------------------------------------------------------------------------------------------

    (3) Step Two. The following example illustrates the application of 
paragraph (c)(3):

    Example 2. (i) X enters into two long-term contracts (D and E) in 
1988. X determines its tax liability for 1988 as follows:

e = estimate
a = amount originally reported (actual)
h = hypothetical

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     8,000e      8,000e   ..........
Total contract price................    10,000e     10,000e   ..........
1988 completion %...................      37.5e         25e   ..........
1988 gross income...................     3,750a      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......       750a        500a     $1,250a
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      (750a)
                                     -----------------------------------
      Tax...........................  ..........  ..........         0a
Refund from NOL carryback fully       ..........  ..........       345a
 absorbed in 1985, at 46%...........
------------------------------------------------------------------------


[[Page 300]]

    (ii) X completes Contract D during 1989. X determines its taxable 
income for 1989 as follows:

------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1989 completion %...................       100a       22.2e   ..........
1989 gross income/(loss)............     6,250a      (278a)   ..........
Less, 1989 costs....................   (3,000a)          0a   ..........
                                     -----------------------------------
      1989 net contract income......     3,250a      (278a)      $2,972a
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      2,972a
Tax at 34%..........................  ..........  ..........      1,011a
------------------------------------------------------------------------

    (iii) For purposes of the look-back method, X must reallocate the 
actual total contract D price between 1988 and 1989 based on the actual 
total contract D costs. This results in the following hypothetical 
underpayment of tax for 1988 for purposes of the look-back method. Note 
that X does not reallocate the contract E price in applying the look-
back method in 1989 because contract E has not been completed, even 
though X's estimate of contract E costs has changed. The following 
computation is only for purposes of applying the look-back method, and 
does not result in the assessment of a tax deficiency.

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     6,000a      8,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1988 completion %...................        50a         25e   ..........
1988 gross income...................     5,000h      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......     2,000h        500a     $2,500h
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........       500h
Tax at 34%..........................  ..........  ..........       170h
Less, previously computed tax.......  ..........  ..........        -0a
Underpayment of 1988 tax............  ..........  ..........       170h
Underpayment of 1985 tax from NOL     ..........  ..........       345h
 carryback refund in 1988...........
                                     -----------------------------------
      Total underpayment of tax.....  ..........  ..........       515h
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1989 is a redetermination year, because the reallocation of 
contract income and redetermination of tax liability are cumulative, X 
will use for 1989 the amount of contract D income and the amount of tax 
liability that would have been reported in 1989 if X had used actual 
contract costs instead of the amounts that were originally reported 
using the estimate of $8,000. Assuming no subsequent revisions (due to, 
for example, adjustments to contract D price and costs determined after 
the end of 1989), this amount would be determined as follows:

------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1989 completion %...................       100a       22.2e   ..........
1989 gross income...................     5,000h       (278a)  ..........

[[Page 301]]

 
Less, 1989 costs....................    (3,000a)         0a   ..........
                                     -----------------------------------
      1989 net contract income......     2,000h       (278a)     $1,722h
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      1,722h
Tax at 34%..........................  ..........  ..........        585h
------------------------------------------------------------------------

    (iv) X completes contract E during 1990. X determines its taxable 
income for 1990 as follows:

------------------------------------------------------------------------
                                               1990
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1990 contract costs.................  ..........    $7,000a   ..........
Total contract costs................  ..........     9,000a   ..........
Total contract price................  ..........    10,000a   ..........
1990 completion %...................  ..........       100a   ..........
1990 gross income...................  ..........     7,778a   ..........
Less, 1990 costs....................  ..........    (7,000a)  ..........
                                     -----------------------------------
      1990 net contract income......  ..........       778a        $778a
Other 1990 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........        778a
Tax at 34%..........................  ..........  ..........        265a
------------------------------------------------------------------------

    (v) For purposes of the look-back method, X must reallocate the 
actual total contract E price between the 1988, 1989, and 1990, based on 
the actual total contract E costs.
This results in the following hypothetical overpayment of tax for 1988. 
Note that X uses the amount of income for contract D determined in the 
last previous application of the look-back method, and not the amount of 
income actually reported:

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1988 completion (%).................        50a       22.2a   ..........
1988 gross income...................    $5,000h     $2,222h   ..........
Less, 1988 costs....................   ($3,000a)   ($2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......    $2,000h       $222h     $2,222h
Other 1988 net income (loss)........  ..........  ..........   ($2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      $222h
                                     -----------------------------------
      Tax at 34%....................  ..........  ..........       $75h
Less, previously computed tax (based  ..........  ..........      $170h
 on most recent application of the
 look-back method)..................
                                     -----------------------------------
      Overpayment of 1988 tax.......  ..........  ..........      ($95h)
------------------------------------------------------------------------

    In applying the look-back method to 1989, X again uses the amounts 
substituted as of the last previous application of the look-back method 
with respect to contract D. Thus, X computes its hypothetical 
underpayment for 1989 as follows:

[[Page 302]]



------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1989 completion (%).................       100a       22.2a   ..........
1989 gross income...................    $5,000h         $0h   ..........
Less, 1989 costs....................   ($3,000a)       ($0a)  ..........
                                     -----------------------------------
      1989 net contract income......    $2,000h          0a     $2,000h
Other 1989 net income (loss)........  ..........  ..........       ($0a)
                                     -----------------------------------
Taxable income (NOL)................  ..........  ..........    $2,000h
Tax at 34%..........................  ..........  ..........      $680h
Less, previously computed tax.......  ..........  ..........      $585h
                                     -----------------------------------
      Underpayment of 1989 tax......  ..........  ..........       $95h
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1990 is a redetermination year, X will use for 1990 the amount 
of Contract E income, and the amount of tax liability, that was 
originally reported in 1990 because X's estimate of the total contract 
costs from $8,000 to $9,000 did not change after 1989. Without regard to 
any subsequent revisions, these amounts are the same as in the table in 
paragraph (h)(3)(iv) above.

    (4) Post-completion adjustments. The following example illustrates 
the application of paragraph (c)(1)(ii):

    Example 3. The facts are the same as in Example 2. In 1991, X 
settles a lawsuit against its customer in Contract E. The customer pays 
X an additional $3,000, without interest, in 1991. Applying the Federal 
mid-term rate then in effect, this $3,000 has a discounted value at the 
time of contract completion in 1990 of $2,700. X is required to apply 
the look-back method for 1991 even though no contract was completed in 
1991. X must include the full $3,000 adjustment (which was not 
previously includible in total contract price) in gross income for 1991. 
X does not elect not to discount adjustments to the contract price or 
costs. Thus, X adjusts the contract price by the discounted amount of 
the adjustment and, therefore, uses $12,700 (not $13,000) for total 
Contract E price, rather than $10,000, which was used when the look-back 
method was first applied with respect to Contract E.
    For purposes of the look-back method, X must allocate the revised 
total Contract E price of $12,700 between 1988, 1989 and 1990 based on 
the actual total Contract E costs, and compare the resulting revised tax 
liability with the tax liability determined for the last previous 
application of the look-back method involving those years. This results 
in the following hypothetical underpayments of tax for purposes of the 
look-back method:

r = revised

------------------------------------------------------------------------
                                               1988
                                    -------------------------    Total
                                          D           E
------------------------------------------------------------------------
1988 contract costs................     $3,000a     $2,000a   ..........
Total contract costs...............     $6,000a     $9,000a   ..........
Total contract price...............    $10,000a    $12,700r   ..........
1988 completion (%)................         50a       22.2a   ..........
1988 gross income..................     $5,000h    $2,822rh   ..........
Less, 1988 costs...................   ($3,000a)    ($2,000a)  ..........
                                    ------------------------------------
      1988 net contract income.....     $2,000h       822rh     $2,222rh
Other 1988 net income (loss).......  ..........  ...........   ($2,000a)
                                    ------------------------------------
      Taxable income...............  ..........  ...........      $822rh
      Tax at 34%...................  ..........  ...........      $279rh
Less, previously computed tax......  ..........  ...........        $75h
      Underpayment of 1988 tax.....  ..........  ...........      $204rh
------------------------------------------------------------------------

    No Contract E costs were incurred in 1989, and there is no 
hypothetical underpayment for 1989.

[[Page 303]]



------------------------------------------------------------------------
                                                    1990
                                  --------------------------------------
                                        D            E          Total
------------------------------------------------------------------------
1990 contract costs..............  ...........     $7,000a   ...........
Total contract costs.............  ...........     $9,000a   ...........
Total contract price.............  ...........    $12,700r   ...........
1990 completion (%)..............  ...........        100a   ...........
1990 gross income................  ...........    $9,878rh   ...........
Less 1990 costs..................  ...........    ($7,000a)  ...........
                                  --------------------------------------
      1990 net contract income...  ...........    $2,878rh     $2,878rh
Other 1990 net income (loss).....  ...........  ...........          0a
                                  --------------------------------------
Taxable income (NOL).............  ...........  ...........    $2,878rh
Tax at 34%.......................  ...........  ...........      $978rh
Less, previously computed tax....  ...........  ...........       $265h
                                  --------------
      Underpayment of 1990 tax...  ...........  ...........      $713rh
------------------------------------------------------------------------

    In 1992, X incurs an additional cost of $1,000 allocable to the 
contract, which was not previously includible in total contract costs. 
Applying the Federal mid-term rate then in effect, the $1,000 has a 
discounted value at the time of contract completion of $800. X deducts 
this additional $1,000 in expenses in 1992. Based on this increase to 
contract costs, X reapplies the look-back method, and determines the 
following hypothetical underpayments for 1988, 1989 and 1990 for 
purposes of the look-back method:

------------------------------------------------------------------------
                                             1988
                                  --------------------------    Total
                                        D            E
------------------------------------------------------------------------
1988 contract costs..............     $3,000a      $2,000a   ...........
Total contract costs.............     $6,000a      $9,800r   ...........
Total contract price.............    $10,000a     $12,700r   ...........
1988 completion (%)..............         50a        20.4r   ...........
1988 gross income................     $5,000h     $2,592rh   ...........
Less, 1988 costs.................    ($3,000a)    ($2,000a)  ...........
                                  --------------------------------------
      1988 net contract income...     $2,000h        592rh     $2,592rh
Other 1988 net income (loss).....  ...........  ...........    ($2,000a)
                                  --------------------------------------
      Taxable income (NOL).......  ...........  ...........      $592rh
Tax at 34%.......................  ...........  ...........      $201rh
Less, previously computed tax....  ...........  ...........      $279rh
                                  --------------------------------------
      Overpayment of 1988 tax....  ...........  ...........      ($78rh)
------------------------------------------------------------------------

    No Contract E costs were incured in 1989, and there is no 
hypothetical underpayment for 1989.

------------------------------------------------------------------------
                                              1990
                                   -------------------------    Total
                                         D           E
------------------------------------------------------------------------
1990 contract costs...............  ..........  ...........     $7,000a
Total contract costs..............  ..........      9,800r   ...........
Total contract price..............  ..........     12,700r   ...........
1990 completion (%)...............  ..........         92a   ...........
1990 gross income.................  ..........     9,071rh   ...........
Less, 1990 costs..................  ..........     (7,000a)  ...........
                                   -------------------------------------
1990 Net contract income..........  ..........     2,071rh     $2,071rh
Other 1990 net income (loss)......  ..........  ...........          0a
                                   -------------------------------------
      Taxable income (NOL)........  ..........  ...........     2,071rh
Tax at 34%........................  ..........  ...........       704rh
Less, previously computed tax.....  ..........  ...........       978rh
                                   -------------------------------------
      Overpayment of 1990 tax.....  ..........  ...........      (274rh)
------------------------------------------------------------------------


[[Page 304]]

    (5) Alternative minimum tax. The operation of the look-back method 
in the case of a taxpayer liable for the alternative minimum tax as 
provided in paragraph (c)(3)(vi) is illustrated by the following 
examples:

    Example 4. Y enters into a long-term contract in 1988 that is 
completed in 1989. Y used regular tax costs for purposes of determining 
the degree of contract completion under the alternative minimum tax.
    (i) Y determines its tax liability for 1988 as follows:

1988 contract costs........................................     $4,000a
Total contract costs.......................................     $8,000e
Total contract price.......................................    $20,000e
1988 completion (%)........................................         50e
1988 gross income..........................................    $10,000a
Less, 1988 contract costs..................................    ($4,000a
                                                            ------------
      1988 net contract income.............................     $6,000a
Other 1988 net income/(loss)...............................    ($3,400a)
Taxable income.............................................     $2,600a
Regular tax at 34%.........................................        884a
Adjustments and preferences to produce alternative minimum        $600a
 taxable income............................................
Alternative minimum taxable income.........................     $3,200a
Tentative minimum tax at 20%...............................        640a
Tax liability..............................................       $884a
 

    In 1989, Y determines the following amounts:

1989 contract costs..........................................    $6,000a
Total contract costs.........................................   $10,000a
Total contract price.........................................   $20,000a
 

    (ii) For purposes of applying the look-back method, Y redetermines 
its tax liability for 1988, which results in a hypothetical overpayment 
of tax. This hypothetical overpayment is determined by comparing Y's 
original regular tax liability for 1988 with the hypothetical total tax 
liability (including alternative minimum tax liability) for that year 
because Y would have paid the alternative minimum tax if Y had used its 
actual contract costs to report income:

1988 contract costs.........................................    $4,000a
Total contract costs........................................   $10,000a
Total contract price........................................   $20,000a
1988 completion(%)..........................................        40a
1988 gross income...........................................    $8,000h
less, 1988 contract costs...................................   ($4,000a)
1988 net contract income....................................    $4,000h
Other 1988 net income/(loss)................................   ($3,400a)
Taxable income..............................................      $600h
Regular tax at 34%..........................................      $204h
Adjustments and preferences to produce alternative minimum        $600a
 taxable income.............................................
Alternative minimum taxable income..........................    $1,200h
Tentative minimum tax at 20%................................       240h
Alternative minimum tax.....................................       $36h
Total tax liability.........................................      $240h
less, previously computed tax...............................      $884a
Underpayment/(overpayment)..................................     ($644h)
 

    (6) Credit carryovers. The operation of the look-back method in the 
case of credit carryovers as provided in paragraph (c)(3)(v) is 
illustrated by the following example:

    Example 5. Z enters into a contract in 1986 that is completed in 
1987. Z determines its tax liability for 1986 as follows:

1986 contract costs..........................................     $400a
Total contract costs.........................................   $1,000e
Total contract price.........................................   $2,000e
1986 completion (%)..........................................       40e
1986 gross income............................................     $800a
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a
Other 1986 net income........................................       $0a
Taxable income...............................................     $400a
Tax at 46%...................................................     $184a
Unused tax credits carried forward from 1985 allowable in         $350a
 1986........................................................
Net tax due..................................................       $0a
 

    Z determines the following amounts for 1987:

1987 contract costs..........................................      $400a
Total contract price.........................................    $2,000a
Total contract costs.........................................      $800a
 

    If Z had used actual rather than estimated contract costs in 
determining gross income for 1986, Z would have reported tax liability 
of $276 (46%x$600) rather than $184. However, Z would have paid no 
additional tax for 1986 because its unused tax credits carried forward 
from 1985 would have been sufficient to offset this increased tax 
liability. Therefore, there is no hypothetical underpayment for 1986 for 
purposes of the look-back method. However, this hypothetical earlier use 
of the credit may increase the hypothetical tax liability for 1987 (or 
another subsequent year) for purposes of subsequent applications of the 
look-back method.

    (7) Net operating losses. The operation of the look-back method in 
the case of net operating loss (``NOL'') carryovers as provided in 
paragraph (c)(3)(v) is illustrated by the following example:

    Example 6. A entered into a long-term contract in 1986, which was 
completed in 1987. A determined its tax liability for 1986 as follows:

1986 contract costs.........................................      $400a
Total contract costs........................................    $1,000e
Total contract price........................................    $2,000e
1986 completion (%).........................................        40e
1986 gross income...........................................      $800a
Less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a
Other 1986 net income/(loss)................................   ($1,000a)
Taxable income/(NOL)........................................     ($600a)
Tax.........................................................        $0a
 

    A elected to carry this loss forward to 1987 pursuant to section 
172(b)(3)(C).
    For 1987, A determined the following amounts:

1987 contract costs...........................................     $400a
Total contract costs..........................................     $800a
Total contract price..........................................   $2,000a
 

    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract rather than

[[Page 305]]

$800, and thus would have reported a loss of $400 rather than $600. 
However, since A would have paid no tax for 1986 regardless of whether 
actual or estimated contract costs had been used, A does not have an 
underpayment for 1986 for purposes of the look-back method. If A had, 
instead, carried back the 1986 NOL, and this NOL had been absorbed in 
the tax years 1983 through 1985, it would have resulted in refunds of 
tax for those years in 1986. When A applies the look-back method, a 
hypothetical underpayment of tax would have resulted for those years due 
to a hypothetical reduction in the amount that would have been refunded 
if income had been reported on the basis of actual contract costs. See 
Example 2(iii).

    (8) Alternative minimum tax credit. The following example 
illustrates the application of the look-back method if affected by the 
alternative minimum tax credit as provided in paragraph (c)(3)(vi):
    (i) Example 4, above illustrates that the reallocation of contract 
income under the look-back method can result in a hypothetical 
underpayment or overpayment determined using the alternative minimum tax 
rate, even though the taxpayer actually paid only the regular tax for 
that year. However, application of the look-back method had no effect on 
the difference between the amount of alternative minimum taxable income 
and the amount of regular taxable income taken into account in that year 
because the taxpayer was required to use the percentage of completion 
method for both regular and alternative minimum tax purposes and used 
the same version of the percentage of completion method for both regular 
and alternative minimum tax purposes (i.e., the taxpayer had made an 
election to use regular tax costs in determining the percentage of 
completion for purposes of computing alternative minimum taxable 
income).
    (ii) The following example illustrates the application of the look-
back method in the case of a taxpayer that does not use the percentage 
of completion method of accounting for long-term contracts in computing 
taxable income for regular tax purposes and thus must make an adjustment 
to taxable income to determine alternative minimum taxable income. The 
example also shows how interest is computed under the look-back method 
when the taxpayer is entitled to a credit under section 53 for minimum 
tax paid because of this adjustment.

    (iii) Example 7. X, a calendar year C corporation, is engaged in the 
construction of real property under contracts that are completed within 
a 24-month period. Its average annual gross receipts for the prior 3-
taxable-year period does not exceed $25,000,000. As permitted by section 
460(e)(1)(B), X uses the completed contract method (CCM) for regular tax 
purposes. However, X is engaged in the construction of commercial real 
property and, for years beginning before January 1, 2018, is required to 
use the percentage of completion method (PCM) for alternative minimum 
tax (AMT) purposes. Assume that for 2017, 2018, and 2019, X has only one 
long-term contract, which is entered into in 2017 and completed in 2019 
and that in 2017 X's average annual gross receipts for the prior 3-
taxable-years do not exceed $10,000,000. Assume further that X estimates 
gross income from the contract to be $2,000, total contract costs to be 
$1,000, and that the contract is 25 percent complete in 2017 and 70 
percent complete in 2018, and 5 percent complete in 2019. In 2019, the 
year of completion, gross income from the contract is actually $3,000, 
instead of $2,000, and costs are actually $1,000. Because X was required 
to use the PCM for 2017 for AMT purposes, X must apply the look-back 
method to its AMT reporting for that year. X has elected to use the 
simplified marginal impact method. For 2017, X's income using estimated 
contract price and costs is as follows:

                    Table 1 to Paragraph (h)(8)(iii)
------------------------------------------------------------------------
                 Estimates                              2017
------------------------------------------------------------------------
Gross Income..............................  $500 = ($2,000 x 25%)
Deductions................................  $(250) = ($1,000 x 25%)
Contract Income--PCM......................  $250
------------------------------------------------------------------------

    (A) When X files its federal income tax return for 2019, the 
contract completion year, X applies the look-back method. For 2017, X's 
income using actual contract price and costs is as follows:

                   Table 2 to Paragraph (h)(8)(iii)(A)
------------------------------------------------------------------------
                  Actual                                2017
------------------------------------------------------------------------
Gross Income..............................  $750 = ($3,000 x 25%)

[[Page 306]]

 
Deductions................................  $(250) = ($1,000 x 25%)
Contract Income--PCM......................  $500
------------------------------------------------------------------------

    (B) Accordingly, the reallocation of contract income under the look-
back method results in an increase of income for AMT purposes for 2017 
of $250 ($500-$250). Under the simplified marginal impact method, X 
applies the highest rate of tax under section 55(b)(1) to this increase, 
which produces a hypothetical underpayment for 2017 of $50 (.20 x $250). 
Interest is charged to X on this $50 underpayment from the due date of 
X's 2017 return until the due date of X's 2019 return. X, a C 
corporation, is not subject to the AMT in 2018. X does not compute 
alternative minimum taxable income or use the PCM in that year. 
Accordingly, look-back does not apply to 2018.
    (9) Period for interest. The following Examples (8) through (11) 
illustrate how to determine the period for computing interest as 
provided in paragraph (c)(4):

    Example 8. The facts are the same as in Example 6, except that the 
contract is completed in 1988, and A determined the following amounts 
for 1987 and 1988:

For 1987:
  1987 contract costs.......................................          0
  Total contract costs......................................    $1,000e
  Total contract price......................................    $2,000e
  1987 completion (%).......................................       $40e
  1987 gross income.........................................         0a
  Less, 1987 costs..........................................         0a
  Other 1987 net income.....................................      $600a
  Net operating loss carryforward from 1986.................     $(600a)
  Taxable income............................................         0a
  Tax.......................................................         0a
For 1988:
  1988 contract costs.......................................      $400a
  Total contract costs......................................      $800a
  Total contract price......................................    $2,000a
 

    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract for 1986 rather than $800, and would have 
reported a net operating loss carryforward to 1987 of $400 rather than 
$600. Therefore, A would have reported taxable income of $200, and would 
have paid tax of $80 (i.e., $200 x 40%) for 1987. The due date for 
filing A's Federal income tax return for its 1988 taxable year is March 
15. A obtains an extension and files its 1988 return on September 15, 
1989. Under the look-back method, A is required to pay interest on the 
amount of this hypothetical underpayment ($80) computed from the due 
date (determined without regard to extensions) for A's return for 1987 
(not 1986, even though 1986 was the year in which the net operating loss 
arose) until March 15 (not September 15), the due date (without regard 
to extensions) of A's return for 1988. A is required to pay additional 
interest from March 15 until September 15 on the amount of interest 
outstanding as of March 15 with respect to the hypothetical underpayment 
of $80.
    Example 9. The facts are the same as in Example 6, except that A 
carries the net operating loss of $600 back to 1983 rather than forward 
to 1987, and receives a refund of $276 ($600 reduction in 1983 taxable 
income x 46% rate in effect in 1983). As in Example 6, if actual 
contract costs had been used, A would have reported a loss for 1986 of 
$400 rather than $600. Thus, A would have received a refund of 1983 tax 
of $184 ($400 x 46%) rather than $276. Under the look-back method A is 
required to pay interest on the difference in these two amounts ($92) 
computed from the due date (determined without regard to extensions) of 
A's return for 1986 (the year in which the carryback arose rather than 
1983, the year in which it was used) until the due date of A's return 
for 1988.
    Example 10. B enters into a long-term contract in 1986 that is 
completed in 1988. B determines its 1986 tax liability as follows:

1986 contract costs..........................................     $400a
Total contract costs.........................................   $1,000e
Total contract price.........................................   $2,000e
1986 completion (%)..........................................       40e
1986 gross income............................................     $800a
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a
Other 1986 net income........................................   $2,000a
Taxable income...............................................   $2,400a
Tax at 46%...................................................   $1,104a
     B determines its tax liability for 1987 as follows:
1987 contract costs..........................................     $400a
Total contract costs.........................................   $1,600e
Total contract price.........................................   $2,000e
1987 completion (%)..........................................       50e
1987 gross income............................................     $200a
( = (50% x $2,000)-$800 previously reported) less, 1987 costs    ($400a)
1987 net contract income.....................................    ($200a)
Other 1987 net income/(loss).................................  ($2,200a)
Taxable income (NOL).........................................  ($2,400a)
Tax..........................................................        0a
 

    Assume that B had no taxable income in either 1984 or 1985, so that 
the entire amount of the $2,400 net operating loss is carried back to 
1986, and B receives a refund, with interest from the due date of B's 
1987 return, of the entire $1,104 in tax that it paid for 1986.
    In 1988, B determines the following amounts:

1988 contract costs...........................................     $800a
Total contract costs..........................................   $1,600a
Total contract price..........................................   $2,000a
 

    If B had used actual contract costs rather than estimated costs in 
determining its gross income for 1986, B would have had gross

[[Page 307]]

income from the contract of $500 rather than $800, and thus would have 
had taxable income of $2,100 rather than $2,400, and would have paid tax 
of $966 rather than $1,104. B is entitled to receive interest on the 
difference between these two amounts, the hypothetical overpayment of 
tax of $138. Interest is computed from the due date (without regard to 
extensions) of B's return for 1986 until the due date for B's return for 
1987. Interest stops running at this date, because B's hypothetical 
overpayment of tax ended when B filed its original 1987 return and 
received a refund for the carryback to 1986, and interest on this refund 
began to run only from the due date of B's 1987 return. See section 
6611(f).
    Example 11. C enters into a long-term contract in 1986, its first 
year in business, which is completed in 1988. C determines its tax 
liability for 1986 as follows:

1986 contract costs.........................................      $400a
Total contract costs........................................    $1,000e
Total contract price........................................    $2,000e
1986 completion (%).........................................        40e
1986 gross income...........................................      $800a
less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a
Other 1986 net income.......................................    $2,000a
Taxable income (NOL)........................................    $2,400a
Tax at 46%..................................................    $1,104a
 

    C determines its tax liability for 1987 as follows:

1987 contract costs.........................................      $400a
Total contract costs........................................    $1,066e
Total contract price........................................    $2,000e
1987 completion (%).........................................        75e
1987 gross income...........................................      $700a
Less, 1987 costs............................................     ($400a)
1987 net contract income....................................      $300a
Other 1987 net income.......................................   ($2,450a)
Taxable income (NOL)........................................   ($2,150a)
Tax.........................................................       $10a
 

    C carries back the net operating loss to 1986, and files an amended 
return for 1986, showing taxable income of $250, and receives a refund 
of $989 (46% x $2,150). Interest on this refund begins to run only as of 
the due date of C's 1987 return. See section 6611(f).
    In 1988, when the contract is completed, C determines the following 
amounts:

1988 contract costs.........................................      $800a
Total contract costs........................................    $1,600a
Total contract price........................................    $2,000a
 

    If C had used actual contract price and contract costs in 
determining gross income for 1986, it would have reported gross income 
from the contract of $500 rather than $800, taxable income of $2,100 
rather than $2,400, and tax liability of $966 rather than $1,104.
    If C had used actual contract price and contract costs in 
determining gross income for 1987, it would have reported gross income 
from the contract of $500 rather than $700, and would have reported a 
net operating loss of $2,350, rather than $2,150, which would have been 
carried back to 1986.
    Under the look-back method, C receives interest with respect to a 
total 1986 hypothetical overpayment of $138 ($1,104 minus $966). C is 
credited with interest on $23 of this amount only from the due date of 
C's 1986 return until the due date of C's 1987 tax return, because this 
portion of C's total hypothetical overpayment for 1986 was refunded to C 
with interest computed from the due date of C's 1987 return and, 
therefore, was no longer held by the government. However, because the 
remainder of the total hypothetical overpayment of $115 was not refunded 
to C, C is credited with interest on this amount from the due date of 
C's 1986 return until the due date of C's 1988 tax return.
    Under the look-back method, C receives no interest with respect to 
1987, because C had no tax liability for 1987 using either estimated or 
actual contract price and costs.

    (i) [Reserved]
    (j) Election not to apply look-back method in de minimis cases. 
Section 460(b)(6) provides taxpayers with an election not to apply the 
look-back method to long-term contracts in de minimis cases, effective 
for contracts completed in taxable years ending after August 5, 1997. To 
make an election, a taxpayer must attach a statement to its timely filed 
original federal income tax return (including extensions) for the 
taxable year the election is to become effective or to an amended return 
for that year, provided the amended return is filed on or before March 
31, 998. This statement must have the legend ``NOTIFICATION OF ELECTION 
UNDER SECTION 460(b)(6)''; provide the taxpayer's name and identifying 
number and the effective date of the election; and identify the trades 
or businesses that involve long-term contracts. An election applies to 
all long-term contracts completed during and after the taxable year for 
which the election is effective. An election may not be revoked without 
the Commissioner's consent. For taxpayers who elected to use the delayed 
reapplication method under paragraph (e) of this section, an election 
under this paragraph (j) automatically revokes the election to use the 
delayed reapplication method for contracts subject to section 460(b)(6). 
A consolidated group of corporations, as defined in Sec.  1.1502-1(h), 
is subject to consistency rules analogous to those in paragraph (e)(2) 
of this section and in paragraph (d)(4)(ii)(C) of this section 
(concerning

[[Page 308]]

election to use simplified marginal impact method).
    (k) Applicability date. Paragraphs (b)(2), (b)(2)(ii), (b)(3)(iii), 
(c)(1)(i), (c)(2)(i), (c)(2)(iv), (c)(3)(ii), (c)(3)(vi), (d)(2)(i), 
(d)(4)(i)(A), and (h)(8)(iii) of this section apply to taxable years 
beginning on or after January 5, 2021. However, for a taxable year 
beginning after December 31, 2017, and before January 5, 2021, a 
taxpayer may apply the paragraphs described in the first sentence of 
this paragraph (k), provided that the taxpayer follows all the 
applicable rules contained in the regulations under section 460 for such 
taxable year and all subsequent taxable years. Further, a taxpayer may 
apply those portions of paragraphs (b)(2)(ii) and (b)(3)(iii) of this 
section that relate to section 460(e)(1)(B) for contracts entered into 
after December 31, 2017, in a taxable year ending after December 31, 
2017, provided that the taxpayer follows all the applicable rules 
contained in the regulations under section 460 for such taxable year and 
all subsequent taxable years.

[T.D. 8315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8775, 63 FR 
36181, July 2, 1998; T.D. 8929, 66 FR 2240, Jan. 11, 2001; T.D. 8995, 67 
FR 34609, May 15, 2002; T.D. 9137, 69 FR 42558, July 16, 2004; T.D. 
9942, 86 FR 273, Jan. 5, 2021; 86 FR 32186, June 17, 2021]

                 taxable year for which deductions taken



Sec.  1.461-0  Table of contents.

    This section lists the captions that appear in the regulations under 
section 461 of the Internal Revenue Code.

        Sec.  1.461-1 General rule for taxable year of deduction.

    (a) General rule.
    (1) Taxpayer using cash receipts and disbursements method.
    (2) Taxpayer using an accrual method.
    (3) Effect in current taxable year of improperly accounting for a 
liability in a prior taxable year.
    (4) Deductions attributable to certain foreign income.
    (b) Special rule in case of death.
    (c) Accrual of real property taxes.
    (1) In general.
    (2) Special rules.
    (3) When election may be made.
    (4) Binding effect of election.
    (5) Apportionment of taxes on real property between seller and 
purchaser.
    (6) Examples.
    (d) Limitation on acceleration of accrual of taxes.
    (e) Dividends or interest paid by certain savings institutions on 
certain deposits or withdrawable accounts.
    (1) Deduction not allowable.
    (2) Computation of amounts not allowed as a deduction.
    (3) When amounts allowable.

                  Sec.  1.461-2 Contested liabilities.

    (a) General rule.
    (1) Taxable year of deduction.
    (2) Exception.
    (3) Refunds includible in gross income.
    (4) Examples.
    (5) Liabilities described in paragraph (g) of Sec.  1.461-4. 
[Reserved]
    (b) Contest of asserted liability.
    (1) Asserted liability.
    (2) Definition of the term ``contest.''
    (3) Example.
    (c) Transfer to provide for the satisfaction of an asserted 
liability.
    (1) In general.
    (2) Examples.
    (d) Contest exists after transfer.
    (e) Deduction otherwise allowed.
    (1) In general.
    (2) Example.
    (f) Treatment of money or property transferred to an escrowee, 
trustee, or court and treatment of any income attributable thereto. 
[Reserved]
    (g) Effective dates.

               Sec.  1.461-3 Prepaid interest. [Reserved]

                   Sec.  1.461-4 Economic performance.

    (a) Introduction.
    (1) In general.
    (2) Overview.
    (b) Exceptions to the economic performance requirement.
    (c) Definitions.
    (1) Liability.
    (2) Payment.
    (d) Liabilities arising out of the provision of services, property, 
or the use of property.
    (1) In general.
    (2) Services or property provided to the taxpayer.
    (3) Use of property provided to the taxpayer.
    (4) Services or property provided by the taxpayer.
    (5) Liabilities that are assumed in connection with the sale of a 
trade or business.
    (6) Rules relating to the provision of services or property to a 
taxpayer.
    (7) Examples.
    (e) Interest.
    (f) Timing of deductions from notional principal contracts.
    (g) Certain liabilities for which payment is economic performance.

[[Page 309]]

    (1) In general.
    (2) Liabilities arising under a workers compensation act or out of 
any tort, breach of contract, or violation of law.
    (3) Rebates and refunds.
    (4) Awards, prizes, and jackpots.
    (5) Insurance, warranty, and service contracts.
    (6) Taxes.
    (7) Other liabilities.
    (8) Examples.
    (h) Liabilities arising under the Nuclear Waste Policy Act of 1982.
    (i) [Reserved]
    (j) Contingent liabilities. [Reserved]
    (k) Special effective dates.
    (1) In general.
    (2) Long-term contracts.
    (3) Payment liabilities.
    (l) [Reserved]
    (m) Change in method of accounting required by this section.
    (1) In general.
    (2) Change in method of accounting for long-term contracts and 
payment liabilities.

                 Sec.  1.461-5 Recurring item exception.

    (a) In general.
    (b) Requirements for use of the exception.
    (1) General rule.
    (2) Amended returns.
    (3) Liabilities that are recurring in nature.
    (4) Materiality requirement.
    (5) Matching requirement.
    (c) Types of liabilities not eligible for treatment under the 
recurring item exception.
    (d) Time and manner of adopting the recurring item exception.
    (1) In general.
    (2) Change to the recurring item exception method for the first 
taxable year beginning after December 31, 1991.
    (3) Retroactive change to the recurring item exception method.
    (e) Examples.

Sec.  1.461-6 Economic performance when certain liabilities are assigned 
           or are extinguished by the establishment of a fund.

    (a) Qualified assignments of certain personal injury liabilities 
under section 130.
    (b) Section 468B.
    (c) Payments to other funds or persons that constitute economic 
performance. [Reserved]
    (d) Effective dates.

[T.D. 8408, 57 FR 12420, Apr. 10, 1992, as amended by T.D. 8593, 60 FR 
18743, Apr. 13, 1995]



Sec.  1.461-1  General rule for taxable year of deduction.

    (a) General rule--(1) Taxpayer using cash receipts and disbursements 
method. Under the cash receipts and disbursements method of accounting, 
amounts representing allowable deductions shall, as a general rule, be 
taken into account for the taxable year in which paid. Further, a 
taxpayer using this method may also be entitled to certain deductions in 
the computation of taxable income which do not involve cash 
disbursements during the taxable year, such as the deductions for 
depreciation, depletion, and losses under sections 167, 611, and 165, 
respectively. If an expenditure results in the creation of an asset 
having a useful life which extends substantially beyond the close of the 
taxable year, such an expenditure may not be deductible, or may be 
deductible only in part, for the taxable year in which made. An example 
is an expenditure for the construction of improvements by the lessee on 
leased property where the estimated life of the improvements is in 
excess of the remaining period of the lease. In such a case, in lieu of 
the allowance for depreciation provided by section 167, the basis shall 
be amortized ratably over the remaining period of the lease. See section 
178 and the regulations thereunder for rules governing the effect to be 
given renewal options in determining whether the useful life of the 
improvements exceeds the remaining term of the lease where a lessee 
begins improvements on leased property after July 28, 1958, other than 
improvements which on such date and at all times thereafter, the lessee 
was under a binding legal obligation to make. See section 263 and the 
regulations thereunder for rules relating to capital expenditures. See 
section 467 and the regulations thereunder for rules under which a 
liability arising out of the use of property pursuant to a section 467 
rental agreement is taken into account.
    (2) Taxpayer using an accrual method--(i) In general. Under an 
accrual method of accounting, a liability (as defined in Sec.  1.446-
1(c)(1)(ii)(B)) is incurred, and generally is taken into account for 
Federal income tax purposes, in the taxable year in which all the events 
have occurred that establish the fact of the liability, the amount of 
the liability can be determined with reasonable accuracy, and economic 
performance

[[Page 310]]

has occurred with respect to the liability. (See paragraph 
(a)(2)(iii)(A) of this section for examples of liabilities that may not 
be taken into account until a taxable year subsequent to the taxable 
year incurred, and see Sec. Sec.  1.461-4 through 1.461-6 for rules 
relating to economic performance.) Applicable provisions of the Code, 
the Income Tax Regulations, and other guidance published by the 
Secretary prescribe the manner in which a liability that has been 
incurred is taken into account. For example, section 162 provides that 
the deductible liability generally is taken into account in the taxable 
year incurred through a deduction from gross income. As a further 
example, under section 263 or 263A, a liability that relates to the 
creation of an asset having a useful life extending substantially beyond 
the close of the taxable year is taken into account in the taxable year 
incurred through capitalization (within the meaning of Sec.  1.263A-
1(c)(3)), and may later affect the computation of taxable income through 
depreciation or otherwise over a period including subsequent taxable 
years, in accordance with applicable Internal Revenue Code sections and 
guidance published by the Secretary. The principles of this paragraph 
(a)(2) also apply in the calculation of earnings and profits and 
accumulated earnings and profits.
    (ii) Uncertainty as to the amount of a liability. While no liability 
shall be taken into account before economic performance and all of the 
events that fix the liability have occurred, the fact that the exact 
amount of the liability cannot be determined does not prevent a taxpayer 
from taking into account that portion of the amount of the liability 
which can be computed with reasonable accuracy within the taxable year. 
For example, A renders services to B during the taxable year for which A 
charges $10,000. B admits a liability to A for $6,000 but contests the 
remainder. B may take into account only $6,000 as an expense for the 
taxable year in which the services were rendered.
    (iii) Alternative timing rules. (A) If any provision of the Code 
requires a liability to be taken into account in a taxable year later 
than the taxable year provided in paragraph (a)(2)(i) of this section, 
the liability is taken into account as prescribed in that Code 
provision. See, for example, section 267 (transactions between related 
parties) and section 464 (farming syndicates).
    (B) If the liability of a taxpayer is subject to section 170 
(charitable contributions), section 192 (black lung benefit trusts), 
section 194A (employer liability trusts), section 468 (mining and solid 
waste disposal reclamation and closing costs), or section 468A (certain 
nuclear decommissioning costs), the liability is taken into account as 
determined under that section and not under section 461 or the 
regulations thereunder. For special rules relating to certain loss 
deductions, see sections 165(e), 165(i), and 165(l), relating to theft 
losses, disaster losses, and losses from certain deposits in qualified 
financial institutions.
    (C) Section 461 and the regulations thereunder do not apply to any 
amount allowable under a provision of the Code as a deduction for a 
reserve for estimated expenses.
    (D) Except as otherwise provided in any Internal Revenue 
regulations, revenue procedure, or revenue ruling, the economic 
performance requirement of section 461(h) and the regulations thereunder 
is satisfied to the extent that any amount is otherwise deductible under 
section 404 (employer contributions to a plan of deferred compensation), 
section 404A (certain foreign deferred compensation plans), or section 
419 (welfare benefit funds). See Sec.  1.461-4(d)(2)(iii).
    (E) Except as otherwise provided by regulations or other published 
guidance issued by the Commissioner (See Sec.  601.601(b)(2) of this 
chapter), in the case of a liability arising out of the use of property 
pursuant to a section 467 rental agreement, the all events test 
(including economic performance) is considered met in the taxable year 
in which the liability is to be taken into account under section 467 and 
the regulations thereunder.
    (3) Effect in current taxable year of improperly accounting for a 
liability in a prior taxable year. Each year's return should be complete 
in itself, and taxpayers shall ascertain the facts necessary to make a 
correct return. The expenses, liabilities, or loss of one year

[[Page 311]]

generally cannot be used to reduce the income of a subsequent year. A 
taxpayer may not take into account in a return for a subsequent taxable 
year liabilities that, under the taxpayer's method of accounting, should 
have been taken into account in a prior taxable year. If a taxpayer 
ascertains that a liability should have been taken into account in a 
prior taxable year, the taxpayer should, if within the period of 
limitation, file a claim for credit or refund of any overpayment of tax 
arising therefrom. Similarly, if a taxpayer ascertains that a liability 
was improperly taken into account in a prior taxable year, the taxpayer 
should, if within the period of limitation, file an amended return and 
pay any additional tax due. However, except as provided in section 
905(c) and the regulations thereunder, if a liability is properly taken 
into account in an amount based on a computation made with reasonable 
accuracy and the exact amount of the liability is subsequently 
determined in a later taxable year, the difference, if any, between such 
amounts shall be taken into account for the later taxable year.
    (4) Deductions attributable to certain foreign income. In any case 
in which, owing to monetary, exchange, or other restrictions imposed by 
a foreign country, an amount otherwise constituting gross income for the 
taxable year from sources without the United States is not includible in 
gross income of the taxpayer for that year, the deductions and credits 
properly chargeable against the amount so restricted shall not be 
deductible in such year but shall be deductible proportionately in any 
subsequent taxable year in which such amount or portion thereof is 
includible in gross income. See paragraph (g) of Sec.  1.905-1 for rules 
relating to credit for foreign income taxes when foreign income is 
subject to exchange controls.
    (b) Special rule in case of death. A taxpayer's taxable year ends on 
the date of his death. See section 443(a)(2) and paragraph (a)(2) of 
Sec.  1.443-1. In computing taxable income for such year, there shall be 
deducted only amounts properly deductible under the method of accounting 
used by the taxpayer. However, if the taxpayer used an accrual method of 
accounting, no deduction shall be allowed for amounts accrued only by 
reason of his death. For rules relating to the inclusion of items of 
partnership deduction, loss, or credit in the return of a decedent 
partner, see subchapter K, chapter 1 of the Code, and the regulations 
thereunder.
    (c) Accrual of real property taxes--(1) In general. If the accrual 
of real property taxes is proper in connection with one of the methods 
of accounting described in section 446(c), any taxpayer using such a 
method of accounting may elect to accrue any real property tax, which is 
related to a definite period of time, ratably over that period in the 
manner described in this paragraph. For example, assume that such an 
election is made by a calendar-year taxpayer whose real property taxes, 
applicable to the period from July 1, 1955, to June 30, 1956, amount to 
$1,200. Under section 461(c), $600 of such taxes accrue in the calendar 
year 1955, and the balance accrues in 1956. For special rule in the case 
of certain contested real property taxes in respect of which the 
taxpayer transfers money or other property to provide for the 
satisfaction of the contested tax, see Sec.  1.461-2. For general rules 
relating to deductions for taxes, see section 164 and the regulations 
thereunder.
    (2) Special rules--(i) Effective date. Section 461(c) and this 
paragraph do not apply to any real property tax allowable as a deduction 
under the Internal Revenue Code of 1939 for any taxable year beginning 
before January 1, 1954.
    (ii) If real property taxes which relate to a period prior to the 
taxpayer's first taxable year beginning on or after January 1, 1954, 
would, but for section 461(c), be deductible in such first taxable year, 
the portion of such taxes which applies to the prior period is 
deductible in such first taxable year (in addition to the amount 
allowable under section 461(c)(1)).
    (3) When election may be made--(i) Without consent. A taxpayer may 
elect to accrue real property taxes ratably in accordance with section 
461(c) and this paragraph without the consent of the Commissioner for 
his first taxable year beginning after December 31, 1953, and ending 
after August 16, 1954, in which the taxpayer incurs real property

[[Page 312]]

taxes. Such election must be made not later than the time prescribed by 
law for filing the return for such year (including extensions thereof). 
An election may be made by the taxpayer for each separate trade or 
business (and for nonbusiness activities, if accounted for separately). 
Such an election shall apply to all real property taxes of the trade, 
business, or nonbusiness activity for which the election is made. The 
election shall be made in a statement submitted with the taxpayer's 
return for the first taxable year to which the election is applicable. 
The statement should set forth:
    (a) The trades or businesses, or nonbusiness activity, to which the 
election is to apply, and the method of accounting used therein;
    (b) The period of time to which the taxes are related; and
    (c) The computation of the deduction for real property taxes for the 
first year of the election (or a summary of such computation).
    (ii) With consent. A taxpayer may elect with the consent of the 
Commissioner to accrue real property taxes ratably in accordance with 
section 461 (c) and this paragraph. A written request for permission to 
make such an election shall be submitted to the Commissioner of Internal 
Revenue, Washington, D.C. 20224, within 90 days after the beginning of 
the taxable year to which the election is first applicable, or before 
March 26, 1958, whichever date is later. The request for permission 
shall state:
    (a) The name and address of the taxpayer;
    (b) The trades or businesses, or nonbusiness activity, to which the 
election is to apply, and the method of accounting used therein;
    (c) The taxable year to which the election first applies;
    (d) The period to which the real property tax relate;
    (e) The computation of the deduction for real property taxes for the 
first year of election (or a summary of such computation); and
    (f) An adequate description of the manner in which all real property 
taxes were deducted in the year prior to the year of election.
    (4) Binding effect of election. An election to accrue real property 
taxes ratably under section 461(c) is binding upon the taxpayer unless 
the consent of the Commissioner is obtained under section 446(e) and 
paragraph (e) of Sec.  1.446-1 to change such method of deducting real 
property taxes. If the last day prescribed by law for filing a return 
for any taxable year (including extensions thereof) to which section 
461(c) is applicable falls before March 25, 1958, consent is hereby 
given for the taxpayer to revoke an election previously made to accrue 
real property taxes in the manner prescribed by section 461(c). If the 
taxpayer revokes his election under the preceding sentence, he must, on 
or before March 25, 1958, notify the district director for the district 
in which the return was filed of such revocation. For any taxable year 
for which such revocation is applicable, an amended return reflecting 
such revocation shall be filed on or before March 25, 1958.
    (5) Apportionment of taxes on real property between seller and 
purchaser. For apportionment of taxes on real property between seller 
and purchaser, see section 164(d) and the regulations thereunder.
    (6) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example 1. A taxpayer on an accrual method reports his taxable 
income for the taxable year ending June 30. He elects to accrue real 
property taxes ratably for the taxable year ending June 30, 1955 (which 
is his first taxable year beginning on or after January 1, 1954). In the 
absence of an election under section 461(c), such taxes would accrue on 
January 1 of the calendar year to which they are related. The real 
property taxes are $1,200 for 1954; $1,600 for 1955; and $1,800 for 
1956. Deductions for such taxes for the fiscal years ending June 30, 
1955, and June 30, 1956, are computed as follows:

                    Fiscal year ending June 30, 1955
July through December 1954.....................................      \1\
                                                                    None
January through June 1955 (\6/12\ of $1,600)...................     $800
  Deduction for fiscal year ending June 30, 1955...............      800
 
\1\ The taxes for 1954 were deductible in the fiscal year ending June
  30, 1954, since such taxes accrued on January 1, 1954.


                    Fiscal year ending June 30, 1956
July through December 1955 (\6/12\ of $1,600)..................     $800
January through June 1956 (\6/12\ of $1,800)...................      900
                                                                --------
  Deduction for fiscal year ending June 30, 1956...............    1,700
 


[[Page 313]]

    Example 2. A calendar-year taxpayer on an accrual method elects to 
accrue real property taxes ratably for 1954. In the absence of an 
election under section 461(c), such taxes would accrue on July 1 and are 
assessed for the 12-month period beginning on that date. The real 
property taxes assessed for the year ending June 30, 1954, are $1,200; 
$1,600 for the year ending June 30, 1955; and $1,800 for the year ending 
June 30, 1956. Deductions for such taxes for the calendar years 1954 and 
1955 are computed as follows:

                      Year ending December 31, 1954
January through June 1954......................................      \1\
                                                                    None
July through December 1954 (\6/12\ of $1,600)..................     $800
                                                                --------
  Deduction for year ending December 31, 1954..................      800
 
\1\ The entire tax of $1,200 for the year ended June 30, 1954, was
  deductible in the return for 1953, since such tax accrued on July 1,
  1953.


                      Year ending December 31, 1955
January through June 1955 (\6/12\ of $1,600)...................     $800
July through December 1955 (\6/12\ of $1,800)..................      900
                                                                --------
  Deduction for year ending December 31, 1955..................    1,700
 

    Example 3. A calendar-year taxpayer on an accrual method elects to 
accrue real property taxes ratably for 1954. In the absence of an 
election under section 461(c), such taxes, which relate to the calendar 
year 1954, are accruable on December 1 of the preceding calendar year. 
No deduction for real property taxes is allowable for the taxable year 
1954 since such taxes accrued in the taxable year 1953 under section 
23(c) of the Internal Revenue Code of 1939.
    Example 4. A taxpayer on an accrual method reports his taxable 
income for the taxable year ending March 31. He elects to accrue real 
property taxes ratably for the taxable year ending March 31, 1955. In 
the absence of an election under section 461(c), such taxes are 
accruable on June 1 of the calendar year to which they relate. The real 
property taxes are $1,200 for 1954; $1,600 for 1955; and $1,800 for 
1956. Deductions for such taxes for the taxable years ending March 31, 
1955, and March 31, 1956, are computed as follows:

                    Fiscal year ending March 31, 1955
April through December 1954 (\9/12\ of $1,200).................     $900
January through March 1955 (\3/12\ of $1,600)..................      400
                                                                --------
  Taxes accrued ratably in fiscal year ending March 31, 1955...    1,800
Tax relating to period January through March 1954, paid in June      300
 1954, and not deductible in prior taxable year (\9/12\ of
 $1,200).......................................................
                                                                --------
  Deduction for fiscal year ending March 31, 1955..............    1,600
                                                                ========
 


                    Fiscal year ending March 31, 1956
April through December 1955 (\9/12\ of $1,600).................   $1,200
January through March 1956 (\3/12\ of $1,800)..................      450
                                                                --------
  Deduction for fiscal year ending March 31, 1956..............    1,650
 

    Example 5. The facts are the same as in Example 4 except that in 
June 1955, when the taxpayer pays his $1,600 real property taxes for 
1955, he pays $400 of such amount under protest. Deductions for taxes 
for the taxable years ending March 31, 1955, and March 31, 1956, are 
computed as follows:

                    Fiscal year ending March 31, 1955
April through December 1954 (\9/12\ of $1,200).................     $900
January through March 1955 (\3/12\ of $1,200, that is, $1,600        300
 minus $400 (the contested portion which is not properly
 accruable))...................................................
                                                                --------
  Taxes accrued ratably in fiscal year ending March 31, 1955...    1,200
 
Tax relating to period January through March 1954, paid in June      300
 1954, and not deductible in prior taxable years (\3/12\ of
 $1,200).......................................................
                                                                --------
  Deduction for fiscal year ending March 31, 1955..............    1,500
                                                                ========
 


                    Fiscal year ending March 31, 1956
April through December 1955 (\9/12\ of $1,200).................     $900
January through March 1956 (\3/12\ of $1,800)..................      450
                                                                --------
  Taxes accrued ratably in fiscal year ending March 31, 1956...    1,350
Contested portion of tax relating to period January through          400
 December 1955, paid in June 1955, and deductible, under
 section 461(f), for taxpayer's fiscal year ending March 31,
 1956..........................................................
                                                                --------
  Deduction for fiscal year ending March 31, 1956..............    1,750
                                                                ========
 


    (d) Limitation on acceleration of accrual of taxes. (1) Section 
461(d)(1) provides that, in the case of a taxpayer whose taxable income 
is computed under an accrual method of accounting, to the extent that 
the time for accruing taxes is earlier than it would be but for any 
action of any taxing jurisdiction taken after December 31, 1960, such 
taxes are to be treated as accruing at the time they would have accrued 
but for such action. Any such action which, but for the provisions of 
section 461(d) and this paragraph, would accelerate the time for 
accruing a tax is to be disregarded in determining the time for accruing 
such tax for purposes of the deduction allowed for such tax. Such action 
is to be disregarded not only with respect to a taxpayer (whose taxable 
income is computed under an accrual method of

[[Page 314]]

accounting) upon whom the tax is imposed at the time of the action, but 
also with respect to such a taxpayer upon whom the tax is imposed at any 
time subsequent to such action. Thus, in the case of a tax imposed on 
property, the acceleration of the time for accruing taxes is to be 
disregarded not only with respect to the taxpayer who owned the property 
at the time of such acceleration, but also with respect to any 
subsequent owner of the property whose taxable income is computed under 
an accrual method of accounting. Similarly, such action is to be 
disregarded with respect to all property subject to such tax, even if 
such property is acquired after the action. Whenever the time for 
accruing taxes is to be disregarded in accordance with the provisions of 
this paragraph, the taxpayer shall accrue the tax at the time (original 
accrual date) the tax would have accrued but for such action, and shall, 
in the absence of any action of the taxing jurisdiction placing the time 
for accruing such tax at a time subsequent to the original accrual date, 
continue to accrue the tax as of the original accrual date for all 
future taxable years.
    (2) For purposes of this paragraph--
    (i) The term ``a taxpayer whose taxable income is computed under an 
accrual method of accounting'' means a taxpayer who, for Federal income 
tax purposes, accounts for any tax which is the subject of ``any 
action'' (as defined in subdivision (iii) of this subparagraph) under an 
accrual method of accounting. See section 446 and the regulations 
thereunder. If a taxpayer uses an accrual method as his overall method 
of accounting, it shall be presumed that he is ``a taxpayer whose 
taxable income is computed under an accrual method of accounting.'' 
However, if the taxpayer establishes to the satisfaction of the district 
director that he has, for Federal income tax purposes, consistently 
accounted for such tax under the cash method of accounting, he shall be 
considered not to be ``a taxpayer whose taxable income is computed under 
an accrual method of accounting.''
    (ii) The time for accruing taxes shall be determined under section 
461 and the regulations in this section.
    (iii) The term ``any action'' includes the enactment or reenactment 
of legislation, the adoption of an ordinance, the exercise of any taxing 
or administrative authority, or the taking of any other step, the result 
of which is an acceleration of the accrual event of any tax. The term 
also applies to the substitution of a substantially similar tax by 
either the original taxing jurisdiction or a substitute jurisdiction. 
However, the term does not include either a judicial interpretation, or 
an administrative determination by the Internal Revenue Service, as to 
the event which fixes the accrual date for the tax.
    (iv) The term ``any taxing jurisdiction'' includes the District of 
Columbia, any State, possession of the United States, city, county, 
municipality, school district, or other political subdivision or 
authority, other than the United States, which imposes, assesses, or 
collects a tax.
    (3) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. State X imposes a tax on intangible and tangible personal 
property used in a trade or business conducted in the State. The tax is 
assessed as of July 1, and becomes a lien as of that date. As a result 
of administrative and judicial decisions, July 1 is recognized as the 
proper date on which accrual method taxpayers may accrue their personal 
property tax for Federal income tax purposes. In 1961 State X, by 
legislative action, changes the assessment and lien dates from July 1, 
1962, to December 31, 1961, for the property tax year 1962. The action 
taken by State X is considered to be ``any action'' of a taxing 
jurisdiction which results in the time for accruing taxes being earlier 
than it would have been but for that action. Therefore, for purposes of 
the deduction allowed for such tax, the personal property tax imposed by 
State X, for the property tax year 1962, shall be treated as though it 
accrued on July 1, 1962.
    Example 2. Assume the same facts as in Example 1 except that State X 
repeals the personal property tax and in lieu thereof enacts a franchise 
tax which is imposed on the privilege of conducting a trade or business 
within State X, and is based on the value of intangible and tangible 
personal property used in the trade or business. The franchise tax is to 
be assessed and will become a lien as of December 31, 1961, for the 
franchise tax year 1962, and on December 31 for all subsequent franchise 
tax years. Since the franchise tax is substantially similar to the 
former personal property tax and since the

[[Page 315]]

enactment of the franchise tax has the effect of accelerating the 
accrual date of the personal property tax from July 1, 1962, to December 
31, 1961, the action taken by State X is considered to be ``any action'' 
of a taxing jurisdiction which results in the time for accruing taxes 
being earlier than it would have been but for that action. Therefore, 
for purposes of the deduction allowed for such tax, the franchise tax 
imposed by State X shall be treated as though it accrued on July 1, 
1962, for the franchise tax year 1962, and on July 1 for all subsequent 
franchise tax years.
    Example 3. Assume the same facts as in Example 1 except that State X 
repealed the personal property tax and empowered the counties within the 
State to impose a personal property tax. Assuming the counties in State 
X subsequently imposed a personal property tax and chose December 31 of 
the preceding year as the assessment and lien date, the action of each 
of the counties would be considered to be ``any action'' of a taxing 
jurisdiction which results in the time for accruing taxes being earlier 
than it would have been but for that action since it is immaterial 
whether the original taxing jurisdiction or a substitute jurisdiction 
took the action.

    (4) Section 461(d)(1) shall not be applicable to the extent that it 
would prevent the taxpayer and all other persons, including successors 
in interest, from ever taking into account, for Federal income tax 
purposes, any tax to which that section would otherwise apply. For 
example, assume that State Y imposes a personal property tax on tangible 
personal property used in a trade or business conducted in the State 
during a calendar year. The tax is assessed as of February 1 of the year 
following the personal property tax year, and becomes a lien as of that 
date. As a result of administrative and judicial decisions, February 1 
of the following year is recognized as the proper date on which accrual 
method taxpayers may accrue the personal property tax for Federal income 
tax purposes. In 1962 State Y, by legislative action, changes the 
assessment and lien dates for the personal property tax year 1962 from 
February 1, 1963, to December 1, 1962, and to December 1 of the personal 
property tax year for all subsequent years. Corporation A, an accrual 
method taxpayer which uses the calendar year as its taxable year, pays 
the tax for 1962 on December 10, 1962. On December 15, 1962, the 
property which was taxed is completely destroyed and, on December 20, 
1962, corporation A transfers all of its remaining assets to its 
shareholders, and is dissolved. Since corporation A is not in existence 
in 1963, and therefore could not take the personal property tax into 
account in computing its 1963 Federal income tax if February 1, 1963, is 
considered to be the time for accruing the tax, and no other person 
could ever take such tax into account in computing his Federal income 
tax, such tax shall be treated as accruing as of December 1, 1962. To 
the extent that any person other than the taxpayer may at any time take 
such tax into account in computing his taxable income, the provisions of 
section 461(d)(1) shall apply. Thus, upon the dissolution of a 
corporation or the termination of a partnership between the time which, 
but for the provisions of section 461(d)(1) and this paragraph, would be 
the time for accruing any tax which was the subject of ``any action'' 
(as defined in subdivision (iii) of subparagraph (2)), and the original 
accrual date, the corporation or the partnership would be entitled to a 
deduction for only that portion, if any, of such tax with respect to 
which it can establish, to the satisfaction of the district director, 
that no other taxpayer can properly take into account in computing his 
taxable income. However, to the extent that the corporation or 
partnership cannot establish, at the time of its dissolution or 
termination, as the case may be, that no other taxpayer would be 
entitled to take such tax into account in computing his taxable income, 
and it is subsequently determined that no other taxpayer is entitled to 
take such tax into account in computing his taxable income, the 
corporation or partnership may file a claim for refund for the year of 
its dissolution or termination (subject to the limitations prescribed in 
section 6511) and claim as a deduction therein the portion of such tax 
determined to be not deductible by any other taxpayer.
    (5) Section 461(d) and this paragraph shall apply to taxable years 
ending after December 31, 1960.
    (e) Dividends or interest paid by certain savings institutions on 
certain deposits or withdrawable accounts--(1) Deduction not allowable--
(i) In general. Except as otherwise provided in this paragraph,

[[Page 316]]

pursuant to section 461(e) amounts paid to, or credited to the accounts 
of, depositors or holders of accounts as dividends or interest on their 
deposits or withdrawable accounts (if such amounts paid or credited are 
withdrawable on demand subject only to customary notice to withdraw) by 
a mutual savings bank not having capital stock represented by shares, a 
domestic building and loan association, or a cooperative bank shall not 
be allowed as a deduction for the taxable year to the extent such 
amounts are paid or credited for periods representing more than 12 
months. The provisions of section 461(e) are applicable with respect to 
taxable years ending after December 31, 1962. Whether amounts are paid 
or credited for periods representing more than 12 months depends upon 
all the facts and circumstances in each case. For example, payments or 
credits which under all the facts and circumstances are in the nature of 
bona fide bonus interest or dividends paid or credited because a 
shareholder or depositor maintained a certain balance for more than 12 
months, will not be considered made for more than 12 months, providing 
the regular payments or credits represent a period of 12 months or less. 
The nonallowance of a deduction to the taxpayer under section 461(e) and 
this subparagraph has no effect either on the proper time for reporting 
dividends or interest by a depositor or holder of a withdrawable 
account, or on the obligation of the taxpayer to make a return setting 
forth, among other things, the aggregate amounts paid to a depositor or 
shareholder under section 6049 (relating to returns regarding payments 
of interest) and the regulations thereunder. With respect to a short 
period (a taxable year consisting of a period of less than 12 months), 
amounts of dividends or interest paid or credited shall not be allowed 
as a deduction to the extent that such amounts are paid or credited for 
a period representing more than the number of months in such short 
period. In such a case, the rules contained in section 461(e) and this 
paragraph apply to the short period in a manner consistent with the 
application of such rules to a 12-month taxable year. Subparagraph (2) 
of this paragraph provides rules for computing amounts not allowed in 
the taxable year and subparagraph (3) provides rules for determining 
when such amounts are allowed. See section 7701(a) (19) and (32) and the 
regulations thereunder for the definitions of domestic building and loan 
association and cooperative bank.
    (ii) Exceptions. The rule of nonallowance set forth in subdivision 
(i) of this subparagraph is not applicable to a taxpayer in the year in 
which it liquidates (other than following, or as part of, an acquisition 
of its assets in which the acquiring corporation, pursuant to section 
381(a), takes into account certain items of the taxpayer, which for 
purposes of this paragraph shall be referred to as an acquisition 
described in section 381(a)). In addition, such rule of nonallowance is 
not applicable to a taxpayer which pays or credits grace interest or 
dividends to terminating depositors or shareholders, provided the total 
amount of the grace interest or dividends paid or credited during the 
payment or crediting period (for example, a quarterly or semiannual 
period) does not exceed 10 percent of the total amount of the interest 
or dividends paid or credited during such period, computed without 
regard to the grace interest or dividends. For example, providing the 10 
percent limitation is met, the rule of nonallowance does not apply in a 
case in which a calendar year taxpayer, with regular interest payment 
dates of January 1, April 1, July 1, and October 1, pays grace interest 
for the period beginning October 1 to a depositor who terminates his 
account on December 10.
    (2) Computation of amounts not allowed as a deduction--(i) Method of 
computation. The amount of the dividends or interest to which 
subparagraph (1) of this paragraph applies, which is not allowed as a 
deduction, shall be computed under the rules of this subparagraph. The 
amount which is not allowed as a deduction is the difference between the 
total amount of dividends or interest paid or credited to that class of 
accounts with respect to which a deduction is not allowed under 
subparagraph (1) of this paragraph during the taxable year (or short 
period, if applicable) and an amount which bears the same ratio

[[Page 317]]

to such total as the number 12 (or number of months in the short period) 
bears to the number of months with respect to which such amounts of 
dividends or interest are paid or credited.
    (ii) Examples. The provisions of subdivision (i) of this 
subparagraph may be illustrated by the following examples:

    Example 1. X Association, a domestic building and loan association 
filing its return on the basis of a calendar year, regularly credits 
dividends on its withdrawable accounts quarterly on the first day of the 
quarter following the quarter with respect to which they are earned. X 
changes the time of crediting dividends commencing with the credit for 
the fourth quarter of 1964. Such credit and all subsequent credits are 
made on the last day of the quarter with respect to which they are 
earned. As a result of this change X's credits for the year 1964 are as 
follows:

------------------------------------------------------------------------
  Period with respect to which earned   Date credited in 1964     Amt.
------------------------------------------------------------------------
4th quarter, 1963.....................  Jan. 1                  $250,000
1st quarter, 1964.....................  Apr. 1                   300,000
2d quarter, 1964......................  July 1                   300,000
3d quarter, 1964......................  Oct. 1                   300,000
4th quarter, 1964.....................  Dec. 31                  350,000
                                       ---------------------------------
   Total dividends credited...........  .....................  1,500,000
------------------------------------------------------------------------


Since the change in the time of crediting dividends results in the 
crediting in 1964 of amounts of dividends representing periods totaling 
15 months (October 1963 through December 1964), amounts shall not be 
allowed as a deduction in 1964 which are in excess of $1,200,000, which 
is the amount which bears the same ratio to the amounts of dividends 
credited during the year ($1,500,000) as the number 12 bears to the 
number of months (15) with respect to which such dividends are credited. 
Thus, $300,000 ($1,500,000 minus $1,200,000) is not allowed as a 
deduction in 1964.
    Example 2. Y Association, a domestic building and loan association 
filing its return on the basis of a calendar year, regularly credits 
dividends on its withdrawable accounts on the basis of a semiannual 
period on March 31 and September 30 of each year. Y changes the period 
with respect to which credits are made from the semiannual period to the 
quarterly basis, commencing with the last quarter in 1964. The credit 
for this last quarter and all subsequent credits are made on the last 
day of the quarter with respect to which they are earned. As a result of 
this change, Y's credits for the year 1964 are as follows:

------------------------------------------------------------------------
  Period with respect to which earned   Date credited in 1964     Amt.
------------------------------------------------------------------------
6-month period ending Mar. 31, 1964...  Mar. 31                 $300,000
6-month period ending Sept. 30, 1964..  Sept. 30                 400,000
4th quarter, 1964.....................  Dec. 31                  200,000
   Total dividends credited...........  .....................    900,000
------------------------------------------------------------------------


Since the change in the basis of crediting dividends results in a 
crediting in 1964 of dividends representing periods totaling 15 months 
(October 1963 through December 1964), amounts shall not be allowed as a 
deduction in 1964 which are in excess of $720,000, which is the amount 
which bears the same ratio to the amounts of dividends credited during 
the year ($900,000) as the number 12 bears to the number of months (15) 
with respect to which such dividends are credited. Thus, $180,000 
($900,000 minus $720,000) is not allowed as a deduction in 1964.
    Example 3. Z Association, a domestic building and loan association 
regularly files its return on the basis of a fiscal year ending on the 
last day of February and regularly credits dividends on its withdrawable 
accounts quarterly on the last day of the quarter with respect to which 
they are earned. Z receives approval from the Commissioner of Internal 
Revenue to change its accounting period to a calendar year and effects 
the change by filing a return for a short period ending on December 31, 
1964. Dividend credits for the short period beginning on March 1 and 
ending on December 31, 1964, are as follows:

------------------------------------------------------------------------
  Period with respect to which earned   Date credited in 1964     Amt.
------------------------------------------------------------------------
January-March 1964....................  Mar. 31                 $250,000
April-June 1964.......................  June 30                  300,000
July-September 1964...................  Sept. 30                 300,000
October-December 1964.................  Dec. 31                  350,000
   Total dividends credited...........  .....................  1,200,000
------------------------------------------------------------------------


Since the change of accounting period results in amounts of dividends 
credited ($1,200,000) representing periods totaling 12 months (January 
through December 1964), and such periods represent more than the number 
of months (10) in the short period, an amount shall not be allowed as a 
deduction in such short period which is in excess of $1,000,000, which 
is the amount which bears the same ratio to the amount of dividends 
credited in the short period ($1,200,000) as the number of months (10) 
in the short period bears to the number of months (12) with respect to 
which such dividends are credited. Thus, $200,000 ($1,200,000 minus 
$1,000,000) is not allowed as a deduction in the short period.


[[Page 318]]


    (3) When amounts allowable. The amount of dividends or interest not 
allowed as a deduction under subparagraph (1) of this paragraph shall be 
allowed as follows (subject to the limitation that the total of the 
amounts so allowed shall not exceed the amount not allowed under 
subparagraph (1)):
    (i) Such amount shall be allowed as a deduction in a later taxable 
year or years subject to the limitation that, when taken together with 
the deductions otherwise allowable in the later taxable year or years, 
it does not bring the deductions for any later taxable year to a total 
representing a period of more than 12 months (or number of months in the 
short period, if applicable). However, in any event, an amount otherwise 
allowable under subdivision (ii) of this subparagraph shall be allowed 
notwithstanding the fact that it may bring the deductions allowable to a 
total representing a period of more than 12 months (or number of months 
in the short period, if applicable).
    (ii) In any case in which it is established to the satisfaction of 
the Commissioner that the taxpayer does not intend to avoid taxes, one-
tenth of such amount shall be allowed as a deduction in each of the 10 
succeeding taxable years--
    (a) Commencing with the taxable year for which such amount is not 
allowed as a deduction under subparagraph (1), or
    (b) In the case of such amount not allowed for a taxable year ending 
before July 1, 1964, commencing with either the first or second taxable 
year after the taxable year for which such amount is not allowed as a 
deduction under subparagraph (1) if the taxpayer has not taken a 
deduction on his return, or filed a claim for credit or refund, in 
respect of such amount under (a).


Normally, if the deduction not allowed under subparagraph (1) is a 
result of a change, not requested by the taxpayer, in the taxpayer's 
annual accounting period or dividend or interest payment or crediting 
dates solely as a consequence of a requirement of a Federal or State 
regulatory authority, or if the deduction is not allowed solely as a 
result of the taxpayer being a party to an acquisition to which section 
381(a) applies, the Commissioner will permit the allowance of the amount 
not allowed in the manner provided in this subdivision. Nothing set 
forth in this subdivision shall be construed as permitting the allowance 
of a credit or refund for any year which is barred by the limitations on 
credit or refund provided by section 6511.
    (iii) If the total of the amounts, if any, allowed under 
subdivisions (i) and (ii) of this subparagraph before the taxable year 
in which the taxpayer liquidates or otherwise ceases to engage in trade 
or business is less than the amount not allowed under subparagraph (1), 
there shall be allowed a deduction in such taxable year for the 
difference between the amount not allowed under subparagraph (1) and the 
amounts allowed, if any, as deductions under subdivisions (i) and (ii) 
unless the circumstances under which the taxpayer ceased to do business 
constitute an acquisition described in section 381(a) (relating to 
carryovers in certain corporate acquisitions). If the circumstances 
under which the taxpayer ceased to do business constitute an acquisition 
described in section 381(a), the acquiring corporation shall succeed to 
and take into account the balance of the amounts not allowed on the same 
basis as the taxpayer, had it not ceased to engage in business.

[T.D. 6500, 25 FR 11720, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting Sec.  
1.461-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.461-2  Contested liabilities.

    (a) General rule--(1) Taxable year of deduction. If--
    (i) The taxpayer contests an asserted liability,
    (ii) The taxpayer transfers money or other property to provide for 
the satisfaction of the asserted liability,
    (iii) The contest with respect to the asserted liability exists 
after the time of the transfer, and
    (iv) But for the fact that the asserted liability is contested, a 
deduction would be allowed for the taxable year of the transfer (or, in 
the case of an accrual method taxpayer, for an earlier

[[Page 319]]

taxable year for which such amount would be accruable),

then the deduction with respect to the contested amount shall be allowed 
for the taxable year of the transfer.
    (2) Exception. Subparagraph (1) of this paragraph shall not apply in 
respect of the deduction for income, war profits, and excess profits 
taxes imposed by the authority of any foreign country or possession of 
the United States, including a tax paid in lieu of a tax on income, war 
profits, or excess profits otherwise generally imposed by any foreign 
country or by any possession of the United States.
    (3) Refunds includible in gross income. If any portion of the 
contested amount which is deducted under subparagraph (1) of this 
paragraph for the taxable year of transfer is refunded when the contest 
is settled, such portion is includible in gross income except as 
provided in Sec.  1.111-1, relating to recovery of certain items 
previously deducted or credited. Such refunded amount is includible in 
gross income for the taxable year of receipt, or for an earlier taxable 
year if properly accruable for such earlier year.
    (4) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example 1. X Corporation, which uses an accrual method of 
accounting, in 1964 contests $20 of a $100 asserted real property tax 
liability but pays the entire $100 to the taxing authority. In 1968, the 
contest is settled and X receives a refund of $5. X deducts $100 for the 
taxable year 1964, and includes $5 in gross income for the taxable year 
1968 (assuming Sec.  1.111-1 does not apply to such amount). If in 1964 
X pays only $80 to the taxing authority, X deducts only $80 for 1964. 
The result would be the same if X Corporation used the cash method of 
accounting.
    Example 2. Y Corporation makes its return on the basis of a calendar 
year and uses an accrual method of accounting. Y's real property taxes 
are assessed and become a lien on December 1, but are not payable until 
March 1 of the following year. On December 10, 1964, Y contests $20 of 
the $100 asserted real property tax which was assessed and became a lien 
on December 1, 1964. On March 1, 1965, Y pays the entire $100 to the 
taxing authority. In 1968, the contest is settled and Y receives a 
refund of $5. Y deducts $80 for the taxable year 1964, deducts $20 for 
the taxable year 1965, and includes $5 in gross income for the taxable 
year 1968 (assuming Sec.  1.111-1 does not apply to such amount).

    (b) Production costs--(1) In general; asserted liability. For 
purposes of paragraph (a)(1) of this section, the term ``asserted 
liability'' means an item with respect to which, but for the existence 
of any contest in respect of such item, a deduction would be allowable 
under an accrual method of accounting. For example, a notice of a local 
real estate tax assessment and a bill received for services may 
represent asserted liabilities.
    (2) Definition of the term ``contest''. Any contest which would 
prevent accrual of a liability under section 461(a) shall be considered 
to be a contest in determining whether the taxpayer satisfies paragraph 
(a)(1)(i) of this section. A contest arises when there is a bona fide 
dispute as to the proper evaluation of the law or the facts necessary to 
determine the existence or correctness of the amount of an asserted 
liability. It is not necessary to institute suit in a court of law in 
order to contest an asserted liability. An affirmative act denying the 
validity or accuracy, or both, of an asserted liability to the person 
who is asserting such liability, such as including a written protest 
with payment of the asserted liability, is sufficient to commence a 
contest. Thus, lodging a protest in accordance with local law is 
sufficient to contest an asserted liability for taxes. It is not 
necessary that the affirmative act denying the validity or accuracy, or 
both, of an asserted liability be in writing if, upon examination of all 
the facts and circumstances, it can be established to the satisfaction 
of the Commissioner that a liability has been asserted and contested.
    (3) Example. The provisions of this paragraph are illustrated by the 
following example:

    Example: O Corporation makes its return on the basis of a calendar 
year and uses an accrual method of accounting. O receives a large 
shipment of typewriter ribbons from S Company on January 30, 1964, which 
O pays for in full on February 10, 1964. Subsequent to their receipt, 
several of the ribbons prove defective because of inferior materials 
used by the manufacturer. On August 9, 1964, O orally notifies S and 
demands refund of the full purchase price of the ribbons. After 
negotiations prove futile and a written demand is rejected by S, O 
institutes an action for

[[Page 320]]

the full purchase price. For purposes of paragraph (a)(1)(i) of this 
section, S has asserted a liability against O which O contests on August 
9, 1964. O deducts the contested amount for 1964.

    (c) Transfer to provide for the satisfaction of an asserted 
liability--(1) In general. (i) A taxpayer may provide for the 
satisfaction of an asserted liability by transferring money or other 
property beyond his control to--
    (A) The person who is asserting the liability;
    (B) An escrowee or trustee pursuant to a written agreement (among 
the escrowee or trustee, the taxpayer, and the person who is asserting 
the liability) that the money or other property be delivered in 
accordance with the settlement of the contest;
    (C) An escrowee or trustee pursuant to an order of the United States 
or of any State or political subdivision thereof or any agency or 
instrumentality of the foregoing, or of a court, that the money or other 
property be delivered in accordance with the settlement of the contest; 
or
    (D) A court with jurisdiction over the contest.
    (ii) In order for money or other property to be beyond the control 
of a taxpayer, the taxpayer must relinquish all authority over the money 
or other property.
    (iii) The following are not transfers to provide for the 
satisfaction of an asserted liability--
    (A) Purchasing a bond to guarantee payment of the asserted 
liability;
    (B) An entry on the taxpayer's books of account;
    (C) A transfer to an account that is within the control of the 
taxpayer;
    (D) A transfer of any indebtedness of the taxpayer or of any promise 
by the taxpayer to provide services or property in the future; and
    (E) A transfer to a person (other than the person asserting the 
liability) of any stock of the taxpayer or of any stock or indebtedness 
of a person related to the taxpayer (as defined in section 267(b)).
    (2) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example 1. M Corporation contests a $5,000 liability asserted 
against it by L Company for services rendered. To provide for the 
contingency that it might have to pay the liability, M establishes a 
separate bank account in its own name. M then transfers $5,000 from its 
general account to such separate account. Such transfer does not qualify 
as a transfer to provide for the satisfaction of an asserted liability 
because M has not transferred the money beyond its control.
    Example 2. M Corporation contests a $5,000 liability asserted 
against it by L Company for services rendered. To provide for the 
contingency that it might have to pay the liability, M transfers $5,000 
to an irrevocable trust pursuant to a written agreement among the 
trustee, M (the taxpayer), and L (the person who is asserting the 
liability) that the money shall be held until the contest is settled and 
then disbursed in accordance with the settlement. Such transfer 
qualifies as a transfer to provide for the satisfaction of an asserted 
liability.

    (d) Contest exists after transfer. In order for a contest with 
respect to an asserted liability to exist after the time of transfer, 
such contest must be pursued subsequent to such time. Thus, the contest 
must have been neither settled nor abandoned at the time of the 
transfer. A contest may be settled by a decision, judgment, decree, or 
other order of any court of competent jurisdiction which has become 
final, or by written or oral agreement between the parties. For example, 
Z Corporation, which uses an accrual method of accounting, in 1964 
contests a $100 asserted liability. In 1967 the contested liability is 
settled as being $80 which Z accrues and deducts for such year. In 1968 
Z pays the $80. Section 461(f) does not apply to Z with respect to the 
transfer because a contest did not exist after the time of such 
transfer.
    (e) Deduction otherwise allowed--(1) In general. The existence of 
the contest with respect to an asserted liability must prevent (without 
regard to section 461(f)) and be the only factor preventing a deduction 
for the taxable year of the transfer (or, in the case of an accrual 
method taxpayer, for an earlier taxable year for which such amount would 
be accruable) to provide for the satisfaction of such liability. Nothing 
in section 461(f) or this section shall be construed to give rise to a 
deduction since section 461(f) and this section relate only to the 
timing of deductions which are otherwise allowable under the Code.

[[Page 321]]

    (2) Application of economic performance rules to transfers under 
section 461(f). (i) A taxpayer using an accrual method of accounting is 
not allowed a deduction under section 461(f) in the taxable year of the 
transfer unless economic performance has occurred.
    (ii) Economic performance occurs for liabilities requiring payment 
to another person arising out of any workers compensation act or any 
tort, or any other liability designated in Sec.  1.461-4(g), as payments 
are made to the person to which the liability is owed. Except as 
provided in section 468B or the regulations thereunder, economic 
performance does not occur when a taxpayer transfers money or other 
property to a trust, an escrow account, or a court to provide for the 
satisfaction of an asserted workers compensation, tort, or other 
liability designated under Sec.  1.461-4(g) that the taxpayer is 
contesting unless the trust, escrow account, or court is the person to 
which the liability is owed or the taxpayer's payment to the trust, 
escrow account, or court discharges the taxpayer's liability to the 
claimant. Rather, economic performance occurs in the taxable year the 
taxpayer transfers money or other property to the person that is 
asserting the workers compensation, tort, or other liability designated 
under Sec.  1.461-4(g) that the taxpayer is contesting or in the taxable 
year that payment is made from a trust, an escrow account, or a court 
registry funded by the taxpayer to the person to which the liability is 
owed.
    (3) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example 1. A, an individual, makes a gift of certain property to B, 
an individual. A pays the entire amount of gift tax assessed against him 
but contests his liability for the tax. Section 275(a)(3) provides that 
gift taxes are not deductible. A does not satisfy the requirement of 
paragraph (a)(1)(iv) of this section because a deduction would not be 
allowed for the taxable year of the transfer even if A did not contest 
his liability to the tax.
    Example 2. Corporation X is a defendant in a class action suit for 
tort liabilities. In 2002, X establishes a trust for the purpose of 
satisfying the asserted liability and transfers $10,000,000 to the 
trust. The trust does not satisfy the requirements of section 468B or 
the regulations thereunder. In 2004, the trustee pays $10,000,000 to the 
plaintiffs in settlement of the litigation. Under paragraph (e)(2) of 
this section, economic performance with respect to X's liability to the 
plaintiffs occurs in 2004. X may deduct the $10,000,000 payment to the 
plaintiffs in 2004.

    (f) Treatment of money or property transferred to an escrowee, 
trustee, or court and treatment of any income attributable thereto. 
[Reserved]
    (g) Effective dates. (1) Except as otherwise provided, this section 
applies to transfers of money or other property in taxable years 
beginning after December 31, 1953, and ending after August 16, 1954.
    (2) Paragraph (c)(1)(iii)(E) of this section applies to transfers of 
any stock of the taxpayer or any stock or indebtedness of a person 
related to the taxpayer on or after November 19, 2003.
    (3) Paragraph (e)(2)(i) of this section applies to transfers of 
money or other property after July 18, 1984.
    (4) Paragraph (e)(2)(ii) and paragraph (e)(3) Example 2 of this 
section apply to--
    (i) Transfers after July 18, 1984, of money or other property to 
provide for the satisfaction of an asserted workers compensation or tort 
liability; and
    (ii) Transfers in taxable years beginning after December 31, 1991, 
of money or other property to provide for the satisfaction of asserted 
liabilities designated in Sec.  1.461-4(g) (other than liabilities for 
workers compensation or tort).

[T.D. 6772, 29 FR 15753, Nov. 24, 1964, as amended by T.D. 8408, 57 FR 
12421, Apr. 10, 1992; T.D. 9095, 68 FR 65636, Nov. 21, 2003; T.D. 9140, 
69 FR 43303, July 20, 2004]



Sec.  1.461-3  Prepaid interest. [Reserved]



Sec.  1.461-4  Economic performance.

    (a) Introduction--(1) In general. For purposes of determining 
whether an accrual basis taxpayer can treat the amount of any liability 
(as defined in Sec.  1.446-1(c)(1)(ii)(B)) as incurred, the all events 
test is not treated as met any earlier than the taxable year in which 
economic performance occurs with respect to the liability.
    (2) Overview. Paragraph (b) of this section lists exceptions to the 
economic performance requirement. Paragraph (c) of this section provides 
cross-

[[Page 322]]

references to the definitions of certain terms for purposes of section 
461 (h) and the regulations thereunder. Paragraphs (d) through (m) of 
this section and Sec.  1.461-6 provide rules for determining when 
economic performance occurs. Section 1.461-5 provides rules relating to 
an exception under which certain recurring items may be incurred for the 
taxable year before the year during which economic performance occurs.
    (b) Exceptions to the economic performance requirement. Paragraph 
(a)(2)(iii)(B) of Sec.  1.461-1 provides examples of liabilities that 
are taken into account under rules that operate without regard to the 
all events test (including economic performance).
    (c) Definitions. The following cross-references identify certain 
terms defined for purposes of section 461(h) and the regulations 
thereunder:
    (1) Liability. See paragraph (c)(1)(ii)(B)d of Sec.  1.446-1 for the 
definition of ``liability.''
    (2) Payment. See paragraph (g)(1)(ii) of this section for the 
definition of ``payment.''
    (d) Liabilities arising out of the provision of services, property, 
or the use of property--(1) In general. The principles of this paragraph 
(d) determine when economic performance occurs with respect to 
liabilities arising out of the performance of services, the transfer of 
property, or the use of property. This paragraph (d) does not apply to 
liabilities described in paragraph (e) (relating to interest expense) or 
paragraph (g) (relating to breach of contract, workers compensation, 
tort, etc.) of this section. In addition, except as otherwise provided 
in Internal Revenue regulations, revenue procedures, or revenue rulings 
this paragraph (d) does not apply to amounts paid pursuant to a notional 
principal contract. The Commissioner may provide additional rules in 
regulations, revenue procedures, or revenue rulings concerning the time 
at which economic performance occurs for items described in this 
paragraph (d).
    (2) Services or property provided to the Taxpayer--(i) In general. 
Except as otherwise provided in paragraph (d)(5) of this section, if the 
liability of a taxpayer arises out of the providing of services or 
property to the taxpayer by another person, economic performance occurs 
as the services or property is provided.
    (ii) Long-term contracts. In the case of any liability of a taxpayer 
described in paragraph (d)(2)(i) of this section that is an expense 
attributable to a long-term contract with respect to which the taxpayer 
uses the percentage of completion method, economic performance occurs--
    (A) As the services or property is provided; or, if earlier,
    (B) As the taxpayer makes payment (as defined in paragraph 
(g)(1)(ii) of this section) in satisfaction of the liability to the 
person providing the services or property. See paragraph (k)(2) of this 
section for the effective date of this paragraph (d)(2)(ii).
    (iii) Employee benefits--(A) In general. Except as otherwise 
provided in any Internal Revenue regulation, revenue procedure, or 
revenue ruling, the economic performance requirement is satisfied to the 
extent that any amount is otherwise deductible under section 404 
(employer contributions to a plan of deferred compensation), section 
404A (certain foreign deferred compensation plans), and section 419 
(welfare benefit funds). See Sec.  1.461-1(a)(2)(iii)(D).
    (B) Property transferred in connection with performance of services. 
[Reserved]
    (iv) Cross-references. See Examples 4 through 6 of paragraph (d)(7) 
of this section. See paragraph (d)(6) of this section for rules relating 
to when a taxpayer may treat services or property as provided to the 
taxpayer.
    (3) Use of property provided to the taxpayer--(i) In general. Except 
as otherwise provided in this paragraph (d)(3)d and paragraph (d)(5) of 
this section, if the liability of a taxpayer arises out of the use of 
property by the taxpayer, economic performance occurs ratably over the 
period of time the taxpayer is entitled to the use of the property 
(taking into account any reasonably expected renewal periods when 
necessary to carry out the purposes of section 461(h)). See Examples 6 
through 9 of paragraph (d)(7) of this section.
    (ii) Exceptions--(A) Volume, frequency of use, or income. If the 
liability of a

[[Page 323]]

taxpayer arises out of the use of property by the taxpayer and all or a 
portion of the liability is determined by reference to the frequency or 
volume of use of the property or the income from the property, economic 
performance occurs for the portion of the liability determined by 
reference to the frequency or volume of use of the property or the 
income from the property as the taxpayer uses the property or includes 
income from the property. See Examples 8 and 9 of paragraph (d)(7) of 
this section. This paragraph (d)(3)(ii) shall not apply if the District 
Director determines, that based on the substance of the transaction, the 
liability of the taxpayer for use of the property is more appropriately 
measured ratably over the period of time the taxpayer is entitled to the 
use of the property.
    (B) Section 467 rental agreements. In the case of a liability 
arising out of the use of property pursuant to a section 467 rental 
agreement, economic performance occurs as provided in Sec.  1.461-
1(a)(2)(iii)(E).
    (4) Services or property provided by the taxpayer--(i) In general. 
Except as otherwise provided in paragraph (d)(5) of this section, if the 
liability of a taxpayer requires the taxpayer to provide services or 
property to another person, economic performance occurs as the taxpayer 
incurs costs (within the meaning of Sec.  1.446-1(c)(1)(ii)) in 
connection with the satisfaction of the liability. See Examples 1 
through 3 of paragraph (d)(7) of this section.
    (ii) Barter transactions. If the liability of a taxpayer requires 
the taxpayer to provide services, property, or the use of property, and 
arises out of the use of property by the taxpayer, or out of the 
provision of services or property to the taxpayer by another person, 
economic performance occurs to the extent of the lesser of--
    (A) The cumulative extent to which the taxpayer incurs costs (within 
the meaning of Sec.  1.446-1(c)(1)(ii)) in connection with its liability 
to provide the services of property; or
    (B) The cumulative extent to which the services or property is 
provided to the taxpayer.
    (5) Liabilities that are assumed in connection with the sale of a 
trade or business--(i) In general. If, in connection with the sale or 
exchange of a trade or business by a taxpayer, the purchaser expressly 
assumes a liability arising out of the trade or business that the 
taxpayer but for the economic performance requirement would have been 
entitled to incur as of the date of the sale, economic performance with 
respect to that liability occurs as the amount of the liability is 
properly included in the amount realized on the transaction by the 
taxpayer. See Sec.  1.1001-2 for rules relating to the inclusion in 
amount realized from a discharge of liabilities resulting from a sale or 
exchange.
    (ii) Trade or business. For purposes of this paragraph (d)(5), a 
trade or business is a specific group of activities carried on by the 
taxpayer for the purpose of earning income or profit if every operation 
that is necessary to the process of earning income or profit is included 
in the group. Thus, for example, the group of activities generally must 
include the collection of income and the payment of expenses.
    (iii) Tax avoidance. This paragraph (d)(5) does not apply if the 
District Director determines that tax avoidance is one of the taxpayer's 
principal purposes for the sale or exchange.
    (6) Rules relating to the provision of services or property to a 
taxpayer. The following rules apply for purposes of this paragraph (d):
    (i) Services or property provided to a taxpayer include services or 
property provided to another person at the direction of the taxpayer.
    (ii) A taxpayer is permitted to treat services or property as 
provided to the taxpayer as the taxpayer makes payment to the person 
providing the services or property (as defined in paragraph (g)(1)(ii) 
of this section), if the taxpayer can reasonably expect the person to 
provide the services or property within 3\1/2\ months after the date of 
payment.
    (iii) A taxpayer is permitted to treat property as provided to the 
taxpayer when the property is delivered or accepted, or when title to 
the property passes. The method used by the taxpayer to determine when 
property is provided is a method of accounting that must comply with the 
rules of

[[Page 324]]

Sec.  1.446-1(e). Thus, the method of determining when property is 
provided must be used consistently from year to year, and cannot be 
changed without the consent of the Commissioner.
    (iv) If different services or items of property are required to be 
provided to a taxpayer under a single contract or agreement, economic 
performance generally occurs over the time each service is provided and 
as each item of property is provided. However, if a service or item of 
property to be provided to the taxpayer is incidental to other services 
or property to be provided under a contract or agreement, the taxpayer 
is not required to allocate any portion of the total contract price to 
the incidental service or property. For purposes of this paragraph 
(d)(6)(iv), services or property is treated as incidental only if--
    (A) The cost of the services or property is treated on the 
taxpayer's books and records as part of the cost of the other services 
or property provided under the contract; and
    (B) The aggregate cost of the services or property does not exceed 
10 percent of the total contract price.
    (7) Examples. The following examples illustrate the principles of 
this paragraph (d). For purposes of these examples, it is assumed that 
the requirements of the all events test other than economic performance 
have been met, and that the recurring item exception is not used. Assume 
further that the examples do not involve section 467 rental agreements 
and, therefore, section 467 is not applicable. The examples are as 
follows:

    Example 1. Services or property provided by the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, is an oil 
company. During March 1990, X enters into an oil and gas lease with Y. 
In November 1990, X installs a platform and commences drilling. The 
lease obligates X to remove its offshore platform and well fixtures upon 
abandonment of the well or termination of the lease. During 1998, X 
removes the platform and well fixtures at a cost of $200,000.
    (ii) Under paragraph (d)(4)(i) of this section, economic performance 
with respect to X's liability to remove the offshore platform and well 
fixtures occurs as X incurs costs in connection with that liability. X 
incurs these costs in 1998 as, for example, X's employees provide X with 
removal services (see paragraph (d)(2) of this section). Consequently, X 
incurs $200,000 for the 1998 taxable year. Alternatively, assume that 
during 1990 X pays Z $130,000 to remove the platform and fixtures, and 
that Z performs these removal services in 1998. Under paragraph (d)(2) 
of this section, X does not incur this cost until Z performs the 
services. Thus, economic performance with respect to the $130,000 X pays 
Z occurs in 1998.
    Example 2. Services or property provided by the taxpayer. (i) W 
corporation, a calendar year, accrual method taxpayer, sells tractors 
under a three-year warranty that obligates W to make any reasonable 
repairs to each tractor it sells. During 1990, W sells ten tractors. In 
1992 W repairs, at a cost of $5,000, two tractors sold during 1990.
    (ii) Under paragraph (d)(4)(i) of this section, economic performance 
with respect to W's liability to perform services under the warranty 
occurs as W incurs costs in connection with that liability. W incurs 
these costs in 1992 as, for example, replacement parts are provided to W 
(see paragraph (d)(2) of this section). Consequently, $5,000 is incurred 
by W for the 1992 taxable year.
    Example 3. Services or property provided by the taxpayer; Long-term 
contracts. (i) W corporation, a calendar year, accrual method taxpayer, 
manufactures machine tool equipment. In November 1992, W contracts to 
provide X corporation with certain equipment. The contract is not a 
long-term contract under section 460 or Sec.  1.451-3. In 1992, W pays Z 
corporation $50,000 to lease from Z, for the one-year period beginning 
on January 1, 1993, testing equipment to perform quality control tests 
required by the agreement with X. In 1992, pursuant to the terms of a 
contract, W pays Y corporation $100,000 for certain parts necessary to 
manufacture the equipment. The parts are provided to W in 1993. W's 
employees provide W with services necessary to manufacture the equipment 
during 1993, for which W pays $150,000 in 1993.
    (ii) Under paragraph (d)(4) of this section, economic performance 
with respect to W's liability to provide the equipment to X occurs as W 
incurs costs in connection with that liability. W incurs these costs 
during 1993, as services, property, and the use of property necessary to 
manufacture the equipment are provided to W (see paragraphs (d)(2) and 
(d)(3) of this section). Thus, $300,000 is incurred by W for the 1993 
taxable year. See section 263A and the regulations thereunder for rules 
relating to the capitalization and inclusion in inventory of these 
incurred costs.
    (iii) Alternatively, assume that the agreement with X is a long-term 
contract as defined in section 460(f), and that W takes into account all 
items with respect to such contracts under the percentage of completion 
method as described in section 460(b)(1). Under paragraph (d)(2)(ii) of 
this section, the $100,000 W pays in 1992 for parts is incurred

[[Page 325]]

for the 1992 taxable year, for purposes of determining the percentage of 
completion under section 460(b)(1)(A). W's other costs under the 
agreement are incurred for the 1993 taxable year for this purpose.
    Example 4. Services or property provided to the taxpayers. (i) LP1, 
a calendar year, accrual method limited partnership, owns the working 
interest in a parcel of property containing oil and gas. During December 
1990, LP1 enters into a turnkey contract with Z corporation pursuant to 
which LP1 pays Z $200,000 and Z is required to provide a completed well 
by the close of 1992. In May 1992, Z commences drilling the well, and, 
in December 1992, the well is completed.
    (ii) Under paragraph (d)(2) of this section, economic performance 
with respect to LP1's liability for drilling and development services 
provided to LP1 by Z occurs as the services are provided. Consequently, 
$200,000 is incurred by LP1 for the 1992 taxable year.
    Example 5. Services or property provided to the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, is an automobile 
dealer. On Jaunary 15, 1990, X agrees to pay an additional $10 to Y, the 
manufacturer of the automobiles, for each automobile purchased by X from 
Y. Y agrees to provide advertising and promotional activities to X.
    (ii) During 1990, X purchases from Y 1,000 new automobiles and pays 
to Y an additional $10,000 as provided in the agreement. Y, in turn, 
uses this $10,000 to provide advertising and promotional activities 
during 1992.
    (iii) Under paragraph (d)(2) of this section, economic performance 
with respect to X's liability for advertising and promotional services 
provided to X by Y occurs as the services are provided. Consequently, 
$10,000 is incurred by X for the 1992 taxable year.
    Example 6. Use of property provided to the taxpayer; services or 
property provided to the taxpayer. (i) V corporation, a calendar year, 
accrual method taxpayer, charters aircrafts. On December 20, 1990, V 
leases a jet aircraft from L for the four-year period that begins on 
January 1, 1991. The lease obligates V to pay L a base rental of 
$500,000 per year. In addition, the lease requires V to pay $25 to an 
escrow account for each hour that the aircraft is flown. The escrow 
account funds are held by V and are to be used by L to make necessary 
repairs to the aircraft. Any amount remaining in the escrow account upon 
termination of the lease is payable to V. During 1991, the aircraft is 
flown 1,000 hours and V pays $25,000 to the escrow account. The aircraft 
is repaired by L in 1993. In 1994, $20,000 is released from the escrow 
account to pay L for the repairs.
    (ii) Under paragraph (d)(3)(i) of this section, economic performance 
with respect to V's base rental liability occurs ratably over the period 
of time V is entitled to use the jet aircraft. Consequently, the 
$500,000 rent is incurred by V for the 1991 taxable year and for each of 
the next three taxable years. Under paragraph (d)(2) of this section, 
economic performance with respect to the liability to place amounts in 
escrow occurs as the aircraft is repaired. Consequently, V incurs $20,00 
for the 1993 taxable year.
    Example 7. Use of property provided to the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, manufactures and 
sells electronic circuitry. On November 15, 1990, X enters into a 
contract with Y that entitles X to the exclusive use of a product owned 
by Y for the five-year period beginning on January 1, 1991. Pursuant to 
the contract, X pays Y $100,000 on December 30, 1990.
    (ii) Under paragraph (d)(3)(i) of this section, economic performance 
with respect to X's liability for the use of property occurs ratably 
over the period of time X is entitled to use the product. Consequently, 
$20,000 is incurred by X for 1991 and for each of the succeeding four 
taxable years.
    Example 8. Use of property provided to the taxpayer. (i) Y 
corporation, a calendar year, accrual method taxpayer, enters into a 
five-year lease with Z for the use of a copy machine on July 1, 1991. Y 
also receives elivery of the copy machine on July 1, 1991. The lease 
obligates Y to pay Z a base rental payment of $6,000 per year at the 
beginning of each lease year and an additional charge of 5 cents per 
copy 30 days after the end of each lease year. The machine is used to 
make 50,000 copies during the first lease year: 20,000 copies in 1991 
and 30,000 copies from January 1, 1992, to July 1, 1992. Y pays the 
$6,000 base rental payment to Z on July 1, 1991, and the $2,500 variable 
use payment on July 30, 1992.
    (ii) under paragraph (d)(3)(i) of this section, economic performance 
with respect to Y's base rental liability occurs ratably over the period 
of time Y is entitled to use the copy machine. Consequently, $3,000 rent 
is incurred by Y for the 1991 taxable year. Under paragraph (d)(3)(ii) 
of this section, economic performance with respect to Y's variable use 
portion of the liability occurs as Y uses the machine. Thus, the $1,000 
of the $2,500 variable-use liability that relates to the 20,000 copies 
made in 1991 is incurred by Y for the 1991 taxable year.
    Example 9. Use of property provided to the taxpayer. (i) X 
corporation, a calendar year, accrual method taxpayer, enters into a 
five-year product distribution agreement with Y, on January 1, 1992. The 
agreement provides for a payment of $100,000 on January 1, 1992, plus 10 
percent of the gross profits earned by X from distribution of the 
product. The variable income portion of X's liability is payable on 
April 1 of each subsequent year. On January 1, 1992, X pays Y $100,000. 
On April 1, 1993, X pays Y $3 million representing 10 percent of X's 
gross profits from January 1 through December 31, 1992.

[[Page 326]]

    (ii) Under paragraph (d)(3)(i) of this section, economic performance 
with respect to X's $100,000 payment occurs ratably over the period of 
time X is entitled to use the product. Consequently, $20,000 is incurred 
by X for each year of the agreement beginning with 1992. Under paragraph 
(d)(3)(ii) of this section, economic performance with respect to X's 
variable income portion of the liability occurs as the income is earned 
by X. Thus, the $3 million variable-income liability is incurred by X 
for the 1992 taxable year.

    (e) Interest. In the case of interest, economic performance occurs 
as the interest cost economically accrues, in accordance with the 
principles of relevant provisions of the Code.
    (f) Timing of deductions from notional principal contracts. Economic 
performance on a notional principal contract occurs as provided under 
Sec.  1.446-3.
    (g) Certain liabilities for which payment is economic performance--
(1) In general--(i) Person to which payment must be made. In the case of 
liabilities described in paragraphs (g) (2) through (7) of this section, 
economic performance occurs when, and to the extent that, payment is 
made to the person to which the liability is owed. Thus, except as 
otherwise provided in paragraph (g)(1)(iv) of this section and Sec.  
1.461-6, economic performance does not occur as a taxpayer makes 
payments in connection with such a liability to any other person, 
including a trust, escrow account, court-administered fund, or any 
similar arrangement, unless the payments constitute payment to the 
person to which the liability is owed under paragraph (g)(1)(ii)(B) of 
this section. Instead, economic performance occurs as payments are made 
from that other person or fund to the person to which the liability is 
owed. The amount of economic performance that occurs as payment is made 
from the other person or fund to the person to which the liability is 
owed may not exceed the amount the taxpayer transferred to the other 
person or fund. For special rules relating to the taxation of amounts 
transferred to ``qualified settlement funds,'' see section 468B and the 
regulations thereunder. The Commissioner may provide additional rules in 
regulations, revenue procedures, and revenue rulings concerning the time 
at which economic performance occurs for items described in this 
paragraph (g).
    (ii) Payment to person to which liability is owed. Paragraph (d)(6) 
of this section provides that for purposes of paragraph (d) of this 
section (relating to the provision of services or property to the 
taxpayer) in certain cases a taxpayer may treat services or property as 
provided to the taxpayer as the taxpayer makes payments to the person 
providing the services or property. In addition, this paragraph (g) 
provides that in the case of certain liabilities of a taxpayer, economic 
performance occurs as the taxpayer makes payment to persons specified 
therein. For these and all other purposes of section 461(h) and the 
regulations thereunder:
    (A) Payment. The term payment has the same meaning as is used when 
determining whether a taxpayer using the cash receipts and disbursements 
method of accounting has made a payment. Thus, for example, payment 
includes the furnishing of cash or cash equivalents and the netting of 
offsetting accounts. Payment does not include the furnishing of a note 
or other evidence of indebtedness of the taxpayer, whether or not the 
evidence is guaranteed by any other instrument (including a standby 
letter of credit) or by any third party (including a government agency). 
As a further example, payment does not include a promise of the taxpayer 
to provide services or property in the future (whether or not the 
promise is evidenced by a contract or other witten agreement). In 
addition, payment does not include an amount transferred as a loan, 
refundable deposit, or contingent payment.
    (B) Person to which payment is made. Payment to a particular person 
is accomplished if paragraph (g)(1)(ii)(A) of this section is satisfied 
and a cash basis taxpayer in the position of that person would be 
treated as having actually or constructively received the amount of the 
payment as gross income under the principles of section 451 (without 
regard to section 104(a) or any other provision that specifically 
excludes the amount from gross income). Thus, for example, the purchase 
of an annuity contract or any other asset generally does not constitute 
payment to the person to which a liability is

[[Page 327]]

owed unless the ownership of the contract or other asset is transferred 
to that person.
    (C) Liabilities that are assumed in connection with the sale of a 
trade or business. Paragraph (d)(5) of this section provides rules that 
determine when economic performance occurs in the case of liabilities 
that are assumed in connection with the sale of a trade or business. The 
provisions of paragraph (d)(5) of this section also apply to any 
liability described in paragraph (g) (2) through (7) of this section 
that the purchaser expressly assumes in connection with the sale or 
exchange of a trade or business by a taxpayer, provided the taxpayer 
(but for the economic performance requirement) would have been entitled 
to incur the liability as of the date of the sale.
    (iii) Person. For purposes of this paragraph (g), ``person'' has the 
same meaning as in section 7701(a)(1), except that it also includes any 
foreign state, the United States, any State or political subdivision 
thereof, any possession of the United States, and any agency or 
instrumentality of any of the foregoing.
    (iv) Assignments. If a person that has a right to receive payment in 
satisfaction of a liability described in paragraphs (g) (2) through (7) 
of this section makes a valid assignment of that right to a second 
person, or if the right is assigned to the second person through 
operation of law, then payment to the second person in satisfaction of 
that liability constitutes payment to the person to which the liability 
is owed.
    (2) Liabilities arising under a workers compensation act or out of 
any tort, breach of contract, or violation of law. If the liability of a 
taxpayer requires a payment or series of payments to another person and 
arises under any workers compensation act or out of any tort, breach of 
contract, or violation of law, economic performance occurs as payment is 
made to the person to which the liability is owed. See Example 1 of 
paragraph (g)(8) of this section. For purposes of this paragraph 
(g)(2)--
    (i) A liability to make payments for services, property, or other 
consideration provided under a contract is not a liability arising out 
of a breach of that contract unless the payments are in the nature of 
incidental, consequential, or liquidated damages; and
    (ii) A liability arising out of a tort, breach of contract, or 
violation of law includes a liability arising out of the settlement of a 
dispute in which a tort, breach of contract, or violation of law, 
respectively, is alleged.
    (3) Rebates and refunds. If the liability of a taxpayer is to pay a 
rebate, refund, or similar payment to another person (whether paid in 
property, money, or as a reduction in the price of goods or services to 
be provided in the future by the taxpayer), economic performance occurs 
as payment is made to the person to which the liability is owed. This 
paragraph (g)(3) applies to all rebates, refunds, and payments or 
transfers in the nature of a rebate or refund regardless of whether they 
are characterized as a deduction from gross income, an adjustment to 
gross receipts or total sales, or an adjustment or addition to cost of 
goods sold. In the case of a rebate or refund made as a reduction in the 
price of goods or services to be provided in the future by the taxpayer, 
``payment'' is deemed to occur as the taxpayer would otherwise be 
required to recognize income resulting from a disposition at an 
unreduced price. See Example 2 of paragraph (g)(8) of this section. For 
purposes of determining whether the recurring item exception of Sec.  
1.461-5 applies, a liability that arises out of a tort, breach of 
contract, or violation of law is not considered a rebate or refund.
    (4) Awards, prizes, and jackpots. If the liability of a taxpayer is 
to provide an award, prize, jackpot, or other similar payment to another 
person, economic performance occurs as payment is made to the person to 
which the liability is owed. See Examples 3 and 4 of paragraph (g)(8) of 
this section.
    (5) Insurance, warranty, and service contracts. If the liability of 
a taxpayer arises out of the provision to the taxpayer of insurance, or 
a warranty or service contract, economic performance occurs as payment 
is made to the person to which the liability is owed. See Examples 5 
through 7 of paragraph (g)(8) of this section. For purposes of this 
paragraph (g)(5)--

[[Page 328]]

    (i) A warranty or service contract is a contract that a taxpayer 
enters into in connection with property bought or leased by the 
taxpayer, pursuant to which the other party to the contract promises to 
replace or repair the property under specified circumstances.
    (ii) The term ``insurance'' has the same meaning as is used when 
determining the deductibility of amounts paid or incurred for insurance 
under section 162.
    (6) Taxes--(i) In general. Except as otherwise provided in this 
paragraph (g)(6), if the liability of a taxpayer is to pay a tax, 
economic performance occurs as the tax is paid to the governmental 
authority that imposed the tax. For purposes of this paragraph (g)(6), 
payment includes payments of estimated income tax and payments of tax 
where the taxpayer subsequently files a claim for credit or refund. In 
addition, for purposes of this paragraph (g)(6), a tax does not include 
a charge collected by a governmental authority for specific 
extraordinary services or property provided to a taxpayer by the 
governmental authority. Examples of such a charge include the purchase 
price of a parcel of land sold to a taxpayer by a governmental authority 
and a charge for labor engaged in by government employees to improve 
that parcel. In certain cases, a liability to pay a tax is permitted to 
be taken into account in the taxable year before the taxable year during 
which economic performance occurs under the recurring item exception of 
Sec.  1.461-5. See Example 8 of paragraph (g)(8) of this section.
    (ii) Licensing fees. If the liability of a taxpayer is to pay a 
licensing or permit fee required by a governmental authority, economic 
performance occurs as the fee is paid to the governmental authority, or 
as payment is made to any other person at the direction of the 
governmental authority.
    (iii) Exceptions--(A) Real property taxes. If a taxpayer has made a 
valid election under section 461 (c), the taxpayer's accrual for real 
property taxes is determined under section 461 (c). Otherwise, economic 
performance with respect to a property tax liability occurs as the tax 
is paid, as specified in paragraph (g)(6)(i) of this section.
    (B) Certain foreign taxes. If the liability of a taxpayer is to pay 
an income, war profits, or excess profits tax that is imposed by the 
authority of any foreign country or possession of the United States and 
is creditable under section 901 (including a creditable tax described in 
section 903 that is paid in lieu of such a tax), economic performance 
occurs when the requirements of the all events test (as described in 
Sec.  1.446-1 (c)(1)(ii)) other than economic performance are met, 
whether or not the taxpayer elects to credit such taxes under section 
901 (a).
    (7) Other liabilities. In the case of a taxpayer's liability for 
which economic perfomance rules are not provided elsewhere in this 
section or in any other Internal Revenue regulation, revenue ruling or 
revenue procedure, economic performance occurs as the taxpayer makes 
payments in satisfaction of the liability to the person to which the 
liability is owed. This paragraph (g)(7) applies only if the liability 
cannot properly be characterized as a liability covered by rules 
provided elsewhere in this section. If a liability may properly be 
characterized as, for example, a liability arising from the provision of 
services or property to, or by, a taxpayer, the determination as to when 
economic performance occurs with respect to that liability is made under 
paragraph (d) of this section and not under this paragraph (g)(7).
    (8) Examples. The following examples illustrate the principles of 
this paragraph (g). For purposes of these examples, it is assumed that 
the requirements of the all events test other than economic performance 
have been met and, except as otherwise provided, that the recurring item 
exception is not used.

    Example 1. Liabilities arising out of a tort. (i) During the period 
1970 through 1975, Z corporation, a calendar year, accrual method 
taxpayer, manufactured and distributed industrial products that 
contained carcinogenic substances. In 1992, a number of lawsuits are 
filed against Z alleging damages due to exposure to these products. In 
settlement of a lawsuit maintained by A, Z agrees to purchase an annuity 
contract that will provide annual payments to A of $50,000 for a period 
of 25 years. On December 15, 1992, Z

[[Page 329]]

pays W, an unrelated life insurance company, $491,129 for such an 
annuity contract. Z retains ownership of the annuity contract.
    (ii) Under paragraph (g)(2) of this section, economic performance 
with respect to Z's liability to A occurs as each payment is made to A. 
Consequently, $50,000 is incurred by Z for each taxable year that a 
payment is made to A under the annuity contract. (Z must also include in 
income a portion of amounts paid under the annuity, pursuant to section 
72.) The result is the same if in 1992 Z secures its obligation with a 
standby letter of credit.
    (iii) If Z later transfers ownership of the annuity contract to A, 
an amount equal to the fair market value of the annuity on the date of 
transfer is incurred by Z in the taxable year of the transfer (see 
paragraph (g)(1)(ii)(B) of this section). In addition, the transfer 
constitutes a transaction to which section 1001 applies.
    Example 2. Rebates and refunds. (i) X corporation, a calendar year, 
accrual method taxpayer, manufactures and sells hardware products. X 
enters into agreements that entitle each of its distributors to a rebate 
(or discount on future purchases) from X based on the amount of 
purchases made by the distributor from X during any calendar year. 
During the 1992 calendar year, X becomes liable to pay a $2,000 rebate 
to distributor A. X pays A $1,200 of the rebate on January 15, 1993, and 
the remaining $800 on October 15, 1993. Assume the rebate is deductible 
(or allowable as an adjustment to gross receipts or cost of goods sold) 
when incurred.
    (ii) If X does not adopt the recurring item exception described in 
Sec.  1.461-5 with respect to rebates and refunds, then under paragraph 
(g)(3) of this section, economic performance with respect to the $2,000 
rebate liability occurs in 1993. However, if X has made a proper 
election under Sec.  1.461-5, and as of December 31, 1992, all events 
have occurred that determine the fact of the rebate liability, X incurs 
$1,200 for the 1992 taxable year. Because economic performance (payment) 
with respect to the remaining $800 does not occur until October 15, 1993 
(more than 8\1/2\ months after the end of 1992), X cannot use the 
recurring item exception for this portion of the liability (see Sec.  
1.461-5). Thus, the $800 is not incurred by X until the 1993 taxable 
year. If, instead of making the cash payments to A during 1993, X 
adjusts the price of hardware purchased by A that is delivered to A 
during 1993, X's ``payment'' occurs as X would otherwise be required to 
recognize income resulting from a disposition at an unreduced price.
    Example 3. Awards, prizes, and jackpots. (i) W corporation, a 
calendar year, accrual method taxpayer, produces and sells breakfast 
cereal. W conducts a contest pursuant to which the winner is entitled to 
$10,000 per year for a period of 20 years. On December 1, 1992, A is 
declared the winner of the contest and is paid $10,000 by W. In 
addition, on December 1 of each of the next nineteen years, W pays 
$10,000 to A.
    (ii) Under paragraph (g)(4) of this section, economic performance 
with respect to the $200,000 contest liability occurs as each of the 
$10,000 payments is made by W to A. Consequently, $10,000 is incurred by 
W for the 1992 taxable year and for each of the succeeding nineteen 
taxable years.
    Example 4. Awards, prizes, and jackpots. (i) Y corporation, a 
calendar year, accrual method taxpayer, owns a casino that contains 
progressive slot machines. A progressive slot machine provides a 
guaranteed jackpot amount that increases as money is gambled through the 
machine until the jackpot is won or until a maximum predetermined amount 
is reached. On July 1, 1993, the guaranteed jackpot amount on one of Y's 
slot machines reaches the maximum predetermined amount of $50,000. On 
October 1, 1994, the $50,000 jackpot is paid to B.
    (ii) Under paragraph (g)(4) of this section, economic performance 
with respect to the $50,000 jackpot liability occurs on the date the 
jackpot is paid to B. Consequently, $50,000 is incurred by Y for the 
1994 taxable year.
    Example 5. Insurance, warranty, and service contracts. (i) V 
corporation, a calendar year, accrual method taxpayer, manufactures 
toys. V enters into a contract with W, an unrelated insurance company, 
on December 15, 1992. The contract obligates V to pay W a premium of 
$500,000 before the end of 1995. The contract obligates W to satisfy any 
liability of V resulting from claims made during 1993 or 1994 against V 
by any third party for damages attributable to defects in toys 
manufactured by V. Pursuant to the contract, V pays W a premium of 
$500,000 on October 1, 1995.
    (ii) Assuming the arrangement constitutes insurance, under paragraph 
(g)(5) of this section economic performance occurs as the premium is 
paid. Thus, $500,000 is incurred by V for the 1995 taxable year.
    Example 6. Insurance, warranty, and service contracts. (i) Y 
corporation, a calendar year, accrual method taxpayer, is a common 
carrier. On December 15, 1992, Y enters into a contract with Z, an 
unrelated insurance company, under which Z must satisfy any liability of 
Y that arises during the succeeding 5 years for damages under a workers 
compensation act or out of any tort, provided the event that causes the 
damages occurs during 1993 or 1994. Under the contract, Y pays $360,000 
to Z on December 31, 1993.
    (ii) Assuming the arrangement constitutes insurance, under paragraph 
(g)(5) of this section economic performance occurs as the

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premium is paid. Consequently, $360,000 is incurred by Y for the 1993 
taxable year. The period for which the $360,000 amount is permitted to 
be taken into account is determined under the capitalization rules 
because the insurance contract is an asset having a useful life 
extending substantially beyond the close of the taxable year.
    Example 7. Insurance, warranty, and service contracts. Assume the 
same facts as in Example 6, except that Y is obligated to pay the first 
$5,000 of any damages covered by the arrangement with Z. Y is, in 
effect, self-insured to the extent of this $5,000 ``deductible.'' Thus, 
under paragraph (g)(2) of this section, economic performance with 
respect to the $5,000 liability does not occur until the amount is paid 
to the person to which the tort or workers compensation liability is 
owed.
    Example 8. Taxes. (i) The laws of State A provide that every person 
owning personal property located in State A on the first day of January 
shall be liable for tax thereon and that a lien for the tax shall attach 
as of that date. In addition, the laws of State A provide that 60% of 
the tax is due on the first day of December following the lien date and 
the remaining 40% is due on the first day of July of the succeeding 
year. On January 1, 1992, X corporation, a calendar year, accrual method 
taxpayer, owns personal property located in State A. State A imposes a 
$10,000 tax on S with respect to that property on January 1, 1992. X 
pays State A $6,000 of the tax on December 1, 1992, and the remaining 
$4,000 on July 1, 1993.
    (ii) Under paragraph (g)(6) of this section, economic performance 
with respect to $6,000 of the tax liability occurs on December 1, 1992. 
Consequently, $6,000 is incurred by X for the 1992 taxable year. 
Economic performance with respect to the remaining $4,000 of the tax 
liability occurs on July 1, 1993. If X has adopted the recurring item 
exception described in Sec.  1.461-5 as a method of accounting for 
taxes, and as of December 31, 1992, all events have occurred that 
determine the liability of X for the remaining $4,000, X also incurs 
$4,000 for the 1992 taxable year. If X does not adopt the recurring item 
exception method, the $4,000 is not incurred by X until the 1993 taxable 
year.

    (h) Liabilities arising under the Nuclear Waste Policy Act of 1982. 
Notwithstanding the principles of paragraph (d) of this section, 
economic performance with respect to the liability of an owner or 
generator of nuclear waste to make payments to the Department of Energy 
(``DOE'') pursuant to a contract required by the Nuclear Waste Policy 
Act of 1982 (Pub. L. 97-425, 42 U.S.C. 10101-10226 (1982)) occurs as 
each payment under the contract is made to DOE and not when DOE 
satisfies its obligations under the contract. This rule applies to the 
continuing fee required by 42 U.S.C. 10222(a)(2) (1982), as well as the 
one-time fee required by 42 U.S.C. 10222 (a)(3) (1982). For rules 
relating to when economic performance occurs with respect to interest, 
see paragraph (e) of this section.
    (i) [Reserved]
    (j) Contingent liabilities. [Reserved]
    (k) Special effective dates--(1) In general. Except as otherwise 
provided in this paragraph (k), section 461(h) and this section apply to 
liabilities that would, under the law in effect before the enactment of 
section 461(h), be allowable as a deduction or otherwise incurred after 
July 18, 1984. For example, the economic performance requirement applies 
to all liabilities arising under a workers compensation act or out of 
any tort that would, under the law in effect before the enactment of 
section 461(h), be incurred after July 18, 1984. For taxable years 
ending before April 7, 1995, see Q&A-2 of Sec.  1.461-7T (as it appears 
in 26 CFR part 1 revised April 1, 1995), which provides an election to 
make this change in method of accounting applicable to either the 
portion of the first taxable year that occurs after July 18, 1984 (part-
year change method), or the entire first taxable year ending after July 
18, 1984 (full-year change method). With respect to the effective date 
rules for interest, section 461(h) applies to interest accruing under 
any obligation (whether or not evidenced by a debt instrument) if the 
obligation is incurred in any transaction occurring after June 8, 1984, 
and is not incurred under a written contract which was binding on March 
1, 1984, and at all times thereafter until the obligation is incurred. 
Interest accruing under an obligation described in the preceding 
sentence is subject to section 461(h) even if the interest accrues 
before July 19, 1984. Similarly, interest accruing under any obligation 
incurred in a transaction occurring before June 9, 1984, (or under a 
written contract which was binding on March 1, 1984, and at all times 
thereafter until the obligation is incurred) is not subject to section 
461(h) even to the extent the interest accrues after July 18, 1984.

[[Page 331]]

    (2) Long-term contracts. Except as otherwise provided in paragraph 
(M)(2) of this section, in the case of liabilities described in 
paragraph (d)(2)(ii) of this section (relating to long-term contracts), 
paragraph (d)(2)(ii) of this section applies to liabilities that would, 
but for the enactment of section 461(h), be allowable as a deduction or 
otherwise incurred for taxable years beginning after December 31, 1991.
    (3) Payment liabilities. Except as otherwise provided in paragraph 
(m)(2) of this section, in the case of liabilities described in 
paragraph (g) of this section (other than liabilities arising under a 
workers compensation act or out of any tort described in paragraph 
(g)(2) of this section), paragraph (g) of this section applies to 
liabilities that would, but for the enactment of section 461(h), be 
allowable as a deduction or otherwise incurred for taxable years 
beginning after December 31, 1991.
    (l) [Reserved]
    (m) Change in method of accounting required by this section--(1) In 
general. For the first taxable year ending after July 18, 1984, a 
taxpayer is granted the consent of the Commissioner to change its method 
of accounting for liabilities to comply with the provisions of this 
section pursuant to any of the following procedures:
    (i) For taxable years ending before April 7, 1995, the part-year 
change in method election described in Q&A-2 through Q&A-6 and Q&A-8 
through Q&A-10 of Sec.  1.461-7T (as it appears in 26 CFR part 1 revised 
April 1, 1995);
    (ii) For taxable years ending before April 7, 1995, the full-year 
change in method election described in Q&A-2 through Q&A-6 and Q&A-8 
through Q&A-10 of Sec.  1.461-7T (as it appears in 26 CFR part 1 revised 
April 1, 1995); or
    (iii) For taxable years ending before April 7, 1995, if no election 
is made, the cut-off method described in Q&A-1 and Q&A-11 of Sec.  
1.461-7T (as it appears in 26 CFR part 1 revised April 1, 1995).
    (2) Change in method of accounting for long-term contracts and 
payment liabilities--(i) First taxable year beginning after December 31, 
1991. For the first taxable year beginning after December 31, 1991, a 
taxpayer is granted the consent of the Commissioner to change its method 
of accounting for long-term contract liabilities described in paragraph 
(D)(2)(ii) of this section and payment liabilities described in 
paragraph (g) of this section (other than liabilities arising under a 
workers compensation act or out of any tort described in paragraph 
(g)(2) of this section) to comply with the provisions of this section. 
The change must be made in accordance with paragraph (m)(1)(ii) or 
(m)(1)(iii) of this section, except the effective date is the first day 
of the first taxable year beginning December 31, 1991.
    (ii) Retroactive change in method of accounting for long-term 
contracts and payment liabilities. For the first taxable year beginning 
after December 31, 1989, or the first taxable year beginning after 
December 31, 1990, a taxpayer is granted the consent of the Commissioner 
to change its method of accounting for long-term contract liabilities 
described in paragraph (d)(2)(ii) of this section and payment 
liabilities described in paragraph (g) of this section (other than 
liabilities arising under a workers compensation act or out of any tort 
described in paragraph (g)(2) of this section) to comply with the 
provisions of this section. The change must be made in accordance with 
paragraph (m)(1)(ii) or (m)(1)(iii) of this section, except the 
effective date is the first day of the first taxable year beginning 
after December 31, 1989, or the first day of the first taxable year 
beginning after December 31, 1990. For taxable years ending before April 
7, 1995, the taxpayer may make the change in method of accounting, 
including a full-year change in method election under paragraph 
(m)(1)(ii) of this section and Q&A-5 of Sec.  1.461-7T (as it appears in 
26 CFR part 1 revised April 1, 1995), by filing an amended return for 
such year, provided the amended return is filed on or before October 7, 
1992.

[T.D. 8408, 57 FR 12421, Apr. 10, 1992, as amended by T.D. 8491, 58 FR 
53135, Oct. 14, 1993; T.D. 8593, 60 FR 18743, Apr. 13, 1995; T.D. 8820, 
64 FR 26851, May 18, 1999; T.D. 8408, 69 FR 44597, July 27, 2004]

[[Page 332]]



Sec.  1.461-5  Recurring item exception.

    (a) In general. Except as otherwise provided in paragraph (c) of 
this section, a taxpayer using an accrual method of accounting may adopt 
the recurring item exception described in paragraph (b) of this section 
as method of accounting for one or more types of recurring items 
incurred by the taxpayer. In the case of the ``other payment 
liabilities'' described in Sec.  1.461-4(g)(7), the Commissioner may 
provide for the application of the recurring item exception by 
regulation, revenue procedure or revenue ruling.
    (b) Requirements for use of the exception--(1) General rule. Under 
the recurring item exception, a liability is treated as incurred for a 
taxable year if--
    (i) As of the end of that taxable year, all events have occurred 
that establish the fact of the liability and the amount of the liability 
can be determined with reasonable accuracy;
    (ii) Economic performance with respect to the liability occurs on or 
before the earlier of--
    (A) The date the taxpayer files a timely (including extensions) 
return for that taxable year; or
    (B) The 15th day of the 9th calendar month after the close of that 
taxable year;
    (iii) The liability is recurring in nature; and
    (iv) Either--
    (A) The amount of the liability is not material; or
    (B) The accrual of the liability for that taxable year results in a 
better matching of the liability with the income to which it relates 
than would result from accruing the liability for the taxable year in 
which economic performance occurs.
    (2) Amended returns. A taxpayer may file an amended return treating 
a liability as incurred under the recurring item exception for a taxable 
year if economic performance with respect to the liability occurs after 
the taxpayer files a return for that year, but within 8\1/2\ months 
after the close of that year.
    (3) Liabilities that are recurring in nature. A liability is 
recurring if it can generally be expected to be incurred from one 
taxable year to the next. However, a taxpayer may treat such a liability 
as recurring in nature even if it is not incurred by the taxpayer in 
each taxable year. In addition, a liability that has never previously 
been incurred by a taxpayer may be treated as recurring if it is 
reasonable to expect that the liability will be incurred on a recurring 
basis in the future.
    (4) Materiality requirement. For purposes of this paragraph (b):
    (i) In determining whether a liability is material, consideration 
shall be given to the amount of the liability in absolute terms and in 
relation to the amount of other items of income and expense attributable 
to the same activity.
    (ii) A liability is material if it is material for financial 
statement purposes under generally acepted accounting principles.
    (iii) A liability that is immaterial for financial statement 
purposes under generally accepted accounting principles may be material 
for purposes of this paragraph (b).
    (5) Matching requirement. (i) In determining whether the matching 
requirement of paragraph (b)(1)(iv)(B) of this section is satisfied, 
generally accepted accounting principles are an important factor, but 
are not dispositive.
    (ii) In the case of a liability described in paragraph (g)(3) 
(rebates and refunds), paragraph (g)(4) (awards, prizes, and jackpots), 
paragraph (g)(5) (insurance, warranty, and service contracts), paragraph 
(g)(6) (taxes), or paragraph (h) (continuing fees under the Nuclear 
Waste Policy Act of 1982) of Sec.  1.461-4, the matching requirement of 
paragraph (b)(1)(iv)(B) of this section shall be deemed satisfied.
    (c) Types of liabilities not eligible for treatment under the 
recurring item exception. The recurring item exception does not apply to 
any liability of a taxpayer described in paragraph (e) (interest), 
paragraph (g)(2) (workers compensation, tort, breach of contract, and 
violation of law), or paragraph (g)(7) (other liabilities) of Sec.  
1.461-4. Moreover, the recurring item exception does not apply to any 
liability incurred by a tax shelter, as defined in section 461(i) and 
Sec.  1.448-1T(b).
    (d) Time and manner of adopting the recurring item exception--(1) In 
general. The recurring item exception is a

[[Page 333]]

method of accounting that must be consistently applied with respect to a 
type of item, or for all items, from one taxable year to the next in 
order to clearly reflect income. A taxpayer is permitted to adopt the 
recurring item exception as part of its method of accounting for any 
type of item for the first taxable year in which that type of item is 
incurred. Except as otherwise provided, the rules of section 446(e) and 
Sec.  1.446-1(e) apply to changes to or from the recurring item 
exception as a method of accounting. For taxable years ending before 
April 7, 1995, see Q&A-7 of Sec.  1.461-7T (as it appears in 26 CFR part 
1 revised April 1, 1995) for rules concerning the time and manner of 
adopting the recurring item exception for taxable years that include 
July 19, 1984. For purposes of this section, items are to be classified 
by type in a manner that results in classifications that are no less 
inclusive than the classifications of production costs provided in the 
full-absorption regulations of Sec.  1.471-11(b) and(c), whether or not 
the taxpayer is required to maintain inventories.
    (2) Change to the recurring item exception method for the first 
taxable year beginning after December 31, 1991--(i) In general. For the 
first taxable year beginning after December 31, 1991, a taxpayer is 
granted the consent of the Commissioner to change to the recurring item 
exception method of accounting. A taxpayer is also granted the consent 
of the Commissioner to expand or modify its use of the recurring item 
exception method for the first taxable year beginning after December 31, 
1991. For each trade or business for which a taxpayer elects to use the 
recurring item exception method, the taxpayer must use the same method 
of change (cut-off or full-year change) it is using for that trade or 
business under Sec.  1.461-4(m). For taxable year sending before April 
7, 1995, see Q&A-11 of Sec.  1.461-7T (as it appears in 26 CFR part 1 
revised April 1, 1995) for an explanation of how amounts are taken into 
account under the cut-off method (except that, for purposes of this 
paragraph (d)(2), the change applies to all amounts otherwise incurred 
on or after the first day of the first taxable year beginning after 
December 31, 1991). For taxable years ending before April 7, 1995, see 
Q&A-6 of Sec.  1.461-7T (as it appears in 26 CFR part 1 revised April 1, 
1995) for an explanation of how amounts are taken into account under the 
full-year change method (except that the change in method occurs on the 
first day of the first taxable year beginning after December 31, 1991). 
For taxable years ending before April 7, 1995, the full-year change in 
method may result in a section 481(a) adjustment that must be taken into 
account in the manner described in Q&A-8 and Q&A-9 of Sec.  1.461-7T (as 
it appears in 26 CFR part 1 revised April 1, 1995) (except that the 
taxable year of change is the first taxable year beginning after 
December 31, 1991).
    (ii) Manner of changing to the recurring item exception method. For 
the first taxable year beginning after December 31, 1991, a taxpayer may 
change to the recurring item exception method by accounting for the item 
on its timely filed original return for such taxable year (including 
extensions). For taxable years ending before April 7, 1995, the 
automatic consent of the Commissioner is limited to those items 
accounted for under the recurring item exception method on the timely 
filed return, unless the taxpayer indicates a wider scope of change by 
filing the statement provided in Q&A-7(b)(2) of Sec.  1.461-7T (as it 
appears in 26 CFR part 1 revised April 1, 1995).
    (3) Retroactive change to the recurring item exception method. For 
the first taxable year beginning after December 31, 1989, or December 
31, 1990, a taxpayer is granted consent of the Commissioner to change to 
the recurring item exception method of accounting, provided the taxpayer 
complies with paragraph (d)(2) of this section on either the original 
return for such year or on an amended return for such year filed on or 
before October 7, 1991. For this purpose the effective date is the first 
day of the first taxable year beginning after December 31, 1989, or the 
first day of the first taxable year beginning after December 31, 1990. A 
taxpayer is also granted the consent of the Commissioner to expand or 
modify its use of the recurring item exception method for the first 
taxable year beginning

[[Page 334]]

after December 31, 1989, December 31, 1990, or December 31, 1991.
    (e) Examples. The following examples illustrate the principles of 
this section:

    Example 1. Requirements for use of the recurring item exception. (i) 
Y corporation, a calendar year, accrual method taxpayer, manufactures 
and distributes video cassette recorders. Y timely files its federal 
income tax return for each taxable year on the extended due date for the 
return (September 15, of the following taxable year). Y offers to refund 
the price of a recorder to any purchaser not satisfied with the 
recorder. During 1992, 100 purchasers request a refund of the $500 
purchase price. Y refunds $30,000 on or before September 15, 1993, and 
the remaining $20,000 after such date but before the end of 1993.
    (ii) Under paragraph (g)(3) of Sec.  1.461-4, economic performance 
with respect to $30,000 of the refund liability occurs on September 15, 
1993. Assume the refund is deductible (or allowable as an adjustment to 
gross receipts or cost of goods sold) when incurred. If Y does not adopt 
the recurring item exception with respect to rebates and refunds, the 
$30,000 refund is incurred by Y for the 1993 taxable year. However, if Y 
has properly adopted the recurring item exception method of accounting 
under this section, and as of December 31, 1992, all events have 
occurred that determine the fact of the liability for the $30,000 
refund, Y incurs that amount for the 1992 taxable year. Because economic 
performance (payment) with respect to the remaining $20,000 occurs after 
September 15, 1993 (more than 8\1/2\ months after the end of 1992), that 
amount is not eligible for recurring item treatment under this section. 
Thus, the $20,000 amount is not incurred by Y until the 1993 taxable 
year.
    Example 2. Requirements for use of the recurring item exception; 
amended returns. The facts are the same as in Example 2, except that Y 
files its income tax return for 1992 on March 15, 1993, and Y does not 
refund the price of any recorder before that date. Under paragraph 
(b)(1) of this section, the refund liability is not eligible for the 
recurring item exception because economic performance with respect to 
the refund does not occur before Y files a return for the taxable year 
for which the item would have been incurred under the exception. 
However, since economic performance occurs within 8\1/2\ months after 
1992, Y may file an amended return claiming the $30,000 as incurred for 
its 1992 taxable year (see paragraph (b)(2) of this section).

[T.D. 8408, 57 FR 12427, Apr. 10, 1992, as amended by T.D. 8593, 60 FR 
18743, Apr. 13, 1995]



Sec.  1.461-6  Economic performance when certain liabilities are assigned 
or are extinguished by the establishment of a fund.

    (a) Qualified assignments of certain personal injury liabilities 
under section 130. In the case of a qualified assignment (within the 
meaning of section 130(c)), economic performance occurs as a taxpayer-
assignor makes payments that are excludible from the income of the 
assignee under section 130(a).
    (b) Section 468B. Economic performance occurs as a taxpayer makes 
qualified payments to a designated settlement fund under section 468B, 
relating to special rules for designated settlement funds.
    (c) Payments to other funds or persons that constitute economic 
performance. [Reserved]
    (d) Effective dates. The rules in paragraph (a) of this section 
apply to payments after July 18, 1984.

[T.D. 8408, 57 FR 12428, Apr. 10, 1992]



Sec.  1.465-1T  Aggregation of certain activities (temporary).

    (a) General rule. A partner in a partnership or an S corporation 
shareholder may aggregate and treat as a single activity--
    (1) The holding, production, or distribution of more than one motion 
picture film or video tape by the partnership or S corporation,
    (2) The farming (as defined in section 464 (e)) of more than one 
farm by the partnership or S corporation,
    (3) The exploration for, or exploitation of, oil and gas resources 
with respect to more than one oil and gas property by the partnership or 
S corporation, or
    (4) The exploration for, or exploitation of, geothermal deposits 
(within the meaning of section 613(e)(3)) with respect to more than one 
geothermal property by the partnership or S corporation.

Thus, for example, if a partnership or S corporation is engaged in the 
activity of exploring for, or exploiting, oil and gas resources with 
respect to 10 oil and gas properties, a partner or S corporation 
shareholder may aggregate those properties and treat the aggregated oil 
and gas activities as a single activity.

[[Page 335]]

If that partnership or S corporation also is engaged in the activity of 
farming with respect to two farms, the partner or shareholder may 
aggregate the farms and treat the aggregated farming activities as a 
single separate activity. Except as provided in section 
465(c)(2)(B)(ii), the partner or shareholder cannot aggregate the 
farming activity with the oil and gas activity.
    (b) Effective date. This section shall apply to taxable years 
beginning after December 31, 1983 and before January 1, 1985.

(Secs. 465(c)(2)(B) and 7805 of the Internal Revenue Code of 1954 (98 
Stat. 814, 68A Stat. 917; 26 U.S.C. 465(c)(2)(B) and 7805))

[T.D. 8012, 50 FR 9614, Mar. 11, 1985]



Sec.  1.465-8  General rules; interest other than that of a creditor.

    (a) In general--(1) Amounts borrowed. This section applies to 
amounts borrowed for use in an activity described in section 465(c)(1) 
or (c)(3)(A). Amounts borrowed with respect to an activity will not 
increase the borrower's amount at risk in the activity if the lender has 
an interest in the activity other than that of a creditor or is related 
to a person (other than the borrower) who has an interest in the 
activity other than that of a creditor. This rule applies even if the 
borrower is personally liable for the repayment of the loan or the loan 
is secured by property not used in the activity. For additional rules 
relating to the treatment of amounts borrowed from these persons, see 
Sec.  1.465-20.
    (2) Certain borrowed amounts excepted. (i) For purposes of 
determining a corporation's amount at risk, an interest in the 
corporation as a shareholder is not an interest in any activity of the 
corporation. Thus, amounts borrowed by a corporation from a shareholder 
may increase the corporation's amount at risk.
    (ii) For purposes of determining a taxpayer's amount at risk in an 
activity of holding real property, paragraph (a)(1) of this section does 
not apply to financing that is secured by real property used in the 
activity and is either--
    (A) Qualified nonrecourse financing described in section 
465(b)(6)(B); or
    (B) Financing that, if it were nonrecourse, would be financing 
described in section 465(b)(6)(B).
    (b) Loans for which the borrower is personally liable for 
repayment--(1) General rule. If a borrower is personally liable for the 
repayment of a loan for use in an activity, a person shall be considered 
a person with an interest in the activity other than that of a creditor 
only if the person has either a capital interest in the activity or an 
interest in the net profits of the activity.
    (2) Capital interest. For the purposes of this section a capital 
interest in an activity means an interest in the assets of the activity 
which is distributable to the owner of the capital interest upon the 
liquidation of the activity. The partners of a partnership and the 
shareholders of an S corporation are considered to have capital 
interests in the activities conducted by the partnership or S 
corporation.
    (3) Interest in net profits. For the purposes of this section it is 
not necessary for a person to have any incidents of ownership in the 
activity in order to have an interest in the net profits of the 
activity. For example, an employee or independent contractor any part of 
whose compensation is determined with reference to the net profits of 
the activity will be considered to have an interest in the net profits 
of the activity.
    (4) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. A, the owner of a herd of cattle sells the herd to 
partnership BCD. BCD pays A $10,000 in cash and executes a note for 
$30,000 payable to A. Each of the three partners, B, C, and D, assumes 
personal liability for repayment of the amount owed A. In addition, BCD 
enters into an agreement with A under which A is to take care of the 
cattle for BCD in return for compensation equal to 6 percent of BCD's 
net profits from the activity. Because A has an interest in the net 
profits of BCD's farming activity, A is considered to have an interest 
in the activity other than that of a creditor. Accordingly, amounts 
payable to A for use in that activity do not increase the partners' 
amount at risk even though the partners assume personal liability for 
repayment.
    Example 2. Assume the same facts as in Example 1 except that instead 
of receiving compensation equal to 6 percent of BCD's net profits from 
the activity, A instead receives

[[Page 336]]

compensation equal to 1 percent of the gross receipts from the activity. 
A does not have a capital interest in BCD. A's interest in the gross 
receipts is not considered an interest in the net profits. Because B, C, 
and D assumed personal liability for the amounts payable to A, and A has 
neither a capital interest nor an interest in the net profits of the 
activity, A is not considered to have an interest in the activity other 
than that of a creditor with respect to the $30,000 loan. Accordingly, 
B, C, and D are at risk for their share of the loan if the other 
provisions of section 465 are met.
    Example 3. Assume the same facts as in Example 1 except that instead 
of receiving compensation equal to 6 percent of BCD's net profits from 
the activity, A instead receives compensation equal to 6 percent of the 
net profits from the activity or $15,000, whichever is greater. A is 
considered to have an interest in the net profits from the activity and 
accordingly will be treated as a person with an interest in the activity 
other than that of a creditor.

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

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

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

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

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

[T.D. 9124, 69 FR 24079, May 3, 2004; 69 FR 26305, May 12, 2004]



Sec.  1.465-20  Treatment of amounts borrowed from certain persons 
and amounts protected against loss.

    (a) General rule. The following amounts are treated in the same 
manner as borrowed amounts for which the taxpayer has no personal 
liability and for which no security is pledged--
    (1) Amounts that do not increase the taxpayer's amount at risk 
because they

[[Page 337]]

are borrowed from a person who has an interest in the activity other 
than that of a creditor or from a person who is related to a person 
(other than the taxpayer) who has an interest in the activity other than 
that of a creditor; and
    (2) Amounts (whether or not borrowed) that are protected against 
loss.
    (b) Interest other than that of a creditor; cross reference. See 
Sec.  1.465-8 for additional rules relating to amounts borrowed from a 
person who has an interest in the activity other than that of a creditor 
or is related to a person (other than the taxpayer) who has an interest 
in the activity other than that of a creditor.
    (c) Amounts protected against loss; cross reference. See Sec.  
1.465-6 for rules relating to amounts protected against loss.
    (d) Effective date. This section applies to amounts borrowed after 
May 3, 2004.

[T.D. 9124, 69 FR 24079, May 3, 2004]



Sec.  1.465-27  Qualified nonrecourse financing.

    (a) In general. Notwithstanding any provision of section 465(b) or 
the regulations under section 465(b), for an activity of holding real 
property, a taxpayer is considered at risk for the taxpayer's share of 
any qualified nonrecourse financing which is secured by real property 
used in such activity.
    (b) Qualified nonrecourse financing secured by real property--(1) In 
general. For purposes of section 465(b)(6) and this section, the term 
qualified nonrecourse financing means any financing--
    (i) Which is borrowed by the taxpayer with respect to the activity 
of holding real property;
    (ii) Which is borrowed by the taxpayer from a qualified person or 
represents a loan from any federal, state, or local government or 
instrumentality thereof, or is guaranteed by any federal, state, or 
local government;
    (iii) For which no person is personally liable for repayment, taking 
into account paragraphs (b)(3), (4), and (5) of this section; and
    (iv) Which is not convertible debt.
    (2) Security for qualified nonrecourse financing--(i) Types of 
property. For a taxpayer to be considered at risk under section 
465(b)(6), qualified nonrecourse financing must be secured only by real 
property used in the activity of holding real property. For this 
purpose, however, property that is incidental to the activity of holding 
real property will be disregarded. In addition, for this purpose, 
property that is neither real property used in the activity of holding 
real property nor incidental property will be disregarded if the 
aggregate gross fair market value of such property is less than 10 
percent of the aggregate gross fair market value of all the property 
securing the financing.
    (ii) Look-through rule for partnerships. For purposes of paragraph 
(b)(2)(i) of this section, a borrower shall be treated as owning 
directly its proportional share of the assets in a partnership in which 
the borrower owns (directly or indirectly through a chain of 
partnerships) an equity interest.
    (3) Personal liability; partial liability. If one or more persons 
are personally liable for repayment of a portion of a financing, the 
portion of the financing for which no person is personally liable may 
qualify as qualified nonrecourse financing.
    (4) Partnership liability. For purposes of section 465(b)(6) and 
this paragraph (b), the personal liability of any partnership for 
repayment of a financing is disregarded and, provided the requirements 
contained in paragraphs (b)(1)(i), (ii), and (iv) of this section are 
satisfied, the financing will be treated as qualified nonrecourse 
financing secured by real property if--
    (i) The only persons personally liable to repay the financing are 
partnerships;
    (ii) Each partnership with personal liability holds only property 
described in paragraph (b)(2)(i) of this section (applying the 
principles of paragraph (b)(2)(ii) of this section in determining the 
property held by each partnership); and
    (iii) In exercising its remedies to collect on the financing in a 
default or default-like situation, the lender may proceed only against 
property that is described in paragraph (b)(2)(i) of this section and 
that is held by the partnership or partnerships (applying the principles 
of paragraph (b)(2)(ii) of this section in determining the property held 
by the partnership or partnerships).

[[Page 338]]

    (5) Disregarded entities. Principles similar to those described in 
paragraph (b)(4) of this section shall apply in determining whether a 
financing of an entity that is disregarded for federal tax purposes 
under Sec.  301.7701-3 of this chapter is treated as qualified 
nonrecourse financing secured by real property.
    (6) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Personal liability of a partnership; incidental property. 
(i) X is a limited liability company that is classified as a partnership 
for federal tax purposes. X engages only in the activity of holding real 
property. In addition to real property used in the activity of holding 
real property, X owns office equipment, a truck, and maintenance 
equipment that it uses to support the activity of holding real property. 
X borrows $500 to use in the activity. X is personally liable on the 
financing, but no member of X and no other person is liable for 
repayment of the financing under local law. The lender may proceed 
against all of X's assets if X defaults on the financing.
    (ii) Under paragraph (b)(2)(i) of this section, the personal 
property is disregarded as incidental property used in the activity of 
holding real property. Under paragraph (b)(4) of this section, the 
personal liability of X for repayment of the financing is disregarded 
and, provided the requirements contained in paragraphs (b)(1)(i), (ii), 
and (iv) of this section are satisfied, the financing will be treated as 
qualified nonrecourse financing secured by real property.
    Example 2. Bifurcation of a financing. The facts are the same as in 
Example 1, except that A, a member of X, is personally liable for 
repayment of $100 of the financing. If the requirements contained in 
paragraphs (b)(1)(i), (ii), and (iv) of this section are satisfied, then 
under paragraph (b)(3) of this section, the portion of the financing for 
which A is not personally liable for repayment ($400) will be treated as 
qualified nonrecourse financing secured by real property.
    Example 3. Personal liability; tiered partnerships. (i) UTP1 and 
UTP2, both limited liability companies classified as partnerships, are 
the only general partners in Y, a limited partnership. Y borrows $500 
with respect to the activity of holding real property. The financing is 
a general obligation of Y. UTP1 and UTP2, therefore, are personally 
liable to repay the financing. Under section 752, UTP1's share of the 
financing is $300, and UTP2's share is $200. No person other than Y, 
UTP1, and UTP2 is personally liable to repay the financing. Y, UTP1, and 
UTP2 each hold only real property.
    (ii) Under paragraph (b)(4) of this section, the personal liability 
of Y, UTP1, and UTP2 to repay the financing is disregarded and, provided 
the requirements of paragraphs (b)(1)(i), (ii), and (iv) of this section 
are satisfied, UTP1's $300 share of the financing and UTP2's $200 share 
of the financing will be treated as qualified nonrecourse financing 
secured by real property.
    Example 4. Personal liability; tiered partnerships. The facts are 
the same as in Example 3, except that Y's general partners are UTP1 and 
B, an individual. Because B, an individual, is also personally liable to 
repay the $500 financing, the entire financing fails to satisfy the 
requirement in paragraph (b)(1)(iii) of this section. Accordingly, 
UTP1's $300 share of the financing will not be treated as qualified 
nonrecourse financing secured by real property.
    Example 5. Personal liability; tiered partnerships. The facts are 
the same as in Example 3, except that Y is a limited liability company 
and UTP1 and UTP2 are not personally liable for the debt. However, UTP1 
and UTP2 each pledge property as security for the loan that is other 
than real property used in the activity of holding real property and 
other than property that is incidental to the activity of holding real 
property. The fair market value of the property pledged by UTP1 and UTP2 
is greater than 10 percent of the sum of the aggregate gross fair market 
value of the property held by Y and the aggregate gross fair market 
value of the property pledged by UTP1 and UTP2. Accordingly, the 
financing fails to satisfy the requirement in paragraph (b)(1)(iii) of 
this section by virtue of its failure to satisfy paragraph (b)(4)(iii) 
of this section. Therefore, the financing is not qualified nonrecourse 
financing secured by real property.
    Example 6. Personal liability; Disregarded entity. (i) X is a single 
member limited liability company that is disregarded as an entity 
separate from its owner for federal tax purposes under Sec.  301.7701-3 
of this chapter. X owns certain real property and property that is 
incidental to the activity of holding the real property. X does not own 
any other property. For federal tax purposes, A, the sole member of X, 
is considered to own all of the property held by X and is engaged in the 
activity of holding real property through X. X borrows $500 and uses the 
proceeds to purchase additional real property that is used in the 
activity of holding real property. X is personally liable to repay the 
financing, but A is not personally liable for repayment of the financing 
under local law. The lender may proceed against all of X's assets if X 
defaults on the financing.
    (ii) X is disregarded so that the assets and liabilities of X are 
treated as the assets and liabilities of A. However, A is not personally 
liable for the $500 liability. Provided that the requirements contained 
in paragraphs

[[Page 339]]

(b)(1)(i), (ii), and (iv) of this section are satisfied, the financing 
will be treated as qualified nonrecourse financing secured by real 
property with respect to A.

    (c) Effective date. This section is effective for any financing 
incurred on or after August 4, 1998. Taxpayers, however, may apply this 
section retroactively for financing incurred before August 4, 1998.

[T.D. 8777, 63 FR 41421, Aug. 4, 1998]



Sec.  1.466-1  Method of accounting for the redemption cost 
of qualified discount coupons.

    (a) Introduction. Section 466 permits taxpayers who elect to use the 
method of accounting description in section 466 to deduct the redemption 
cost (as defined in paragraph (b) of this section) of qualified discount 
coupons (as defined in paragraph (c) of this section) outstanding at the 
end of the taxable year and redeemed during the redemption period 
(within the meaning of paragraph (d)(2) of this section) in addition to 
the redemption cost of qualified discount coupons redeemed during the 
taxable year which were not deducted for a prior taxable year. For the 
taxable year in which the taxpayer first uses this method of accounting, 
the taxpayer is not allowed to deduct the redemption costs of qualified 
discount coupons redeemed during the taxable year that would have been 
deductible for the prior taxable year had the taxpayer used this method 
of accounting for such prior year. (See paragraph (e) of this section 
for rules describing how this amount should be taken into account.) A 
taxpayer must use the accrual method of accounting for any trade or 
business for which an election is made under section 466. Furthermore, 
the taxpayer must make an election in accordance with the rules in 
section 466(d) and Sec.  1.466-3 for that trade or business. The method 
of accounting in section 466 is applicable only to the taxpayer's 
redemption of qualified discount coupons. Section 466 does not apply to 
trading stamps or premium coupons, which are subject to the method of 
accounting in Sec.  1.451-4, or to discount coupons that are not 
qualified discount coupons.
    (b) Redemption costs--(1) Costs deductible under section 466. The 
deduction allowed by section 466 applies only to the redemption cost of 
qualified discount coupons. The term ``redemption cost'' means an amount 
equal to:
    (i) The lesser of:
    (A) The amount of the discount stated on the coupon, or
    (B) The cost incurred by the taxpayer for paying the discount; plus
    (ii) The amount payable to the retailer (or other person redeeming 
the coupon from the person receiving the price discount) for services in 
redeeming the coupon.

The amount payable to the retailer or other person for services in 
redeeming the coupon is allowed only if the amount payable is stated on 
the coupon.
    (2) Costs not deductible under section 466. The term ``redemption 
cost'' includes only the amounts stated in paragraph (b)(1) of this 
section. Amounts other than those mentioned in paragraph (b)(1) of this 
section cannot be deducted under the method of accounting described in 
section 466 even though such amounts are incurred in relation to the 
redemption of qualified discount coupons. Therefore, those amounts must 
be taken into account as if section 466 did not apply. Examples of such 
amounts are fees paid to the redemption center or clearinghouse and 
amounts payable to the retailer in excess of the amount stated on the 
coupon.
    (c) Qualified discount coupons--(1) General rule. In order for a 
discount coupon (as defined in paragraph (c)(2)(i) of this section) to 
be considered a qualified discount coupon, all of the following 
requirements must be met:
    (i) The coupon must have been issued by and must be redeemable by 
the taxpayer;
    (ii) The coupon must allow a discount on the purchase price of 
merchandise or other tangible personal property;
    (iii) The face amount of the coupon must not exceed five dollars;
    (iv) The coupon, by its terms, may not be used with other coupons to 
bring about a price discount reimbursable by the issuer of more than 
five dollars with respect to any item; and
    (v) There must exist a redemption chain (as defined in paragraph 
(c)(2)(ii)

[[Page 340]]

of this section) with respect to the coupon.
    (2) Definitions--(i) Discount coupon. A discount coupon is a sales 
promotion device used to encourage the purchase of a specific product by 
allowing a purchaser of that product to receive a discount on its 
purchase price. The term ``discount coupon'' does not include trading 
stamps or premium coupons, which are subject to the method of accounting 
in Sec.  1.451-4. A discount coupon may or may not be issued as part of 
a prior purchase. A discount coupon normally entitles its holders to 
receive nothing more than a reduction in the sales price of one of the 
issuer's products. The discount may be stated in terms of a cash amount, 
a percentage or fraction of the purchase price, a ``two for the price of 
one'' deal, or any other similar provision. A discount coupon need not 
be printed on paper in the form usually associated with coupons; it may 
be a token or other object so long as it functions as a coupon.
    (ii) Redemption chain. A redemption chain exists when the issuer 
redeems the coupon from some person other than the customer who used the 
coupon to receive the price discount. Thus, in order to be treated as a 
qualified discount coupon, the coupon must not be issued by the person 
that initially redeems the coupon from the customer. For purposes of 
determining whether a redemption chain exists, corporations that are 
members of the same controlled group of corporations (as defined in 
section 1563(a)) as the issuer of the coupon shall be treated as the 
issuer. Thus, if the issuer of the coupon and the retailer that 
initially redeems the coupon from the customer are members of the same 
controlled group of corporations, the coupon shall not be treated as a 
qualified discount coupon.
    (d) Deduction for coupons redeemed during the redemption period--(1) 
General rule. Two special conditions must be met before the cost of 
redeeming qualified discount coupons during the redemption period can be 
deducted from the taxpayer's gross income for the taxable year preceding 
the redemption period. First, the qualified discount coupons must have 
been outstanding at the close of such taxable year. Second, the 
qualified discount coupons must have been received by the taxpayer 
before the close of the redemption period for that taxable year.
    (2) Redemption period. The taxpayer can select any redemption period 
so long as the period does not extend longer than 6 months after the 
close of the taxapayer's taxable year. A change in the redemption period 
so selected shall be treated as a change in method of accounting.
    (3) Coupons received. The deduction provided for in section 
466(a)(1) is limited to the redemption costs associated with coupons 
that are actually received by the taxpayer within the redemption period. 
For purposes of this paragraph, if the issuer uses a redemption agent or 
clearinghouse to group, count, and verify coupons after they have been 
redeemed by a retailer, the coupons received by the redemption agent or 
clearinghouse will be

considered to have been received by the issuer. Nothing in section 466, 
however, allows deductions to be made on the basis of estimated 
redemptions, whether such estimates are made by either the issuer or 
some other party.
    (e) Transitional adjustment--(1) In general. An election to change 
from some other method of accounting for the redemption of discount 
coupons to the method of accounting described in section 466 is a change 
in method of accounting that requires a transitional adjustment. Unless 
the taxpayer can qualify for a waiver of the suspense account 
requirement as provided for in section 373(c) of the Revenue Act of 1978 
(92 Stat. 2865), the taxpayer should compute the transitional adjustment 
described in section 481(a)(2) according to the rules contained in this 
section. This adjustment should be taken into account according to the 
special rules in subsections (e) and (f) of section 466.
    (2) Net increase in taxable income. In the case of a transitional 
adjustment that would result in a net increase in taxable income under 
section 481(a)(2) for the year of change, that increase should be taken 
into income over a ten-year period consisting of the year of change and 
the immediately succeeding nine taxable years. For example, assume that 
A, a calendar year taxpayer, makes an election to use the

[[Page 341]]

method of accounting described in section 466 for the year 1980 and for 
subsequent years. Assume further that the amount of the transitional 
adjustment computed under section 481(a)(2) would result in a net 
increase in taxable income of $100 for 1980. Under these facts, A should 
increase taxable income for 1980 and each of the next nine taxable years 
by $10.
    (3) Suspense account--(i) In general. In the case of a transitional 
adjustment that would result in a net decrease in taxable income under 
section 481(a)(2) for the year of change, in lieu of applying section 
481, the taxpayer must establish a separate suspense account for each 
trade or business for which the taxpayer has made an election to use 
section 466. The computation of the initial opening balance in the 
suspense account is described in paragraph (e)(3)(ii)(A) of this 
section. An initial adjustment to gross income for the year of election 
is described in paragraph (e)(3)(ii)(B) of this section. Annual 
adjustments to the suspense account are described in paragraph 
(e)(3)(iii)(A) of this section, and gross income adjustments are 
described in paragraph (e)(3)(iii)(B) of this section. Examples are 
provided in paragraph (e)(4) of this section. The effect of the suspense 
account is to defer some part of, or all of, the deduction of the 
transitional adjustment until the taxpayer no longer redeems discount 
coupons in connection with the trade or business to which the suspense 
account relates.
    (ii) Establishing a suspense account--(A) Initial opening balance. 
To compute the initial opening balance of the suspense account for the 
first taxable year for which the election to use section 466 is 
effective, the taxpayer must determine the dollar amount of the 
deduction that would have been allowed for qualified discount coupon 
redemption costs during the redemption period for each of the three 
immediately preceding taxable years had the election to use section 466 
been in effect for those years. The initial opening balance of the 
suspense account is the largest such dollar amount reduced by the sum of 
the adjustments attributable to the change in method of accounting that 
increase income for the year of change.
    (B) Initial year adjustment. If, in computing the initial opening 
balance, the largest dollar amount of deduction that would have been 
allowed in any of the three prior years exceeds the actual cost of 
redeeming qualified discount coupons received during the redemption 
period following the close of the year immediately preceding the year of 
election, the excess is included in income in the year of election. 
Section 481(b) does not apply to this increase in gross income.
    (iii) Annual adjustments--(A) Adjustment to the suspense account. 
Adjustments are made to the suspense account each year to account for 
fluctuations in coupon redemptions. To compute the annual adjustment, 
the taxpayer must determine the amount to be deducted under section 
466(a)(1) for the taxable year. If the amount is less than the opening 
balance in the suspense account for the taxable year, the balance in the 
suspense account is reduced by the difference. Conversely, if such 
amount is greater than the opening balance in the suspense account for 
the taxable year, the account is increased by the difference (but not to 
an amount in excess of the initial opening balance described in 
paragraph (e)(3)(ii) of this section). Therefore, the balance in the 
suspense account will never be greater than the initial opening balance 
in the suspense account determined in paragraph (e)(3)(ii) of this 
section. However, the balance in the suspense account after adjustments 
may be less than this initial opening balance in the suspense account.
    (B) Gross income adjustments. Adjustments to the suspense account 
for years subsequent to the year of the election also produce 
adjustments in the taxpayer's gross income. Adjustments which reduce the 
balance in the suspense account reduce gross income for the year in 
which the adjustment to the suspense account is made. Adjustments which 
increase the balance in the suspense account increase gross income for 
the year in which the adjustment to the suspense account is made.
    (4) Examples. (i) The provisions of paragraph (e)(3) of this section 
may be illustrated by the following examples:


[[Page 342]]


    Example 1. Assume that the issuer of qualified discount coupons 
makes a timely election under section 466 for its taxable year ending 
December 31, 1979, and does not select a coupon redemption period 
shorter than the statutory period of 6 months. Assume further that the 
taxpayer's qualified discount coupon redemption costs in the first 6 
months of 1977, 1978, and 1979 were $7, $13, and $8 respectively, and 
that the accounting change adjustments that increase income for 1979 are 
$10. Since the accounting change adjustment that increases income for 
1979, ($10), is greater than the taxpayer's discount coupon redemptions 
during the first 6 months of 1979 ($8), the net section 481(a)(2) 
adjustment for the year of change results in a positive adjustment. 
Because of this, a suspense account is not required. The taxpayer should 
instead follow the rules in section 466(f) and in paragraph (e)(2) of 
this section in order to take this positive transitional adjustment into 
account.
    Example 2. Assume the same facts as in Example 1, except that the 
sum of the accounting change adjustments that increase income for 1979 
is equal to $2. Under these facts the initial opening balance in the 
suspense account on January 1, 1979 would be $11 (that is, the largest 
dollar amount of qualified coupon redemption costs in the pertinent 
years ($13), reduced by the sum of the accounting change adjustments 
that increase income in the year of change ($2)). Since the coupon 
redemption costs taken into account in determining the initial opening 
balance ($13 in 1979) exceed the actual redemption costs in the first 6 
months of the taxable year for which the election is first effective ($8 
in 1979), the excess of $5 is added to gross income for the year of 
election (1979).
    Example 3. Assume, in addition to the facts of Example 2, that 
coupon redemption costs during the redemption period for the 1979 
taxable year are $7. Since the qualifying redemption costs ($7) during 
the redemption period for the taxable year are less than the opening 
balance in the suspense account ($11) the taxpayer must reduce the 
suspense account balance by the difference ($4). The taxpayer is also 
allowed to take a deduction equal to the amount of this adjustment to 
the suspense account. Thus, the net amount deductible for the 1979 
taxable year after taking into account the coupon redemptions during the 
redemption period, the amount deductible because of the decrease in the 
suspense account, and the initial year adjustment determined in Example 
2 is $6 ($7 + $4-$5).
    Example 4. Assume, in addition to the facts of Example 3, that 
coupon redemption costs during the redemption period for the 1980 
taxable year are $10. Since the qualifying redemption costs during the 
redemption period for the taxable year ($10) exceed the opening balance 
of the suspense account at the beginning of the taxable year ($7), the 
suspense account must be increased by the difference ($3). The taxpayer 
must also include $3 in gross income for the taxable year. Thus, the net 
amount deductible for the 1980 taxable year is $7 ($10-$3).
    Example 5. Assume, in addition to the facts of Example 4, that 
coupon redemption costs during the redemption period for the 1981 
taxable year are $12. Since the qualifying redemption costs for the 1961 
taxable year ($12) exceed the opening balance of the suspense account at 
the beginning of the taxable year ($10), the suspense account must be 
increased by the difference ($2) but not above the initial opening 
balance ($11). Thus, the taxpayer will increase the balance by $1. The 
taxpayer must also include $1 in gross income for the taxable year. 
Thus, the net amount deductible for the 1981 taxable year is $11 ($12-
$1).

    (ii) The following table summarizes examples (2) through (5):

------------------------------------------------------------------------
                                         Years ending Dec. 31--
                               -----------------------------------------
                                 1977   1978   1979   1980   1981   1982
------------------------------------------------------------------------
Facts:
    Actual coupon redemption       $7    $13     $8     $7    $10    $12
     costs in first six months
    Accounting change           .....  .....      2  .....  .....  .....
     adjustments that increase
     income in year of change.
                               -----------------------------------------
    Net adjustment decreasing   .....  .....      6  .....  .....  .....
     income in year of change
     under sec. 481(a)(2).....
                               -----------------------------------------
Adjustment to suspense
 account:
    Opening balance...........  .....  .....     11      7     10     11
    Addition to account.......  .....  .....  .....      3      1  .....
    Reduction to account......  .....  .....    (4)  .....  .....  .....
                               -----------------------------------------
        Opening balance for     .....  .....      7     10     11  .....
         next year............
                               -----------------------------------------
Amount deductible:
    Initial year adjustment...  .....  .....    (5)  .....  .....  .....
    Amount of deductible as     .....  .....      7     10     12  .....
     actual coupon redemptions
     during redemption period.
    Adjustment for increase in  .....  .....  .....    (3)    (1)  .....
     suspense account.........

[[Page 343]]

 
    Adjustment for decrease in  .....  .....      4  .....  .....  .....
     suspense account.........
                               -----------------------------------------
        Net amount deductible   .....  .....      6      7     11  .....
         for the year for
         coupons redeemed
         during the redemption
         period...............
------------------------------------------------------------------------

    (f) Subchapter C transactions--(1) General rule. If a transfer of 
substantially all the assets of a trade or business in which discount 
coupons are redeemed is made to an acquiring corporation, and if the 
acquiring corporation determines its bases in these assets, in whole or 
part, with reference to the basis of these assets in the hands of the 
transferor, then for the purposes of section 466(e) the principles of 
section 381 and Sec.  1.381(c)(4)-1 will apply. The application of this 
rule is not limited to the transactions described in section 381(a). 
Thus, the rule also applies, for example, to transactions described in 
section 351.
    (2) Special rules. If, in the case of a transaction described in 
paragraph (f)(1) of this section, an acquiring corporation acquires 
assets that were used in a trade or business that was not subject to a 
section 466 election from a transferor that is owned or controlled 
directly (or indirectly through a chain of corporations) by the same 
interests, and if the acquiring corporation uses the acquired assets in 
a trade or business for which the acquiring corporation later makes an 
election to use section 466, then the acquiring corporation must 
establish a suspense account by taking into account not only its own 
experience but also the transferor's experience when the transferor held 
the assets in its trade or business. Furthermore, the transferor is not 
allowed a deduction for qualified discount coupons redeemed after the 
date of the transfer attributable to discount coupons issued by the 
transferor before the date of the transfer. Such redemptions shall be 
considered to be made by the acquiring corporation.
    (3) Example. The provisions of paragraph (f)(2) of this section may 
be illustrated by the following example:

    Example. Corporation S, a calendar year taxpayer, is a wholly owned 
subsidiary of Corporation P, a calendar year taxpayer. On December 31, 
1982, S acquires from P sustantially all of the assets used in a trade 
or business in which qualified disount coupons are redeemed. P had not 
made an election under section 466 with respect to the redemption costs 
of the qualified discount coupons issued in connection with that trade 
or business. S makes an election to use section 466 for its taxable year 
ending December 31, 1983, for the trade or business in which the 
acquired assets are used, and selects a redemption period of 6 months. 
Assume that P's qualified discount coupon redemption costs in the first 
6 months of 1981 and 1982 were $120 and $140 respectively. Assume 
further that S's qualified discount coupon redemption costs in the first 
6 months of 1983 were $130, and that there are no accounting change 
adjustments that increase income with respect to the election. S must 
establish a suspense account by taking into account the largest dollar 
amount of deductions that would have been allowed under section 
466(a)(1) for the 3 immediately preceding taxable years of P, including 
both P's and S's experience with respect to costs actually incurred 
during the redemption periods relating to those years. Thus, the initial 
opening balance of S's suspense account is $140. S must also make an 
initial year adjustment of $10 ($140-$130), which S must include in 
income for S's taxable year ending December 31, 1983. P may not take a 
deduction for the qualified coupon redemptions made after December 31, 
1982, that are attributable to coupons issued by P before December 31, 
1982. Thus, none of the $130 qualified discount coupon redemption costs 
incurred by S during the first six months of 1983 may be deducted by P.

[T.D. 8022, 50 FR 18474, May 1, 1985, as amended at 50 FR 21046, May 22, 
1985]



Sec.  1.466-2  Special protective election for certain taxpayers.

    (a) General rule. Section 373(c) of the Revenue Act of 1978 (92 
Stat. 2865) allows certain taxpayers, who in prior years have accounted 
for discount coupons under a method of accounting reasonably similar to 
the method described in Sec.  1.451-4, to elect to treat that method of 
accounting as a proper one for those prior years. There are

[[Page 344]]

several differences between this protective election and the section 
466(d) election. First, the protective election applies only to a single 
continuous period of taxable years the last year of which ends before 
January 1, 1979. Second, an otherwise qualifying protective election may 
apply to coupons which are discount coupons but which would not be 
treated as qualified discount coupons under Code section 466. Third, 
certain expenses such as the cost of redemption center service fees, and 
amounts that are payable to the retailer (or other person redeeming the 
coupons from the person receiving the price discount) for services in 
redeeming the coupons but that are not stated on the coupon, can be 
subtracted from gross receipts for prior years covered by a protective 
election (if treated as deductible under the accounting method for such 
years), even though such expenses would not be deductible under Code 
section 466.
    (b) Requirements. In order to qualify for this special protective 
election, the following conditions must be met:
    (1) For a continuous period of one or more prior taxable years, (the 
last year of which ends before Jan. 1, 1979), the taxpayer must have 
used a method of accounting for discount coupons that is reasonably 
similar to the method provided in Sec.  1.451-4 or its predecessors 
under the Internal Revenue Code of 1954;
    (2) The taxpayer must make an election under section 466 of the 
Internal Revenue Code of 1954 according to the rules contained in Sec.  
1.466-3 for its first taxable year ending after December 31, 1978; and
    (3) The taxpayer must make an election under section 373(c) of the 
Revenue Act of 1978 according to the rules contained in Sec.  1.466-4 
for its first taxable year ending after December 31, 1978.
    (c) Amount to be subtracted from gross receipts. The amount the 
taxpayer may subtract under this section for the redemption costs of 
coupons shall include only:
    (1) Costs of the type permitted by Sec.  1.451-4 to be included in 
the estimated average cost of redeeming coupons, plus
    (2) Any amount designated or referred to on the coupon payable by 
the taxpayer to the person who allowed the discount on a sale by such 
person to the user of the coupon.

Nothing in this paragraph shall allow an item to be deducted more than 
once.
    (d) Right to amend prior tax returns. This paragraph applies only to 
those taxpayers who have agreed in a prior year to discontinue the use 
of the method of accounting described in Sec.  1.451-4 for discount 
coupon redemptions. If the taxpayer used such method of accounting on 
the original return filed for the prior taxable year, and if any such 
year is not closed under the statute of limitations or by reason of a 
closing agreement with the Internal Revenue Service, a taxpayer who has 
made a protective election may file an amended return and a claim for 
refund for such years. In this amended return, the taxpayer should 
account for its discount coupon redemptions, according to the method of 
accounting described in Sec.  1.451-4. This is not to be construed, 
however, to abrogate in any way the rules regarding the close of taxable 
years due to the statute of limitations or a binding closing agreement 
between the Internal Revenue Service and the taxpayer.
    (e) Suspense account not required. If the following three conditions 
are satisfied, the taxpayer need not establish the suspense account 
otherwise required by section 466(e). First, the taxpayer must make a 
timely election under these rules to protect prior years. Second, the 
method of accounting used in those years must have been used for all 
discount coupons issued by the taxpayer in those years in all the 
taxpayer's separate trades or

businesses in which coupons were issued. Third, either before or after 
an amendment to the taxpayer's tax returns as described in paragraph (d) 
of this section, a method of accounting reasonably similar to the method 
of accounting described in Sec.  1.451-4 must have been used for the 
taxable year ending on or before December 31, 1978. If these conditions 
are met, the taxpayer will treat the election of the method under 
section 466 as a change in method of accounting to which the

[[Page 345]]

rules in section 481 and the regulations thereunder apply.
    (f) Definition: reasonably similar. For purposes of paragraphs 
(b)(1) and (e) of this section, a taxpayer will be considered to have 
used a method of accounting for discount coupons that is ``reasonably 
similar'' to the method of accounting provided in Sec.  1.451-4 if the 
taxpayer followed the method of accounting described in Sec.  1.451-4 as 
if that method were a valid method of accounting for discount coupon 
redemptions.

[T.D. 8022, 50 FR 18476, May 1, 1985]



Sec.  1.466-3  Manner of and time for making election under section 466.

    (a) In general. Section 466 provides a special method of accounting 
for accrual basis taxpayers who issue qualified discount coupons (as 
defined in section 466(b)). In order to use the special method under 
section 466, a taxpayer must make an election with respect to the trade 
or business in connection with which the qualified discount coupons are 
issued. If a taxpayer issues qualified discount coupons in connection 
with more than one trade or business, the taxpayer may use the special 
method of accounting under section 466 only with respect to the 
qualified discount coupons issued in connection with a trade or business 
for which an election is made. The election must be made in the manner 
prescribed in this section. The election does not require the prior 
consent of the Internal Revenue Service. An election under section 466 
is effective for the taxable year for which it is made and for all 
subsequent taxable years, unless the taxpayer secures the prior consent 
of the Internal Revenue Service to revoke such election.
    (b) Manner of and time for making election--(1) General rule. Except 
as provided in paragraph (b)(2) of this section, an election is made 
under section 466 and this section by filing a statement of election 
containing the information described in paragraph (c) of this section 
with the taxpayer's income tax return for the taxpayer's first taxable 
year for which the election is made. The election must be made not later 
than the time prescribed by law (including extensions thereof) for 
filing the income tax return for the first taxable year for which the 
election is made. Thus, the election may not be made for a taxable year 
by filing an amended income tax return after the time prescribed 
(including extensions) for filing the original return for such year.
    (2) Transitional rule. If the last day of the time prescribed by law 
(including extensions thereof) for filing a taxpayer's income tax return 
for the taxpayer's first taxable year ending after December 31, 1978, 
falls before December 3, 1979, and the taxpayer does not make an 
election under section 466 with respect to such taxable year in the 
manner prescribed by paragraph (b)(1) of this section, an election is 
made under section 466 and this section with respect to such taxable 
year if--
    (i) Within the time prescribed by law (including extensions thereof) 
for filing the taxpayer's income tax return for such taxable year, the 
taxpayer has made a reasonable effort to notify the Commissioner of the 
taxpayer's intent to make an election under section 466 with respect to 
such taxable year, and
    (ii) Before January 2, 1980, the taxpayer files a statement of 
election

containing the information described in paragraph (c) of this section to 
be associated with the taxpayer's income tax return for such taxable 
year.

For purposes of paragraph (b)(2)(i) of this section, a reasonable effort 
to notify the Commissioner of an intent to make an election under 
section 466 with respect to a taxable year includes the timely filing of 
an income tax return for such taxable year if the taxable income 
reported on the return reflects a deduction for the redemption costs of 
qualified discount coupons as determined under section 466(a).
    (c) Required information. The statement of election required by 
paragraph (b) of this section must indicate that the taxpayer 
(identified by name, address, and taxpayer identification number) is 
making an election under section 466 and must set forth the following 
information:
    (1) A description of each trade or business for which the election 
is made;
    (2) The first taxable year for which the election is made;

[[Page 346]]

    (3) The redemption period (as defined in section 466(c)(2)) for each 
trade or business for which the election is made;
    (4) If the taxpayer is required to establish a suspense account 
under section 466(e) for a trade or business for which the election is 
made, the initial opening balance of such account (as defined in section 
466(e)(2)) for each such trade or business; and
    (5) In the case of an election under section 466 that results in a 
net increase in taxable income under section 481(a)(2), the amount of 
such net increase.

The statement of election should be made on a Form 3115, which need 
contain no information other than that required by this paragraph or 
paragraph (c) of Sec.  1.466-4.

[T.D. 8022, 50 FR 18477, May 1, 1985]



Sec.  1.466-4  Manner of and time for making election under section 373(c) 
of the Revenue Act of 1978.

    (a) In general. Section 373(c)(2) of the Revenue Act of 1978 (92 
Stat. 2865) provides an election for taxpayers who satisfy the 
requirements of section 373(c)(2)(A) (i) and (ii) of the Act. The 
election is made with respect to a method of accounting for the 
redemption costs of discount coupons used by the electing taxpayer in a 
continuous period of one or more taxable years ending before January 1, 
1979. The election must be made in the manner prescribed by this 
section. The election does not require the prior consent of the Internal 
Revenue Service.
    (b) Manner of and time for making election--(1) General rule. Except 
as provided in paragraph (b)(2) of this section, the election under 
section 373(c) of the Revenue Act of 1978 is made by filing a statement 
of election containing the information described in paragraph (c) of 
this section with the taxpayer's income tax return for the taxpayer's 
first taxable year ending after December 31, 1978. The election must be 
made not later than the time prescribed by law (including extensions 
thereof) for filing the income tax return for the taxpayer's first 
taxable year ending after December 31, 1978. Thus, the election may not 
be made with an amended income tax return for such year filed after the 
time prescribed (including extensions) for filing the original return.
    (2) Transitional rule. If the last day of the time prescribed by law 
(including extensions thereof) for filing a taxpayer's income tax return 
for the taxpayer's first taxable year ending after December 31, 1978, 
falls before December 3, 1979, and the taxpayer does not make an 
election in the manner prescribed by paragraph (b)(1) of this section, 
an election is made under section 373(c) of the Act and this section 
with respect to a continuous period if--
    (i) Within the time prescribed by law (including extensions thereof) 
for filing the taxpayer's income tax return for the taxpayer's first 
taxable year ending after December 31, 1978, the taxpayer has made a 
reasonable effort to notify the Commissioner of the taxpayer's intent to 
make election under section 373(c) of the Act with respect to the 
continuous period, and
    (ii) Before January 2, 1980, the taxpayer files a statement of 
election containing the information described in paragraph (c) of this 
section to be associated with the taxpayer's income tax return for the 
taxpayer's first taxable year ending after December 31, 1978.
    (c) Required information. The statement of election required by 
paragraph (b) of this section must indicate that the taxpayer 
(identified by name, address, and taxpayer identification number) is 
making an election under section 373(c) of the Revenue Act of 1978 and 
must set forth the taxable years in the continuous period for which the 
election is made. The statement of election should be made on the same 
form 3115 on which the taxpayer has made a statement of election under 
section 466. The Form 3115 need contain no information other than that 
required by this paragraph or paragraph (c) of Sec.  1466-3.

[T.D. 8022, 50 FR 18478, May 1, 1985]



Sec.  1.467-0  Table of contents.

    This section lists the captions that appear in Sec. Sec.  1.467-1 
through 1.467-9.

        Sec.  1.467-1 Treatment of lessors and lessees generally.

    (a) Overview.
    (1) In general.

[[Page 347]]

    (2) Cases in which rules are inapplicable.
    (3) Summary of rules.
    (i) Basic rules.
    (ii) Special rules.
    (4) Scope of rules.
    (5) Application of other authorities.
    (b) Method of accounting for section 467 rental agreements.
    (c) Section 467 rental agreements.
    (1) In general.
    (2) Increasing or decreasing rent.
    (i) Fixed rent.
    (A) In general.
    (B) Certain rent holidays disregarded.
    (ii) Fixed rent allocated to a rental period.
    (A) Specific allocation.
    (1) In general.
    (2) Rental agreements specifically allocating fixed rent.
    (B) No specific allocation.
    (iii) Contingent rent.
    (A) In general.
    (B) Certain contingent rent disregarded.
    (3) Deferred or prepaid rent.
    (i) Deferred rent.
    (ii) Prepaid rent.
    (iii) Rent allocated to a calendar year.
    (iv) Examples.
    (4) Rental agreements involving total payments of $250,000 or less.
    (i) In general.
    (ii) Special rules in computing amount described in paragraph 
(c)(4)(i) of this section.
    (d) Section 467 rent.
    (1) In general.
    (2) Fixed rent for a rental period.
    (i) Constant rental accrual.
    (ii) Proportional rental accrual.
    (iii) Section 467 rental agreement accrual.
    (e) Section 467 interest.
    (1) In general.
    (2) Interest on fixed rent for a rental period.
    (i) In general.
    (ii) Section 467 rental agreements with adequate interest.
    (3) Treatment of interest.
    (f) Substantial modification of a rental agreement.
    (1) Treatment as new agreement.
    (i) In general.
    (ii) Limitation.
    (2) Post-modification agreement; in general.
    (3) Other effects of a modification.
    (4) Special rules.
    (i) Carryover of character; leasebacks.
    (ii) Carryover of character; long-term agreements.
    (iii) Carryover of character; disqualified agreements.
    (iv) Allocation of rent.
    (v) Difference between aggregate rent and interest and aggregate 
payments.
    (A) In general.
    (B) Constant rental accrual prior to the modification.
    (C) Agreements described in this paragraph (f)(4)(v)(C).
    (vi) Principal purpose of tax avoidance.
    (5) Definitions.
    (6) Safe harbors.
    (7) Special rules for certain transfers.
    (i) In general.
    (ii) Exception.
    (g) Treatment of amounts payable by lessor to lessee.
    (1) Interest.
    (2) Other amounts. [Reserved]
    (h) Meaning of terms.
    (i) [Reserved]
    (j) Computational rules.
    (1) Counting conventions.
    (2) Conventions regarding timing of rent and payments.
    (i) In general.
    (ii) Time amount is payable.
    (3) Annualized fixed rent.
    (4) Allocation of fixed rent within a period.
    (5) Rental period length.

  Sec.  1.467-2 Rent accrual for section 467 rental agreements without 
                           adequate interest.

    (a) Section 467 rental agreements for which proportional rental 
accrual is required.
    (b) Adequate interest on fixed rent.
    (1) In general.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest.
    (3) Agreements with both deferred and prepaid rent.
    (c) Computation of proportional rental amount.
    (1) In general.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest.
    (d) Present value.
    (e) Applicable Federal rate.
    (1) In general.
    (2) Source of applicable Federal rates.
    (3) 110 percent of applicable Federal rate.
    (4) Term of the section 467 rental agreement.
    (i) In general.
    (ii) Section 467 rental agreements with variable interest.
    (f) Examples.

     Sec.  1.467-3 Disqualified leasebacks and long-term agreements.

    (a) General rule.
    (b) Disqualified leaseback or long-term agreement.
    (1) In general.
    (2) Leaseback.
    (3) Long-term agreement.
    (i) In general.
    (ii) Statutory recovery period.
    (A) In general.
    (B) Special rule for rental agreements relating to properties having 
different statutory recovery periods.
    (c) Tax avoidance as principal purpose for increasing or decreasing 
rent.

[[Page 348]]

    (1) In general.
    (2) Tax avoidance.
    (i) In general.
    (ii) Significant difference in tax rates.
    (iii) Special circumstances.
    (3) Safe harbors.
    (4) Uneven rent test.
    (i) In general.
    (ii) Special rule for real estate.
    (iii) Operating rules.
    (d) Calculating constant rental amount.
    (1) In general.
    (2) Initial or final short periods.
    (3) Method to determine constant rental amount; no short periods.
    (i) Step 1.
    (ii) Step 2.
    (iii) Step 3.
    (e) Examples.

                     Sec.  1.467-4 Section 467 loan.

    (a) In general.
    (1) Overview.
    (2) No section 467 loan in the case of certain section 467 rental 
agreements.
    (3) Rental agreements subject to constant rental accrual.
    (4) Special rule in applying the provisions of Sec.  1.467-7 (e), 
(f), or (g).
    (b) Principal balance.
    (1) In general.
    (2) Section 467 rental agreements that provide for prepaid fixed 
rent and adequate interest.
    (3) Timing of payments.
    (c) Yield.
    (1) In general.
    (i) Method of determining yield.
    (ii) Method of stating yield.
    (iii) Rounding adjustments.
    (2) Yield of section 467 rental agreements for which constant rental 
amount or proportional rental amount is computed.
    (3) Yield for purposes of applying paragraph (a)(4) of this section.
    (4) Determination of present values.
    (d) Contingent payments.
    (e) Section 467 rental agreements that call for payments before or 
after the lease term.
    (f) Examples.

   Sec.  1.467-5 Section 467 rental agreements with variable interest.

    (a) Variable interest on deferred or prepaid rent.
    (1) In general.
    (2) Exceptions.
    (b) Variable rate treated as fixed.
    (1) In general.
    (2) Variable interest adjustment amount.
    (i) In general.
    (ii) Positive or negative adjustment.
    (3) Section 467 loan balance.
    (c) Examples.

 Sec.  1.467-6 Section 467 rental agreements with contingent payments. 
                               [Reserved]

    Sec.  1.467-7 Section 467 recapture and other rules relating to 
                     dispositions and modifications.

    (a) Section 467 recapture.
    (b) Recapture amount.
    (1) In general.
    (2) Prior understated inclusion.
    (3) Section 467 gain.
    (i) In general.
    (ii) Certain dispositions.
    (c) Special rules.
    (1) Gifts.
    (2) Dispositions at death.
    (3) Certain tax-free exchanges.
    (i) In general.
    (ii) Dispositions covered.
    (A) In general.
    (B) Transfers to certain tax-exempt organizations.
    (4) Dispositions by transferee.
    (5) Like-kind exchanges and involuntary conversions.
    (6) Installment sales.
    (7) Dispositions covered by section 170(e), 341(e)(12), or 751(c).
    (d) Examples.
    (e) Other rules relating to dispositions.
    (1) In general.
    (2) Treatment of section 467 loan.
    (3) [Reserved]
    (4) Examples.
    (f) Treatment of assignments by lessee and lessee-financed renewals.
    (1) Substitute lessee use.
    (2) Treatment of section 467 loan.
    (3) Lessor use.
    (4) Examples.
    (g) Application of section 467 following a rental agreement 
modification.
    (1) Substantial modifications.
    (i) Treatment of pre-modification items.
    (ii) Computations with respect to post-modification items.
    (iii) Adjustments.
    (A) Adjustment relating to certain prepayments.
    (B) Adjustment relating to retroactive beginning of lease term.
    (iv) Coordination with rules relating to dispositions and 
assignments.
    (A) Dispositions.
    (B) Assignments.
    (2) Other modifications.
    (i) Computation of section 467 loan for modified agreement.
    (ii) Change in balance of section 467 loan.
    (iii) Section 467 rent and interest after the modification.
    (iv) Applicable Federal rate.
    (v) Modification effective within a rental period.
    (vi) Other adjustments.
    (vii) Coordination with rules relating to dispositions and 
assignments.

[[Page 349]]

    (viii) Exception for agreements entered into prior to effective date 
of section 467.
    (3) Adjustment by Commissioner.
    (4) Effective date of modification.
    (5) Examples.
    (h) Omissions or duplications.
    (1) In general.
    (2) Example.

Sec.  1.467-8 Automatic consent to change to constant rental accrual for 
                       certain rental agreements.

    (a) General rule.
    (b) Agreements to which automatic consent applies.

 Sec.  1.467-9 Effective dates and automatic method changes for certain 
                               agreements.

    (a) In general.
    (b) Automatic consent for certain rental agreements.
    (c) Application of regulation project IA-292-84 to certain 
leasebacks and long-term agreements.
    (d) Entered into.
    (e) Change in method of accounting.
    (1) In general.
    (2) Application of regulation project IA-292-84.
    (3) Automatic change procedures.

[T.D. 8820, 64 FR 26851, May 18, 1999, as amended by T.D. 8917, 66 FR 
1039, Jan. 5, 2001]



Sec.  1.467-1  Treatment of lessors and lessees generally.

    (a) Overview--(1) In general. When applicable, section 467 requires 
a lessor and lessee of tangible property to treat rents consistently and 
to use the accrual method of accounting (and time value of money 
principles) regardless of their overall method of accounting. In 
addition, in certain cases involving tax avoidance, the lessor and 
lessee must take rent and stated or imputed interest into account under 
a constant rental accrual method, pursuant to which the rent is treated 
as accruing ratably over the entire lease term.
    (2) Cases in which rules are inapplicable. Section 467 applies only 
to leases (or other similar arrangements) that constitute section 467 
rental agreements as defined in paragraph (c) of this section. For 
example, a rental agreement is not a section 467 rental agreement, and, 
therefore, is not subject to the provisions of this section and 
Sec. Sec.  1.467-2 through 1.467-9 (the section 467 regulations), if it 
specifies equal amounts of rent for each month throughout the lease term 
and all payments of rent are due in the calendar year to which the rent 
relates (or in the preceding or succeeding calendar year). In addition, 
the section 467 regulations do not apply to a rental agreement that 
requires total rents of $250,000 or less. For purposes of determining 
whether the agreement has total rents of $250,000 or less, certain 
specified contingent rent is disregarded.
    (3) Summary of rules--(i) Basic rules. Paragraph (c) of this section 
provides rules for determining whether a rental agreement is a section 
467 rental agreement. Paragraphs (d) and (e) of this section provide 
rules for determining the amount of rent and interest, respectively, 
required to be taken into account by a lessor and lessee under a section 
467 rental agreement. Paragraphs (f) through (h) and (j) of this section 
provide various definitions and special rules relating to the 
application of the section 467 regulations. Paragraph (i) of this 
section is reserved.
    (ii) Special rules. Section 1.467-2 provides rules for section 467 
rental agreements that have deferred or prepaid rents without providing 
for adequate interest. Section 1.467-3 provides rules for application of 
the constant rental accrual method, including criteria for determining 
whether an agreement is subject to this method. Section 1.467-4 provides 
rules for establishing and adjusting a section 467 loan (the amount that 
a lessor is deemed to have loaned to the lessee, or vice versa, pursuant 
to the application of the section 467 regulations). Section 1.467-5 
provides rules for applying the section 467 regulations where a rental 
agreement requires payments of interest at a variable rate. Section 
1.467-6, relating to the treatment of certain section 467 rental 
agreements with contingent payments, is reserved. Section 1.467-7 
provides rules for the treatment of dispositions by a lessor of property 
subject to a section 467 rental agreement and the treatment of 
assignments by lessees and certain lessee-financed renewals of a section 
467 rental agreement. Section 1.467-7 also provides rules for the 
treatment of modified rental agreements. Section 1.467-8 provides 
special transitional rules relating to the method of

[[Page 350]]

accounting for certain rental agreements entered into on or before May 
18, 1999. Finally, Sec.  1.467-9 provides the effective date rules for 
the section 467 regulations.
    (4) Scope of rules. No inference should be drawn from any provision 
of this section or Sec. Sec.  1.467-2 through 1.467-9 concerning 
whether--
    (i) For Federal tax purposes, an arrangement constitutes a lease; or
    (ii) For Federal tax purposes, any obligation of the lessee under a 
rental agreement is treated as rent.
    (5) Application of other authorities. Notwithstanding section 467 
and the regulations thereunder, other authorities such as section 446(b) 
clear-reflection-of-income principles, section 482, and the substance-
over-form doctrine, may be applied by the Commissioner to determine the 
income and expense from a rental agreement (including the proper 
allocation of fixed rent under a rental agreement).
    (b) Method of accounting for section 467 rental agreements. If a 
rental agreement is a section 467 rental agreement, as described in 
paragraph (c) of this section, the lessor and lessee must each take into 
account for any taxable year the sum of--
    (1) The section 467 rent for the taxable year (as defined in 
paragraph (d) of this section); and
    (2) The section 467 interest for the taxable year (as defined in 
paragraph (e) of this section).
    (c) Section 467 rental agreements--(1) In general. Except as 
otherwise provided in paragraph (c)(4) of this section, the term section 
467 rental agreement means a rental agreement, as defined in paragraph 
(h)(12) of this section, that has increasing or decreasing rents (as 
described in paragraph (c)(2) of this section), or deferred or prepaid 
rents (as described in paragraph (c)(3) of this section).
    (2) Increasing or decreasing rent--(i) Fixed rent--(A) In general. A 
rental agreement has increasing or decreasing rent if the annualized 
fixed rent, as described in paragraph (j)(3) of this section, allocated 
to any rental period exceeds the annualized fixed rent allocated to any 
other rental period in the lease term.
    (B) Certain rent holidays disregarded. Notwithstanding the 
provisions of paragraph (c)(2)(i)(A) of this section, a rental agreement 
does not have increasing or decreasing rent if the increasing or 
decreasing rent is solely attributable to a rent holiday provision 
allowing reduced rent (or no rent) for a period of three months or less 
at the beginning of the lease term.
    (ii) Fixed rent allocated to a rental period--(A) Specific 
allocation--(1) In general. If a rental agreement provides a specific 
allocation of fixed rent, as described in paragraph (c)(2)(ii)(A)(2) of 
this section, the amount of fixed rent allocated to each rental period 
during the lease term is the amount of fixed rent allocated to that 
period by the rental agreement.
    (2) Rental agreements specifically allocating fixed rent. A rental 
agreement specifically allocates fixed rent if the rental agreement 
unambiguously specifies, for periods no longer than a year, a fixed 
amount of rent for which the lessee becomes liable on account of the use 
of the property during that period, and the total amount of fixed rent 
specified is equal to the total amount of fixed rent payable under the 
lease. For example, a rental agreement providing that rent is $100,000 
per calendar year, and providing for total payments of fixed rent equal 
to the total amount specified, specifically allocates rent. A rental 
agreement stating only when rent is payable does not specifically 
allocate rent.
    (B) No specific allocation. If a rental agreement does not provide a 
specific allocation of fixed rent (for example, because the total amount 
of fixed rent specified is not equal to the total amount of fixed rent 
payable under the lease), the amount of fixed rent allocated to a rental 
period is the amount of fixed rent payable during that rental period. If 
an amount of fixed rent is payable before the beginning of the lease 
term, it is allocated to the first rental period in the lease term. If 
an amount of fixed rent is payable after the end of the lease term, it 
is allocated to the last rental period in the lease term.

[[Page 351]]

    (iii) Contingent rent--(A) In general. A rental agreement has 
increasing or decreasing rent if it requires (or may require) the 
payment of contingent rent (as defined in paragraph (h)(2) of this 
section), other than contingent rent described in paragraph 
(c)(2)(iii)(B) of this section.
    (B) Certain contingent rent disregarded. For purposes of this 
paragraph (c)(2)(iii), rent is disregarded to the extent it is 
contingent as the result of one or more of the following provisions--
    (1) A qualified percentage rents provision, as defined in paragraph 
(h)(8) of this section;
    (2) An adjustment based on a reasonable price index, as defined in 
paragraph (h)(10) of this section;
    (3) A provision requiring the lessee to pay third-party costs, as 
defined in paragraph (h)(15) of this section;
    (4) A provision requiring the payment of late payment charges, as 
defined in paragraph (h)(4) of this section;
    (5) A loss payment provision, as defined in paragraph (h)(7) of this 
section;
    (6) A qualified TRAC provision, as defined in paragraph (h)(9) of 
this section;
    (7) A residual condition provision, as defined in paragraph (h)(13) 
of this section;
    (8) A tax indemnity provision, as defined in paragraph (h)(14) of 
this section;
    (9) A variable interest rate provision, as defined in paragraph 
(h)(16) of this section; or
    (10) Any other provision provided in regulations or other published 
guidance issued by the Commissioner, but only if the provision is 
designated as contingent rent to be disregarded for purposes of this 
paragraph (c)(2)(iii).
    (3) Deferred or prepaid rent--(i) Deferred rent. A rental agreement 
has deferred rent under this paragraph (c)(3) if the cumulative amount 
of rent allocated as of the close of a calendar year (determined under 
paragraph (c)(3)(iii) of this section) exceeds the cumulative amount of 
rent payable as of the close of the succeeding calendar year.
    (ii) Prepaid rent. A rental agreement has prepaid rent under this 
paragraph (c)(3) if the cumulative amount of rent payable as of the 
close of a calendar year exceeds the cumulative amount of rent allocated 
as of the close of the succeeding calendar year (determined under 
paragraph (c)(3)(iii) of this section).
    (iii) Rent allocated to a calendar year. For purposes of this 
paragraph (c)(3), the rent allocated to a calendar year is the sum of--
    (A) The fixed rent allocated to any rental period (determined under 
paragraph (c)(2)(ii) of this section) that begins and ends in the 
calendar year;
    (B) A ratable portion of the fixed rent allocated to any other 
rental period that begins or ends in the calendar year; and (C) Any 
contingent rent that accrues during the calendar year.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(3):

    Example 1. (i) A and B enter into a rental agreement that provides 
for the lease of property to begin on January 1, 2000, and end on 
December 31, 2003. The rental agreement provides that rent of $100,000 
accrues during each year of the lease term. Under the rental agreement, 
no rent is payable during calendar year 2000, a payment of $100,000 is 
to be made on December 31, 2001, and December 31, 2002, and a payment of 
$200,000 is to be made on December 31, 2003. A and B both select the 
calendar year as their rental period. Thus, the amount of rent allocated 
to each rental period under paragraph (c)(2)(ii) of this section is 
$100,000. Therefore, the rental agreement does not have increasing or 
decreasing rent as described in paragraph (c)(2)(i) of this section.
    (ii) Under paragraph (c)(3)(i) of this section, a rental agreement 
has deferred rent if, at the close of a calendar year, the cumulative 
amount of rent allocated under paragraph (c)(3)(iii) of this section 
exceeds the cumulative amount of rent payable as of the close of the 
succeeding year. In this example, there is no deferred rent: the rent 
allocated to 2000 ($100,000) does not exceed the cumulative rent payable 
as of December 31, 2001 ($100,000); the rent allocated to 2001 and 
preceding years ($200,000) does not exceed the cumulative rent payable 
as of December 31, 2002 ($200,000); the rent allocated to 2002 and 
preceding years ($300,000) does not exceed the cumulative rent payable 
as of December 31, 2003 ($400,000); and the rent allocated to 2003 and 
preceding years ($400,000) does not exceed the cumulative rent payable 
as of December 31, 2004 ($400,000). Therefore, because the rental 
agreement does not have increasing or decreasing rent and does not have 
deferred or prepaid rent, the rental agreement is not a section 467 
rental agreement.
    Example 2. (i) A and B enter into a rental agreement that provides 
for a 10-year lease

[[Page 352]]

of personal property, beginning on January 1, 2000, and ending on 
December 31, 2009. The rental agreement provides for accruals of rent of 
$10,000 during each month of the lease term. Under paragraph (c)(3)(iii) 
of this section, $120,000 is allocated to each calendar year. The rental 
agreement provides for a $1,200,000 payment on December 31, 2000.
    (ii) The rental agreement does not have increasing or decreasing 
rent as described in paragraph (c)(2)(i) of this section. The rental 
agreement, however, provides prepaid rent under paragraph (c)(3)(ii) of 
this section because the cumulative amount of rent payable as of the 
close of a calendar year exceeds the cumulative amount of rent allocated 
as of the close of the succeeding calendar year. For example, the 
cumulative amount of rent payable as of the close of 2000 ($1,200,000 is 
payable on December 31, 2000) exceeds the cumulative amount of rent 
allocated as of the close of 2001, the succeeding calendar year 
($240,000). Accordingly, the rental agreement is a section 467 rental 
agreement.

    (4) Rental agreements involving total payments of $250,000 or less--
(i) In general. A rental agreement is not a section 467 rental agreement 
if, as of the agreement date (as defined in paragraph (h)(1) of this 
section), it is not reasonably expected that the sum of the aggregate 
amount of rental payments under the rental agreement and the aggregate 
value of all other consideration to be received for the use of property 
(taking into account any payments of contingent rent, and any other 
contingent consideration) will exceed $250,000.
    (ii) Special rules in computing amount described in paragraph 
(c)(4)(i) of this section of this section. The following rules apply in 
determining the amount described in paragraph (c)(4)(i) of this section:
    (A) Stated interest on deferred rent is not taken into account. 
However, the Commissioner may recharacterize a portion of stated 
interest as additional rent if a rental agreement provides for interest 
on deferred rent at a rate that, in light of all of the facts and 
circumstances, is clearly greater than the arm's-length rate of interest 
that would have been charged in a lending transaction between the lessor 
and lessee.
    (B) Consideration that does not involve a cash payment is taken into 
account at its fair market value. A liability that is either assumed or 
secured by property acquired subject to the liability is taken into 
account at the sum of its remaining principal amount and accrued 
interest (if any) thereon or, in the case of an obligation originally 
issued at a discount, at the sum of its adjusted issue price and accrued 
qualified stated interest (if any), within the meaning of Sec.  1.1273-
1(c)(1).
    (C) All rental agreements that are part of the same transaction or a 
series of related transactions involving the same lessee (or any related 
person) and the same lessor (or any related person) are treated as a 
single rental agreement. Whether two or more rental agreements are part 
of the same transaction or a series of related transactions depends on 
all the facts and circumstances.
    (D) If an agreement includes a provision increasing or decreasing 
rent payable solely as a result of an adjustment based on a reasonable 
price index, the amount described in paragraph (c)(4)(i) of this section 
must be determined as if the applicable price index did not change 
during the lease term.
    (E) If an agreement includes a variable interest rate provision (as 
defined in paragraph (h)(16) of this section), the amount described in 
paragraph (c)(4)(i) of this section must be determined by using fixed 
rate substitutes (determined in the same manner as under Sec.  1.1275-
5(e), treating the agreement date as the issue date) for the variable 
rates of interest applicable to the lessor's indebtedness.
    (F) Contingent rent described in paragraphs (c)(2)(iii)(B)(3) 
through (8) of this section is not taken into account.
    (d) Section 467 rent--(1) In general. The section 467 rent for a 
taxable year is the sum of--
    (i) The fixed rent for any rental period (determined under paragraph 
(d)(2) of this section) that begins and ends in the taxable year;
    (ii) A ratable portion of the fixed rent for any other rental period 
beginning or ending in the taxable year; and
    (iii) In the case of a section 467 rental agreement that provides 
for contingent rent, the contingent rent that accrues during the taxable 
year.
    (2) Fixed rent for a rental period--(i) Constant rental accrual. In 
the case of a

[[Page 353]]

section 467 rental agreement that is a disqualified leaseback or long-
term agreement (as described in Sec.  1.467-3(b)), the fixed rent for a 
rental period is the constant rental amount (as determined under Sec.  
1.467-3(d)).
    (ii) Proportional rental accrual. In the case of a section 467 
rental agreement that is not described in paragraph (d)(2)(i) of this 
section, and does not provide adequate interest on fixed rent (as 
determined under Sec.  1.467-2(b)), the fixed rent for a rental period 
is the proportional rental amount (as determined under Sec.  1.467-
2(c)).
    (iii) Section 467 rental agreement accrual. In the case of a section 
467 rental agreement that is not described in either paragraph (d)(2)(i) 
or (ii) of this section, the fixed rent for a rental period is the 
amount of fixed rent allocated to the rental period under the rental 
agreement, as determined under paragraph (c)(2)(ii) of this section.
    (e) Section 467 interest--(1) In general. The section 467 interest 
for a taxable year is the sum of--
    (i) The interest on fixed rent for any rental period that begins and 
ends in the taxable year;
    (ii) A ratable portion of the interest on fixed rent for any other 
rental period beginning or ending in the taxable year; and
    (iii) In the case of a section 467 rental agreement that provides 
for contingent rent, any interest that accrues on the contingent rent 
during the taxable year.
    (2) Interest on fixed rent for a rental period--(i) In general. 
Except as provided in paragraph (e)(2)(ii) of this section and Sec.  
1.467-5(b)(1)(ii), the interest on fixed rent for a rental period is 
equal to the product of--
    (A) The principal balance of the section 467 loan (as described in 
Sec.  1.467-4(b)) at the beginning of the rental period; and
    (B) The yield of the section 467 loan (as described in Sec.  1.467-
4(c)).
    (ii) Section 467 rental agreements with adequate interest. Except in 
the case of a section 467 rental agreement that is a disqualified 
leaseback or long-term agreement, if a section 467 rental agreement 
provides adequate interest under Sec.  1.467-2(b)(1)(i) (agreements with 
no deferred or prepaid rent) or Sec.  1.467-2(b)(1)(ii) (agreements with 
adequate interest stated at a single fixed rate), the interest on fixed 
rent for a rental period is the amount of interest provided in the 
rental agreement for the period.
    (3) Treatment of interest. If the section 467 interest for a rental 
period is a positive amount, the lessor has interest income and the 
lessee has an interest expense. If the section 467 interest for a rental 
period is a negative amount, the lessee has interest income and the 
lessor has an interest expense. Section 467 interest is treated as 
interest for all purposes of the Internal Revenue Code.
    (f) Substantial modification of a rental agreement--(1) Treatment as 
new agreement--(i) In general. If a substantial modification of a rental 
agreement occurs after June 3, 1996, the post-modification agreement is 
treated as a new agreement and the date on which the modification occurs 
is treated as the agreement date in applying section 467 and the 
regulations thereunder to the post-modification agreement. Thus, for 
example, the post-modification agreement is treated as a new agreement 
entered into on the date the modification occurs for purposes of 
determining whether it is a section 467 rental agreement under this 
section, whether it is a disqualified leaseback or long-term agreement 
under Sec.  1.467-3, and whether it is entered into after the applicable 
effective date in Sec.  1.467-9.
    (ii) Limitation. In the case of a substantial modification of a 
rental agreement occurring on or before May 18, 1999, this paragraph (f) 
applies only if--
    (A) The rental agreement was a disqualified leaseback or long-term 
agreement before the modification and the agreement date, determined 
without regard to the modification, is after June 3, 1996; or
    (B) The post-modification agreement would, after application of the 
rules in this paragraph (f) (other than the special rule for 
disqualified agreements in paragraph (f)(4)(iii) of this section), be a 
disqualified leaseback or long-term agreement.
    (2) Post-modification agreement; in general. For purposes of 
determining whether a post-modification agreement is a section 467 
rental agreement or a

[[Page 354]]

disqualified leaseback or long-term agreement under paragraph (f)(1) of 
this section, the terms of the post-modification agreement are, except 
as provided in paragraph (f)(4) of this section, only those terms that 
provide for rights and obligations relating to post-modification items 
(within the meaning of paragraph (f)(5)(iv) of this section).
    (3) Other effects of a modification. For rules relating to amounts 
that must be taken into account following certain modifications, see 
Sec.  1.467-7(g).
    (4) Special rules--(i) Carryover of character; leasebacks. If an 
agreement is a leaseback prior to its modification and the lessee prior 
to the modification (or a related person) is the lessee after the 
modification, the post-modification agreement is a leaseback even if the 
post-modification lessee did not have an interest in the property at any 
time during the two-year period ending on the date on which the 
modification occurs.
    (ii) Carryover of character; long-term agreements. If an agreement 
is a long-term agreement prior to its modification and the entire 
agreement (as modified) would be a long-term agreement, the post-
modification agreement is a long-term agreement.
    (iii) Carryover of character; disqualified agreements. If an 
agreement (as in effect before its modification) is a disqualified 
leaseback or long-term agreement as the result of a determination 
(whether occurring before or after the modification) under Sec.  1.467-
3(b)(1)(ii) and the post-modification agreement is a section 467 rental 
agreement (or the entire agreement (as modified) would be a section 467 
rental agreement), the post-modification agreement will, notwithstanding 
its treatment as a new agreement under paragraph (f)(1)(i) of this 
section, be subject to constant rental accrual unless the Commissioner 
determines that, because of the absence of tax avoidance potential, the 
post-modification agreement should not be treated as a disqualified 
leaseback or long-term agreement.
    (iv) Allocation of rent. If the entire agreement (as modified) 
provides a specific allocation of fixed rent, as described in paragraph 
(c)(2)(ii)(A)(2) of this section, the post-modification agreement is 
treated as an agreement that provides a specific allocation of fixed 
rent. If the entire agreement (as modified) does not provide a specific 
allocation of fixed rent, the fixed rent allocated to rental periods 
during the lease term of the post-modification agreement is determined 
by applying the rules of paragraph (c)(2)(ii)(B) of this section to the 
entire agreement (as modified).
    (v) Difference between aggregate rent and interest and aggregate 
payments--(A) In general. Except as provided in paragraph (f)(4)(v)(B) 
of this section, a post-modification agreement described in paragraph 
(f)(4)(v)(C) of this section is treated as a section 467 rental 
agreement subject to proportional rental accrual (determined under Sec.  
1.467-2(c)).
    (B) Constant rental accrual prior to the modification. A post-
modification agreement described in paragraph (f)(4)(v)(C) of this 
section is treated as a section 467 rental agreement subject to constant 
rental accrual if--
    (1) Constant rental accrual is required under paragraph (f)(4)(iii) 
of this section; or
    (2) The post-modification agreement involves total payments of more 
than $250,000 (as described in paragraph (c)(4) of this section), and 
the Commissioner determines that the post-modification agreement is a 
disqualified leaseback or long-term agreement.
    (C) Agreements described in this paragraph (f)(4)(v)(C). A post-
modification agreement is described in this paragraph (f)(4)(v)(C) if 
the aggregate amount of fixed rent and stated interest treated as post-
modification items does not equal the aggregate amount of payments 
treated as post-modification items.
    (vi) Principal purpose of tax avoidance. If a principal purpose of a 
substantial modification is to avoid the purpose or intent of section 
467 or the regulations thereunder, the Commissioner may treat the entire 
agreement (as modified) as a single agreement for purposes of section 
467 and the regulations thereunder.
    (5) Definitions. The following definitions apply for purposes of 
this paragraph (f) and Sec.  1.467-7(g):
    (i) A modification of a rental agreement is any alteration, 
including any

[[Page 355]]

deletion or addition, in whole or in part, of a legal right or 
obligation of the lessor or lessee thereunder, whether the alteration is 
evidenced by an express agreement (oral or written), conduct of the 
parties, or otherwise.
    (ii) A modification is substantial only if, based on all of the 
facts and circumstances, the legal rights or obligations that are 
altered and the degree to which they are altered are economically 
substantial. A modification of a rental agreement will not be treated as 
substantial solely because it is not described in paragraph (f)(6) of 
this section.
    (iii) A modification occurs on the earlier of the first date on 
which there is a binding contract that substantially sets forth the 
terms of the modification or the date on which agreement to such terms 
is otherwise evidenced.
    (iv) Post-modification items with respect to any modification of a 
rental agreement are all items (other than pre-modification items) 
provided under the terms of the entire agreement (as modified).
    (v) Pre-modification items with respect to any modification of a 
rental agreement are pre-modification rent, interest thereon, and 
payments allocable thereto (whether payable before or after the 
modification.) For this purpose--
    (A) Pre-modification rent is rent allocable to periods before the 
effective date of the modification, but only to the extent such rent is 
payable under the entire agreement (as modified) at the time such rent 
was due under the agreement in effect before the modification; and
    (B) Pre-modification items are identified by applying payments, in 
the order payable under the entire agreement (as modified) unless the 
agreement specifies otherwise, to rent and interest thereon in the order 
in which amounts accrue.
    (vi) The entire agreement (as modified) with respect to any 
modification is the agreement consisting of pre-modification terms 
providing for rights and obligations that are not affected by the 
modification and post-modification terms providing for rights and 
obligations that differ from the rights and obligations under the 
agreement in effect before the modification. For example, if a 10-year 
rental agreement that provides for rent of $25,000 per year is modified 
at the end of the 5th year to provide for rent of $30,000 per year in 
subsequent years, the entire agreement (as modified) provides for a 10-
year lease term and provides for rent of $25,000 per year in years 1 
through 5 and rent of $30,000 per year in years 6 through 10. The result 
would be the same if the modification provided for both the increase in 
rent and the substitution of a new lessee.
    (6) Safe harbors. Notwithstanding the provisions of paragraph (f)(5) 
of this section, a modification of a rental agreement is not a 
substantial modification if the modification occurs solely as the result 
of one or more of the following--
    (i) The refinancing of any indebtedness incurred by the lessor to 
acquire the property subject to the rental agreement and secured by such 
property (or any refinancing thereof) but only if all of the following 
conditions are met--
    (A) Neither the amount, nor the time for payment, of the principal 
amount of the new indebtedness differs from the amount and time for 
payment of the remaining principal amount of the refinanced 
indebtedness, except for de minimis changes;
    (B) For each of the remaining rental periods, the rent allocation 
schedule, the payments of rent and interest, and the amount accrued 
under section 467 are changed only to the extent necessary to take into 
account the change in financing costs, and such changes are made 
pursuant to the terms of the rental agreement in effect before the 
modification;
    (C) The lessor and the lessee are not related persons to each other 
or to any lender to the lessor with respect to the property (whether 
under the refinanced indebtedness or the new indebtedness); and
    (D) With respect to the indebtedness being refinanced, the lessor 
was granted a unilateral option (within the meaning of Sec.  1.1001-
3(c)(3)) by the creditor to repay the refinanced indebtedness, 
exercisable with or without the lessee's consent;

[[Page 356]]

    (ii) A change in the obligation of the lessee to make any of the 
contingent payments described in paragraphs (c)(2)(iii)(B)(3) through 
(8) of this section; or
    (iii) A change in the amount of fixed rent allocated to a rental 
period that, when combined with all previous changes in the amount of 
fixed rent allocated to the rental period, does not exceed one percent 
of the fixed rent allocated to that rental period prior to the 
modification.
    (7) Special rules for certain transfers--(i) In general. For 
purposes of this paragraph (f), a substitution of a new lessee or a 
sale, exchange, or other disposition by a lessor of property subject to 
a rental agreement will not, by itself, be treated as a substantial 
modification unless a principal purpose of the transaction giving rise 
to the modification is the avoidance of Federal income tax. In 
determining whether a principal purpose of the transaction giving rise 
to the modification is the avoidance of Federal income tax--
    (A) The safe harbors and other principles of Sec.  1.467-3(c) are 
taken into account; and
    (B) The Commissioner may treat the post-modification agreement as a 
new agreement or treat the entire agreement (as modified) as a single 
agreement.
    (ii) Exception. Notwithstanding the provisions of paragraph 
(f)(7)(i) of this section, the continuing lessor and the new lessee (in 
the case of a substitution of a new lessee) or the new lessor and the 
continuing lessee (in the case of a sale, exchange, or other disposition 
by a lessor of property subject to a rental agreement) may, in 
appropriate cases, request the Commissioner to treat the transaction as 
if it were a substantial modification in order to have the provisions of 
paragraph (f)(4)(iii) of this section and Sec.  1.467-7(g)(1) apply to 
the transaction.
    (g) Treatment of amounts payable by lessor to lessee--(1) Interest. 
For purposes of determining present value, any amounts payable by the 
lessor to the lessee as interest on prepaid rent are treated as negative 
amounts.
    (2) Other amounts. [Reserved]
    (h) Meaning of terms. The following meanings apply for purposes of 
this section and Sec. Sec.  1.467-2 through 1.467-9:
    (1) Agreement date means the earlier of the lease date or the first 
date on which there is a binding written contract that substantially 
sets forth the terms under which the property will be leased.
    (2) Contingent rent means any rent that is not fixed rent, including 
any amount reflecting an adjustment based on a reasonable price index 
(as defined in paragraph (h)(10) of this section) or a variable interest 
rate provision (as defined in paragraph (h)(16) of this section).
    (3) Fixed rent means any rent to the extent its amount and the time 
at which it is required to be paid are fixed and determinable under the 
terms of the rental agreement as of the lease date. The following rules 
apply for the purpose of determining the extent to which rent is fixed 
rent:
    (i) The possibility of a breach, default, or other early termination 
of the rental agreement and any adjustments based on a reasonable price 
index or a variable interest rate provision are disregarded.
    (ii) Rent will not fail to be treated as fixed rent merely because 
of the possibility of impairment by insolvency, bankruptcy, or other 
similar circumstances.
    (iii) If the lease term (as defined in paragraph (h)(6) of this 
section) includes one or more periods as to which either the lessor or 
the lessee has an option to renew or extend the term of the agreement, 
rent will not fail to be treated as fixed rent merely because the option 
has not been exercised.
    (iv) If the lease term includes one or more periods during which a 
substitute lessee or lessor may have use of the property, rent will not 
fail to be treated as fixed rent merely because the contingencies 
relating to the obligation of the lessee (or a related person) to make 
payments in the nature of rent have not occurred.
    (v) If either the lessor or the lessee has an unconditional option 
or options, exercisable on one or more dates during the lease term, 
that, if exercised, require payments of rent to be made under an 
alternative payment schedule

[[Page 357]]

or schedules, the amount of fixed rent and the dates on which such rent 
is required to be paid are determined on the basis of the payment 
schedule that, as of the agreement date, is most likely to occur. If 
payments of rent are made under an alternative payment schedule that 
differs from the payment schedule assumed in applying the preceding 
sentence, then, for purposes of paragraph (f) of this section, the 
rental agreement is treated as having been modified at the time the 
option to make payments on such alternative schedule is exercised.
    (4) Late payment charge means any amount required to be paid by the 
lessee to the lessor as additional compensation for the lessee's failure 
to make any payment of rent under a rental agreement when due.
    (5) Lease date means the date on which the lessee first has the 
right to use of the property that is the subject of the rental 
agreement.
    (6) Lease term means the period during which the lessee has use of 
the property subject to the rental agreement, including any option of 
the lessor to renew or extend the term of the agreement. An option of 
the lessee to renew or extend the term of the agreement is included in 
the lease term only if it is expected, as of the agreement date, that 
the option will be exercised. For this purpose, a lessee is generally 
expected to exercise an option if, for example, as of the agreement date 
the rent for the option period is less than the expected fair market 
value rental for such period. The lessor's or lessee's determination 
that an option period is either included in or excluded from the lease 
term is not binding on the Commissioner. If the lessee (or a related 
person) agrees that one or both of them will or could be obligated to 
make payments in the nature of rent (within the meaning of Sec.  
1.168(i)-2(b)(2)) for a period when another lessee (the substitute 
lessee) or the lessor will have use of the property subject to the 
rental agreement, the Commissioner may, in appropriate cases, treat the 
period when the substitute lessee or lessor will have use of the 
property as part of the lease term. See Sec.  1.467-7(f) for special 
rules applicable to the lessee, substitute lessee, and lessor. This 
paragraph (h)(6) applies to section 467 rental agreements entered into 
after March 6, 2001. However, taxpayers may choose to apply this 
paragraph (h)(6) to any rental agreement that is described in Sec.  
1.467-9(a) and is entered into on or before March 6, 2001.
    (7) A loss payment provision means a provision that requires the 
lessee to pay the lessor a sum of money (which may be either a 
stipulated amount or an amount determined by reference to a formula or 
other objective measure) if the property subject to the rental agreement 
is lost, stolen, damaged or destroyed, or otherwise rendered unsuitable 
for any use (other than for scrap purposes).
    (8) A qualified percentage rents provision means a provision 
pursuant to which the rent is equal to a fixed percentage of the 
lessee's receipts or sales (whether or not receipts or sales are 
adjusted for returned merchandise or Federal, state, or local sales 
taxes), but only if the percentage does not vary throughout the lease 
term. A provision will not fail to be treated as a qualified percentage 
rents provision solely by reason of one or more of the following 
additional terms:
    (i) Differing percentages of receipts or sales apply to different 
departments or separate floors of a retail store, but only if the 
percentage applicable to a particular department or floor does not vary 
throughout the lease term.
    (ii) The percentage is applied to receipts or sales in excess of 
determinable dollar amounts, but only if the determinable dollar amounts 
are fixed and do not vary throughout the lease term.
    (9) A qualified TRAC provision means a terminal rental adjustment 
clause (as defined in section 7701(h)(3)) contained in a qualified motor 
vehicle operating agreement (as defined in section 7701(h)(2)), but only 
if the adjustment to the rental price is based on a reasonable estimate, 
determined as of any date between the agreement date and the lease date 
(or, in the event the agreement date is the same as or later than the 
lease date, determined as of the agreement date), of the fair market 
value of the motor vehicle (including any trailer) at the end of the 
lease term.

[[Page 358]]

    (10) An adjustment is based on a reasonable price index if the 
adjustment reflects inflation or deflation occurring over a period 
during the lease term and is determined consistently under a generally 
recognized index for measuring inflation or deflation (for example, the 
non-seasonally adjusted U.S. City Average All Items Consumer Price Index 
for All Urban Consumers (CPI-U), which is published by the Bureau of 
Labor Statistics of the Department of Labor). An adjustment will not 
fail to be treated as one that is based on a reasonable price index 
merely because the adjustment may be limited to a fixed percentage, but 
only if the parties reasonably expect, as of any date between the 
agreement date and the lease date (or, in the event the agreement date 
is the same as the lease date, as of such date), that the fixed 
percentage will actually limit the amount of the rent payable during 
less than 50 percent of the lease term.
    (11) For purposes of determining whether a section 467 rental 
agreement is a leaseback within the meaning of Sec.  1.467-3(b)(2), two 
persons are related persons if they are related persons within the 
meaning of section 465(b)(3)(C). In all other cases, two persons are 
related persons if they either have a relationship to each other that is 
specified in section 267(b) or section 707(b)(1) or are related entities 
within the meaning of sections 168(h)(4)(A), (B), or (C).
    (12) Rental agreement includes any agreement, whether written or 
oral, that provides for the use of tangible property and is treated as a 
lease for Federal income tax purposes.
    (13) A residual condition provision means a provision in a rental 
agreement that requires a payment to be made by either the lessor or the 
lessee to the other party based on the difference between the actual 
condition of the property subject to the agreement, determined as of the 
expiration of the lease term, and the expected condition of the property 
at the expiration of the lease term, as set forth in the rental 
agreement. The amount of any such payment may be determined by reference 
to any objective measure relating to the use or condition of the 
property, such as miles, hours or other duration of use, units of 
production, or similar measure. A provision will be treated as a 
residual condition provision only if the payment represents compensation 
for the use of, or wear and tear on, the property in excess of, or 
below, a standard set forth in the rental agreement, and the standard is 
reasonably expected, as of any date between the agreement date and the 
lease date (or, in the event the agreement date is the same as or later 
than the lease date, as of the agreement date), to be met at the 
expiration of the lease term.
    (14) A tax indemnity provision means a provision in a rental 
agreement that may require the lessee to make one or more payments to 
the lessor in the event that the Federal, foreign, state, or local 
income tax consequences actually realized by a lessor from owning the 
property subject to the rental agreement and leasing it to the lessee 
differ from the consequences reasonably expected by the lessor, but only 
if the differences in such consequences result from a misrepresentation, 
act, or failure to act on the part of the lessee, or any other factor 
not within the control of the lessor or any related person.
    (15) Third-party costs include any real estate taxes, insurance 
premiums, maintenance costs, and any other costs (excluding a debt 
service cost) that relate to the leased property and are not within the 
control of the lessor or lessee or any person related to the lessor or 
lessee.
    (16) A variable interest rate provision means a provision in a 
rental agreement that requires the rent payable by the lessee to the 
lessor to be adjusted by the dollar amount of changes in the amount of 
interest payable by the lessor on any indebtedness that was incurred to 
acquire the property subject to the rental agreement (or any refinancing 
thereof), but--
    (i) Only to the extent the changes are attributable to changes in 
the interest rate; and
    (ii) Only if the indebtedness provides for interest at one or more 
qualified floating rates (within the meaning of Sec.  1.1275-5(b)), or 
the changes are attributable to a refinancing at a fixed rate or one or 
more qualified floating rates.

[[Page 359]]

    (i) [Reserved]
    (j) Computational rules. For purposes of this section and Sec. Sec.  
1.467-2 through 1.467-9, the following rules apply--
    (1) Counting conventions. Any reasonable counting convention may be 
used (for example, 30 days per month/360 days per year) to determine the 
length of a rental period or to perform any computation. Rental periods 
of the same descriptive length, for example annual, semiannual, 
quarterly, or monthly, may be treated as being of equal length.
    (2) Conventions regarding timing of rent and payments--(i) In 
general. For purposes of determining present values and yield only, 
except as otherwise provided in this section and Sec. Sec.  1.467-2 
through 1.467-8--
    (A) The rent allocated to a rental period is taken into account on 
the last day of the rental period;
    (B) Any amount payable during the first half of the first rental 
period is treated as payable on the first day of that rental period;
    (C) Any amount payable during the first half of any other rental 
period is treated as payable on the last day of the preceding rental 
period;
    (D) Any amount payable during the second half of a rental period is 
treated as payable on the last day of the rental period; and
    (E) Any amount payable at the midpoint of a rental period is 
treated, in applying this paragraph (j)(2), as an amount payable during 
the first half of the rental period.
    (ii) Time amount is payable. For purposes of this section and 
Sec. Sec.  1.467-2 through 1.467-9, an amount is payable on the last day 
for timely payment (that is, the last day such amount may be paid 
without incurring interest, computed at an arm's-length rate, a 
substantial penalty, or other substantial detriment (such as giving the 
lessor the right to terminate the agreement, bring an action to enforce 
payment, or exercise other similar remedies under the terms of the 
agreement or applicable law)). This paragraph (j)(2)(ii) applies to 
section 467 rental agreements entered into after March 6, 2001. However, 
taxpayers may choose to apply this paragraph (j)(2)(ii) to any rental 
agreement that is described in Sec.  1.467-9(a) and is entered into on 
or before March 6, 2001.
    (3) Annualized fixed rent. Annualized fixed rent is determined by 
multiplying the fixed rent allocated to the rental period under 
paragraph (c)(2)(ii) of this section by the number of periods of the 
rental period's length in a calendar year. Thus, if the fixed rent 
allocated to a rental period is $10,000 and the rental period is one 
month, the annualized fixed rent for that rental period is $120,000 
($10,000 times 12).
    (4) Allocation of fixed rent within a period. A rental agreement 
that allocates fixed rent to any period is treated as allocating fixed 
rent ratably within that period. Thus, if a rental agreement provides 
that $120,000 is allocated to each calendar year in the lease term, 
$10,000 of rent is allocated to each calendar month.
    (5) Rental period length. Except as provided in Sec.  1.467-3(d)(1) 
(relating to agreements for which constant rental accrual is required), 
rental periods may be of any length, may vary in length, and may be 
different as between the lessor and the lessee as long as--
    (i) The rental periods are one year or less, cover the entire lease 
term, and do not overlap;
    (ii) Each scheduled payment under the rental agreement (other than a 
payment scheduled to occur before or after the lease term) occurs within 
30 days of the beginning or end of a rental period; and
    (iii) In the case of a rental agreement that does not provide a 
specific allocation of fixed rent, the rental periods selected do not 
cause the agreement to be treated as a section 467 rental agreement 
unless all alternative rental period schedules would result in such 
treatment.

[T.D. 8820, 64 FR 26853, May 18, 1999, as amended by T.D. 8917, 66 FR 
1039, Jan. 5, 2001]



Sec.  1.467-2  Rent accrual for section 467 rental agreements without 
adequate interest.

    (a) Section 467 rental agreements for which proportional rental 
accrual is required. Under Sec.  1.467-1(d)(2)(ii), the fixed rent for 
each rental period is the proportional rental amount, computed under 
paragraph (c) of this section, if--

[[Page 360]]

    (1) The section 467 rental agreement is not a disqualified leaseback 
or long-term agreement under Sec.  1.467-3(b); and
    (2) The section 467 rental agreement does not provide adequate 
interest on fixed rent under paragraph (b) of this section.
    (b) Adequate interest on fixed rent--(1) In general. A section 467 
rental agreement provides adequate interest on fixed rent if, 
disregarding any contingent rent--
    (i) The rental agreement has no deferred or prepaid rent as 
described in Sec.  1.467-1(c)(3);
    (ii) The rental agreement has deferred or prepaid rent, and--
    (A) The rental agreement provides interest (the stated rate of 
interest) on deferred or prepaid fixed rent at a single fixed rate (as 
defined in Sec.  1.1273-1(c)(1)(iii));
    (B) The stated rate of interest on fixed rent is no lower than 110 
percent of the applicable Federal rate (as defined in paragraph (e)(3) 
of this section);
    (C) The amount of deferred or prepaid fixed rent on which interest 
is charged is adjusted at least annually to reflect the amount of 
deferred or prepaid fixed rent as of a date no earlier than the date of 
the preceding adjustment and no later than the date of the succeeding 
adjustment; and
    (D) The rental agreement requires interest to be paid or compounded 
at least annually;
    (iii) The rental agreement provides for deferred rent but no prepaid 
rent, and the sum of the present values (within the meaning of paragraph 
(d) of this section) of all amounts payable by the lessee as fixed rent 
(and interest, if any, thereon) is equal to or greater than the sum of 
the present values of the fixed rent allocated to each rental period; or
    (iv) The rental agreement provides for prepaid rent but no deferred 
rent, and the sum of the present values of all amounts payable by the 
lessee as fixed rent, plus the sum of the negative present values of all 
amounts payable by the lessor as interest, if any, on prepaid fixed 
rent, is equal to or less than the sum of the present values of the 
fixed rent allocated to each rental period.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest. For purposes of the adequate interest test under paragraph 
(b)(1) of this section, if a section 467 rental agreement provides for 
variable interest, the rental agreement is treated as providing for 
fixed rates of interest on deferred or prepaid fixed rent equal to the 
fixed rate substitutes (determined in the same manner as under Sec.  
1.1275-5(e), treating the agreement date as the issue date) for the 
variable rates called for by the rental agreement. For purposes of this 
section, a rental agreement provides for variable interest if all stated 
interest provided by the agreement is paid or compounded at least 
annually at a rate or rates that meet the requirements of Sec.  1.1275-
5(a)(3)(i)(A) or (B) and (a)(4).
    (3) Agreements with both deferred and prepaid rent. If an agreement 
has both deferred and prepaid rent, the agreement provides adequate 
interest under paragraph (b)(1) of this section if the conditions set 
forth in paragraph (b)(1)(ii)(A) through (D) of this section are met for 
both the prepaid and the deferred rent. For purposes of this paragraph 
(b)(3), an agreement will be considered to meet the condition set forth 
in paragraph (b)(1)(ii)(A) of this section if the agreement provides a 
single fixed rate of interest on the deferred rent and a single fixed 
rate of interest on the prepaid rent, even if those rates are not the 
same. This paragraph (b)(3) applies to section 467 rental agreements 
entered into after March 6, 2001. However, taxpayers may choose to apply 
this paragraph (b)(3) to any rental agreement that is described in Sec.  
1.467-9(a) and is entered into on or before March 6, 2001.
    (c) Computation of proportional rental amount--(1) In general. The 
proportional rental amount for a rental period is the amount of fixed 
rent allocated to the rental period under Sec.  1.467-1(c)(2)(ii), 
multiplied by a fraction. The numerator of the fraction is the sum of 
the present values of the amounts payable under the terms of the section 
467 rental agreement as fixed rent and interest thereon. The denominator 
of the fraction is the sum of the present values of the fixed rent 
allocated to each

[[Page 361]]

rental period under the rental agreement.
    (2) Section 467 rental agreements that provide for a variable rate 
of interest. To calculate the proportional rental amount for a section 
467 rental agreement that provides for a variable rate of interest, see 
Sec.  1.467-5.
    (d) Present value. For purposes of determining adequate interest 
under paragraph (b) of this section or the proportional rental amount 
under paragraph (c) of this section, the present value of any amount is 
determined using a discount rate equal to 110 percent of the applicable 
Federal rate. In general, present values are determined as of the first 
day of the first rental period in the lease term. However, if a section 
467 rental agreement calls for payments of fixed rent prior to the lease 
term, present values are determined as of the first day a fixed rent 
payment is called for by the agreement. For purposes of the present 
value determination under paragraph (b)(1)(iv) of this section, the 
fixed rent allocated to a rental period must be discounted from the 
first day of the rental period. For other conventions and rules relating 
to the determination of present value, see Sec.  1.467-1(g) and (j).
    (e) Applicable Federal rate--(1) In general. The applicable Federal 
rate for a section 467 rental agreement is the applicable Federal rate 
in effect on the agreement date. The applicable Federal rate for a 
rental agreement means--
    (i) The Federal short-term rate if the term of the rental agreement 
is not over 3 years;
    (ii) The Federal mid-term rate if the term of the rental agreement 
is over 3 years but not over 9 years; and
    (iii) The Federal long-term rate if the term of the rental agreement 
is over 9 years.
    (2) Source of applicable Federal rates. The Internal Revenue Service 
publishes the applicable Federal rates, based on annual, semiannual, 
quarterly, and monthly compounding, each month in the Internal Revenue 
Bulletin (see Sec.  601.601(d) of this chapter). However, the applicable 
Federal rates may be based on any compounding assumption. To convert a 
rate based on one compounding assumption to an equivalent rate based on 
a different compounding assumption, see Sec.  1.1272-1(j), Example 1.
    (3) 110 percent of applicable Federal rate. For purposes of Sec.  
1.467-1, this section and Sec. Sec.  1.467-3 through 1.467-9, 110 
percent of the applicable Federal rate means 110 percent of the 
applicable Federal rate based on semiannual compounding or any rate 
based on a different compounding assumption that is equivalent to 110 
percent of the applicable Federal rate based on semiannual compounding. 
The Internal Revenue Service publishes 110 percent of the applicable 
Federal rates, based on annual, semiannual, quarterly, and monthly 
compounding, each month in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter).
    (4) Term of the section 467 rental agreement--(i) In general. For 
purposes of determining the applicable Federal rate under this paragraph 
(e), the term of the section 467 rental agreement includes the lease 
term, any period before the lease term beginning with the first day an 
amount of fixed rent is payable under the terms of the rental agreement, 
and any period after the lease term ending with the last day an amount 
of fixed rent or interest thereon is payable under the rental agreement.
    (ii) Section 467 rental agreements with variable interest. If a 
section 467 rental agreement provides variable interest on deferred or 
prepaid fixed rent, the term of the rental agreement for purposes of 
calculating the applicable Federal rate is the longest period between 
interest rate adjustment dates, or, if the rental agreement provides an 
initial fixed rate of interest on deferred or prepaid fixed rent, the 
period between the agreement date and the last day the fixed rate 
applies, if this period is longer. If, as described in Sec.  1.1274-
4(c)(2)(ii), the rental agreement provides for a qualified floating rate 
(as defined in Sec.  1.1275-5(b)) that in substance resembles a fixed 
rate, the applicable Federal rate is determined by reference to the 
lease term.
    (f) Examples. The following examples illustrate the application of 
this section. In each of these examples it is assumed that the rental 
agreement is not a disqualified leaseback or long-term

[[Page 362]]

agreement subject to constant rental accrual. The examples are as 
follows:

    Example 1. (i) C agrees to lease property from D for five years 
beginning on January 1, 2000, and ending on December 31, 2004. The 
section 467 rental agreement provides that rent of $100,000 accrues in 
each calendar year in the lease term and that rent of $500,000 plus 
$120,000 of interest is payable on December 31, 2004. Assume that the 
parties select the calendar year as the rental period and that 110 
percent of the applicable Federal rate is 10 percent, compounded 
annually.
    (ii) The rental agreement has deferred rent under Sec.  1.467-
1(c)(3)(i) because the fixed rent allocated to calendar years 2000, 
2001, and 2002 is not paid until 2004. In addition, because the rental 
agreement does not state an interest rate, the rental agreement does not 
satisfy the requirements of paragraph (b)(1)(ii) of this section.
    (iii)(A) Because the rental agreement has deferred fixed rent and no 
prepaid rent, the agreement has adequate interest only if the present 
value test provided in paragraph (b)(1)(iii) of this section is met. The 
present value of all fixed rent and interest payable under the rental 
agreement is $384,971.22, determined as follows: $620,000/(1.10) \5\ = 
$384,971.22. The present value of all fixed rent allocated under the 
rental agreement (discounting the amount of fixed rent allocated to a 
rental period from the last day of the rental period) is $379,078.68, 
determined as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.000

    (B) The rental agreement provides adequate interest on fixed rent 
because the present value of the single amount payable under the section 
467 rental agreement exceeds the sum of the present values of fixed rent 
allocated.
    (iv) For an example illustrating the computation of the yield on the 
rental agreement and the allocation of the interest and rent provided 
for under the rental agreement, see Sec.  1.467-4(f), Example 2.
    Example 2. (i) E and F enter into a section 467 rental agreement for 
the lease of equipment beginning on January 1, 2000, and ending on 
December 31, 2004. The rental agreement provides that rent of $100,000 
accrues for each calendar month during the lease term. All rent is 
payable on December 31, 2004, together with interest on accrued rent at 
a qualified floating rate set at a current value (as defined in Sec.  
1.1275-5(a)(4)) that is compounded at the end of each calendar month and 
adjusted at the beginning of each calendar month throughout the lease 
term. Therefore, the rental agreement provides for variable interest 
within the meaning of paragraph (b)(2) of this section.
    (ii) On the agreement date the qualified floating rate is 7.5 
percent, and 110 percent of the applicable Federal rate, as defined in 
paragraph (e)(3) of this section, based on monthly compounding, is 7 
percent. Under paragraph (b)(2) of this section, the fixed rate 
substitute for the qualified floating rate is 7.5 percent and the 
agreement is treated as providing for interest at this fixed rate for 
purposes of determining whether adequate interest is provided under 
paragraph (b) of this section. Accordingly, the requirements of 
paragraph (b)(1)(ii) of this section are satisfied, and the rental 
agreement has adequate interest.
    Example 3. (i) X and Y enter into a section 467 rental agreement for 
the lease of real property beginning on January 1, 2000, and ending on 
December 31, 2002. The rental agreement provides that rent of $800,000 
is allocable to 2000, $1,000,000 is allocable to 2001, and $1,200,000 is 
allocable to 2002. Under the rental agreement, Y must make a $3,000,000 
payment on December 31, 2002. Assume that both X and Y choose the 
calendar year as the rental period, X and Y are calendar year taxpayers, 
and 110 percent of the applicable Federal rate is 8.5 percent compounded 
annually.
    (ii) The rental agreement fails to provide adequate interest under 
paragraph (b)(1) of this section. Therefore, under Sec.  1.467-
1(d)(2)(ii), the fixed rent for each rental period is the proportional 
rental amount.
    (iii)(A) The proportional rental amount is computed under paragraph 
(c) of this section. Because the rental agreement does not call for any 
fixed rent payments prior to the lease term, under paragraph (d) of this 
section, the present value is determined as of the first day of the 
first rental period in the lease term. The present value of the single 
amount payable by the lessee under the rental agreement is computed as 
follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.001

    (B) The sum of the present values of the fixed rent allocated to 
each rental period (discounting the fixed rent allocated to a rental 
period from the last day of such rental period) is computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.002


[[Page 363]]


    (C) Thus, the fraction for determining the proportional rental 
amount is .9297194 ($2,348,724.30/$2,526,272.20). The section 467 
interest for each of the taxable years within the lease term is computed 
and taken into account as provided in Sec.  1.467-4. The section 467 
rent for each of the taxable years within the lease term is as follows:

------------------------------------------------------------------------
           Taxable year                       Section 467 rent
------------------------------------------------------------------------
2000.............................  $743,775.52
                                   ($ 800,000 x .9297194).
2001.............................  929,719.40
                                   ($1,000,000 x .9297194).
2002.............................  1,115,663.28
                                   ($1,200,000 x .9297194).
------------------------------------------------------------------------


[T.D. 8820, 64 FR 26859, May 18, 1999, as amended by T.D. 8917, 66 FR 
1040, Jan. 5, 2001]



Sec.  1.467-3  Disqualified leasebacks and long-term agreements.

    (a) General rule. Under Sec.  1.467-1(d)(2)(i), constant rental 
accrual (as described under paragraph (d) of this section) must be used 
to determine the fixed rent for each rental period in the lease term if 
the section 467 rental agreement is a disqualified leaseback or long-
term agreement within the meaning of paragraph (b) of this section. 
Constant rental accrual may not be used in the absence of a 
determination by the Commissioner, pursuant to paragraph (b)(1)(ii) of 
this section, that the rental agreement is disqualified. Such 
determination may be made either on a case-by-case basis or in 
regulations or other guidance published by the Commissioner (see Sec.  
601.601(d)(2) of this chapter) providing that a certain type or class of 
leaseback or long-term agreement will be treated as disqualified and 
subject to constant rental accrual.
    (b) Disqualified leaseback or long-term agreement--(1) In general. A 
leaseback (as defined in paragraph (b)(2) of this section) or a long-
term agreement (as defined in paragraph (b)(3) of this section) is 
disqualified only if--
    (i) A principal purpose for providing increasing or decreasing rent 
is the avoidance of Federal income tax (as described in paragraph (c) of 
this section);
    (ii) The Commissioner determines that, because of the tax avoidance 
purpose, the agreement should be treated as a disqualified leaseback or 
long-term agreement; and
    (iii) For section 467 rental agreements entered into before July 19, 
1999, the amount determined with respect to the rental agreement under 
Sec.  1.467-1(c)(4) (relating to the exception for rental agreements 
involving total payments of $250,000 or less) exceeds $2,000,000.
    (2) Leaseback. A section 467 rental agreement is a leaseback if the 
lessee (or a related person) had any interest (other than a de minimis 
interest) in the property at any time during the two-year period ending 
on the agreement date. For this purpose, interests in property include 
options and agreements to purchase the property (whether or not the 
lessee or related person was considered the owner of the property for 
Federal income tax purposes) and, in the case of subleased property, any 
interest as a sublessor.
    (3) Long-term agreement--(i) In general. A section 467 rental 
agreement is a long-term agreement if the lease term exceeds 75 percent 
of the property's statutory recovery period.
    (ii) Statutory recovery period--(A) In general. The term statutory 
recovery period means--
    (1) In the case of property depreciable under section 168, the 
applicable period determined under section 467(e)(3)(A);
    (2) In the case of land, 19 years; and
    (3) In the case of any other tangible property, the period that 
would apply under section 467(e)(3)(A) if the property were property to 
which section 168 applied.
    (B) Special rule for rental agreements relating to properties having 
different statutory recovery periods. In the case of a rental agreement 
relating to two or more related properties that have different statutory 
recovery periods, the statutory recovery period for purposes of 
paragraph (b)(3)(ii)(A) of this section is the weighted average, based 
on the fair market values of the properties on the agreement date, of 
the statutory recovery periods of each of the properties.
    (c) Tax avoidance as principal purpose for increasing or decreasing 
rent--(1) In general. In determining whether a principal purpose for 
providing increasing or decreasing rent is the avoidance of Federal 
income tax, all relevant facts

[[Page 364]]

and circumstances are taken into account. However, an agreement will not 
be treated as a disqualified leaseback or long-term agreement if either 
of the safe harbors set forth in paragraph (c)(3) of this section is 
met. The mere failure of a leaseback or long-term agreement to meet one 
of these safe harbors will not, by itself, cause the agreement to be 
treated as one in which tax avoidance was a principal purpose for 
providing increasing or decreasing rent.
    (2) Tax avoidance--(i) In general. If, as of the agreement date, a 
significant difference between the marginal tax rates of the lessor and 
lessee can reasonably be expected at some time during the lease term, 
the agreement will be closely scrutinized and clear and convincing 
evidence will be required to establish that tax avoidance is not a 
principal purpose for providing increasing or decreasing rent. The term 
``marginal tax rate'' means the percentage determined by dividing one 
dollar into the amount of the increase or decrease in the Federal income 
tax liability of the taxpayer that would result from an additional 
dollar of rental income or deduction.
    (ii) Significant difference in tax rates. A significant difference 
between the marginal tax rates of the lessor and lessee is reasonably 
expected if--
    (A) The rental agreement has increasing rents and the lessor's 
marginal tax rate is reasonably expected to exceed the lessee's marginal 
tax rate by more than 10 percentage points during any rental period to 
which the rental agreement allocates annualized fixed rent that is less 
than the average rent allocated to all calendar years (determined by 
taking into account the rules set forth in paragraph (c)(4)(iii) of this 
section); or
    (B) The rental agreement has decreasing rents and the lessee's 
marginal tax rate is reasonably expected to exceed the lessor's marginal 
tax rate by more than 10 percentage points during any rental period to 
which the rental agreement allocates annualized fixed rent that is 
greater than the average rent allocated to all calendar years 
(determined by taking into account the rules set forth in paragraph 
(c)(4)(iii) of this section).
    (iii) Special circumstances. In determining the expected marginal 
tax rates of the lessor and lessee, net operating loss and credit 
carryovers and any other attributes or special circumstances reasonably 
expected to affect the Federal income tax liability of the taxpayer 
(including the alternative minimum tax) are taken into account. For 
example, in the case of a partnership or S corporation, the amount of 
rental income or deduction that would be allocable to the partners or 
shareholders, respectively, is taken into account.
    (3) Safe harbors. Tax avoidance will not be considered a principal 
purpose for providing increasing or decreasing rent if--
    (i) The uneven rent test (as defined in paragraph (c)(4) of this 
section) is met; or
    (ii) The increase or decrease in rent is wholly attributable to one 
or more of the following provisions--
    (A) A contingent rent provision set forth in Sec.  1.467-
1(c)(2)(iii)(B); or
    (B) A single rent holiday provision allowing reduced rent (or no 
rent) for one consecutive period during the lease term, but only if--
    (1) The rent holiday is for a period of three months or less at the 
beginning of the lease term and for no other period; or
    (2) The duration of the rent holiday is reasonable, determined by 
reference to commercial practice (as of the agreement date) in the 
locality where the use of the property occurs, and does not exceed the 
lesser of 24 months or 10 percent of the lease term.
    (4) Uneven rent test--(i) In general. The uneven rent test is met if 
the rent allocated to each calendar year does not vary from the average 
rent allocated to all calendar years (determined in accordance with the 
rules set forth in paragraph (c)(4)(iii) of this section) by more than 
10 percent.
    (ii) Special rule for real estate. Paragraph (c)(4)(i) of this 
section is applied by substituting ``15 percent'' for ``10 percent'' if 
the rental agreement is a long-term agreement and at least 90 percent of 
the property subject to the agreement (determined on the basis of fair 
market value as of the agreement

[[Page 365]]

date) consists of real property (as defined in Sec.  1.856-3(d)).
    (iii) Operating rules. In determining whether the uneven rent test 
has been met, the following rules apply:
    (A) Any contingent rent attributable to a provision set forth in 
Sec.  1.467-1(c)(2)(iii)(B)(3) through (9) is disregarded.
    (B) If the lease term includes one or more partial calendar years (a 
period less than a complete calendar year), the average rent allocated 
to each calendar year is the total rent allocated under the rental 
agreement, divided by the actual length (in years) of the lease term. 
The rent allocated to a partial calendar year is annualized by 
multiplying the allocated rent by the number of periods of the partial 
calendar year's length in a full calendar year and the annualized rent 
is treated as the amount of rent allocated to that year in determining 
whether the uneven rent test is met.
    (C) In the case of a rental agreement not described in paragraph 
(c)(4)(ii) of this section, an initial rent holiday period and any rent 
allocated to such period are disregarded for purposes of this paragraph 
(c)(4) if taking such period and rent into account would cause the 
agreement to fail to meet the uneven rent test. For purposes of this 
paragraph (c)(4), an initial rent holiday period is any period of three 
months or less at the beginning of the lease term during which 
annualized fixed rent (determined by treating such period as a rental 
period for purposes of Sec.  1.467-1(j)(3)) is less than the average 
rent allocated to all calendar years (determined before the application 
of this paragraph (c)(4)(iii)(C)).
    (D) In the case of a rental agreement described in paragraph 
(c)(4)(ii) of this section, one qualified rent holiday period and any 
rent allocated to such period are disregarded for purposes of this 
paragraph (c)(4) if taking such period and rent into account would cause 
the agreement to fail the uneven rent test. For this purpose, a 
qualified rent holiday period is a consecutive period that is an initial 
rent holiday period or that meets the following conditions:
    (1) The period does not exceed the lesser of 24 months or 10 percent 
of the lease term (determined before the application of this paragraph 
(c)(4)(iii)(D)).
    (2) Annualized fixed rent during the period (determined by treating 
the period as a rental period for purposes of Sec.  1.467-1(j)(3)) is 
less than the average rent allocated to all calendar years (determined 
before the application of this paragraph (c)(4)(iii)(D)).
    (3) Providing less than average rent for the period is reasonable, 
determined by reference to commercial practice (as of the agreement 
date) in the locality where the use of the property occurs.
    (E) If the rental agreement contains a variable interest rate 
provision, the uneven rent test is applied by treating the rent as 
having been fixed under the terms of the rental agreement for the entire 
lease term using fixed rate substitutes (determined in the same manner 
as Sec.  1.1275-5(e), treating the agreement date as the issue date) for 
the variable rates of interest provided under the terms of the lessor's 
indebtedness.
    (d) Calculating constant rental amount--(1) In general. Except as 
provided in paragraph (d)(2) of this section, the constant rental amount 
is the amount that, if paid at the end of each rental period, would 
result in a present value equal to the present value of all amounts 
payable under the disqualified leaseback or long-term agreement as rent 
and interest. In computing the constant rental amount, the rules for 
determining present value are the same as those provided in Sec.  1.467-
2(d) for computing the proportional rental amount. If constant rental 
accrual is required, all rental periods (other than an initial or final 
short period of not more than one month) must be equal in length and 
satisfy the requirements of Sec.  1.467-1(j)(5).
    (2) Initial or final short periods. If a disqualified leaseback or 
long-term agreement has an initial or final short rental period, the 
constant rental amount for the initial or final short period may be 
determined under any reasonable method. However, the sum of the present 
values of all the constant rental amounts must equal the present values 
of all amounts payable under the disqualified leaseback or long-term 
agreement as rent and interest. Any

[[Page 366]]

adjustment necessary to eliminate the section 467 loan balance because 
of the method used to determine the constant rental amount for short 
periods must be taken into account as section 467 rent for the final 
rental period.
    (3) Method to determine constant rental amount; no short periods--
(i) Step 1. Determine the present value of amounts payable under the 
disqualified leaseback or long-term agreement as rent or interest.
    (ii) Step 2. Determine the present value of $1 to be received at the 
end of each rental period during the lease term as of the first day of 
the first rental period during the lease term (or, if earlier, the first 
day a rent payment is required under the rental agreement).
    (iii) Step 3. Divide the amount determined in paragraph (d)(3)(i) of 
this section (Step 1) by the number of dollars determined in paragraph 
(d)(3)(ii) of this section (Step 2).
    (e) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) K, lessor, and L, lessee, enter into a long-term 
agreement for a 10-year lease of personal property beginning on January 
1, 2000. K and L are C corporations that use the calendar year as their 
taxable year. K does not have any unused losses or credits from taxable 
years preceding 2000. In addition, as of the agreement date, K expects 
that it will be subject to the maximum rate of tax imposed by section 11 
in 2000 and that it will not be limited in its ability to use any losses 
or credits. As of the agreement date, L expects that it will be subject 
to the alternative minimum tax imposed by section 55 in 2000. The rental 
agreement provides for rent allocations in each year of the lease term, 
as follows:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $427,500
2001....................................................         442,500
2002....................................................         457,500
2003....................................................         472,500
2004....................................................         487,500
2005....................................................         502,500
2006....................................................         517,500
2007....................................................         532,500
2008....................................................         547,500
2009....................................................         562,500
------------------------------------------------------------------------

    (ii) As described in paragraph (c)(2) of this section, as of the 
agreement date, a significant difference between the marginal tax rates 
of the lessor and lessee can reasonably be expected at some time during 
the lease term. First, the rental agreement has increasing rents. 
Second, the lessor's marginal tax rate exceeds the lessee's marginal tax 
rate by more than 10 percentage points during a rental period to which 
the rental agreement allocates less than a ratable portion of the 
aggregate amount of rent payable under the agreement. For example, for 
the year 2000, the lessor's expected marginal tax rate is 35 percent, 
the percentage determined by dividing the increase in the Federal income 
tax liability of K that would result from an additional dollar of rental 
income ($.35) by $1. Because the lessee is subject to the alternative 
minimum tax, the lessee's expected marginal tax rate for 2000 is 20 
percent, the percentage determined by dividing the decrease in the 
Federal income tax liability (taking into account both the decrease in 
the lessee's regular tax and the increase in the lessee's alternative 
minimum tax) that would result from an additional dollar of rental 
deduction ($.20) by $1. Further, for the year 2000, the rent allocated 
in accordance with the rental agreement is $427,500, which is less than 
a ratable portion of the aggregate amount of rental payments, $495,000, 
determined by dividing the total rents payable under the agreement 
($4,950,000) by the number of years in the lease term (10). Thus, 
because a significant difference between the marginal tax rates of the 
lessor and lessee can reasonably be expected during the lease term, the 
agreement will be closely scrutinized and clear and convincing evidence 
will be required to establish that tax avoidance is not a principal 
purpose for providing increasing rent.
    Example 2. (i) A and B enter into a long-term agreement for a 5-year 
lease of personal property beginning on July 1, 2000, and ending on June 
30, 2005. The rental agreement provides that the rent is allocated to 
the calendar years in the lease term in accordance with the following 
schedule and is paid at successive six-month intervals (on December 31 
and June 30) during the lease term:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $450,000
2001....................................................         900,000
2002....................................................         900,000
2003....................................................       1,100,000
2004....................................................       1,100,000
2005....................................................         550,000
------------------------------------------------------------------------

    (ii) In determining whether the uneven rent test described in 
paragraph (c)(4)(i) of this section is met, the total amount of rent 
allocated under the rental agreement is $5,000,000, and the lease term 
is five years. The average rent for each year is $1,000,000 (see 
paragraph (c)(4)(iii)(B) of this section), and the uneven rent test is 
met if the rent for each year is not less than $900,000 and not more 
than $1,100,000. The test is met for 2000 because the annualized rent 
for that year is

[[Page 367]]

$900,000. The test is met for 2005 because the annualized rent for that 
year is $1,100,000. The test is met for each of the years 2001 through 
2004 because the rent for each of these years is not less than $900,000 
and not more than $1,100,000. Accordingly, because the uneven rent test 
of paragraph (c)(4)(i) of this section is met, the long-term agreement 
will not be treated as disqualified.
    Example 3. (i) C and D enter into a long-term agreement for a lease 
of personal property beginning on October 1, 1999, and ending on 
December 31, 2005. The rental agreement provides that the rent is 
allocated to the calendar years in the lease term in accordance with the 
following schedule and is paid at successive six-month intervals (on 
December 31 and June 30) during the lease term:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
1999....................................................              $0
2000....................................................         900,000
2001....................................................         900,000
2002....................................................         900,000
2003....................................................       1,100,000
2004....................................................       1,100,000
2005....................................................       1,100,000
------------------------------------------------------------------------

    (ii) The three-month rent holiday period at the beginning of the 
lease term is an initial rent holiday within the meaning of paragraph 
(c)(4)(iii)(C) of this section. Moreover, the agreement would fail the 
uneven rent test if the rent holiday period and the rent allocated to 
the period were taken into account. Thus, under paragraph (c)(4)(iii)(C) 
of this section, the period and the rent allocated to the period are 
disregarded for purposes of applying the uneven rent test. In that case, 
the lease term is six years, and the uneven rent test is met because the 
average rent for each year in the lease term is $1,000,000 and the rent 
for each calendar year in the lease term is not less than $900,000 nor 
more than $1,100,000. Accordingly, the long-term agreement will not be 
treated as disqualified.
    Example 4. (i) E and F enter into a long-term agreement for a 6-year 
lease of personal property beginning on January 1, 2000, and ending on 
December 31, 2005. The rental agreement provides that the rent allocated 
to the calendar years in the lease term and paid at successive six-month 
intervals (on June 30 and December 31) during the lease term is the sum 
of the interest on the lessor's indebtedness, in the amount of 
$4,637,577, and an amount determined in accordance with the following 
schedule:

------------------------------------------------------------------------
                          Year                                Amount
------------------------------------------------------------------------
2000....................................................        $539,574
2001....................................................         583,603
2002....................................................         631,225
2003....................................................         886,733
2004....................................................         959,090
2005....................................................       1,037,352
------------------------------------------------------------------------

    (ii) Assume further that the lessor's indebtedness bears interest at 
the rate of 2 percent in excess of the 6-month London Interbank Offered 
Rate (LIBOR) in effect on the first day of the 6-month period for each 
rental period and that, on the agreement date, the interest rate under 
this formula would be 8 percent. If the interest rate remained fixed 
during the entire lease term, the formula for determining the rent 
payable by the lessee would result in payments of rent in the amount of 
$450,000 for each six-month period in 2000, 2001, and 2002, and $550,000 
for each six-month period in 2003, 2004, and 2005.
    (iii) Under paragraph (c)(4)(iii)(E) of this section, the fixed rate 
substitute for the variable interest rate provision produces a schedule 
of fixed rents that meets the uneven rent test of paragraph (c)(4)(i) of 
this section. Thus, even if the actual rents payable under the rental 
agreement do not meet the uneven rent test because of fluctuations in 
the 6-month LIBOR, the uneven rent test will be treated as having been 
met, and the long-term agreement will not be treated as disqualified.
    Example 5. (i) G and H enter into a long-term agreement for a 5-year 
lease of personal property beginning on January 1, 2000, and ending on 
December 31, 2004. The rental agreement provides that the rent is 
payable to G at the rate of $40,000 per month in arrears, subject to an 
adjustment based on changes in prevailing interest rates during the 
lease term. Under this adjustment, the lessor is entitled to receive an 
amount equal to the sum of a specified dollar amount, which increases 
each month as payments of rent are made, and interest on a notional 
principal amount (as defined in Sec.  1.446-3(c)(3)) at a qualified 
floating rate (as defined in Sec.  1.1275-5(b)). The notional principal 
amount is initially established at 80 percent of the cost of the 
property. As each payment of rent is made, the notional principal amount 
is reduced (but not below zero) to an amount that would represent the 
outstanding principal balance of a loan the payments on which are equal 
to the monthly payments of rent. As of the agreement date, the value of 
the qualified floating rate is 9 percent. Although G did not incur 
indebtedness specifically for the purpose of acquiring the property, the 
parties agreed to the adjustment provisions in order to compensate G for 
its general costs of borrowing.
    (ii) The adjustment provision produces a schedule of rent payments 
that is virtually identical to the schedule that would have resulted if 
G had actually borrowed money in an amount and on terms identical to the 
terms used in determining interest on the notional principal amount and 
the adjustment were based on that indebtedness. An adjustment based on 
actual indebtedness of the lessor would have been a variable interest 
rate provision eligible for a safe harbor

[[Page 368]]

under paragraph (c)(3)(ii)(A) of this section. Accordingly, based on all 
the facts and circumstances, the adjustment provision did not have as 
one of its principal purposes the avoidance of Federal income tax, and 
thus the long-term agreement will not be treated as disqualified.
    Example 6. (i) X and Y enter into a leaseback for a 5-year lease of 
personal property beginning on January 1, 1998, and ending on December 
31, 2002. The rental agreement provides that $0 of rent is allocated to 
years 1998, 1999, and 2000, and that rent of $17,500,000 is allocated to 
years 2001 and 2002. The rental agreement provides that the rent 
allocated to each year is payable on December 31 of that year. Assume 
all rental periods are the calendar year. Assume also that 110 percent 
of the applicable Federal rate based on annual compounding is 12 
percent.
    (ii)(A) If the Commissioner determines that the leaseback is 
disqualified, the constant rental amount is computed as follows:
    (B) Step 1 in calculating the constant rental amount is to determine 
the present value of the two payments due under the rental agreement as 
follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.003

    (iii) Because no amounts of rent are payable before the lease term, 
Step 2 in calculating the constant rental amount is to determine the 
present value as of the first day of the lease term of $1 to be received 
at the end of each rental period during the lease term. This results in 
a present value of $3.6047762. In Step 3 the amount determined in Step 1 
is divided by the number of dollars determined in Step 2. Thus, the 
constant rental amount is $5,839,901 for each calendar year during the 
lease term computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.004


[T.D. 8820, 64 FR 26860, May 18, 1999, as amended by T.D. 8917, 66 FR 
1040, Jan. 5, 2001]



Sec.  1.467-4  Section 467 loan.

    (a) In general--(1) Overview. Except as provided in paragraph (a)(2) 
of this section, the section 467 loan rules of this section apply to a 
section 467 rental agreement if, as of the first day of a rental period, 
there is a difference between the amount of fixed rent payable under the 
rental agreement on or before the first day and the amount of fixed rent 
required to be accrued in accordance with Sec.  1.467-1(d)(2) before the 
first day. Paragraph (b) of this section provides rules for computing 
the principal balance of a section 467 loan at the beginning of any 
rental period. The principal balance of a section 467 loan may be 
positive or negative. For Federal tax purposes, if the principal balance 
is positive, the amount represents a loan from the lessor to the lessee, 
and if the principal balance is negative, the amount represents a loan 
from the lessee to the lessor.
    (2) No section 467 loan in the case of certain section 467 rental 
agreements. Except as provided in paragraphs (a)(3) and (4) of this 
section, this section does not apply to section 467 rental agreements 
that provide adequate interest under Sec.  1.467-2(b)(1)(i) (agreements 
with no deferred or prepaid rent) or Sec.  1.467-2(b)(1)(ii) (agreements 
with deferred or prepaid rent that provide adequate stated interest at a 
single fixed rate).
    (3) Rental agreements subject to constant rental accrual. 
Notwithstanding the provisions of paragraph (a)(2) of this section, this 
section applies to rental agreements subject to constant rental accrual 
under Sec.  1.467-3 (relating to disqualified leasebacks or long-term 
agreements).
    (4) Special rule in applying the provisions of Sec.  1.467-7(e), 
(f), or (g). Notwithstanding the provisions of paragraph (a)(2) of this 
section, section 467 loan balances must be computed for section 467 
rental agreements that are not subject to constant rental accrual under 
Sec.  1.467-3 and that provide adequate interest under Sec.  1.467-
2(b)(1)(i) or (ii), but only for purposes of applying the provisions of 
Sec.  1.467-7(e) (relating to dispositions of property subject to a 
section 467 rental agreement), Sec.  1.467-7(f) (relating to assignments 
by lessees and lessee-financed renewals), and Sec.  1.467-7(g) (relating 
to modifications of rental agreements).
    (b) Principal balance--(1) In general. Except as provided in 
paragraph (b)(2) of this section or in Sec.  1.467-7(e), (f), or (g), 
the principal balance of the section 467 loan at the beginning of a 
rental period equals--
    (i) The fixed rent accrued in preceding rental periods;
    (ii) Increased by the sum of--
    (A) The interest on fixed rent includible in the gross income of the 
lessor for preceding rental periods; and

[[Page 369]]

    (B) Any amount payable by the lessor on or before the first day of 
the rental period as interest on prepaid fixed rent; and
    (iii) Decreased by the sum of--
    (A) The interest on prepaid fixed rent includible in the gross 
income of the lessee for preceding rental periods; and
    (B) Any amount payable by the lessee on or before the first day of 
the rental period as fixed rent or interest thereon.
    (2) Section 467 rental agreements that provide for prepaid fixed 
rent and adequate interest. If a section 467 rental agreement calls for 
prepaid fixed rent and provides adequate interest under Sec.  1.467-
2(b)(1)(iv), the principal balance of the section 467 loan at the 
beginning of a rental period equals the principal balance determined 
under paragraph (b)(1) of this section, plus the fixed rent accrued for 
that rental period.
    (3) Timing of payments. For purposes of this paragraph (b), the day 
on which an amount is payable is determined under the rules of Sec.  
1.467-1(j)(2)(i)(B) through (E) and Sec.  1.467-1(j)(2)(ii).
    (c) Yield--(1) In general--(i) Method of determining yield. Except 
as provided in paragraphs (c)(2) and (3) of this section, the yield of a 
section 467 loan is the discount rate at which the sum of the present 
values of all amounts payable by the lessee as fixed rent and interest 
on fixed rent, plus the sum of the present values of all amounts payable 
by the lessor as interest on prepaid fixed rent, equals the sum of the 
present values of the fixed rent that accrues in accordance with Sec.  
1.467-1(d)(2). The yield must be constant over the term of the section 
467 rental agreement and, when expressed as a percentage, must be 
calculated to at least two decimal places.
    (ii) Method of stating yield. In determining the section 467 
interest for a rental period, the yield of the section 467 loan must be 
stated appropriately by taking into account the length of the rental 
period. Section 1.1272-1(j), Example 1, provides a formula for 
converting a yield based on a period of one length to an equivalent 
yield based on a period of a different length.
    (iii) Rounding adjustments. Any adjustment necessary to eliminate 
the section 467 loan because of rounding the yield to two or more 
decimal places must be taken into account as an adjustment to the 
section 467 interest for the final rental period determined as provided 
in paragraph (e) of this section.
    (2) Yield of section 467 rental agreements for which constant rental 
amount or proportional rental amount is computed. In the case of a 
section 467 rental agreement to which Sec.  1.467-1(d)(2)(i) or (ii) 
applies, the yield of the section 467 loan equals 110 percent of the 
applicable Federal rate (based on a compounding period equal to the 
length of the rental period).
    (3) Yield for purposes of applying paragraph (a)(4) of this section. 
For purposes of applying paragraph (a)(4) of this section, the yield of 
the section 467 loan balance of any party, or prior party, to a section 
467 rental agreement for a period is the same for all parties and is the 
yield that results in the net accrual of positive or negative interest 
for that period equal to the amount of such interest that accrues under 
the terms of the rental agreement for that period. For example, if 
property subject to a section 467 rental agreement is sold (transferred) 
and the beginning section 467 loan balance of the transferor (as 
described in Sec.  1.467-7(e)(2)(i)) is positive and the beginning 
section 467 loan balance of the transferee (as described in Sec.  1.467-
7(e)(2)(ii)) is negative, the yield on each of these loan balances for 
any period is the same for all parties and is the yield that results in 
the net accrual of positive or negative interest, taking into account 
the aggregate positive or negative interest on the section 467 loan 
balances of both the transferor and transferee, equal to the amount of 
such interest that accrues under the terms of the rental agreement for 
that period.
    (4) Determination of present values. The rules for determining 
present value in computing the yield of a section 467 loan are the same 
as those provided in Sec.  1.467-2(d) for computing the proportional 
rental amount.
    (d) Contingent payments. Except as otherwise required, contingent 
payments are not taken into account in calculating either the yield or 
the principal balance of a section 467 loan.
    (e) Section 467 rental agreements that call for payments before or 
after the lease

[[Page 370]]

term. If a section 467 rental agreement calls for the payment of fixed 
rent or interest thereon before the beginning of the lease term, this 
section is applied by treating the period beginning on the first day an 
amount is payable and ending on the day before the beginning of the 
first rental period of the lease term as one or more rental periods. If 
a rental agreement calls for the payment of fixed rent or interest 
thereon after the end of the lease term, this section is applied by 
treating the period beginning on the day after the end of the last 
rental period of the lease term and ending on the last day an amount of 
fixed rent or interest thereon is payable as one or more rental periods. 
Rental period length for the period before the lease term or after the 
lease term is determined in accordance with the rules of Sec.  1.467-
1(j)(5).
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i)(A) A leases property to B for a three-year period 
beginning on January 1, 2000, and ending on December 31, 2002. The 
section 467 rental agreement has the following rent allocation schedule 
and payment schedule:

------------------------------------------------------------------------
                                                    Rent
                                                 allocation    Payment
------------------------------------------------------------------------
2000..........................................     $400,000  ...........
2001..........................................      600,000  ...........
2002..........................................      800,000   $1,800,000
------------------------------------------------------------------------

    (B) The rental agreement requires a $1.8 million payment to be made 
on December 31, 2002, but does not provide for interest on deferred 
rent. Assume A and B choose the calendar year as the rental period 
length and that 110 percent of the applicable Federal rate based on 
annual compounding is 10 percent. Assume also that the agreement is not 
a leaseback or long-term agreement and, therefore, is not subject to 
constant rental accrual.
    (ii) Because the section 467 rental agreement does not provide 
adequate interest under Sec.  1.467-2(b) and is not subject to constant 
rental accrual, the fixed rent that accrues during each rental period is 
the proportional rental amount as described in Sec.  1.467-2(c). The 
proportional rental amounts for each rental period are as follows:

2000......................................................   $370,370.37
2001......................................................    555,555.56
2002......................................................    740,740.73
 

    (iii) A section 467 loan arises at the beginning of the second 
rental period because the rent payable on or before that day (zero) is 
less than the fixed rent accrued under Sec.  1.467-1(d)(2) in all 
preceding rental periods ($370,370.37). Under paragraph (c)(2) of this 
section, the yield of the loan is equal to 110 percent of the applicable 
Federal rate (10 percent compounded annually). Because no payments are 
treated as made on or before the first day of the second rental period, 
the principal balance of the loan at the beginning of the second rental 
period is $370,370.37. The interest for the second rental period on 
fixed rent is $37,037.04 (.10 x $370,370.37) and, under Sec.  1.467-
1(e)(3), is treated as interest income of the lessor and as an interest 
expense of the lessee.
    (iv) Because no payments are made on or before the first day of the 
third rental period, the principal balance of the loan at the beginning 
of the third rental period is equal to the fixed rent accrued during the 
first and second rental periods plus the lessor's interest income on 
fixed rent for the second rental period ($962,962.97 = $370,370.37 + 
$555,555.56 + $37,037.04). The interest for the third rental period on 
fixed rent is $96,296.30 (.10 x $962,962.97). Thus, the sum of the fixed 
rent and interest on fixed rent for the three rental periods is equal to 
the total amount paid over the lease term (first year fixed rent 
accrual, $370,370.37, plus second year fixed rent and interest accrual, 
$555,555.56 + $37,037.04, plus third year fixed rent and interest 
accrual, $740,740.73 + $96,296.30, equals $1,800,000). B takes the 
amounts of interest and rent into account as interest and rent expense, 
respectively, and A takes such amounts into account as interest and rent 
income, respectively, for the calendar years identified above, 
regardless of their respective overall methods of accounting.
    Example 2. (i) The facts are the same as in Example 1, Sec.  1.467-
2(f). C agrees to lease property from D for five years beginning on 
January 1, 2000, and ending on December 31, 2004. The section 467 rental 
agreement provides that rent of $100,000 accrues in each calendar year 
in the lease term and that rent of $500,000 plus $120,000 of interest is 
payable on December 31, 2004. The parties select the calendar year as 
the rental period, and 110 percent of the applicable Federal rate is 10 
percent, compounded annually. The rental agreement has deferred rent but 
provides adequate interest on fixed rent.
    (ii)(A) Pursuant to paragraph (c)(1) of this section, the yield of 
the section 467 loan is 10.775078%, compounded annually. The following 
is a schedule of the rent allocable to each rental period during the 
lease term, the balance of the section 467 loan as of the end of each 
rental period (determined, in the case of the calendar year 2004, 
without regard to the single payment of rent and interest in the amount 
of $620,000 payable on the last day of the lease term), and the interest 
on the section 467 loan allocable to each rental period:

[[Page 371]]



----------------------------------------------------------------------------------------------------------------
                                                                    Section 467     Section 467     Section 467
                          Calendar year                              interest          rent        loan balance
----------------------------------------------------------------------------------------------------------------
2000............................................................              $0     $100,000.00     $100,000.00
2001............................................................       10,775.08      100,000.00      210,775.08
2002............................................................       22,711.18      100,000.00      333,486.26
2003............................................................       35,933.41      100,000.00      469,419.67
2004............................................................       50,580.33      100,000.00      620,000.00
----------------------------------------------------------------------------------------------------------------

    (B) C takes the amounts of interest and rent into account as expense 
and D takes such amounts into account as income for the calendar years 
identified above, regardless of their respective overall methods of 
accounting.

[T.D. 8820, 64 FR 26863, May 18, 1999]



Sec.  1.467-5  Section 467 rental agreements with variable interest.

    (a) Variable interest on deferred or prepaid rent--(1) In general. 
This section provides rules for computing section 467 rent and interest 
in the case of section 467 rental agreements providing variable 
interest. For purposes of this section, a rental agreement provides for 
variable interest if the rental agreement provides for stated interest 
that is paid or compounded at least annually at a rate or rates that 
meet the requirements of Sec.  1.1275-5(a)(3)(i)(A) or (B) and (a)(4). 
If a section 467 rental agreement provides for interest that is neither 
variable interest nor fixed interest, the agreement provides for 
contingent payments.
    (2) Exceptions. This section is not applicable to section 467 rental 
agreements that provide adequate interest under Sec.  1.467-2(b)(1)(i) 
(agreements with no deferred or prepaid rent) or (b)(1)(ii) (rental 
agreements with stated interest at a single fixed rate). The exceptions 
in this paragraph (a)(2) do not apply to rental agreements subject to 
constant rental accrual under Sec.  1.467-3.
    (b) Variable rate treated as fixed--(1) In general. If a section 467 
rental agreement provides variable interest--
    (i) The fixed rate substitutes (determined in the same manner as 
under Sec.  1.1275-5(e), treating the agreement date as the issue date) 
for the variable rates of interest on deferred or prepaid fixed rent 
provided by the rental agreement must be used in computing the 
proportional rental amount under Sec.  1.467-2(c), the constant rental 
amount under Sec.  1.467-3(d), the principal balance of a section 467 
loan under Sec.  1.467-4(b), and the yield of a section 467 loan under 
Sec.  1.467-4(c); and
    (ii) The interest on fixed rent for any rental period is equal to 
the amount that would be determined under Sec.  1.467-1(e)(2) if the 
section 467 rental agreement did not provide variable interest, using 
the fixed rate substitutes determined under paragraph (b)(1)(i) of this 
section in place of the variable rates called for by the rental 
agreement, plus the variable interest adjustment amount provided in 
paragraph (b)(2) of this section.
    (2) Variable interest adjustment amount--(i) In general. The 
variable interest adjustment amount for a rental period equals the 
difference between--
    (A) The amount of interest that, without regard to section 467, 
would have accrued during the rental period under the terms of the 
section 467 rental agreement; and
    (B) The amount of interest that, without regard to section 467, 
would have accrued during the rental period under the terms of the 
section 467 rental agreement using the fixed rate substitutes determined 
under paragraph (b)(1)(i) of this section in place of the variable 
interest rates called for by the rental agreement.
    (ii) Positive or negative adjustment. If the amount determined under 
paragraph (b)(2)(i)(A) of this section is greater than the amount 
determined under paragraph (b)(2)(i)(B) of this section, the variable 
interest adjustment amount is positive. If the amount determined under 
paragraph (b)(2)(i)(A) of this section is less than the amount 
determined under paragraph (b)(2)(i)(B) of this section, the variable 
interest adjustment amount is negative.
    (3) Section 467 loan balance. The variable interest adjustment 
amount is not taken into account in determining the principal balance of 
a section 467 loan under Sec.  1.467-4(b). Instead, the section 467 loan 
balance is computed as if all

[[Page 372]]

amounts payable under the section 467 rental agreement were based on the 
fixed rate substitutes determined under paragraph (b)(1)(i) of this 
section.
    (c) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) X and Y enter into a section 467 rental agreement for 
the lease of personal property beginning on January 1, 2000, and ending 
on December 31, 2002. The rental agreement allocates $100,000 of rent to 
2000, $200,000 to 2001, and $100,000 to 2002, and requires the lessee to 
pay all $400,000 of rent on December 31, 2002. The rental agreement 
requires the accrual of interest on unpaid accrued rent at two different 
qualified floating rates (as defined in Sec.  1.1275-5(b)), one for 2001 
and the other for 2002, such interest to be paid on December 31 of the 
year it accrues. The rental agreement provides that the qualified 
floating rate is set at a current value within the meaning of Sec.  
1.1275-5(a)(4). Assume that on the agreement date, 110 percent of the 
applicable Federal rate is 10 percent, compounded annually. Assume also 
that the agreement is not a leaseback or long-term agreement and, 
therefore, is not subject to constant rental accrual.
    (ii) To determine if the section 467 rental agreement provides for 
adequate interest under Sec.  1.467-2(b), Sec.  1.467-2(b)(2) requires 
the use of fixed rate substitutes (in this example determined in the 
same manner as under Sec.  1.1275-5(e)(3)(i) treating the agreement date 
as the issue date) in place of the variable rates called for by the 
rental agreement. Assume that on the agreement date the qualified 
floating rates, and therefore the fixed rate substitutes, relating to 
2001 and 2002 are 10 and 15 percent compounded annually. Taking into 
account the fixed rate substitutes, the sum of the present values of all 
amounts payable by the lessee as fixed rent and interest thereon is 
greater than the sum of the present values of the fixed rent allocated 
to each rental period. Accordingly, the rental agreement provides 
adequate interest under Sec.  1.467-2(b)(1)(iii) and the fixed rent 
accruing in each calendar year during the rental agreement is the fixed 
rent allocated under the rental agreement.
    (iii) Because the section 467 rental agreement provides for variable 
interest on unpaid accrued fixed rent at qualified floating rates and 
the qualified floating rates are set at a current value, the 
requirements of Sec.  1.1275-5(a)(3)(i)(A) and (4) are met and the 
rental agreement provides for variable interest within the meaning of 
paragraph (a)(1) of this section. Therefore, under paragraph (b)(1)(i) 
of this section, the yield of the section 467 loan is computed based on 
the fixed rate substitutes. Under Sec.  1.467-4(c), the constant yield 
(rounded to two decimal places) equals 13.63 percent compounded 
annually. Based on the fixed rate substitutes, the fixed rent, interest 
on fixed rent, and the principal balance of the section 467 loan, for 
each calendar year during the lease term, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                     Accrued        Projected       Cumulative
                                                  Accrued rent      interest         payment           loan
----------------------------------------------------------------------------------------------------------------
2000...........................................        $100,000              $0              $0         $100,000
2001...........................................         200,000          13,630         (10,000)         303,630
2002...........................................         100,000          41,370        (445,000)               0
----------------------------------------------------------------------------------------------------------------

    (iv) To compute the actual reported interest on fixed rent for each 
calendar year, the variable interest adjustment amount, as described in 
paragraph (b)(2) of this section, must be added to the accrued interest 
determined in paragraph (iii) of this Example 1. Assume that the 
variable rates for 2001 and 2002 are actually 11 and 14 percent, 
respectively. Without regard to section 467, the interest that would 
have accrued during each calendar year under the terms of the section 
467 rental agreement, and the interest that would have accrued under the 
terms of the rental agreement using the fixed rate substitutes 
determined under paragraph (b)(1)(i) of this section are as follows:

------------------------------------------------------------------------
                                            Accrued          Accrued
                                         interest under   interest using
                                             rental         fixed rate
                                           agreement       substitutes
------------------------------------------------------------------------
2000..................................               $0               $0
2001..................................           11,000           10,000
2002..................................           42,000           45,000
------------------------------------------------------------------------

    (v) Under paragraph (b)(2) of this section, the variable interest 
adjustment amount is $1,000 ($11,000-$10,000) for 2001 and is -$3,000 
($42,000-$45,000) for 2002. Thus, under paragraph (b)(1)(ii) of this 
section, the actual interest on fixed rent for 2001 is $14,630 ($13,630 
+ $1,000) and for 2002 is $38,370 ($41,370-$3,000).
    Example 2. (i) The facts are the same as in Example 1 except that 
110 percent of the applicable Federal rate is 15 percent compounded 
annually and the section 467 rental agreement does not provide adequate 
interest under Sec.  1.467-2(b). Consequently, the fixed

[[Page 373]]

rent for each calendar year during the lease is the proportional rental 
amount.
    (ii) The sum of the present values of the fixed rent provided for 
each calendar year during the lease term, discounted at 15 percent 
compounded annually, equals $303,936.87.
    (iii)(A) Paragraph (b)(1)(i) of this section requires the 
proportional rental amount to be computed based on the assumption that 
interest will accrue and be paid based on the fixed rate substitutes. 
Thus, the sum of the present values of the projected payments under the 
section 467 rental agreement equals $300,156.16, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.005

    (B) The fraction for computing the proportional rental amount equals 
.9875609 ($300,156.16/$303,936.87).
    (iv) Based on the fixed rate substitutes, the fixed rent, interest 
on fixed rent, and the balance of the section 467 loan for each calendar 
year during the lease term are as follows:

----------------------------------------------------------------------------------------------------------------
                                                  Proportional       Accrued        Projected       Cumulative
                                                      rent          interest         payment           loan
----------------------------------------------------------------------------------------------------------------
2000...........................................      $98,756.09           $0.00              $0       $98,756.09
2001...........................................      197,512.18       14,813.41         (10,000)      301,081.68
2002...........................................       98,756.09       45,162.23        (445,000)            0.00
----------------------------------------------------------------------------------------------------------------

    (v) The variable interest adjustment amount in this example is the 
same as in Example 1. Under paragraph (b)(1)(ii) of this section, the 
actual interest on fixed rent for 2001 is $15,813.41 ($14,813.41 + 
$1,000) and for 2002 is $42,162.23 ($45,162.23-$3,000).

[T.D. 8820, 64 FR 26865, May 18, 1999]



Sec.  1.467-6  Section 467 rental agreements with contingent payments. 
[Reserved]



Sec.  1.467-7  Section 467 recapture and other rules relating to dispositions 
and modifications.

    (a) Section 467 recapture. Notwithstanding any other provision of 
the Internal Revenue Code, except as provided in paragraph (c) of this 
section, a lessor disposing of property in a transaction to which this 
paragraph (a) applies must recognize the recapture amount (determined 
under paragraph (b) of this section) and treat that amount as ordinary 
income. This paragraph (a) applies to any disposition of property 
subject to a section 467 rental agreement that--
    (1) Is a leaseback (as defined in Sec.  1.467-3(b)(2)) or a long-
term agreement (as defined in Sec.  1.467-3(b)(3));
    (2) Is not disqualified under Sec.  1.467-3(b)(1); and
    (3) Allocates to any rental period fixed rent that, when annualized, 
exceeds the annualized fixed rent allocated to any preceding rental 
period.
    (b) Recapture amount--(1) In general. The recapture amount for a 
disposition is the lesser of--
    (i) The prior understated inclusion (determined under paragraph 
(b)(2) of this section); or
    (ii) The section 467 gain (determined under paragraph (b)(3) of this 
section).
    (2) Prior understated inclusion. The prior understated inclusion is 
the excess (if any) of--
    (i) The aggregate amount of section 467 rent and section 467 
interest for the period during which the lessor held the property, 
determined as if the section 467 rental agreement were a disqualified 
leaseback or long-term agreement subject to constant rental accrual 
under Sec.  1.467-3; over
    (ii) The aggregate amount of section 467 rent and section 467 
interest accrued by the lessor during that period.
    (3) Section 467 gain--(i) In general. Except as otherwise provided 
in paragraph (b)(3)(ii) of this section, the section 467 gain is the 
excess (if any) of--
    (A) The amount realized from the disposition; over
    (B) The sum of the adjusted basis of the property and the amount of 
any gain from the disposition that is treated as ordinary income under 
any provision of subtitle A of the Internal Revenue Code other than 
section 467(c) (for example, section 1245 or 1250).

[[Page 374]]

    (ii) Certain dispositions. In the case of a disposition that is not 
a sale or exchange, the section 467 gain is the excess (if any) of the 
fair market value of the property on the date of disposition over the 
amount determined under paragraph (b)(3)(i)(B) of this section.
    (c) Special rules--(1) Gifts. Paragraph (a) of this section does not 
apply to a disposition by gift. However, see paragraph (c)(4) of this 
section for dispositions by transferees. If a disposition is in part a 
sale or exchange and in part a gift, paragraph (a) of this section 
applies to the disposition but the prior understated inclusion is 
determined by taking into account only section 467 rent and section 467 
interest properly allocable to the portion of the property not disposed 
of by gift.
    (2) Dispositions at death. Paragraph (a) of this section does not 
apply to a disposition if the basis of the property in the hands of the 
transferee is determined under section 1014(a) or section 1022. However, 
see paragraph (c)(4) of this section for dispositions of property 
subject to section 1022 by transferees. This paragraph (c)(2) does not 
apply to property that constitutes a right to receive an item of income 
in respect of a decedent. See sections 691, 1014(c), and 1022(f).
    (3) Certain tax-free exchanges--(i) In general. The recapture amount 
in the case of a disposition to which this paragraph (c)(3) applies is 
limited to the amount of gain recognized to the transferor (determined 
without regard to paragraph (a) of this section), reduced by the amount 
of any gain from the disposition that is treated as ordinary income 
under any provision of subtitle A of the Internal Revenue Code other 
than section 467(c). However, see paragraph (c)(4) of this section for 
dispositions by transferees.
    (ii) Dispositions covered--(A) In general. Except as provided in 
paragraph (c)(3)(ii)(B) of this section, this paragraph (c)(3) applies 
to a disposition of property if the basis of the property in the hands 
of the transferee is determined by reference to its basis in the hands 
of the transferor by reason of the application of section 332, 351, 361, 
721, or 731.
    (B) Transfers to certain tax-exempt organizations. This paragraph 
(c)(3) does not apply to a disposition to an organization (other than a 
cooperative described in section 521) which is exempt from tax imposed 
by chapter 1, subtitle A of the Internal Revenue Code (a tax-exempt 
entity) except to the extent the property is used in an activity the 
income from which is subject to tax under section 511(a) (a section 
511(a) activity). However, if assets used to any extent in a section 
511(a) activity are disposed of by the tax-exempt entity, then, 
notwithstanding any other provision of law (except section 1031 or 
section 1033) the recapture amount with respect to such disposition, to 
the extent attributable under paragraph (c)(4) of this section to the 
period of the transferor's ownership of the property prior to the first 
disposition, shall be included in the tax-exempt entity's unrelated 
business taxable income. To the extent that the tax-exempt entity ceases 
to use the property in a section 511(a) activity, the entity will be 
treated for purposes of this paragraph (c)(3) and paragraph (c)(4) of 
this section as having disposed of the property to such extent on the 
date of the cessation.
    (4) Dispositions by transferee. If the recapture amount with respect 
to a disposition of property (the first disposition) is limited under 
paragraph (c)(1) or (c)(3) of this section, or under paragraph (c)(2) of 
this section because the basis of the property in the hands of the 
transferee is determined under section 1022, and the transferee 
subsequently disposes of the property in a transaction to which 
paragraph (a) of this section applies, the prior understated inclusion 
determined under paragraph (b)(2) of this section is computed by taking 
into account the amounts attributable to the period of the transferor's 
ownership of the property prior to the first disposition. Thus, for 
example, the section 467 rent and section 467 interest that would have 
been taken into account by the transferee if the section 467 rental 
agreement were a disqualified leaseback or long-term agreement subject 
to constant rental accrual include the amounts that would have been 
taken into account by the transferor, and the aggregate amount of 
section 467 rent and section 467 interest accrued by the transferee 
includes the aggregate

[[Page 375]]

amount of section 467 rent and section 467 interest that was taken into 
account by the transferor. The prior understated inclusion determined 
under this paragraph (c)(4) must be reduced by any recapture amount 
taken into account under paragraph (a) of this section by the 
transferor.
    (5) Like-kind exchanges and involuntary conversions. If property is 
disposed of or converted and, before the application of paragraph (a) of 
this section, gain is not recognized in whole or in part under section 
1031 or 1033, then the amount of section 467 gain taken into account by 
the lessor is limited to the sum of--
    (i) The amount of gain recognized on the disposition or conversion 
of the property (determined without regard to paragraph (a) of this 
section); and
    (ii) The fair market value of property acquired that is not subject 
to the same section 467 rental agreement and that is not taken into 
account under paragraph (c)(5)(i) of this section.
    (6) Installment sales. In the case of an installment sale of 
property to which paragraph (a) of this section applies--
    (i) The recapture amount is recognized and treated as ordinary 
income in the year of the disposition; and
    (ii) Any gain in excess of the recapture amount is reported under 
the installment method of accounting if and to the extent that method is 
otherwise available under section 453.
    (7) Dispositions covered by section 170(e), 341(e)(12), or 751(c). 
For purposes of sections 170(e), 341(e)(12), and 751(c), amounts treated 
as ordinary income under paragraph (a) of this section must be treated 
in the same manner as amounts treated as ordinary income under section 
1245 or 1250.
    (d) Examples. The following examples illustrate the application of 
paragraphs (a), (b), and (c) of this section. In each of these examples 
the transferor of property subject to a section 467 rental agreement is 
entitled to the rent for the day of the disposition. The examples are as 
follows:

    Example 1. (i)(A) X and Y enter into a section 467 rental agreement 
for a 5-year lease of personal property beginning on January 1, 2000, 
and ending on December 31, 2004. The rental agreement provides that the 
calendar year will be the rental period and that rents accrue and are 
paid in the following pattern:

------------------------------------------------------------------------
                                            Allocation        Payment
------------------------------------------------------------------------
2000....................................              $0              $0
2001....................................          87,500               0
2002....................................          87,500         175,000
2003....................................          87,500         175,000
2004....................................          87,500               0
------------------------------------------------------------------------

    (B) Assume that both X and Y are calendar year taxpayers and that 
110 percent of the applicable Federal rate is 11 percent, compounded 
annually. Assume also that the rental agreement is a long-term agreement 
(as defined in Sec.  1.467-3(b)(3)), but it is not a disqualified 
leaseback or long-term agreement. Further, because the agreement does 
not provide prepaid or deferred rent, proportional rental accrual is not 
applicable. (See Sec.  1.467-2(b)(1)(i)). Therefore, the rent taken into 
account under Sec.  1.467-1(d)(2) is the fixed rent allocated to the 
rental periods under Sec.  1.467-1(c)(2)(ii).
    (ii) On December 31, 2000, X sells the property subject to the 
section 467 rental agreement to an unrelated person for $575,000. At the 
time of the sale, X's adjusted basis in the property is $175,000. Thus, 
X's gain on the sale of the property is $400,000. Assume that $175,000 
of this gain would be treated as ordinary income under provisions of the 
Internal Revenue Code other than section 467(c). Under paragraph (a) of 
this section, X is required to take the recapture amount into account as 
ordinary income. Under paragraph (b) of this section, the recapture 
amount is the lesser of the prior understated inclusion or the section 
467 gain.
    (iii)(A) In computing the prior understated inclusion under 
paragraph (b)(2) of this section, assume that the section 467 rent and 
section 467 interest (based on constant rental accrual) would be taken 
into account as follows if the section 467 rental agreement were a 
disqualified long-term agreement:

------------------------------------------------------------------------
                                           Section 467     Section 467
                                              rent           interest
------------------------------------------------------------------------
2000...................................      $65,812.55              $0
2001...................................       65,812.55        7,239.38
2002...................................       65,812.55       15,275.09
2003...................................       65,812.55        4,944.73
2004...................................       65,812.55       (6,521.95)
------------------------------------------------------------------------

    (B) The total amount of section 467 rent and section 467 interest 
for 2000, based on constant rental accrual, is $65,812.55. Since X did 
not take any section 467 rent or section 467 interest into account in 
2000, the prior understated inclusion is also $65,812.55. X's section 
467 gain is $225,000, which is the excess of the gain realized 
($400,000) over the amount of that gain treated as ordinary income under 
non-section 467 provisions ($175,000). Accordingly, the recapture amount 
(the lesser of the prior understated inclusion

[[Page 376]]

or the section 467 gain) treated as ordinary income is $65,812.55.
    Example 2. (i) The facts are the same as in Example 1, except that 
the section 467 rental agreement specifies that rents accrue and are 
paid in the following pattern:

------------------------------------------------------------------------
                                            Allocation        Payment
------------------------------------------------------------------------
2000....................................         $60,000              $0
2001....................................          65,000               0
2002....................................          70,000         175,000
2003....................................          75,000         175,000
2004....................................          80,000               0
------------------------------------------------------------------------

    (ii)(A) Assume the section 467 rental agreement does not provide for 
adequate interest under Sec.  1.467-2(b), and, therefore, the fixed rent 
for a rental period is the proportional rental amount. See Sec.  1.467-
1(d)(2)(ii). Under Sec.  1.467-2(c), the following amounts would be 
required to be taken into account:

------------------------------------------------------------------------
                                           Section 467     Section 467
                                              rent           interest
------------------------------------------------------------------------
2000...................................      $57,260.43             $ 0
2001...................................       62,032.13        6,298.65
2002...................................       66,803.83       13,815.03
2003...................................       71,575.53        3,433.11
2004...................................       76,347.23       (7,565.94)
------------------------------------------------------------------------

    (B) The amount of section 467 rent and section 467 interest taken 
into account by X for 2000 is $57,260.43. Thus, the prior understated 
inclusion is $8,552.12 (the excess of the amount of section 467 rent and 
section 467 interest based on constant rental accrual for 2000, 
$65,812.55, over the amount of section 467 rent and section 467 interest 
actually taken into account, $57,260.43). Since the prior understated 
inclusion is less than the section 467 gain ($225,000, as determined in 
Example 1(iii)(B)), the recapture amount treated as ordinary income is 
also $8,552.12.
    Example 3. (i) The facts are the same as in Example 1, except that, 
instead of selling the property, X transfers the property to S on 
December 31, 2002, in exchange for stock of S in a transaction that 
meets the requirements of section 351(a). Under paragraph (c)(3) of this 
section, because of the application of section 351, X is not required to 
take into account any section 467 recapture.
    (ii) On December 31, 2003, S sells the property subject to the 
section 467 rental agreement to an unrelated person for $450,000. At the 
time of the sale, S's adjusted basis in the property is $105,000. Thus, 
S's gain on the sale of the property is $345,000. Assume that $245,000 
of this gain would be treated as ordinary income under provisions of the 
Internal Revenue Code other than section 467(c). Under paragraph (a) of 
this section, S is required to take the recapture amount into account as 
ordinary income which, under paragraph (b) of this section, is the 
lesser of the prior understated inclusion or the section 467 gain.
    (iii) S owned the property in 2003 and, under paragraph (c)(4) of 
this section, for purposes of determining S's prior understated 
inclusion, S is treated as if it had owned the property during the years 
2000 through 2002. In computing S's prior understated inclusion under 
paragraph (b)(2) of this section, the section 467 rent and section 467 
interest based on constant rental accrual are the same as the amounts 
set forth in the schedule in Example 1(iii)(A). Thus, the constant 
rental amount for 2000, 2001, 2002, and 2003 is $290,709.40 ((4 x 
$65,812.55) + $7,239.38 + $15,275.09 + $4,944.73). The section 467 rent 
and section 467 interest actually taken into account prior to the 
disposition is $262,500. Thus, S's prior understated inclusion is 
$28,209.40 ($290,709.40 minus $262,500 (3 x $87,500)). S's section 467 
gain is $100,000, the difference between the gain realized on the 
disposition ($345,000) and the amount of gain that is treated as 
ordinary income under non-section 467 Code provisions ($245,000). 
Accordingly, S's recapture amount, the lesser of the prior understated 
inclusion or the section 467 gain, is $28,209.40.

    (e) Other rules relating to dispositions--(1) In general. If there 
is a sale, exchange, or other disposition of property subject to a 
section 467 rental agreement (the transfer), the section 467 rent and, 
if applicable, section 467 interest for a period are taken into account 
by the owner of the property during the period. The following rules 
apply in determining the section 467 rent and section 467 interest for 
the portion of the rental period ending immediately prior to the 
transfer:
    (i) The section 467 rent and section 467 interest for the portion of 
the rental period ending immediately prior to the transfer are a pro 
rata portion of the section 467 rent and the section 467 interest, 
respectively, for the rental period. Such amounts are also taken into 
account in determining the transferor's section 467 loan balance, prior 
to any adjustment thereof that may be required under paragraph (h) of 
this section, immediately before the transfer.
    (ii) If the transferor of the property is entitled to the rent for 
the day of transfer, the transfer is treated as occurring at the end of 
the day of the transfer.
    (iii) If the transferee of the property is entitled to the rent for 
the day of transfer, the transfer is treated as occurring at the 
beginning of the day of the transfer.

[[Page 377]]

    (2) Treatment of section 467 loan. If there is a transfer described 
in paragraph (e)(1) of this section, the following rules apply in 
determining the transferor's and the transferee's section 467 loans for 
the period after the transfer, the amount realized by the transferor, 
and the transferee's basis in the property:
    (i) The beginning balance of the transferor's section 467 loan is 
equal to the net present value at the time of the transfer (but after 
giving effect to the transfer) of all subsequent amounts payable as 
fixed rent and interest on fixed rent to the transferor and all 
subsequent amounts payable as interest on prepaid fixed rent by the 
transferor. The transferor must continue to take into account interest 
on the transferor's section 467 loan balance after the date of the 
transfer.
    (ii) The beginning balance of the transferee's section 467 loan is 
equal to the principal balance of the transferor's section 467 loan 
immediately before the transfer reduced (below zero, if appropriate) by 
the beginning balance of the transferor's section 467 loan. Amounts 
payable to the transferor are not taken into account in adjusting the 
transferee's section 467 loan balance.
    (iii) If the beginning balance of the transferee's section 467 loan 
is negative, the transferor and transferee must treat the balance as a 
liability that is either assumed in connection with the transfer of the 
property or secured by the property acquired subject to the liability. 
If the beginning balance of the transferee's section 467 loan is 
positive, the transferor and transferee must treat the balance as an 
additional asset acquired in connection with the transfer of the 
property. In the case of a positive beginning balance of the 
transferee's section 467 loan, the transferee will have an initial cost 
basis in the section 467 loan equal to the lesser of the beginning 
balance of the loan or the aggregate consideration for the transfer of 
the property subject to the section 467 rental agreement and the 
transfer of the transferor's interest in the section 467 loan.
    (3) [Reserved]
    (4) Examples. The following examples illustrate the application of 
this paragraph (e). In each of these examples the transferor of property 
subject to a section 467 rental agreement is entitled to the rent for 
the day of the transfer. The examples are as follows:

    Example 1. (i) Q and R enter into a section 467 rental agreement for 
a 5-year lease of personal property beginning on January 1, 2000, and 
ending on December 31, 2004. The rental agreement provides that $0 of 
rent is allocated to 2000, 2001, and 2002, and $1,750,000 is allocated 
to each of the years 2003 and 2004. The rental agreement provides that 
the calendar year will be the rental period and that the rent allocated 
to each calendar year is payable on the last day of that calendar year. 
Assume that both Q and R are calendar year taxpayers and that 110 
percent of the applicable Federal rate is 11 percent, compounded 
annually. Assume further that the rental agreement is a disqualified 
long-term agreement (as defined in Sec.  1.467-3(b)(3)) and that the 
section 467 rent, the section 467 interest, and the section 467 loan 
balance would be the following amounts:

----------------------------------------------------------------------------------------------------------------
                                                            Section 467                         Section 467 loan
            Calendar year                  Payment            interest       Section 467 rent       balance
----------------------------------------------------------------------------------------------------------------
2000................................                 $0                 $0        $592,905.87        $592,905.87
2001................................                  0          65,219.65         592,905.87       1,251,031.39
2002................................                  0         137,613.45         592,905.87       1,981,550.71
2003................................       1,750,000.00         217,970.58         592,905.87       1,042,427.16
2004................................       1,750,000.00         114,666.97         592,905.87                  0
----------------------------------------------------------------------------------------------------------------

    (ii) On December 31, 2002, Q sells the property subject to the 
section 467 rental agreement to P, an unrelated person, for $3,000,000. 
Q does not retain the right to receive any amounts payable by R under 
the rental agreement after the date of sale, but the agreement is not 
otherwise modified. At the time of the sale, Q's adjusted basis in the 
property is $975,000. Assume that, under Sec.  1.467-1(f)(7), the 
disposition is not a substantial modification. Further, the Commissioner 
does not determine that the treatment of the agreement as a disqualified 
long-term agreement should be changed and, under Sec.  1.467-
1(f)(4)(iii), the agreement remains subject to constant rental accrual. 
Thus, under paragraph (g)(2)(iii) of this section, section 467 rent and 
section 467 interest for periods after the disposition will be taken 
into account on the basis of constant rental

[[Page 378]]

accrual applied to the terms of the entire agreement (as modified).
    (iii) Under paragraph (e)(2)(ii) of this section, the beginning 
balance of P's section 467 loan is $1,981,550.71. P's section 467 loan 
balance is computed by reducing the balance of the section 467 loan 
immediately before the transfer ($1,981,550.71) by the beginning balance 
of the transferor's section 467 loan ($0 because Q does not retain the 
right to receive any amounts payable under the rental agreement 
subsequent to the transfer).
    (iv) Q will be treated as if it had received $1,981,550.71 from the 
disposition of the section 467 loan and $1,018,449.29 from the sale of 
the property subject to the rental agreement. Thus, Q's gain on the sale 
of the property is $43,449.29 ($1,018,449.29 amount realized less 
$975,000 adjusted basis). Q's gain is not subject to the recapture 
provisions of section 467(c) and paragraph (a) of this section because 
the rental agreement was disqualified under Sec.  1.467-3(b)(1) and, 
thus, the requirement of paragraph (a)(2) of this section is not met. Q 
recognizes no gain on the disposition of the section 467 loan because 
Q's basis in the loan equals the amount considered received for the 
loan. Further, Q does not take into account any of the section 467 rent 
or section 467 interest attributable to periods after the transfer of 
the property.
    (v) P is treated as if it had acquired the property and the positive 
balance in the transferee's section 467 loan. P's cost basis in the 
property is $1,018,449.29, and its cost basis in the section 467 loan 
immediately following the transfer is $1,981,550.71. P takes section 467 
rent and section 467 interest into account for the calendar years 2002 
and 2003 under the constant rental accrual method and, accordingly, 
treats payments received under the rental agreement as recoveries of the 
principal balance of the section 467 loan (as adjusted from time to 
time).
    Example 2. (i) The facts are the same as Example 1, except that on 
December 31, 2002, Q transfers the property to P in exchange for stock 
of P having a fair market value of $3,000,000 and the transaction meets 
the requirements of section 351(a).
    (ii) Q is treated as having transferred two assets to P, the 
property subject to the rental agreement and the positive balance of the 
section 467 loan. Under section 351(a), because only stock of P is 
received by Q, Q does not recognize any of the gain realized on the 
transaction. Pursuant to section 358(a), the basis of Q in the P stock 
received in the exchange is the same as the aggregate basis of the 
property exchanged, or $2,956,550.71 (the sum of the balance of the 
section 467 loan, $1,981,550.71, and the adjusted basis of the property, 
$975,000). Q does not take into account any of the section 467 rent or 
section 467 interest attributable to periods after the transfer of the 
property.
    (iii) P is treated as if it had acquired the property and the 
positive balance in the transferee's section 467 loan in the 
transaction. Pursuant to section 362(a), P's basis in each asset is the 
same as the basis of Q immediately preceding the transfer. Thus, the 
basis of P in the property subject to the rental agreement is $975,000, 
and the basis of P in the section 467 loan immediately following the 
transfer is $1,981,550.71. P takes section 467 rent and section 467 
interest into account for the calendar years 2003 and 2004 under the 
constant rental accrual method and, accordingly, treats payments 
received under the rental agreement as recoveries of the principal 
balance of the section 467 loan (as adjusted from time to time).

    (f) Treatment of assignments by lessee and lessee-financed 
renewals--(1) Substitute lessee use. If a lessee assigns its interest in 
a section 467 rental agreement to a substitute lessee, or if a period 
when a substitute lessee has the use of property subject to a section 
467 rental agreement is otherwise included in the lease term under Sec.  
1.467-1(h)(6), the section 467 rent for a period is taken into account 
by the person having the use of the property during the period. The 
following rules apply in determining the section 467 rent and section 
467 interest for the portion of the rental period ending immediately 
prior to the assignment:
    (i) The section 467 rent and section 467 interest for the portion of 
the rental period ending immediately prior to the assignment are a pro 
rata portion of the section 467 rent and the section 467 interest, 
respectively, for the rental period. Such amounts are also taken into 
account in determining the lessee's section 467 loan balance, prior to 
any adjustment thereof that may be required under paragraph (h) of this 
section, immediately before the substitute lessee first has use of the 
property.
    (ii) If the lessee is liable for the rent for the day that the 
substitute lessee first has use of the property, the substitute lessee's 
use shall be treated as beginning at the end of that day.
    (iii) If the substitute lessee is liable for the rent for the day 
that the substitute lessee first has use of the property, the substitute 
lessee's use shall be treated as beginning at the beginning of that day.
    (2) Treatment of section 467 loan. If, as described in paragraph 
(f)(1) of this section, a lessee assigns its interest in a

[[Page 379]]

section 467 rental agreement to a substitute lessee or a period when a 
substitute lessee has the use of property subject to a section 467 
rental agreement is otherwise included in the lease term under Sec.  
1.467-1(h)(6), the following rules apply in determining the amount of 
the lessee's and the substitute lessee's section 467 loans for the 
period when the substitute lessee has use of the property and in 
computing the taxable income of the lessee and substitute lessee:
    (i) The beginning balance of the lessee's section 467 loan is equal 
to the net present value, as of the time the substitute lessee first has 
use of the property (but after giving effect to the transfer of the 
right to use the property), of all amounts subsequently payable by the 
lessee as fixed rent and interest on fixed rent and all amounts 
subsequently payable as interest on prepaid fixed rent to the lessee. 
For purposes of this paragraph (f), any amount otherwise payable by the 
lessee is not treated as an amount subsequently payable by the lessee to 
the extent that such payment, if made by the lessee, would give rise to 
a right of contribution or other similar claim against the substitute 
lessee or any other person. The lessee must continue to take into 
account interest on the lessee's section 467 loan balance after the 
substitute lessee first has use of the property.
    (ii) The beginning balance of the substitute lessee's section 467 
loan is equal to the principal balance of the lessee's section 467 loan 
immediately before the substitute lessee first has use of the property 
reduced (below zero, if appropriate) by the beginning balance of the 
lessee's section 467 loan. Amounts payable by the lessee to any person 
other than the substitute lessee (or a related person) or payable to the 
lessee by any person other than the substitute lessee (or a related 
person) are not taken into account in adjusting the substitute lessee's 
section 467 loan balance.
    (iii) If the beginning balance of the substitute lessee's section 
467 loan is positive, the beginning balance is treated as--
    (A) Gross receipts of the lessee for the taxable year in which the 
substitute lessee first has use of the property; and
    (B) A liability that is either assumed in connection with the 
transfer of the leasehold interest to the substitute lessee or secured 
by property acquired subject to the liability.
    (iv) If the beginning balance of the substitute lessee's section 467 
loan is negative, the following rules apply:
    (A) If the principal balance of the lessee's section 467 loan 
immediately before the substitute lessee first has use of the property 
was negative, any consideration paid by the substitute lessee to the 
lessee in conjunction with the transfer of the use of the property shall 
be treated as a nontaxable return of capital to the lessee to the extent 
that--
    (1) The consideration does not exceed the amount owed to the lessee 
under the lessee's section 467 loan balance immediately before the 
substitute lessee first has use of the property; and
    (2) The lessee has basis in the principal balance of the lessee's 
section 467 loan immediately before the substitute lessee first has use 
of the property.
    (B) Except as provided in paragraph (f)(2)(iv)(D) of this section, 
the excess, if any, of the beginning balance of the amount owed to the 
substitute lessee under the section 467 loan, over any consideration 
paid by the substitute lessee to the lessee in conjunction with the 
transfer of the use of the property, is treated as an amount incurred by 
the lessee for the taxable year in which the substitute lessee first has 
use of the property.
    (C) To the extent the beginning balance of the amount owed to the 
substitute lessee under the section 467 loan exceeds any consideration 
paid by the substitute lessee to the lessee in conjunction with the 
transfer of the use of the property, repayments of the beginning balance 
are items of gross income of the substitute lessee in the taxable year 
in which repayment occurs (determined by applying any repayment first to 
the beginning balance of the substitute lessee's section 467 loan).
    (D) Any amount incurred by the lessee under paragraph (f)(2)(iv)(B) 
of this section with respect to a transfer of

[[Page 380]]

the use of property (the current transfer) shall be reduced (but not 
below zero) to the extent that the lessee, in its capacity, if any, as a 
substitute lessee with respect to an earlier transfer of the use of the 
property would have recognized additional gross income under paragraph 
(f)(2)(iv)(C) of this section if the current transfer had not occurred.
    (v) For purposes of paragraph (f)(2)(iv)(C) of this section, 
repayments occur as the negative balance is amortized through the net 
accrual of rent and negative interest.
    (3) Lessor use. If a period when the lessor has the use of property 
subject to a section 467 rental agreement is included in the lease term 
under Sec.  1.467-1(h)(6), the section 467 rent for the period is not 
taken into account and the lessor is treated as a substitute lessee for 
purposes of this paragraph (f).
    (4) Examples. The following examples illustrate the application of 
this paragraph (f). In each of these examples, the substitute lessee is 
liable for the rent for the day on which the substitute lessee first has 
use of the property subject to the section 467 rental agreement. 
Further, assume that in each example the lessee assignment is not a 
substantial modification under Sec.  1.467-1(f). The examples are as 
follows:

    Example 1. (i) The facts are the same as in Example 1 of paragraph 
(e)(4) of this section, except that on December 31, 2001, R, the lessee, 
contracts to assign its entire remaining interest in the leasehold to S, 
a calendar year taxpayer. The assignment becomes effective at the 
beginning of January 1, 2002. Pursuant to the terms of the assignment, R 
agrees with S that R will make $1,400,000 of the $1,750,000 rental 
payment required on December 31, 2003.
    (ii) Under paragraph (f)(2)(i) of this section, R's section 467 loan 
balance as of the beginning of January 1, 2002, the time S first has use 
of the property, is $1,136,271.41 ($1,400,000/(1.11)2). Under paragraph 
(f)(2)(ii) of this section, S's section 467 loan balance as of the 
beginning of January 1, 2002, is $114,759.98 (the principal balance of 
R's section 467 loan immediately before S has use of the property 
($1,251,031.39), less R's section 467 loan balance at the beginning of 
January 1, 2002 ($1,136,271.41)).
    (iii) Because S's $114,759.98 section 467 loan balance is positive, 
under paragraph (f)(2)(iii)(A) of this section, such amount is treated 
as gross receipts of R for 2002, R's taxable year in which S first has 
use of the property. R will treat the $114,759.98 as an amount received 
in exchange for the transfer of the leasehold interest. Under paragraph 
(f)(2)(iii)(B) of this section, S will treat that amount as a liability 
assumed in acquiring the leasehold interest. Thus, S's cost basis in the 
leasehold interest is $114,759.98.
    (iv) Under paragraph (f)(1) of this section, S takes the section 467 
rent attributable to the property into account for the period beginning 
on January 1, 2002. For 2002, S takes section 467 interest into account 
based on S's section 467 loan balance at the beginning of 2002. S's 
amounts payable, section 467 rent, section 467 interest, and end-of-year 
section 467 loan balances for calendar years 2002 through 2004 are as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                            Section 467                         Section 467 loan
            Calendar year                  Payment            interest       Section 467 rent       balance
----------------------------------------------------------------------------------------------------------------
Beginning...........................  .................  .................  .................        $114,759.98
2002................................                 $0         $12,623.60        $592,905.87         720,289.45
2003................................         350,000.00          79,231.83         592,905.87       1,042,427.15
2004................................       1,750,000.00         114,666.98         592,905.87                  0
----------------------------------------------------------------------------------------------------------------

    (v) Under paragraph (f)(2)(i) of this section, R must continue to 
take into account section 467 interest on R's section 467 loan balance 
after S first has use of the property. R's section 467 loan balance 
beginning when S first has use of the property is $1,136,271.41. R's 
section 467 interest and end-of-year section 467 loan balances for 
calendar years 2002 through 2003 are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               Section 467      Section 467 loan
                     Calendar year                            Payment            interest           balance
----------------------------------------------------------------------------------------------------------------
Beginning..............................................  .................  .................      $1,136,271.41
2002...................................................                 $0        $124,989.85       1,261,261.26
2003...................................................       1,400,000.00         138,738.74                  0
----------------------------------------------------------------------------------------------------------------


[[Page 381]]

    Example 2. (i) On January 1, 2000, B leases tangible personal 
property from C for a period of five years. The rental agreement 
provides that the rental period is the calendar year and that rent 
payments are due at the end of the calendar year. The rental agreement 
does not provide for interest on prepaid rent. Assume that B and C are 
both calendar year taxpayers and that 110 percent of the applicable 
Federal rate is 10 percent, compounded annually. The rental agreement 
allocates rents and provides for payments of rent as follows:

------------------------------------------------------------------------
              Calendar year                    Rent          Payments
------------------------------------------------------------------------
2000....................................        $200,000        $400,000
2001....................................         200,000         300,000
2002....................................         200,000         200,000
2003....................................         200,000         100,000
2004....................................         200,000               0
------------------------------------------------------------------------

    (ii) The rental agreement has prepaid rent within the meaning of 
Sec.  1.467-1(c)(3)(ii) because the cumulative amount of rent payable 
through the end of 2001 ($700,000) exceeds the cumulative amount of rent 
allocated to calendar years 2000 through 2002 ($600,000). Because the 
rental agreement does not provide for adequate interest on prepaid fixed 
rent, the rent for each calendar year during the lease term is the 
proportional rental amount, as described in Sec.  1.467-2(c). The 
amounts payable, section 467 rent, section 467 interest, and end-of-year 
section 467 loan balances for each calendar year are as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
           Calendar year                 Payment            interest        Section 467 rent        balance
----------------------------------------------------------------------------------------------------------------
2000..............................           $400,000                 $0         $218,987.40       ($181,012.60)
2001..............................            300,000         (18,101.26)         218,987.40        (280,126.46)
2002..............................            200,000         (28,012.64)         218,987.40        (289,151.70)
2003..............................            100,000         (28,915.17)         218,987.40        (199,079.47)
2004..............................                  0         (19,907.93)         218,987.40                  0
----------------------------------------------------------------------------------------------------------------

    (iii) On December 31, 2001, B contracts to assign its entire 
remaining interest in the leasehold to D, a calendar year taxpayer. The 
assignment becomes effective at the beginning of January 1, 2002. D pays 
B $278,000 on January 1, 2002, in conjunction with the assignment of the 
leasehold interest. Under the terms of the assignment, B is not 
obligated to make any rental payments due after the assignment.
    (iv) Under paragraph (f)(2)(i) of this section, B's section 467 loan 
balance as of the beginning of January 1, 2002, the time D first has use 
of the property, is zero because D is obligated to make all rent 
payments due after the assignment of the leasehold interest. Under 
paragraph (f)(2)(ii) of this section, D's section 467 loan balance as of 
the beginning of January 1, 2002, is negative $280,126.46 (the principal 
balance of B's section 467 loan immediately before D has use of the 
property (negative $280,126.46), less B's section 467 loan balance when 
D first has use of the property (zero)). Because D's beginning section 
467 loan balance is negative, paragraph (f)(2)(iv) of this section 
applies.
    (v) Because B's $280,126.46 section 467 loan balance at the end of 
2001 (that is, immediately before D has use of the property) is 
negative, paragraph (f)(2)(iv)(A) of this section applies. B's loan 
balance is the amount owed to B under the section 467 loan and consists 
of the excess of B's payments to C over the net amount of rent and 
negative interest B has taken into account through the end of 2001. 
Thus, B's basis in the negative section 467 loan balance at the end of 
2001 is $280,126.46. Because the $278,000 paid by D to B in conjunction 
with the transfer of the leasehold interest does not exceed the amount 
owed to B under the section 467 loan at the end of 2001, and does not 
exceed B's basis in that loan balance, under paragraph (f)(2)(iv)(A) of 
this section B treats the $278,000 payment from D as a nontaxable return 
of capital.
    (vi) The beginning balance of the amount owed to D under the section 
467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 paid by D to B 
in conjunction with the transfer of the leasehold interest. Paragraph 
(f)(2)(iv)(B) of this section treats the $2,126.46 as an amount incurred 
by B in 2002, B's taxable year in which D first has use of the property. 
Paragraph (f)(2)(iv)(D) of this section does not apply to reduce the 
amount incurred by B because B is the original lessee under the section 
467 rental agreement.
    (vii) Under paragraph (f)(1) of this section, D takes the section 
467 rent into account for the period beginning when D first has use of 
the property. D takes section 467 interest into account based on a 
beginning section 467 loan balance of negative $280,126.46.
    (viii) The beginning balance of the amount owed to D under the 
section 467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 paid by 
D to B in conjunction with the transfer of the leasehold interest. Under 
paragraph (f)(2)(iv)(C) of this section, D must include this amount in 
gross income in 2002, the year in which this amount of D's beginning 
section 467 loan balance is paid through the net accrual of rent and 
negative interest.

[[Page 382]]

This inclusion in gross income ensures that the reductions in D's 
taxable income attributable to the section 467 rental agreement will not 
exceed the actual amount of D's expenditures.

    (g) Application of section 467 following a rental agreement 
modification--(1) Substantial modifications. The following rules apply 
to any substantial modification of a rental agreement occurring after 
May 18, 1999 unless the entire agreement (as modified) is treated as a 
single agreement under Sec.  1.467-1(f)(4)(vi):
    (i) Treatment of pre-modification items. The lessor and lessee must 
take pre-modification items (within the meaning of Sec.  1.467-
1(f)(5)(v)) into account under their method of accounting used before 
the modification to report income and expense attributable to the rental 
agreement.
    (ii) Computations with respect to post-modification items. In 
computing section 467 rent, section 467 interest, and the amount of the 
section 467 loan with respect to post-modification items--
    (A) Post-modification items are treated as provided under a rental 
agreement (the post-modification agreement) separate from the agreement 
under which pre-modification items are provided;
    (B) The lease term of the post-modification agreement begins at the 
beginning of the first period for which rent other than pre-modification 
rent is provided; and
    (C) The applicable Federal rate for the post-modification agreement 
is the applicable Federal rate in effect on the day on which the 
modification occurs.
    (iii) Adjustments--(A) Adjustment relating to certain prepayments. 
If any payments before the beginning of the lease term of the post-
modification agreement are post-modification items, the lessor and 
lessee must take into account, in the taxable year in which the 
modification occurs, any adjustment necessary to prevent duplication 
with respect to such payments or the omission of interest thereon for 
periods before the beginning of the lease term.
    (B) Adjustment relating to retroactive beginning of lease term. If 
the lease term of a post-modification agreement begins before the date 
on which the modification occurs, the lessor and lessee must take into 
account in the taxable year in which the modification occurs any amount 
necessary to prevent the duplication or omission of rent or interest for 
the period after the beginning of the lease term of the post-
modification agreement and before the beginning of the taxable year in 
which the modification occurs. For this purpose, the amount necessary to 
prevent duplication or omission is determined after taking into account 
any adjustments required by the Commissioner for taxable years ending 
prior to the beginning of the taxable year in which the modification 
occurs. In determining any adjustments required by the Commissioner for 
taxable years ending prior to the beginning of the taxable year in which 
the modification occurs, the Commissioner will disregard the 
modification.
    (iv) Coordination with rules relating to dispositions and 
assignments--(A) Dispositions. If the modification involves a sale, 
exchange, or other disposition of the property subject to the rental 
agreement--
    (1) Adjustments required under this paragraph (g) are taken into 
account before applying paragraphs (a), (b), (c), and (e) of this 
section;
    (2) The prior understated inclusion for purposes of paragraph (b) of 
this section is the sum of the prior understated inclusion with respect 
to pre-modification items and the prior understated inclusion with 
respect to post-modification items; and
    (3) Paragraph (e) of this section applies separately with respect to 
pre-modification items and post-modification items.
    (B) Assignments. If the modification involves an assignment of the 
lessee's interest in the rental agreement to a substitute lessee or a 
substitute lessee having use of the property during a period otherwise 
included in the lease term--
    (1) Adjustments required under this paragraph (g) are taken into 
account before applying paragraph (f) of this section; and
    (2) Paragraph (f) of this section applies separately with respect to 
pre-modification items and post-modification items.

[[Page 383]]

    (2) Other modifications. The following rules apply to a modification 
(other than a substantial modification) of a rental agreement occurring 
after May 18, 1999:
    (i) Computation of section 467 loan for modified agreement. The 
amount of the section 467 loan relating to the agreement is computed as 
of the effective date of the modification. The section 467 rent and 
section 467 interest for periods before the effective date of the 
modification are determined, solely for purposes of computing the amount 
of the section 467 loan, under the terms of the entire agreement (as 
modified).
    (ii) Change in balance of section 467 loan. (A) If the balance of 
the section 467 loan determined under paragraph (g)(2)(i) of this 
section is greater than the balance of the section 467 loan immediately 
before the effective date of the modification, the difference is taken 
into account, in the taxable year in which the modification occurs, as 
additional rent.
    (B) If the balance of the section 467 loan determined under 
paragraph (g)(2)(i) of this section is less than the balance of the 
section 467 loan immediately before the effective date of the 
modification, the difference is taken into account, in the taxable year 
in which the modification occurs, as a reduction of the rent previously 
taken into account by the lessor and lessee.
    (C) For purposes of this paragraph (g)(2)(ii), a negative balance is 
less than a positive balance, a zero balance, or any other negative 
balance that is closer to a zero balance.
    (iii) Section 467 rent and interest after the modification. The 
section 467 rent and section 467 interest for periods after the 
effective date of the modification are determined under the terms of the 
entire agreement (as modified).
    (iv) Applicable Federal rate. The applicable Federal rate for the 
agreement does not change as a result of the modification.
    (v) Modification effective within a rental period. If the effective 
date of a modification does not coincide with the beginning or end of a 
rental period under the agreement in effect before the modification, the 
section 467 rent and section 467 interest for the portion of the rental 
period ending immediately prior to the effective date of the 
modification are a pro rata portion of the section 467 rent and the 
section 467 interest, respectively, for the rental period. Such amounts 
are also taken into account in determining the section 467 loan balance, 
prior to any adjustment thereof that may be required under paragraph (h) 
of this section, immediately before the effective date of the 
modification. Similar rules apply with respect to the section 467 rent 
and section 467 interest determined under the terms of the entire 
agreement (as modified) for purposes of computing the amount of the 
section 467 loan under paragraph (g)(2)(i) of this section and the 
section 467 rent and section 467 interest for a partial rental period 
beginning on the effective date of the modification.
    (vi) Other adjustments. The lessor and lessee must take into 
account, in the taxable year in which a retroactive modification occurs, 
any amount necessary to prevent the duplication or omission of rent or 
interest for the period before the beginning of the taxable year in 
which the modification occurs.
    (vii) Coordination with rules relating to dispositions and 
assignments. If the modification involves a sale, exchange, or other 
disposition of the property subject to the rental agreement, an 
assignment of the lessee's interest in the rental agreement to a 
substitute lessee or a substitute lessee having use of the property 
during a period otherwise included in the lease term, adjustments 
required under this paragraph (g) are taken into account before applying 
paragraphs (a), (b), (c), (e), and (f) of this section.
    (viii) Exception for agreements entered into prior to effective date 
of section 467. This paragraph (g)(2) does not apply to a modification 
of a rental agreement that is not subject to section 467 because of the 
effective date provisions of section 92(c) of the Tax Reform Act of 1984 
(Public Law 98-369 (98 Stat. 612)).
    (3) Adjustment by Commissioner. If the entire agreement (as 
modified) is treated as a single agreement under Sec.  1.467-
1(f)(4)(vi), the Commissioner may require adjustments to taxable income 
to reflect the effect of the modification, including adjustments that 
are similar

[[Page 384]]

to those required under paragraph (g)(2) of this section.
    (4) Effective date of modification. The effective date of a 
modification of a rental agreement occurs at the earliest of--
    (i) The date on which the modification occurs;
    (ii) The beginning of the first period for which the amount of rent 
or interest provided under the entire agreement (as modified) differs 
from the amount of rent or interest provided under the agreement in 
effect before the modification;
    (iii) The due date of the first payment, under either the entire 
agreement (as modified) or the agreement in effect before the 
modification, that is not identical, in due date and amount, under both 
such agreements;
    (iv) The date, in the case of a modification involving the 
substitution of a new lessor, on which the property subject to the 
rental agreement is transferred; or
    (v) The date, in the case of a modification involving the 
substitution of a new lessee, on which the substitute lessee first has 
use of the property subject to the rental agreement.
    (5) Examples. The following examples illustrate the application of 
this paragraph (g):

    Example 1. (i) F, a cash method lessor, and G, an accrual method 
lessee, agree to a 7-year lease of tangible personal property for the 
period beginning on January 1, 1998, and ending on December 31, 2004. 
The rental agreement allocates $100,000 of rent to each calendar year 
during the lease term, such rent to be paid December 31 following the 
close of the calendar year to which it is allocated. Because the rental 
agreement does not provide for increasing rent, or deferred rent within 
the meaning of section 467(d)(1)(A), section 467 does not apply to the 
rental agreement.
    (ii) Prior to January 1, 2001, G timely makes the $100,000 rental 
payments required as of December 31, 1999, and December 31, 2000. On 
January 1, 2001, F and G modify the rental agreement payment schedule to 
provide for a single final payment of $500,000 on December 31, 2004. 
Assume that the change is a substantial modification within the meaning 
of Sec.  1.467-1(f)(5)(ii). Because the modification occurs after May 
18, 1999, the post-modification agreement is treated, under Sec.  1.467-
1(f)(1), as a new agreement for purposes of determining whether it is a 
section 467 rental agreement.
    (iii) Under Sec.  1.467-1(f)(5)(v), the $200,000 of rent allocated 
to calendar years 1998 and 1999 (periods prior to the modification) 
constitutes pre-modification rent, and the $100,000 rent payments made 
on December 31, 1999, and December 31, 2000, constitute pre-modification 
payments. Although calendar year 2000 is also prior to the modification, 
the rent allocated to calendar year 2000 is not pre-modification rent 
and the related payment is not a pre-modification payment because the 
modification changed the time at which that rent is payable. See Sec.  
1.467-1(f)(5)(v)(A).
    (iv) Under paragraph (g)(1)(i) of this section, F and G take pre-
modification rent and pre-modification payments into account under the 
method of accounting they used to report income and deductions 
attributable to the pre-modification agreement.
    (v) Under Sec.  1.467-1(f)(1)(i), the post-modification agreement 
providing rent for the period beginning on January 1, 2000, and ending 
on December 31, 2004, is treated as a new rental agreement. This rental 
agreement allocates $100,000 of rent to each of the calendar years 2000 
through 2004 and provides for a single rental payment of $500,000 on 
December 31, 2004. Because the post-modification agreement provides for 
deferred rent under Sec.  1.467-1(c)(3)(i), section 467 applies. 
Further, the post-modification agreement does not provide for adequate 
interest on fixed rent, and therefore F and G must account for fixed 
rent and interest on fixed rent using proportional rental accrual. Under 
paragraph (g)(1)(iii) of this section, for their taxable years which 
include January 1, 2001, F and G must adjust reported rent for the 
difference between the rent taken into account for the calendar year 
2000 under the unmodified agreement and the proportional rental amount 
for that year under the post-modification agreement.
    Example 2. (i) On January 1, 2000, X, lessee, and Y, lessor, enter 
into a rental agreement for a 6-year lease of tangible personal property 
beginning January 1, 2000, and endingDecember 31, 2005. The agreement 
provides that the calendar year is the rental period and all rent 
payments are due on July 15 of all years in which a payment is required. 
Assume the agreement is not a disqualified leaseback or long-term 
agreement within the meaning of Sec.  1.467-3(b), and has the following 
allocation schedule and payment schedule:

------------------------------------------------------------------------
                  Year                      Allocation        Payment
------------------------------------------------------------------------
2000....................................        $800,000              $0
2001....................................         900,000               0
2002....................................       1,000,000       1,500,000
2003....................................       1,000,000       1,500,000
2004....................................       1,100,000       1,500,000
2005....................................       1,200,000       1,500,000
------------------------------------------------------------------------


[[Page 385]]

    (ii) The rental agreement has deferred rent within the meaning of 
Sec.  1.467-1(c)(3)(i) because the rent allocated to 2000 is not payable 
until 2002 and some of the rent allocable to 2001 is not payable until 
2003. Further, the rental agreement does not provide adequate interest 
on fixed rent within the meaning of Sec.  1.467-2(b). Therefore, the 
rent amount to be accrued by X and Y for each rental period is the 
proportional rental amount, as described in Sec.  1.467-2(c). Assuming 
110 percent of the applicableFederal rate is 10 percent compounded 
annually, the section 467 rent, interest, and loan balances are as 
follows:

----------------------------------------------------------------------------------------------------------------
                          Year                                  Rent             Interest         Loan balance
----------------------------------------------------------------------------------------------------------------
2000...................................................        $736,949.55                 $0        $736,949.55
2001...................................................         829,068.24          73,694.96       1,639,712.75
2002...................................................         921,186.94         163,971.28       1,224,870.97
2003...................................................         921,186.94         122,487.10         768,545.01
2004...................................................       1,013,305.63          76,854.50         358,705.14
2005...................................................       1,105,424.33          35,870.53                  0
----------------------------------------------------------------------------------------------------------------

    (iii)(A) On January 1, 2004, X and Y agree that the $1,500,000 
payment scheduled for July 15, 2005, will be made in three equal 
installments on June 15, 2005, July 15, 2005, and August 15, 2005. Under 
Sec.  1.467-1(j)(2)(i)(C) (relating to timing conventions), the payment 
to be made on June 15, 2005, is treated as if it were payable on 
December 31, 2004, for purposes of determining present values and yield 
of the section 467 loan. Assume that this change, which results in the 
following allocation schedule and payment schedule, is not a substantial 
modification within the meaning of Sec.  1.467-1(f)(5)(ii):

------------------------------------------------------------------------
                  Year                      Allocation        Payment
------------------------------------------------------------------------
2000....................................        $800,000              $0
2001....................................         900,000               0
2002....................................       1,000,000       1,500,000
2003....................................       1,000,000       1,500,000
2004....................................       1,100,000       2,000,000
2005....................................       1,200,000       1,000,000
------------------------------------------------------------------------

    (B) The agreement remains subject to proportional rental accrual 
after the modification because it has deferred rent and does not provide 
adequate interest on fixed rent within the meaning of Sec.  1.467-2(b).
    (iv) Because the modification occurs after May 18, 1999, and is not 
substantial within the meaning of Sec.  1.467-1(f)(5)(ii), paragraph 
(g)(2) of this section applies. Under paragraph (g)(2)(i) of this 
section, the amount of the section 467 loan relating to the modified 
agreement is computed as of the effective date of the modification, and, 
solely for purposes of recomputing the amount of the section 467 loan, 
the section 467 rent and section 467 interest for periods before the 
modification are determined under the terms of the entire agreement (as 
modified). In addition, the applicable Federal rate does not change as a 
result of the modification. Thus, the recomputed section 467 rent, 
interest, and loan balances are as follows:

----------------------------------------------------------------------------------------------------------------
                         Year                                 Rent             Interest          Loan balance
----------------------------------------------------------------------------------------------------------------
2000.................................................       $ 742,242.59                $ 0        $ 742,242.59
2001.................................................         835,022.91          74,224.26        1,651,489.76
2002.................................................         927,803.24         165,148.98        1,244,441.98
2003.................................................         927,803.24         124,444.20          796,689.42
2004.................................................       1,020,583.56          79,668.94         (103,058.08)
2005.................................................       1,113,363.88         (10,305.80)                  0
----------------------------------------------------------------------------------------------------------------

    (v) Under paragraph (g)(2)(ii) of this section, the difference 
between the section 467 loan balance immediately before the effective 
date of the modification and the recomputed section 467 loan balance as 
of the effective date of the modification is taken into account. In this 
example, the loan balance immediately before the effective date of the 
modification is $768,545.01 and the recomputed loan balance as of the 
effective date of the modification is $796,689.42. Thus, because the 
recomputed loan balance exceeds the original loan balance, the 
difference ($28,144.41) is taken into account, in the taxable year in 
which the modification occurs, as additional rent. Beginning on January 
1, 2004, section 467 rent and interest are taken into account by X and Y 
in accordance with the recomputed rent schedule set forth in paragraph 
(iv) of this example.

    (h) Omissions or duplications--(1) In general. In applying the rules 
of this section in conjunction with the rules of Sec. Sec.  1.467-1 
through 1.467-5, adjustments must be made to the extent necessary to 
prevent the omission or duplication of items of income, deduction, gain, 
or loss. For example, if a transferee lessor acquires property subject 
to a section 467 rental agreement at other than the

[[Page 386]]

beginning or end of a rental period, and the transferee lessor's 
beginning section 467 loan balance differs from the transferor lessor's 
section 467 loan balance immediately prior to the transfer, it will be 
necessary to treat the rental period that includes the day of transfer 
as consisting of two rental periods, one beginning at the beginning of 
the rental period that includes the day of transfer and ending with or 
immediately prior to the transfer and one beginning with or immediately 
after the transfer and ending immediately prior to the beginning of the 
succeeding rental period. Because the substitution of two rental periods 
for one rental period may change the proportional rental amount or 
constant rental amount, the change in rental periods should be treated 
as a modification of the rental agreement that occurs immediately prior 
to the transfer. The change in rental periods, by itself, is not treated 
as a substantial modification of the rental agreement although the 
substitution of a new lessor may constitute a substantial modification 
of the rental agreement. Likewise, Sec.  1.467-1(j)(2), which provides 
rules regarding when amounts are treated as payable, is designed to 
simplify calculations of present values, section 467 loan balances, and 
proportional and constant rental amounts. These simplifying conventions 
assume that there will be no change in the lessor or lessee under a 
section 467 rental agreement and that the terms of the section 467 
rental agreement will not be modified. Therefore, as illustrated in the 
example in paragraph (h)(2) of this section, when actual events do not 
reflect these assumptions, it may be necessary to alter the application 
of these rules to properly reflect taxable income.
    (2) Example. The following example illustrates an application of 
this paragraph (h):

    Example. (i) J leases tangible personal property from K for five 
years beginning on January 1, 2000, and ending on December 31, 2004. 
Under the rental agreement, rent is payable on July 15 of the calendar 
year to which it is allocated. Both J and K treat the calendar year as 
the rental period. The allocation of rent and payments of rent required 
under the rental agreement are as follows:

------------------------------------------------------------------------
              Calendar year                    Rent          Payments
------------------------------------------------------------------------
2000....................................        $200,000        $450,000
2001....................................         200,000         250,000
2002....................................         200,000         200,000
2003....................................         200,000         100,000
2004....................................         200,000               0
------------------------------------------------------------------------

    (ii) The rental agreement does not provide for interest on prepaid 
rent. The rental agreement has prepaid rent under Sec.  1.467-
1(c)(3)(ii) because the rent payable at the end of 2000 exceeds the 
cumulative amount of rent allocated to 2000 and 2001. Therefore, J and K 
must take section 467 rent into account under the proportional rental 
method of Sec.  1.467-2(c). Assume that 110 percent of the applicable 
Federal rate is 10 percent, compounded annually. The section 467 rent, 
section 467 interest, amounts payable, and section 467 loan balances for 
each of the calendar years under the terms of the rental agreement are 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
           Calendar Year             Section 467 rent       interest            Payments            balance
----------------------------------------------------------------------------------------------------------------
2000..............................        $220,077.48                 $0            $450,000       $(229,922.52)
2001..............................         220,077.48         (22,992.25)            250,000        (282,837.29)
2002..............................         220,077.48         (28,283.73)            200,000        (291,043.54)
2003..............................         220,077.48         (29,104.35)            100,000        (200,070.41)
2004..............................         220,077.48         (20,007.07)                  0                  0
----------------------------------------------------------------------------------------------------------------

    (iii) On January 1, 2002, J and K amend the terms of the rental 
agreement to advance the due date of the $200,000 payment originally due 
on July 15, 2002, to June 15, 2002. This change in the payment schedule 
constitutes a modification of the terms of the rental agreement within 
the meaning of Sec.  1.467-1(f)(5)(i). Assume, however, that the change 
is not a substantial modification within the meaning of Sec.  1.467-
1(f)(5)(ii). Because the modification occurs after May 18, 1999, and is 
not substantial, paragraph (g)(2) of this section applies. Thus, the 
section 467 loan balance at the beginning of 2002 must be recomputed as 
if the June 15, 2002, payment date had been included in the terms of the 
pre-modification rental agreement. If this had been the case, the 
section 467 rent, section 467 interest, amounts payable, and section 467 
loan balances for each of the calendar years under the terms of the 
rental agreement would have been as follows:

[[Page 387]]



----------------------------------------------------------------------------------------------------------------
                                                           Section 467                         Section 467 loan
             Calendar                Section 467 rent       interest            Payments            balance
----------------------------------------------------------------------------------------------------------------
2000..............................        $224,041.38                 $0            $450,000       $(225,958.62)
2001..............................         224,041.38         (22,595.86)            450,000        (474,513.10)
2002..............................         224,041.38         (47,451.31)                  0        (297,923.03)
2003..............................         224,041.38         (29,792.30)            100,000        (203,673.95)
2004..............................         224,041.38         (20,367.43)                  0                  0
----------------------------------------------------------------------------------------------------------------

    (iv) Section 1.467-4(b)(3) incorporates the conventions of Sec.  
1.467-1(j)(2) in determining when amounts are treated as payable for 
purposes of determining the section 467 loan balance. Section 1.467-
1(j)(2)(i)(C) treats amounts payable during the first half of any rental 
period except the first rental period as payable on the last day of the 
preceding rental period. Therefore, because June 15, 2002, occurs in the 
first half of 2002, in determining the section 467 loan balance at the 
beginning of 2002 under the amended terms of the rental agreement, the 
$200,000 payment due on June 15, 2002, is treated as payable on December 
31, 2001.
    (v) Under paragraph (g)(2)(ii)(B) of this section, if the recomputed 
section 467 loan balance is less than the section 467 loan balance 
immediately before the modification, the difference is taken into 
account as a reduction of the rent previously taken into account by the 
lessor and the lessee. In this example, the recomputed section 467 loan 
balance immediately after the modification is negative $474,513.10 and 
the section 467 loan balance immediately before the modification is 
negative $282,837.29. However, the section 467 loan balance immediately 
before the modification does not take into account the $200,000 payment 
originally payable on July 15, 2002, whereas, under the conventions of 
Sec.  1.467-1(j)(2)(i)(C), the recomputed section 467 loan balance 
immediately after the modification takes into account that $200,000 
payment because it is now payable in the first half of the rental period 
(June 15). Under these circumstances, if the recomputed section 467 loan 
balance immediately after the modification is treated as negative 
$474,513.10 for purposes of applying paragraph (g)(2)(ii)(B) of this 
section, K's gross income and J's deductions attributable to the section 
467 rental agreement will be understated by $200,000. Therefore, under 
paragraph (h)(1) of this section, only for purposes of applying 
paragraph (g)(2)(ii)(B) of this section, the $200,000 payment due on 
June 15, 2002, should not be taken into account in determining the 
recomputed section 467 loan balance immediately after the modification.

[T.D. 8820, 64 FR 26867, May 18, 1999, as amended by T.D. 9811, 82 FR 
6238, Jan. 19, 2017]



Sec.  1.467-8  Automatic consent to change to constant rental accrual 
for certain rental agreements.

    (a) General rule. For the first taxable year ending after May 18, 
1999, a taxpayer may change to the constant rental accrual method, as 
described in Sec.  1.467-3, for all of its section 467 rental agreements 
described in paragraph (b) of this section. A change to the constant 
rental accrual method is a change in method of accounting to which the 
provisions of sections 446 and 481 and the regulations thereunder apply. 
A taxpayer changing its method of accounting in accordance with this 
section must follow the automatic change in accounting method provisions 
of Rev. Proc. 98-60 (see Sec.  601.601(d)(2) of this chapter) except, 
for purposes of this paragraph (a), the scope limitations in section 
4.02 of Rev. Proc. 98-60 are not applicable. Taxpayers changing their 
method of accounting in accordance with this section must do so for all 
of their section 467 rental agreements described in paragraph (b) of 
this section.
    (b) Agreements to which automatic consent applies. A section 467 
rental agreement is described in this paragraph (b) if--
    (1) The property subject to the section 467 rental agreement is 
financed with an ``exempt facility bond'' within the meaning of section 
142;
    (2) The facility subject to the section 467 rental agreement is 
described in section 142(a)(1), (2), (3), or (12);
    (3) The section 467 rental agreement does not include a specific 
allocation of fixed rent within the meaning of Sec.  1.467-
1(c)(2)(ii)(A)(2); and
    (4) The section 467 rental agreement was entered into on or before 
May 18, 1999.

[T.D. 8820, 64 FR 26875, May 18, 1999]

[[Page 388]]



Sec.  1.467-9  Effective/applicability dates and automatic method changes 
for certain agreements.

    (a) In general. Sections 1.467-1 through 1.467-7 are applicable 
for--
    (1) Disqualified leasebacks and long-term agreements entered into 
after June 3, 1996; and
    (2) Rental agreements not described in paragraph (a)(1) of this 
section that are entered into after May 18, 1999.
    (b) Automatic consent for certain rental agreements. Section 1.467-8 
applies only to rental agreements described in Sec.  1.467-8.
    (c) Application of regulation project IA-292-84 to certain 
leasebacks and long-term agreements. In the case of any leaseback or 
long-term agreement (other than a disqualified leaseback or long-term 
agreement) entered into after June 3, 1996, and on or before May 18, 
1999, a taxpayer may choose to apply the provisions of regulation 
project IA-292-84 (1996-2 C.B. 462)(see Sec.  601.601(d)(2) of this 
chapter).
    (d) Entered into. For purposes of this section and Sec.  1.467-8, a 
rental agreement is entered into on its agreement date (within the 
meaning of Sec.  1.467-1(h)(1) and, if applicable, Sec.  1.467-
1(f)(1)(i)).
    (e) Change in method of accounting--(1) In general. For the first 
taxable year ending after May 18, 1999, a taxpayer is granted consent of 
the Commissioner to change its method of accounting for rental 
agreements described in paragraph (a)(2) of this section to comply with 
the provisions of Sec. Sec.  1.467-1 through 1.467-7.
    (2) Application of regulation project IA-292-84. For the first 
taxable year ending after May 18, 1999, a taxpayer is granted consent of 
the Commissioner to change its method of accounting for any rental 
agreement described in paragraph (c) of this section to comply with the 
provisions of regulation project IA-292-84 (1996-2 C.B. 462) (see Sec.  
601.601(d)(2) of this chapter).
    (3) Automatic change procedures. A taxpayer changing its method of 
accounting in accordance with this paragraph (e) must follow the 
automatic change in accounting method provisions of Rev. Proc. 98-60 
(see Sec.  601.601(d)(2) of this chapter) except, for purposes of this 
paragraph (e), the scope limitations in section 4.02 of Rev. Proc. 98-60 
are not applicable. A method change in accordance with paragraph (e)(1) 
of this section is made on a cut-off basis so no adjustment under 
section 481(a) is required.
    (f) Application of section 1022. The provisions of Sec.  1.467-
7(c)(2) and (4) relating to section 1022 are effective on and after 
January 19, 2017.

[T.D. 8820, 64 FR 26875, May 18, 1999, as amended by T.D. 9811, 82 FR 
6238, Jan. 19, 2017]



Sec.  1.468A-0  Nuclear decommissioning costs; table of contents.

    This section lists the paragraphs contained in Sec. Sec.  1.468A-1 
through 1.468A-9.

      Sec.  1.468A-1 Nuclear decommissioning costs; general rules.

    (a) Introduction.
    (b) Definitions.
    (c) Special rules applicable to certain experimental nuclear 
facilities.

             Sec.  1.468A-2 Treatment of electing taxpayer.

    (a) In general.
    (b) Limitation on payments to a nuclear decommissioning fund.
    (1) In general.
    (2) Excess contributions not deductible.
    (c) Deemed payment rules.
    (1) In general.
    (2) Cash payment by customer.
    (d) Treatment of distributions.
    (1) In general.
    (2) Exceptions to inclusion in gross income.
    (i) Payment of administrative costs and incidental expenses.
    (ii) Withdrawals of excess contributions.
    (iii) Actual distributions of amounts included in gross income as 
deemed distributions.
    (e) Deduction when economic performance occurs.

                      Sec.  1.468A-3 Ruling amount.

    (a) In general.
    (b) Level funding limitation.
    (c) Funding period.
    (d) Decommissioning costs allocable to a fund.
    (1) General rule.
    (2) Total estimated cost of decommissioning.
    (3) Taxpayer's share.
    (e) Manner of requesting schedule of ruling amounts.
    (1) In general.
    (2) Information required.
    (3) Administrative procedures.
    (f) Review and revision of schedule of ruling amounts.

[[Page 389]]

    (1) Mandatory review.
    (2) Elective review.
    (3) Determination of revised schedule of ruling amounts.
    (g) Special rule permitting payments to a nuclear decommissioning 
fund before receipt of an initial or revised ruling amount applicable to 
a taxable year.

        Sec.  1.468A-4 Treatment of nuclear decommissioning fund.

    (a) In general.
    (b) Modified gross income.
    (c) Special rules.
    (1) Period for computation of modified gross income.
    (2) Gain or loss upon distribution of property by a fund.
    (3) Denial of credits against tax.
    (4) Other corporate taxes inapplicable.
    (d) Treatment as corporation for purposes of subtitle F.

 Sec.  1.468A-5 Nuclear decommissioning fund--miscellaneous provisions.

    (a) Qualification requirements.
    (1) In general.
    (2) Limitation on contributions.
    (3) Limitation on use of fund.
    (i) In general.
    (ii) Definition of administrative costs and expenses.
    (4) Trust provisions.
    (b) Prohibitions against self-dealing.
    (1) In general.
    (2) Self-dealing defined.
    (3) Disqualified person defined.
    (c) Disqualification of nuclear decommissioning fund.
    (1) In general.
    (2) Exception to disqualification.
    (i) In general.
    (ii) Excess contribution defined.
    (iii) Taxation of income attributable to an excess contribution.
    (3) Effect of disqualification.
    (4) Further effects of disqualification.
    (d) Termination of nuclear decommissioning fund upon substantial 
completion of decommissioning.
    (1) In general.
    (2) Additional rules.
    (3) Substantial completion of decommissioning defined.

   Sec.  1.468A-6 Disposition of an interest in a nuclear power plant.

    (a) In general.
    (b) Requirements.
    (c) Tax consequences.
    (1) The transferor and its Fund.
    (2) The transferee and its Fund.
    (3) Basis.
    (d) Determination of proportionate amount.
    (e) Calculation of schedule of ruling amounts and schedule of 
deduction amounts for dispositions described in this section.
    (1) Transferor.
    (i) Taxable year of disposition.
    (ii) Taxable years after the disposition.
    (2) Transferee.
    (i) Taxable year of disposition.
    (ii) Taxable years after the disposition.
    (3) Examples.
    (f) Anti-abuse provision.

         Sec.  1.468A-7 Manner of and time for making election.

    (a) In general.
    (b) Required information.

Sec.  1.468A-8 Special transfers to qualified funds pursuant to section 
                                468A(f).

    (a) General rule.
    (1) In general.
    (2) Pre-2005 nonqualifying amount.
    (i) In general.
    (ii) Pre-2005 nonqualifying amount of transferee.
    (3) Transfers in multiple years.
    (4) Deemed payment rules.
    (i) In general.
    (ii) Special rule for certain transfers.
    (b) Deduction for amounts transferred.
    (1) In general.
    (2) Amount of deduction.
    (i) General Rule.
    (ii) Election.
    (A) In general.
    (B) Manner of making election.
    (C) Election allowed for property transferred prior to December 23, 
2010.
    (3) Denial of deduction for previously deducted amounts.
    (4) Transfers of qualified nuclear decommissioning funds.
    (5) Special rules.
    (i) Gain or loss not recognized on transfers to fund.
    (ii) Taxpayer basis in fund.
    (iii) Fund basis in transferred property.
    (A) In general.
    (B) Basis in case of election.
    (c) Schedule of deductions required.
    (1) In general.
    (2) Transfers in multiple taxable years.
    (3) Transfer of partial interest in fund.
    (4) Special transfer permitted before receipt of schedule.
    (d) Manner of requesting schedule of deduction amounts.
    (1) In general.
    (2) Information required.
    (3) Statement required.
    (4) Administrative procedures.

              Sec.  1.468A-9 Effective/applicability date.

[T.D. 9512, 75 FR 80701, Dec. 23, 2010]

[[Page 390]]



Sec.  1.468A-1  Nuclear decommissioning costs; general rules.

    (a) Introduction. Section 468A provides an elective method for 
taking into account nuclear decommissioning costs for Federal income tax 
purposes. In general, an eligible taxpayer that elects the application 
of section 468A pursuant to the rules contained in Sec.  1.468A-7 is 
allowed a deduction (as determined under Sec.  1.468A-2) for the taxable 
year in which the taxpayer makes a cash payment to a nuclear 
decommissioning fund. Taxpayers using an accrual method of accounting 
that do not elect the application of section 468A are not allowed a 
deduction for nuclear decommissioning costs prior to the taxable year in 
which economic performance occurs with respect to such costs (see 
section 461(h)).
    (b) Definitions. The following terms are defined for purposes of 
section 468A and Sec. Sec.  1.468A-1 through 1.468A-9:
    (1) The term eligible taxpayer means any taxpayer that possesses a 
qualifying interest in a nuclear power plant (including a nuclear power 
plant that is under construction).
    (2) The term qualifying interest means--
    (i) A direct ownership interest; and
    (ii) A leasehold interest in any portion of a nuclear power plant 
if--
    (A) The holder of the leasehold interest is primarily liable under 
Federal or State law for decommissioning such portion of the nuclear 
power plant; and
    (B) No other person establishes a nuclear decommissioning fund with 
respect to such portion of the nuclear power plant.
    (3) The term direct ownership interest includes an interest held as 
a tenant in common or joint tenant, but does not include stock in a 
corporation that owns a nuclear power plant or an interest in a 
partnership that owns a nuclear power plant. Thus, in the case of a 
partnership that owns a nuclear power plant, the election under section 
468A must be made by the partnership and not by the partners. In the 
case of an unincorporated organization described in Sec.  1.761-2(a)(3) 
that elects under section 761(a) to be excluded from the application of 
subchapter K, each taxpayer that is a co-owner of the nuclear power 
plant is eligible to make a separate election under section 468A.
    (4) The terms nuclear decommissioning fund and qualified nuclear 
decommissioning fund mean a fund that satisfies the requirements of 
Sec.  1.468A-5. The term nonqualified fund means a fund that does not 
satisfy those requirements.
    (5) The term nuclear power plant means any nuclear power reactor 
that is used predominantly in the trade or business of the furnishing or 
sale of electric energy. Each unit (that is, nuclear reactor) located on 
a multi-unit site is a separate nuclear power plant. The term nuclear 
power plant also includes the portion of the common facilities of a 
multi-unit site allocable to a unit on that site.
    (6) The term nuclear decommissioning costs or decommissioning costs 
includes all otherwise deductible expenses to be incurred in connection 
with the entombment, decontamination, dismantlement, removal and 
disposal of the structures, systems and components of a nuclear power 
plant, whether that nuclear power plant will continue to produce 
electric energy or has permanently ceased to produce electric energy. 
Such term includes all otherwise deductible expenses to be incurred in 
connection with the preparation for decommissioning, such as engineering 
and other planning expenses, and all otherwise deductible expenses to be 
incurred with respect to the plant after the actual decommissioning 
occurs, such as physical security and radiation monitoring expenses. 
Such term also includes costs incurred in connection with the 
construction, operation, and ultimate decommissioning of a facility used 
solely to store, pending acceptance by the government for permanent 
storage or disposal, spent nuclear fuel generated by the nuclear power 
plant or plants located on the same site as the storage facility. Such 
term does not include otherwise deductible expenses to be incurred in 
connection with the disposal of spent nuclear fuel under the Nuclear 
Waste Policy Act of 1982 (Pub. L. 97-425). An expense is otherwise 
deductible for purposes of this paragraph (b)(6) if it would be 
deductible under chapter 1 of the Internal

[[Page 391]]

Revenue Code without regard to section 280B.
    (i) For the purpose of this title, the term nuclear decommissioning 
costs or decommissioning costs includes all expenses related to land 
improvements and otherwise deductible expenses to be incurred in 
connection with the entombment, decontamination, dismantlement, removal 
and disposal of the structures, systems and components of a nuclear 
power plant, whether that nuclear power plant will continue to produce 
electric energy or has permanently ceased to produce electric energy. 
Such term includes all expenses related to land improvements and 
otherwise deductible expenses to be incurred in connection with the 
preparation for decommissioning, such as engineering and other planning 
expenses, and all otherwise deductible expenses to be incurred with 
respect to the plant after the actual decommissioning occurs, such as 
physical security and radiation monitoring expenses. An expense is 
otherwise deductible for purposes of this paragraph (b)(6) if it would 
be deductible or recoverable through depreciation or amortization under 
chapter 1 of the Internal Revenue Code without regard to section 280B.
    (ii) The term nuclear decommissioning costs or decommissioning 
costs, as applicable to this title, also includes expenses incurred in 
connection with the construction, operation, and ultimate 
decommissioning of a facility used solely to store, pending delivery to 
a permanent repository or disposal, spent nuclear fuel generated by one 
or more nuclear power plants (for example, an Independent Spent Fuel 
Storage Installation). Such term does not include otherwise deductible 
expenses to be incurred in connection with the disposal of spent nuclear 
fuel under the Nuclear Waste Policy Act of 1982 (Pub. L. 97-425).
    (7) The term public utility commission means any State or political 
subdivision thereof, any agency, instrumentality or judicial body of the 
United States, or any judicial body, commission or other similar body of 
the District of Columbia or of any State or any political subdivision 
thereof that establishes or approves rates for the furnishing or sale of 
electric energy.
    (8) The term ratemaking proceeding means any proceeding before a 
public utility commission in which rates for the furnishing or sale of 
electric energy are established or approved. Such term includes a 
generic proceeding that applies to two or more taxpayers that are 
subject to the jurisdiction of a single public utility commission.
    (9) The term special transfer means any transfer of funds to a 
qualified nuclear decommissioning fund pursuant to Sec.  1.468A-8.
    (c) Special rules applicable to certain experimental nuclear 
facilities. (1) The owner of a qualifying interest in an experimental 
nuclear facility possesses a qualifying interest in a nuclear power 
plant for purposes of paragraph (b) of this section if such person is 
engaged in the trade or business of the furnishing or sale of electric 
energy.
    (2) An owner of stock in a corporation that owns an experimental 
nuclear facility possesses a qualifying interest in a nuclear power 
plant for purposes of paragraph (b)(1) of this section if--
    (i) Such stockholder satisfies the conditions of paragraph (c)(1) of 
this section; and
    (ii) The corporation that directly owns the facility is not engaged 
in the trade or business of the furnishing or sale of electric energy.
    (3) For purposes of this paragraph (c), an experimental nuclear 
facility is a nuclear power reactor that is used predominantly for the 
purpose of conducting experimentation and research.

[T.D. 9512, 75 FR 80701, Dec. 23, 2010, as amended by T.D. 9906, 85 FR 
55190, Sept. 4, 2020]



Sec.  1.468A-2  Treatment of electing taxpayer.

    (a) In general. An eligible taxpayer that elects the application of 
section 468A pursuant to the rules contained in Sec.  1.468A-7 (an 
electing taxpayer) is allowed a deduction for the taxable year in which 
the taxpayer makes a cash payment (or is deemed to make a cash payment 
as provided in paragraph (c) of this section) to a nuclear 
decommissioning fund and for any taxable year in which a deduction is 
allowed for a special transfer described in Sec.  1.468A-8.

[[Page 392]]

The amount of the deduction for any taxable year equals the total amount 
of cash payments made (or deemed made) by the electing taxpayer to a 
nuclear decommissioning fund (or nuclear decommissioning funds) during 
such taxable year under this section, plus any amount allowable as a 
deduction in that taxable year for a special transfer described in Sec.  
1.468A-8. The amount of a special transfer permitted under Sec.  1.468A-
8 is not treated as a cash payment for purposes of this paragraph (a), 
and a taxpayer making a special transfer is allowed a ratable deduction 
in each taxable year during the remaining useful life of the nuclear 
power plant for the special transfer. A payment may not be made (or 
deemed made) to a nuclear decommissioning fund before the first taxable 
year in which all of the following conditions are satisfied:
    (1) The construction of the nuclear power plant to which the nuclear 
decommissioning fund relates has commenced.
    (2) A ruling amount is applicable to the nuclear decommissioning 
fund (see Sec.  1.468A-3).
    (b) Limitation on payments to a nuclear decommissioning fund--(1) In 
general. For purposes of paragraph (a) of this section, the maximum 
amount of cash payments made (or deemed made) to a nuclear 
decommissioning fund under paragraph (a) of this section during any 
taxable year shall not exceed the ruling amount applicable to the 
nuclear decommissioning fund for such taxable year (as determined under 
Sec.  1.468A-3).
    (2) Excess contributions not deductible. If the amount of cash 
payments made (or deemed made) to a nuclear decommissioning fund during 
any taxable year exceeds the limitation of paragraph (b)(1) of this 
section, the excess is not deductible by the electing taxpayer. In 
addition, see paragraph (c) of Sec.  1.468A-5 for rules which provide 
that the Internal Revenue Service may disqualify a nuclear 
decommissioning fund if the amount of cash payments made (or deemed 
made) to a nuclear decommissioning fund during any taxable year exceeds 
the limitation of paragraph (b)(1) of this section.
    (3) Special transfer disregarded. The amount of a special transfer 
permitted under Sec.  1.468A-8 is not treated as a cash payment for 
purposes of this paragraph (b).
    (c) Deemed payment rules--(1) In general. The amount of any cash 
payment made by an electing taxpayer to a nuclear decommissioning fund 
on or before the 15th day of the third calendar month after the close of 
any taxable year (the deemed payment deadline date) shall be deemed made 
during such taxable year if the electing taxpayer irrevocably designates 
the amount as relating to such taxable year on its timely filed Federal 
income tax return for such taxable year (see Sec.  1.468A-7(b)(4)(iii) 
and (iv) for rules relating to such designation).
    (2) Cash payment by customer. The amount of any cash payment made by 
a customer of an electing taxpayer to a nuclear decommissioning fund of 
such electing taxpayer shall be deemed made by the electing taxpayer if 
the amount is included in the gross income of the electing taxpayer in 
the manner prescribed by section 88 and Sec.  1.88-1.
    (d) Treatment of distributions--(1) In general. Except as otherwise 
provided in paragraph (d)(2) of this section, the amount of any actual 
or deemed distribution from a nuclear decommissioning fund shall be 
included in the gross income of the electing taxpayer for the taxable 
year in which the distribution occurs. The amount of any distribution of 
property equals the fair market value of the property on the date of the 
distribution. See Sec.  1.468A-5(c) and (d) for rules relating to the 
deemed distribution of the assets of a nuclear decommissioning fund in 
the case of a disqualification or termination of the fund. A 
distribution from a nuclear decommissioning fund shall include an 
expenditure from the fund or the use of the fund's assets--
    (i) To satisfy, in whole or in part, the liability of the electing 
taxpayer for decommissioning costs of the nuclear power plant to which 
the fund relates; and
    (ii) To pay administrative costs and other incidental expenses of 
the fund.
    (2) Exceptions to inclusion in gross income--(i) Payment of 
administrative costs and incidental expenses. The amount of any payment 
by a nuclear decommissioning fund for administrative costs

[[Page 393]]

or other incidental expenses of such fund (as defined in Sec.  1.468A-
5(a)(3)(ii)) shall not be included in the gross income of the electing 
taxpayer unless such amount is paid to the electing taxpayer (in which 
case the amount of the payment is included in the gross income of the 
electing taxpayer under section 61).
    (ii) Withdrawals of excess contributions. The amount of a withdrawal 
of an excess contribution (as defined in Sec.  1.468A-5(c)(2)(ii)) by an 
electing taxpayer pursuant to the rules of Sec.  1.468A-5(c)(2) shall 
not be included in the gross income of the electing taxpayer. See 
paragraph (b)(2) of this section, which provides that the payment of 
such amount to the nuclear decommissioning fund is not deductible by the 
electing taxpayer.
    (iii) Actual distributions of amounts included in gross income as 
deemed distributions. If the amount of a deemed distribution is included 
in the gross income of the electing taxpayer for the taxable year in 
which the deemed distribution occurs, no further amount is required to 
be included in gross income when the amount of the deemed distribution 
is actually distributed by the nuclear decommissioning fund. The amount 
of a deemed distribution is actually distributed by a nuclear 
decommissioning fund as the first actual distributions are made by the 
nuclear decommissioning fund on or after the date of the deemed 
distribution.
    (e) Deduction when economic performance occurs. An electing taxpayer 
using an accrual method of accounting is allowed a deduction for nuclear 
decommissioning costs no earlier than the taxable year in which economic 
performance occurs with respect to such costs (see section 461(h)(2)). 
The amount of nuclear decommissioning costs that is deductible under 
this paragraph (e) is determined without regard to section 280B (see 
Sec.  1.468A-1(b)(6)). A deduction is allowed under this paragraph (e) 
whether or not a deduction was allowed with respect to such costs under 
section 468A(a) and paragraph (a) of this section for an earlier taxable 
year.

[T.D. 9512, 75 FR 80701, Dec. 23, 2010]



Sec.  1.468A-3  Ruling amount.

    (a) In general. (1) Except as otherwise provided in paragraph (g) of 
this section or in Sec.  1.468A-8 (relating to deductions for special 
transfers into a nuclear decommissioning fund), an electing taxpayer is 
allowed a deduction under section 468A(a) for the taxable year in which 
the taxpayer makes a cash payment (or is deemed to make a cash payment) 
to a nuclear decommissioning fund only if the taxpayer has received a 
schedule of ruling amounts for the nuclear decommissioning fund that 
includes a ruling amount for such taxable year. Except as provided in 
paragraph (a)(4) or (5) of this section, a schedule of ruling amounts 
for a nuclear decommissioning fund (schedule of ruling amounts) is a 
ruling (within the meaning of Sec.  601.201(a)(2) of this chapter) 
specifying the annual payments (ruling amounts) that, over the taxable 
years remaining in the funding period as of the date the schedule first 
applies, will result in a projected balance of the nuclear 
decommissioning fund as of the last day of the funding period equal to 
(and in no event greater than) the amount of decommissioning costs 
allocable to the fund. The projected balance of a nuclear 
decommissioning fund as of the last day of the funding period shall be 
calculated by taking into account the fair market value of the assets of 
the fund as of the first day of the first taxable year to which the 
schedule of ruling amounts applies and the estimated rate of return to 
be earned by the assets of the fund after payment of the estimated 
administrative costs and incidental expenses to be incurred by the fund 
(as defined in Sec.  1.468A-5(a)(3)(ii)), including all Federal, State 
and local income taxes to be incurred by the fund (the after-tax rate of 
return). See paragraph (c) of this section for a definition of funding 
period and paragraph (d) of this section for guidance with respect to 
the amount of decommissioning costs allocable to a fund.
    (2) Each schedule of ruling amounts must be consistent with the 
principles and provisions of this section and must be based on 
reasonable assumptions concerning--

[[Page 394]]

    (i) The after-tax rate of return to be earned by the assets of the 
qualified nuclear decommissioning fund;
    (ii) The total estimated cost of decommissioning the nuclear power 
plant (see paragraph (d)(2) of this section); and
    (iii) The frequency of contributions to a nuclear decommissioning 
fund for a taxable year (for example, monthly, quarterly, semi-annual or 
annual contributions).
    (3) The Internal Revenue Service (IRS) shall provide a schedule of 
ruling amounts that is identical to the schedule of ruling amounts 
proposed by the taxpayer in connection with the taxpayer's request for a 
schedule of ruling amounts (see paragraph (e)(2)(viii) of this section), 
but no schedule of ruling amounts shall be provided unless the 
taxpayer's proposed schedule of ruling amounts is consistent with the 
principles and provisions of this section and is based on reasonable 
assumptions. If a proposed schedule of ruling amounts is not consistent 
with the principles and provisions of this section or is not based on 
reasonable assumptions, the taxpayer may propose an amended schedule of 
ruling amounts that is consistent with such principles and provisions 
and is based on reasonable assumptions.
    (4) The taxpayer bears the burden of demonstrating that the proposed 
schedule of ruling amounts is consistent with the principles and 
provisions of this section and is based on reasonable assumptions. If a 
public utility commission established or approved the currently 
applicable rates for the furnishing or sale by the taxpayer of 
electricity from the plant, the taxpayer can generally satisfy this 
burden of proof by demonstrating that the schedule of ruling amounts is 
calculated using the assumptions used by the public utility commission 
in its most recent order. In addition, a taxpayer that owns an interest 
in a deregulated nuclear plant may submit assumptions used by a public 
utility commission that formerly had regulatory jurisdiction over the 
plant as support for the assumptions used in calculating the taxpayer's 
proposed schedule of ruling amounts, with the understanding that the 
assumptions used by the public utility commission may be given less 
weight if they are out of date or were developed in a proceeding for a 
different taxpayer. The use of other industry standards, such as the 
assumptions underlying the taxpayer's most recent financial assurance 
filing with the NRC, are an alternative means of demonstrating that the 
taxpayer has calculated its proposed schedule of ruling amounts on a 
reasonable basis. Consistency with financial accounting statements is 
not sufficient, in the absence of other supporting evidence, to meet the 
taxpayer's burden of proof under this paragraph (a)(4).
    (5) The IRS will approve, at the request of the taxpayer, a formula 
or method for determining a schedule of ruling amounts (rather than 
providing a schedule specifying a dollar amount for each taxable year) 
if the formula or method is consistent with the principles and 
provisions of this section and is based on reasonable assumptions. See 
paragraph (f)(1)(ii) of this section for a special rule relating to the 
mandatory review of ruling amounts that are determined pursuant to a 
formula or method.
    (6) The IRS may, in its discretion, provide a schedule of ruling 
amounts that is determined on a basis other than the rules of paragraphs 
(a) through (d) of this section if--
    (i) In connection with its request for a schedule of ruling amounts, 
the taxpayer explains the need for special treatment and sets forth an 
alternative basis for determining the schedule of ruling amounts; and
    (ii) The IRS determines that special treatment is consistent with 
the purpose of section 468A.
    (b) Level funding limitation. (1) Except as otherwise provided in 
paragraph (b)(3) of this section, the ruling amount specified in a 
schedule of ruling amounts for any taxable year in the funding period 
(as defined in paragraph (c) of this section) shall not be less than the 
ruling amount specified in such schedule for any earlier taxable year.
    (2) The ruling amount specified in a schedule of ruling amounts for 
a taxable year after the end of the funding period may be less than the 
ruling

[[Page 395]]

amount specified in such schedule for an earlier taxable year.
    (3) The ruling amount specified in a schedule of ruling amounts for 
the last taxable year in the funding period may be less than the ruling 
amount specified in such schedule for an earlier taxable year if, when 
annualized, the amount specified for the last taxable year is not less 
than the amount specified for such earlier taxable year. The amount 
specified for the last taxable year is annualized by--
    (i) Determining the number of days between the beginning of the 
taxable year and the end of the plant's estimated useful life;
    (ii) Dividing the amount specified for the last taxable year by such 
number of days; and
    (iii) Multiplying the result by the number of days in the last 
taxable year (generally 365).
    (c) Funding period--(1) In general. For purposes of this section, 
the funding period for a nuclear decommissioning fund is the period 
that--
    (i) Begins on the first day of the first taxable year for which a 
deductible payment is made (or deemed made) to such nuclear 
decommissioning fund (see Sec.  1.468A-2(a) for rules relating to the 
first taxable year for which a payment may be made (or deemed made) to a 
nuclear decommissioning fund); and
    (ii) Ends on the last day of the taxable year that includes the last 
day of the estimated useful life of the nuclear power plant to which the 
nuclear decommissioning fund relates.
    (2) Estimated useful life. The last day of the estimated useful life 
of a nuclear power plant is determined under the following rules:
    (i) Except as provided in paragraph (c)(2)(ii) of this section--
    (A) The last day of the estimated useful life of a nuclear power 
plant that has been included in rate base for ratemaking purposes in any 
ratemaking proceeding that established rates for a period before January 
1, 2006, is the date used in the first such ratemaking proceeding as the 
estimated date on which the nuclear power plant will no longer be 
included in the taxpayer's rate base for ratemaking purposes;
    (B) The last day of the estimated useful life of a nuclear power 
plant that is not described in paragraph (c)(2)(i)(A) of this section is 
the last day of the estimated useful life of the plant determined as of 
the date it is placed in service;
    (C) A taxpayer with an interest in a plant that is not described in 
paragraph (c)(2)(i)(A) of this section may use any reasonable method for 
determining the last day of such estimated useful life; and
    (D) A reasonable method for purposes of paragraph (c)(2)(i)(C) of 
this section may include use of the period for which a public utility 
commission has included a comparable nuclear power plant in rate base 
for ratemaking purposes.
    (ii) If it can be established that the estimated useful life of the 
nuclear power plant will end on a date other than the date determined 
under paragraph (c)(2)(i) of this section, the taxpayer may use such 
other date as the last day of the estimated useful life but is not 
required to do so. If the last day of the estimated useful life was 
determined under paragraph (c)(2)(i)(A) of this section and the most 
recent ratemaking proceeding used an alternative date as the estimated 
date on which the nuclear power plant will no longer be included rate 
base, the most recent ratemaking proceeding will generally be treated as 
establishing such alternative date as the last day of the estimated 
useful life.
    (iii) The estimated useful life of a nuclear power plant determined 
for purposes of paragraph (c)(1) of this section may end on a different 
date from the estimated useful life of a nuclear power plant determined 
for purposes of Sec.  1.468A-8(b)(1) and (c)(1).
    (d) Decommissioning costs allocable to a fund. The amount of 
decommissioning costs allocable to a nuclear decommissioning fund is 
determined for purposes of this section by applying the following rules 
and definitions:
    (1) General rule. The amount of decommissioning costs allocable to a 
nuclear decommissioning fund is the taxpayer's share of the total 
estimated cost of decommissioning the nuclear power plant to which the 
fund relates.
    (2) Total estimated cost of decommissioning. Under paragraph (a)(2) 
of this

[[Page 396]]

section, the taxpayer must demonstrate the reasonableness of the 
assumptions concerning the total estimated cost of decommissioning the 
nuclear power plant.
    (3) Taxpayer's share. The taxpayer's share of the total estimated 
cost of decommissioning a nuclear power plant equals the total estimated 
cost of decommissioning such nuclear power plant multiplied by the 
percentage of such nuclear power plant that the qualifying interest of 
the taxpayer represents. (See Sec.  1.468A-1(b)(2) for circumstances in 
which a taxpayer possesses a qualifying interest in a nuclear power 
plant).
    (e) Manner of requesting schedule of ruling amounts--(1) In general. 
(i) In order to receive a ruling amount for any taxable year, a taxpayer 
must file a request for a schedule of ruling amounts that complies with 
the requirements of this paragraph (e), the applicable procedural rules 
set forth in Sec.  601.201(e) of this chapter (Statement of Procedural 
Rules), and the requirements of any applicable revenue procedure that is 
in effect on the date the request is filed.
    (ii) A separate request for a schedule of ruling amounts is required 
for each nuclear decommissioning fund established by a taxpayer. (See 
paragraph (a) of Sec.  1.468A-5 for rules relating to the number of 
nuclear decommissioning funds that a taxpayer can establish.)
    (iii) Except as provided by Sec. Sec.  1.468A-5(a)(1)(iv) (relating 
to certain unincorporated organizations that may be taxable as 
corporations) and 1.468A-8 (relating to a special transfer under section 
468A(f)(1)), a request for a schedule of ruling amounts must not contain 
a request for a ruling on any other issue, whether the issue involves 
section 468A or another section of the Internal Revenue Code.
    (iv) In the case of an affiliated group of corporations that join in 
the filing of a consolidated return, the common parent of the group may 
request a schedule of ruling amounts for each member of the group that 
possesses a qualifying interest in the same nuclear power plant by 
filing a single submission with the IRS.
    (v) The IRS will not provide or revise a ruling amount applicable to 
a taxable year in response to a request for a schedule of ruling amounts 
that is filed after the deemed payment deadline date (as defined in 
Sec.  1.468A-2(c)(1)) for such taxable year. In determining the date 
when a request is filed, the principles of sections 7502 and 7503 shall 
apply.
    (vi) Except as provided in paragraph (e)(1)(vii) of this section, a 
request for a schedule of ruling amounts shall be considered filed only 
if such request complies substantially with the requirements of this 
paragraph (e).
    (vii) If a request does not comply substantially with the 
requirements of this paragraph (e), the IRS will notify the taxpayer of 
that fact. If the information or materials necessary to comply 
substantially with the requirements of this paragraph (e) are provided 
to the IRS within 30 days after this notification, the request will be 
considered filed on the date of the original submission. In addition, 
the request will be considered filed on the date of the original 
submission in a case in which the information and materials are provided 
more than 30 days after the notification if the IRS determines that the 
electing taxpayer made a good faith effort to provide the applicable 
information or materials within 30 days after notification and also 
determines that treating the request as filed on the date of the 
original submission is consistent with the purposes of section 468A. In 
any other case in which the information or materials necessary to comply 
substantially with the requirements of this paragraph (e) are not 
provided within 30 days after the notification, the request will be 
considered filed on the date that all information or materials necessary 
to comply with the requirements of this paragraph (e) are provided.
    (2) Information required. A request for a schedule of ruling amounts 
must contain the following information:
    (i) The taxpayer's name, address, and taxpayer identification 
number.
    (ii) Whether the request is for an initial schedule of ruling 
amounts, a mandatory review of the schedule of ruling amounts (see 
paragraph (f)(1) of this section), or an elective review of the schedule 
of ruling amounts (see paragraph (f)(2) of this section).

[[Page 397]]

    (iii) The name and location of the nuclear power plant with respect 
to which a schedule of ruling amounts is requested.
    (iv) A description of the taxpayer's qualifying interest in the 
nuclear power plant and the percentage of such nuclear power plant that 
the qualifying interest of the taxpayer represents.
    (v) Where applicable, an identification of each public utility 
commission that establishes or approves rates for the furnishing or sale 
by the taxpayer of electric energy generated by the nuclear power plant, 
and, for each public utility commission identified--
    (A) Whether the public utility commission has determined the amount 
of decommissioning costs to be included in the taxpayer's cost of 
service for ratemaking purposes;
    (B) The amount of decommissioning costs that are to be included in 
the taxpayer's cost of service for each taxable year under the current 
determination and amounts that otherwise are required to be included in 
the taxpayer's income under section 88 and the regulations thereunder;
    (C) A description of the assumptions, estimates and other factors 
used by the public utility commission to determine the amount of 
decommissioning costs;
    (D) A copy of such portions of any order or opinion of the public 
utility commission as pertain to the public utility commission's most 
recent determination of the amount of decommissioning costs to be 
included in cost of service; and
    (E) A copy of each engineering or cost study that was relied on or 
used by the public utility commission in determining the amount of 
decommissioning costs to be included in the taxpayer's cost of service 
under the current determination.
    (vi) A description of the assumptions, estimates and other factors 
that were used by the taxpayer to determine the amount of 
decommissioning costs, including each of the following if applicable:
    (A) A description of the proposed method of decommissioning the 
nuclear power plant (for example, prompt removal/dismantlement, safe 
storage entombment with delayed dismantlement, or safe storage 
mothballing with delayed dismantlement).
    (B) The estimated year in which substantial decommissioning costs 
will first be incurred.
    (C) The estimated year in which the decommissioning of the nuclear 
power plant will be substantially complete (see Sec.  1.468A-5(d)(3) for 
a definition of substantial completion of decommissioning).
    (D) The total estimated cost of decommissioning expressed in current 
dollars (that is, based on price levels in effect at the time of the 
current determination).
    (E) The total estimated cost of decommissioning expressed in future 
dollars (that is, based on anticipated price levels when expenses are 
expected to be paid).
    (F) For each taxable year in the period that begins with the year 
specified in paragraph (e)(2)(vi)(B) of this section (the estimated year 
in which substantial decommissioning costs will first be incurred) and 
ends with the year specified in paragraph (e)(2)(vi)(C) of this section 
(the estimated year in which the decommissioning of the nuclear power 
plant will be substantially complete), the estimated cost of 
decommissioning expressed in future dollars.
    (G) A description of the methodology used in converting the 
estimated cost of decommissioning expressed in current dollars to the 
estimated cost of decommissioning expressed in future dollars.
    (H) The assumed after-tax rate of return to be earned by the assets 
of the qualified nuclear decommissioning fund.
    (I) A copy of each engineering or cost study that was relied on or 
used by the taxpayer in determining the amount of decommissioning costs.
    (vii) A proposed schedule of ruling amounts for each taxable year 
remaining in the funding period as of the date the schedule of ruling 
amounts will first apply.
    (viii) A description of the assumptions, estimates and other factors 
that were used in determining the proposed schedule of ruling amounts, 
including, if applicable--

[[Page 398]]

    (A) The funding period (as such term is defined in paragraph (c) of 
this section);
    (B) The assumed after-tax rate of return to be earned by the assets 
of the nuclear decommissioning fund;
    (C) The fair market value of the assets (if any) of the nuclear 
decommissioning fund as of the first day of the first taxable year to 
which the schedule of ruling amounts will apply;
    (D) The amount expected to be earned by the assets of the nuclear 
decommissioning fund (based on the after-tax rate of return applicable 
to the fund) over the period that begins on the first day of the first 
taxable year to which the schedule of ruling amounts will apply and ends 
on the last day of the funding period;
    (E) The amount of decommissioning costs allocable to the nuclear 
decommissioning fund (as determined under paragraph (d) of this 
section);
    (F) The total estimated cost of decommissioning (as determined under 
paragraph (d)(2) of this section); and
    (G) The taxpayer's share of the total estimated cost of 
decommissioning (as such term is defined in paragraph (d)(3) of this 
section).
    (ix) If the request is for a revised schedule of ruling amounts, the 
after-tax rate of return earned by the assets of the nuclear 
decommissioning fund for each taxable year in the period that begins 
with the date of the initial contribution to the fund and ends with the 
first day of the first taxable year to which the revised schedule of 
ruling amounts applies.
    (x) If applicable, an explanation of the need for a schedule of 
ruling amounts determined on a basis other than the rules of paragraphs 
(a) through (d) of this section and a description of an alternative 
basis for determining a schedule of ruling amounts (see paragraph (a)(5) 
of this section).
    (xi) A chart or table, based upon the assumed after-tax rate of 
return to be earned by the assets of the nuclear decommissioning fund, 
setting forth the years the fund will be in existence, the annual 
contribution to the fund, the estimated annual earnings of the fund and 
the cumulative total balance in the fund.
    (xii) If the request is for a revised schedule of ruling amounts, a 
copy of the schedule of ruling amounts that the revised schedule would 
replace.
    (xiii) If the request for a schedule of ruling amounts contains a 
request, pursuant to Sec.  1.468A-5(a)(1)(iv), that the IRS rule whether 
an unincorporated organization through which the assets of the fund are 
invested is an association taxable as a corporation for Federal tax 
purposes, a copy of the legal documents establishing or otherwise 
governing the organization.
    (xiv) Any other information required by the IRS that may be 
necessary or useful in determining the schedule of ruling amounts.
    (3) Administrative procedures. The IRS may prescribe administrative 
procedures that supplement the provisions of paragraph (e)(1) and (2) of 
this section. In addition, the IRS may, in its discretion, waive the 
requirements of paragraph (e)(1) and (2) of this section under 
appropriate circumstances.
    (f) Review and revision of schedule of ruling amounts--(1) Mandatory 
review. (i) Any taxpayer that has obtained a schedule of ruling amounts 
pursuant to paragraph (e) of this section must file a request for a 
revised schedule of ruling amounts on or before the deemed payment 
deadline date for the 10th taxable year that begins after the taxable 
year in which the most recent schedule of ruling amounts was received. 
If the taxpayer calculated its most recent schedule of ruling amounts on 
any basis other than an order issued by a public utility commission, the 
taxpayer must file a request for a revised schedule of ruling amounts on 
or before the deemed payment deadline date for the 5th taxable year that 
begins after the taxable year in which the most recent schedule of 
ruling amounts was received.
    (ii)(A) Any taxpayer that has obtained a formula or method for 
determining a schedule of ruling amounts for any taxable year under 
paragraph (a)(5) of this section must file a request for a revised 
schedule on or before the earlier of the deemed payment deadline for the 
5th taxable year that begins after its taxable year in which the

[[Page 399]]

most recent formula or method was approved or the deemed payment 
deadline for the first taxable year that begins after a taxable year in 
which there is a substantial variation in the ruling amount determined 
under the most recent formula or method. There is a substantial 
variation in the ruling amount determined under the formula or method in 
effect for a taxable year if the ruling amount for the year and the 
ruling amount for any earlier year since the most recent formula or 
method was approved differ by more than 50 percent of the smaller 
amount.
    (B) Any taxpayer that has determined its ruling amount for any 
taxable year under a formula prescribed by Sec.  1.468A-6 (which 
prescribes ruling amounts for the taxable year in which there is a 
disposition of a qualifying interest in a nuclear power plant) must file 
a request for a revised schedule of ruling amounts on or before the 
deemed payment deadline for its first taxable year that begins after the 
disposition.
    (iii) A taxpayer requesting a schedule of deduction amounts for a 
nuclear decommissioning fund under Sec.  1.468A-8 must also request a 
revised schedule of ruling amounts for the fund. The revised schedule of 
ruling amounts must apply beginning with the first taxable year 
following the first year in which a deduction is allowed under the 
schedule of deduction amounts.
    (iv) If the operating license of the nuclear power plant to which a 
nuclear decommissioning fund relates is renewed, the taxpayer 
maintaining the fund must request a revised schedule of ruling amounts. 
The request for the revised schedule must be submitted on or before the 
deemed payment deadline for the taxable year that includes the date on 
which the operating license is renewed.
    (v) A request for a schedule of ruling amounts required by this 
paragraph (f)(1) must be made in accordance with the rules of paragraph 
(e) of this section. If a taxpayer does not properly file a request for 
a revised schedule of ruling amounts by the date provided in paragraph 
(f)(1)(i), (ii) or (iv) of this section (whichever is applicable), the 
taxpayer's ruling amount for the first taxable year to which the revised 
schedule of ruling amounts would have applied and for all succeeding 
taxable years until a new schedule is obtained shall be zero dollars, 
unless, in its discretion, the IRS provides otherwise in such new 
schedule of ruling amounts. Thus, if a taxpayer is required to request a 
revised schedule of ruling amounts under any provision of this section, 
and each ruling amount in the revised schedule would equal zero dollars, 
the taxpayer may, instead of requesting a new schedule of ruling 
amounts, begin treating the ruling amounts under its most recent 
schedule as equal to zero dollars.
    (2) Elective review. Any taxpayer that has obtained a schedule of 
ruling amounts pursuant to paragraph (e) of this section can request a 
revised schedule of ruling amounts. Such a request must be made in 
accordance with the rules of paragraph (e) of this section; thus, the 
IRS will not provide a revised ruling amount applicable to a taxable 
year in response to a request for a schedule of ruling amounts that is 
filed after the deemed payment deadline date for such taxable year (see 
paragraph (e)(1)(vi) of this section).
    (3) Determination of revised schedule of ruling amounts. A revised 
schedule of ruling amounts for a nuclear decommissioning fund shall be 
determined under this section without regard to any schedule of ruling 
amounts for such nuclear decommissioning fund that was issued prior to 
such revised schedule. Thus, a ruling amount specified in a revised 
schedule of ruling amounts for any taxable year in the funding period 
can be less than one or more ruling amounts specified in a prior 
schedule of ruling amounts for a prior taxable year.
    (g) Special rule permitting payments to a nuclear decommissioning 
fund before receipt of an initial or revised ruling amount applicable to 
a taxable year. (1) If an electing taxpayer has filed a timely request 
for an initial or revised ruling amount for a taxable year beginning on 
or after January 1, 2006, and does not receive the ruling amount on or 
before the deemed payment deadline date for such taxable year, the 
taxpayer may make a payment to a nuclear decommissioning fund on the 
basis of the ruling amount proposed in the taxpayer's

[[Page 400]]

request. Thus, under the preceding sentence, an electing taxpayer may 
make a payment to a nuclear decommissioning fund for such taxable year 
that does not exceed the ruling amount proposed by the taxpayer for such 
taxable year in a timely filed request for a schedule of ruling amounts.
    (2) If an electing taxpayer makes a payment to a nuclear 
decommissioning fund for any taxable year pursuant to paragraph (g)(1) 
of this section and the ruling amount that is provided by the IRS is 
greater than the ruling amount proposed by the taxpayer for such taxable 
year, the taxpayer is not allowed to make an additional payment to the 
fund for such taxable year after the deemed payment deadline date for 
such taxable year.
    (3) If the payment or transfer that an electing taxpayer makes to a 
nuclear decommissioning fund for any taxable year pursuant to paragraph 
(g)(1) of this section exceeds the ruling amount that is provided by the 
IRS for such taxable year, the following rules apply:
    (i) The amount of the excess is an excess contribution (as defined 
in Sec.  1.468A-5(c)(2)(ii)) for such taxable year.
    (ii) The amount of the excess contribution is not deductible (see 
Sec.  1.468A-2(b)(2)) and must be withdrawn by the taxpayer pursuant to 
the rules of Sec.  1.468A-5(c)(2)(i).
    (iii) The taxpayer must withdraw the after-tax earnings on the 
excess contribution.
    (iv) If the taxpayer claimed a deduction for the excess 
contribution, the taxpayer should file an amended return for the taxable 
year.

[T.D. 9512, 75 FR 80701, Dec. 23, 2010]



Sec.  1.468A-4  Treatment of nuclear decommissioning fund.

    (a) In general. A nuclear decommissioning fund is subject to tax on 
all of its modified gross income (as defined in paragraph (b) of this 
section). The rate of tax is 20 percent for taxable years beginning 
after December 31, 1995. This tax is in lieu of any other tax that may 
be imposed under subtitle A of the Internal Revenue Code (Code) on the 
income earned by the assets of the nuclear decommissioning fund.
    (b) Modified gross income. For purposes of this section, the term 
modified gross income means gross income as defined under section 61 
computed with the following modifications:
    (1) The amount of any payment or special transfer to the nuclear 
decommissioning fund with respect to which a deduction is allowed under 
section 468A(a) or section 468A(f) is excluded from gross income.
    (2) A deduction is allowed for the amount of administrative costs 
and other incidental expenses of the nuclear decommissioning fund 
(including taxes, legal expenses, accounting expenses, actuarial 
expenses and trustee expenses, but not including decommissioning costs) 
that are otherwise deductible and that are paid by the nuclear 
decommissioning fund to any person other than the electing taxpayer. An 
expense is otherwise deductible for purposes of this paragraph (b)(2) if 
it would be deductible under chapter 1 of the Code in determining the 
taxable income of a corporation. For example, because Federal income 
taxes are not deductible under chapter 1 of the Code in determining the 
taxable income of a corporation, the tax imposed by section 468A(e)(2) 
and paragraph (a) of this section is not deductible in determining the 
modified gross income of a nuclear decommissioning fund. Similarly, 
because certain expenses allocable to tax-exempt interest income are not 
deductible under section 265 in determining the taxable income of a 
corporation, such expenses are not deductible in determining the 
modified gross income of a nuclear decommissioning fund.
    (3) A deduction is allowed for the amount of an otherwise deductible 
loss that is sustained by the nuclear decommissioning fund in connection 
with the sale, exchange or worthlessness of any investment. A loss is 
otherwise deductible for purposes of this paragraph (b)(3) if such loss 
would be deductible by a corporation under section 165(f) or (g) and 
sections 1211(a) and 1212(a).
    (4) A deduction is allowed for the amount of an otherwise deductible 
net operating loss of the nuclear decommissioning fund. For purposes of 
this paragraph (b), the net operating loss of a nuclear decommissioning 
fund for a

[[Page 401]]

taxable year is the amount by which the deductions allowable under 
paragraphs (b)(2) and (3) of this section exceed the gross income of the 
nuclear decommissioning fund computed with the modification described in 
paragraph (b)(1) of this section. A net operating loss is otherwise 
deductible for purposes of this paragraph (b)(4) if such a net operating 
loss would be deductible by a corporation under section 172(a).
    (c) Special rules--(1) Period for computation of modified gross 
income. The modified gross income of a nuclear decommissioning fund must 
be computed on the basis of the taxable year of the electing taxpayer. 
If an electing taxpayer changes its taxable year, each nuclear 
decommissioning fund of the electing taxpayer must change to the new 
taxable year. See section 442 and Sec.  1.442-1 for rules relating to 
the change to a new taxable year.
    (2) Gain or loss upon distribution of property by a fund. A 
distribution of property by a nuclear decommissioning fund (whether an 
actual distribution or a deemed distribution) shall be considered a 
disposition of property by the nuclear decommissioning fund for purposes 
of section 1001. In determining the amount of gain or loss from such 
disposition, the amount realized by the nuclear decommissioning fund 
shall be the fair market value of the property on the date of 
disposition.
    (3) Denial of credits against tax. The tax imposed on the modified 
gross income of a nuclear decommissioning fund under paragraph (a) of 
this section is not to be reduced or offset by any credits against tax 
provided by part IV of subchapter A of chapter 1 of the Code other than 
the credit provided by section 31(c) for amounts withheld under section 
3406 (back-up withholding).
    (4) Other corporate taxes inapplicable. Although the modified gross 
income of a nuclear decommissioning fund is subject to tax at the rate 
specified by section 468A(e)(2) and paragraph (a) of this section, a 
nuclear decommissioning fund is not subject to the other taxes imposed 
on corporations under subtitle A of the Code. For example, a nuclear 
decommissioning fund is not subject to the alternative minimum tax 
imposed by section 55, the accumulated earnings tax imposed by section 
531, the personal holding company tax imposed by section 541, and the 
alternative tax imposed on a corporation under section 1201(a).
    (d) Treatment as corporation for purposes of subtitle F. For 
purposes of subtitle F of the Code and Sec. Sec.  1.468A-1 through 
1.468A-9, a nuclear decommissioning fund is to be treated as if it were 
a corporation and the tax imposed by section 468A(e)(2) and paragraph 
(a) of this section is to be treated as a tax imposed by section 11. 
Thus, for example, the following rules apply:
    (1) A nuclear decommissioning fund must file a return with respect 
to the tax imposed by section 468A(e)(2) and paragraph (a) of this 
section for each taxable year (or portion thereof) that the fund is in 
existence even though no amount is included in the gross income of the 
fund for such taxable year. The return is to be made on Form 1120-ND in 
accordance with the instructions relating to such form. For purposes of 
this paragraph (d)(1), a nuclear decommissioning fund is in existence 
for the period that--
    (i) Begins on the date that the first deductible payment is actually 
made to such nuclear decommissioning fund; and
    (ii) Ends on the date of termination (see Sec.  1.468A-5(d)), the 
date that the entire fund is disqualified (see Sec.  1.468A-5(c)), or 
the date that the electing taxpayer disposes of its entire qualifying 
interest in the nuclear power plant to which the nuclear decommissioning 
fund relates (other than in connection with the transfer of the entire 
fund to the person acquiring such interest), whichever is applicable.
    (2) For each taxable year of the nuclear decommissioning fund, the 
return described in paragraph (d)(1) of this section must be filed on or 
before the 15th day of the third month following the close of such 
taxable year unless the nuclear decommissioning fund is granted an 
extension of time for filing under section 6081. If such an extension is 
granted for any taxable year, the return for such taxable year must be 
filed on or before the extended due date for such taxable year.

[[Page 402]]

    (3) A nuclear decommissioning fund must provide its employer 
identification number on returns, statements and other documents as 
required by the forms and instructions relating thereto. The employer 
identification number is obtained by filing a Form SS-4, Application for 
Employer Identification Number, in accordance with the instructions 
relating thereto.
    (4) A nuclear decommissioning fund must deposit all payments of tax 
imposed by section 468A(e)(2) and paragraph (a) of this section 
(including any payments of estimated tax) with an authorized government 
depositary in accordance with Sec.  1.6302-1.
    (5) A nuclear decommissioning fund is subject to the addition to tax 
imposed by section 6655 in case of a failure to pay estimated income 
tax. For purposes of section 6655 and this section--
    (i) The tax with respect to which the amount of the underpayment is 
computed in the case of a nuclear decommissioning fund is the tax 
imposed by section 468A(e)(2) and paragraph (a) of this section; and
    (ii) The taxable income with respect to which the nuclear 
decommissioning fund's status as a large corporation is measured is 
modified gross income (as defined by paragraph (b) of this section).

[T.D. 9512, 75 FR 80701, Dec. 23, 2010]



Sec.  1.468A-5  Nuclear decommissioning fund--miscellaneous provisions.

    (a) Qualification requirements--(1) In general. (i) A nuclear 
decommissioning fund must be established and maintained at all times in 
the United States pursuant to an arrangement that qualifies as a trust 
under State law. Such trust must be established for the exclusive 
purpose of providing funds for the decommissioning of one or more 
nuclear power plants, but a single trust agreement may establish 
multiple funds for such purpose. Thus, for example--
    (A) Two or more nuclear decommissioning funds can be established and 
maintained pursuant to a single trust agreement; and
    (B) One or more funds that are to be used for the decommissioning of 
a nuclear power plant and that do not qualify as nuclear decommissioning 
funds under this paragraph (a) can be established and maintained 
pursuant to a trust agreement that governs one or more nuclear 
decommissioning funds.
    (ii) A separate nuclear decommissioning fund is required for each 
electing taxpayer and for each nuclear power plant with respect to which 
an electing taxpayer possesses a qualifying interest. The Internal 
Revenue Service (IRS) will issue a separate schedule of ruling amounts 
with respect to each nuclear decommissioning fund, and each nuclear 
decommissioning fund must file a separate income tax return even if 
other nuclear decommissioning funds or nonqualified funds are 
established and maintained pursuant to the trust agreement governing 
such fund or the assets of other nuclear decommissioning funds or 
nonqualified funds are pooled with the assets of such fund.
    (iii) An electing taxpayer can maintain only one nuclear 
decommissioning fund for each nuclear power plant with respect to which 
the taxpayer elects the application of section 468A. If a nuclear power 
plant is subject to the ratemaking jurisdiction of two or more public 
utility commissions and any such public utility commission requires a 
separate fund to be maintained for the benefit of ratepayers whose rates 
are established or approved by the public utility commission, the 
separate funds maintained for such plant (whether or not established and 
maintained pursuant to a single trust agreement) shall be considered a 
single nuclear decommissioning fund for purposes of section 468A and 
Sec. Sec.  1.468A-1 through 1.468A-4, this section and Sec. Sec.  
1.468A-7 through 1.468A-9. Thus, for example, the IRS will issue one 
schedule of ruling amounts with respect to such nuclear power plant, the 
nuclear decommissioning fund must file a single income tax return (see 
Sec.  1.468A-4(d)(1)), and, if the IRS disqualifies the nuclear 
decommissioning fund, the assets of each separate fund are treated as 
distributed on the date of disqualification (see paragraph (c)(3) of 
this section).
    (iv) If assets of a nuclear decommissioning fund are (or will be) 
invested

[[Page 403]]

through an unincorporated organization, within the meaning of Sec.  
301.7701-2 of this chapter, the IRS will rule, if requested, whether the 
organization is an association taxable as a corporation for Federal tax 
purposes. A request for this ruling may be made by the electing taxpayer 
as part of its request for a schedule of ruling amounts or as part of a 
request under Sec.  1.468A-8 for a schedule of deduction amounts.
    (2) Limitation on contributions. Except as otherwise provided in 
Sec.  1.468A-8 (relating to special transfers under section 468A(f)), a 
nuclear decommissioning fund is not permitted to accept any 
contributions in cash or property other than cash payments with respect 
to which a deduction is allowed under section 468A(a) and Sec.  1.468A-
2(a). Thus, for example, except in the case of a special transfer 
pursuant to Sec.  1.468A-8, securities may not be contributed to a 
nuclear decommissioning fund even if the taxpayer or a fund established 
by the taxpayer previously held such securities for the purpose of 
providing funds for the decommissioning of a nuclear power plant.
    (3) Limitation on use of fund--(i) In general. The assets of a 
nuclear decommissioning fund are to be used exclusively--
    (A) To satisfy, in whole or in part, the liability of the electing 
taxpayer for decommissioning costs of the nuclear power plant to which 
the nuclear decommissioning fund relates;
    (B) To pay administrative costs and other incidental expenses of the 
nuclear decommissioning fund; and
    (C) To the extent that the assets of the nuclear decommissioning 
fund are not currently required for the purposes described in paragraph 
(a)(3)(i)(A) or (B) of this section, to make investments.
    (ii) Definition of administrative costs and expenses. For purposes 
of paragraph (a)(3)(i) of this section, the term administrative costs 
and other incidental expenses of a nuclear decommissioning fund means 
all ordinary and necessary expenses incurred in connection with the 
operation of the nuclear decommissioning fund. Such term includes the 
tax imposed by section 468A(e)(2) and Sec.  1.468A-4(a), any State or 
local tax imposed on the income or the assets of the fund, legal 
expenses, accounting expenses, actuarial expenses and trustee expenses. 
Such term does not include decommissioning costs or the payment of 
insurance premiums on a policy to pay for the nuclear decommissioning 
costs of a nuclear power plant. Such term also does not include the 
excise tax imposed on the trustee or other disqualified person under 
section 4951 or the reimbursement of any expenses incurred in connection 
with the assertion of such tax unless such expenses are considered 
reasonable and necessary under section 4951(d)(2)(C) and it is 
determined that the trustee or other disqualified person is not liable 
for the excise tax.
    (4) Trust provisions. Each qualified nuclear decommissioning fund 
trust agreement must provide that assets in the fund must be used as 
authorized by section 468A and Sec. Sec.  1.468A-1 through 1.468A-9 and 
that the agreement may not be amended so as to violate section 468A or 
Sec. Sec.  1.468A-1 through 1.468A-9.
    (b) Prohibitions against self-dealing--(1) In general. Except as 
otherwise provided in this paragraph (b), the excise taxes imposed by 
section 4951 shall apply to each act of self-dealing between a 
disqualified person and a nuclear decommissioning fund.
    (2) Self-dealing defined. For purposes of this paragraph (b), the 
term self-dealing means any act described in section 4951(d), except--
    (i) A payment by a nuclear decommissioning fund for the purpose of 
satisfying, in whole or in part, the liability of the electing taxpayer 
for decommissioning costs of the nuclear power plant to which the 
nuclear decommissioning fund relates, whether such payment is made to an 
unrelated party in satisfaction of the decommissioning liability or to 
the plant operator or other otherwise disqualified person as 
reimbursement solely for actual expenses paid by such person in 
satisfaction of the decommissioning liability;
    (ii) A withdrawal of an excess contribution by the electing taxpayer 
pursuant to the rules of paragraph (c)(2) of this section;
    (iii) A withdrawal by the electing taxpayer of amounts that have 
been treated as distributed under paragraph (c)(3) of this section;

[[Page 404]]

    (iv) A payment of amounts remaining in a nuclear decommissioning 
fund to the electing taxpayer after the termination of such fund (as 
determined under paragraph (d) of this section);
    (v) Any act described in section 4951(d)(2)(B) or (C). Whether 
payments under section 4951(c)(2)(C) are not excessive is determined 
under Sec.  1.162-7. See Sec.  53.4941(d)-3(c)(1). The fact that the 
amount of such payments that are not excessive are also more than the 
disqualified person's actual expenses for such personal services does 
not cause the payments to constitute acts of self-dealing, even if the 
difference is properly characterized as profit, or direct or indirect 
overhead;
    (vi) Any act that is described in Sec.  53.4951-1(c) of this chapter 
and is undertaken to facilitate the temporary investment of assets or 
the payment of reasonable administrative expenses of the nuclear 
decommissioning fund; or
    (vii) A payment by a nuclear decommissioning fund for the 
performance of trust functions and certain general banking services by a 
bank or trust company that is a disqualified person if the banking 
services are reasonable and necessary to carry out the purposes of the 
fund and the compensation paid to the bank or trust company for such 
services, taking into account the fair interest rate for the use of the 
funds by the bank or trust company, is not excessive.
    (3) Disqualified person defined. For purposes of this paragraph (b), 
the term disqualified person includes each person described in section 
4951(e)(4) and Sec.  53.4951-1(d).
    (4) General banking services. The general banking services allowed 
by paragraph (b)(2)(vii) of this section are--
    (i) Checking accounts, as long as the bank does not charge interest 
on any overwithdrawals;
    (ii) Savings accounts, as long as the fund may withdraw its funds on 
no more than 30 days' notice without subjecting itself to a loss of 
interest on its money for the time during which the money was on 
deposit; and
    (iii) Safekeeping activities (see Sec.  53.4941(d)-3(c)(2), Example 
3, of this chapter).
    (c) Disqualification of nuclear decommissioning fund--(1) In 
general--(i) Disqualification events. Except as otherwise provided in 
paragraph (c)(2) of this section, the IRS may, in its discretion, 
disqualify all or any portion of a nuclear decommissioning fund if at 
any time during a taxable year of the fund--
    (A) The fund does not satisfy the requirements of paragraph (a) of 
this section; or
    (B) The fund and a disqualified person engage in an act of self-
dealing (as defined in paragraph (b)(2) of this section).
    (ii) Date of disqualification. (A) Except as otherwise provided in 
this paragraph (c)(1)(ii), the date on which a disqualification under 
this paragraph (c) will take effect (date of disqualification) is the 
date that the fund does not satisfy the requirements of paragraph (a) of 
this section or the date on which the act of self-dealing occurs, 
whichever is applicable.
    (B) If the IRS determines, in its discretion, that the 
disqualification should take effect on a date subsequent to the date 
specified in paragraph (c)(1)(ii)(A) of this section, the date of 
disqualification is such subsequent date.
    (iii) Notice of disqualification. The IRS will notify the electing 
taxpayer of the disqualification of a nuclear decommissioning fund and 
the date of disqualification by registered or certified mail to the last 
known address of the electing taxpayer (the notice of disqualification). 
For further guidance regarding the definition of last known address, see 
Sec.  301.6212-2 of this chapter.
    (2) Exception to disqualification--(i) In general. A nuclear 
decommissioning fund will not be disqualified under paragraph (c)(1) of 
this section by reason of an excess contribution or the withdrawal of 
such excess contribution by an electing taxpayer if the amount of the 
excess contribution is withdrawn by the electing taxpayer on or before 
the date prescribed by law (including extensions) for filing the return 
of the nuclear decommissioning fund for the taxable year to which the 
excess contribution relates. In the case of an excess contribution that 
is the result of a payment made pursuant to Sec.  1.468A-3(g)(1), a 
nuclear decommissioning fund

[[Page 405]]

will not be disqualified under paragraph (c)(1) of this section if the 
amount of the excess contribution is withdrawn by the electing taxpayer 
on or before the later of--
    (A) The date prescribed by law (including extensions) for filing the 
return of the nuclear decommissioning fund for the taxable year to which 
the excess contribution relates; or
    (B) The date that is 30 days after the date that the taxpayer 
receives the ruling amount for such taxable year.
    (ii) Excess contribution defined. For purposes of this section, an 
excess contribution is the amount by which cash payments made (or deemed 
made) to a nuclear decommissioning fund during any taxable year exceed 
the payment limitation contained in section 468A(b) and Sec.  1.468A-
2(b). The amount of a special transfer permitted under Sec.  1.468A-8 is 
not treated as a cash payment for this purpose.
    (iii) Taxation of income attributable to an excess contribution. The 
income of a nuclear decommissioning fund attributable to an excess 
contribution is required to be included in the gross income of the 
nuclear decommissioning fund under Sec.  1.468A-4(b).
    (3) Disqualification treated as distribution. If all or any portion 
of a nuclear decommissioning fund is disqualified under paragraph (c)(1) 
of this section, the portion of the nuclear decommissioning fund that is 
disqualified is treated as distributed to the electing taxpayer on the 
date of disqualification. Such a distribution shall be treated for 
purposes of section 1001 as a disposition of property held by the 
nuclear decommissioning fund (see Sec.  1.468A-4(c)(2)). In addition, 
the electing taxpayer must include in gross income for the taxable year 
that includes the date of disqualification an amount equal to the fair 
market value of the distributable assets of the nuclear decommissioning 
fund multiplied by the fraction of the nuclear decommissioning fund that 
was disqualified under paragraph (c)(1) of this section. For this 
purpose, the fair market value of the distributable assets of the 
nuclear decommissioning fund is equal to the fair market value of the 
assets of the fund determined as of the date of disqualification, 
reduced by--
    (i) The amount of any excess contribution that was not withdrawn 
before the date of disqualification if no deduction was allowed with 
respect to such excess contribution;
    (ii) The amount of any deemed distribution that was not actually 
distributed before the date of disqualification (as determined under 
Sec.  1.468A-2(d)(2)(iii)) if the amount of the deemed distribution was 
included in the gross income of the electing taxpayer for the taxable 
year in which the deemed distribution occurred; and
    (iii) The amount of any tax that--
    (A) Is imposed on the income of the fund;
    (B) Is attributable to income taken into account before the date of 
disqualification or as a result of the disqualification; and
    (C) Has not been paid as of the date of disqualification.
    (4) Further effects of disqualification. Contributions made to a 
disqualified fund after the date of disqualification are not deductible 
under section 468A(a) and Sec.  1.468A-2(a), or, if the fund is 
disqualified only in part, are deductible only to the extent provided in 
the notice of disqualification. In addition, if any assets of the fund 
that are deemed distributed under paragraph (c)(3) of this section are 
held by the fund after the date of disqualification (or if additional 
assets are acquired with nondeductible contributions made to the fund 
after the date of disqualification), the income earned by such assets 
after the date of disqualification must be included in the gross income 
of the electing taxpayer (see section 671) to the extent that such 
income is otherwise includible under chapter 1 of the Internal Revenue 
Code (Code). An electing taxpayer can establish a nuclear 
decommissioning fund to replace a fund that has been disqualified in its 
entirety only if the IRS specifically consents to the establishment of a 
replacement fund in connection with the issuance of an initial schedule 
of ruling amounts for such replacement fund.
    (d) Termination of nuclear decommissioning fund upon substantial 
completion of decommissioning--(1) In general. Upon substantial 
completion of the decommissioning of a nuclear power plant to which a 
nuclear decommissioning fund

[[Page 406]]

relates, such nuclear decommissioning fund shall be considered 
terminated and treated as having distributed all of its assets on the 
date the termination occurs (the termination date). Such a distribution 
shall be treated for purposes of section 1001 as a disposition of 
property held by the nuclear decommissioning fund (see Sec.  1.468A-
4(c)(2)). In addition, the electing taxpayer shall include in gross 
income for the taxable year in which the termination occurs an amount 
equal to the fair market value of the assets of the fund determined as 
of the termination date, reduced by--
    (i) The amount of any deemed distribution that was not actually 
distributed before the termination date if the amount of the deemed 
distribution was included in the gross income of the electing taxpayer 
for the taxable year in which the deemed distribution occurred; and
    (ii) The amount of any tax that--
    (A) Is imposed on the income of the fund;
    (B) Is attributable to income taken into account before the 
termination date or as a result of the termination; and
    (C) Has not been paid as of the termination date.
    (2) Additional rules. Contributions made to a nuclear 
decommissioning fund after the termination date are not deductible under 
section 468A(a) and Sec.  1.468A-2(a). In addition, if any assets are 
held by the fund after the termination date, the income earned by such 
assets after the termination date must be included in the gross income 
of the electing taxpayer (see section 671) to the extent that such 
income is otherwise includible under chapter 1 of the Code. Finally, 
under Sec.  1.468A-2(e), an electing taxpayer using an accrual method of 
accounting is allowed a deduction for nuclear decommissioning costs that 
are incurred during any taxable year even if such costs are incurred 
after substantial completion of decommissioning (for example, expenses 
incurred to monitor or safeguard the plant site).
    (3) Substantial completion of decommissioning and termination date. 
(i) The substantial completion of the decommissioning of a nuclear power 
plant occurs on the date on which all Federal, state, local, and 
contractual decommissioning requirements are fully satisfied (the 
substantial completion date). Except as otherwise provided in paragraph 
(d)(3)(ii) of this section, the substantial completion date is also the 
termination date.
    (ii) If a significant portion of the total estimated decommissioning 
costs with respect to a nuclear power plant are not incurred on or 
before the substantial completion date, an electing taxpayer may 
request, and the IRS will issue, a ruling that designates a date 
subsequent to the substantial completion date as the termination date. 
The termination date designated in the ruling will not be later than the 
last day of the third taxable year after the taxable year that includes 
the substantial completion date. The request for a ruling under this 
paragraph (d)(3)(ii) must be filed during the taxable year that includes 
the substantial completion date and must comply with the procedural 
rules in effect at the time of the request.

[T.D. 9512, 75 FR 80701, Dec. 23, 2010, as amended by T.D. 9906, 85 FR 
55190, Sept. 4, 2020]



Sec.  1.468A-6  Disposition of an interest in a nuclear power plant.

    (a) In general. This section describes the Federal income tax 
consequences of a transfer of the assets of a nuclear decommissioning 
fund (Fund) within the meaning of Sec.  1.468A-1(b)(4) in connection 
with a sale, exchange, or other disposition by a taxpayer (transferor) 
of all or a portion of its qualifying interest in a nuclear power plant 
to another taxpayer (transferee). This section also explains how a 
schedule of ruling amounts will be determined for the transferor and 
transferee. For purposes of this section, a nuclear power plant includes 
a plant that previously qualified as a nuclear power plant and that has 
permanently ceased to produce electricity.
    (b) Requirements. This section applies if--
    (1) Immediately before the disposition, the transferor maintained a 
Fund with respect to the interest disposed of;
    (2) Immediately after the disposition--

[[Page 407]]

    (i) The transferee maintains a Fund with respect to the interest 
acquired;
    (ii) The interest acquired is a qualifying interest of the 
transferee in the nuclear power plant;
    (3) In connection with the disposition, either--
    (i) The transferee acquires part or all of the transferor's 
qualifying interest in the plant and a proportionate amount of the 
assets of the transferor's Fund (all such assets if the transferee 
acquires the transferor's entire qualifying interest in the plant) is 
transferred to a Fund of the transferee; or
    (ii) The transferee acquires the transferor's entire qualifying 
interest in the plant and the transferor's entire Fund is transferred to 
the transferee; and
    (4) The transferee continues to satisfy the requirements of Sec.  
1.468A-5(a)(1)(iii), which permits an electing taxpayer to maintain only 
one Fund for each plant.
    (c) Tax consequences. A disposition that satisfies the requirements 
of paragraph (b) of this section will have the following tax 
consequences at the time it occurs:
    (1) The transferor and its Fund. (i) Except as provided in paragraph 
(c)(1)(ii) of this section, neither the transferor nor the transferor's 
Fund will recognize gain or loss or otherwise take any income or 
deduction into account by reason of the transfer of a proportionate 
amount of the assets of the transferor's Fund to the transferee's Fund 
(or by reason of the transfer of the transferor's entire Fund to the 
transferee). For purposes of Sec. Sec.  1.468A-1 through 1.468A-9, this 
transfer (or the transfer of the transferor's Fund) will not be 
considered a distribution of assets by the transferor's Fund.
    (ii) Notwithstanding paragraph (c)(1)(i) of this section, if the 
transferor has made a special transfer under Sec.  1.468A-8 prior to the 
transfer of the Fund or Fund assets, any deduction with respect to that 
special transfer allowable under section 468A(f)(2) for a taxable year 
ending after the date of the transfer of the Fund or Fund assets (the 
unamortized special transfer deduction) is allowed under section 
468A(f)(2)(C) for the taxable year that includes the date of the 
transfer of the Fund or Fund assets. If the taxpayer transfers only a 
portion of its interest in a nuclear power plant, only the corresponding 
portion of the unamortized special transfer deduction qualifies for the 
acceleration under section 468A(f)(2)(C).
    (2) The transferee and its Fund. Neither the transferee nor the 
transferee's Fund will recognize gain or loss or otherwise take any 
income or deduction into account by reason of the transfer of a 
proportionate amount of the assets of the transferor's Fund to the 
transferee's Fund (or by reason of the transfer of the transferor's Fund 
to the transferee). For purposes of Sec. Sec.  1.468A-1 through 1.468A-
9, this transfer (or the transfer of the transferor's Fund) will not 
constitute a payment or a contribution of assets by the transferee to 
its Fund.
    (3) Basis. Transfers of assets of a Fund to which this section 
applies do not affect basis. Thus, the transferee's Fund will have a 
basis in the assets received from the transferor's Fund that is the same 
as the basis of those assets in the transferor's Fund immediately before 
the disposition.
    (d) Determination of proportionate amount. For purposes of this 
section, a transferor of a qualifying interest in a nuclear power plant 
is considered to transfer a proportionate amount of the assets of its 
Fund to a Fund of a transferee of the interest if, on the date of the 
transfer of the interest, the percentage of the fair market value of the 
Fund's assets attributable to the assets transferred equals the 
percentage of the transferor's qualifying interest that is transferred.
    (e) Calculation of schedule of ruling amounts and schedule of 
deduction amounts for dispositions described in this section--(1) 
Transferor. If a transferor disposes of all or a portion of its 
qualifying interest in a nuclear power plant in a transaction to which 
this section applies, the transferor's schedule of ruling amounts with 
respect to the interests disposed of and retained (if any) and, if 
applicable, the amount allowable as a deduction for a special transfer 
under Sec.  1.468A-8 will be determined under the following rules:
    (i) Taxable year of disposition; ruling amount. If the transferor 
does not file a request for a revised schedule of ruling

[[Page 408]]

amounts on or before the deemed payment deadline for the taxable year of 
the transferor in which the disposition of its interest in the nuclear 
power plant occurs (that is, the date that is two and one-half months 
after the close of that year), the transferor's ruling amount with 
respect to that plant for that year will equal the sum of--
    (A) The ruling amount contained in the transferor's current schedule 
of ruling amounts with respect to that plant for that taxable year 
multiplied by the portion of the qualifying interest that is retained 
(if any); and
    (B) The ruling amount contained in the transferor's current schedule 
of ruling amounts with respect to that plant for that taxable year 
multiplied by the product of--
    (1) The portion of the transferor's qualifying interest that is 
disposed of; and
    (2) A fraction, the numerator of which is the number of days in that 
taxable year that precede the date of disposition, and the denominator 
of which is the number of days in that taxable year.
    (ii) Taxable year of disposition; deduction under Sec.  1.468A-8. If 
the transferor has elected to make a special transfer under section 
468A(f), the amount allowable as a deduction under Sec.  1.468A-8 for 
the taxable year in which it transfers a portion of its interest in the 
nuclear plant is equal to the deduction amount for that taxable year 
from its existing schedule of deduction amounts multiplied by the 
percentage of its interest that it retains. This deduction is in 
addition to the deduction described in paragraph (c)(1)(ii) of this 
section.
    (iii) Taxable years after the year of disposition. A transferor that 
retains a qualifying interest in a nuclear power plant must file a 
request for a revised schedule of ruling amounts (and, if applicable, a 
revised schedule of deduction amounts) with respect to that interest on 
or before the deemed payment deadline for the first taxable year of the 
transferor beginning after the disposition. See Sec. Sec.  1.468A-
3(f)(1)(ii)(B) and 1.468A-8(c)(3). If the transferor does not timely 
file such a request, the transferor's ruling amount and the transferor's 
deduction amount under Sec.  1.468A-8 with respect to that interest for 
the affected year or years will be zero, unless the Internal Revenue 
Service (IRS) waives the application of this paragraph (e)(1)(iii) upon 
a showing of good cause for the delay.
    (2) Transferee. If a transferee acquires all or a portion of a 
transferor's qualifying interest in a nuclear power plant in a 
transaction to which this section applies, the transferee's schedule of 
ruling amounts with respect to the interest acquired will be determined 
under the following rules:
    (i) Taxable year of disposition. If the transferee does not file a 
request for a schedule of ruling amounts on or before the deemed payment 
deadline for the taxable year of the transferee in which the disposition 
occurs (that is, the date that is two and one-half months after the 
close of that year), the transferee's ruling amount with respect to the 
interest acquired in the nuclear power plant for that year is equal to 
the amount contained in the transferor's current schedule of ruling 
amounts for that plant for the taxable year of the transferor in which 
the disposition occurred, multiplied by the product of--
    (A) The portion of the transferor's qualifying interest that is 
transferred; and
    (B) A fraction, the numerator of which is the number of days in the 
taxable year of the transferor including and following the date of 
disposition, and the denominator of which is the number of days in that 
taxable year.
    (ii) Taxable years after the year of disposition. A transferee of a 
qualifying interest in a nuclear power plant must file a request for a 
revised schedule of ruling amounts with respect to that interest on or 
before the deemed payment deadline for the first taxable year of the 
transferee beginning after the disposition. See Sec.  1.468A-
3(f)(1)(ii)(B). If the transferee does not timely file such a request, 
the transferee's ruling amount with respect to that interest for the 
affected year or years will be zero, unless the IRS waives the 
application of this paragraph (e)(2)(ii) upon a showing of good cause 
for the delay.
    (3) Examples. The following examples illustrate the provisions of 
this paragraph (e):

    Example 1. (i) X Corporation is a calendar year taxpayer engaged in 
the sale of electric

[[Page 409]]

energy generated by a nuclear power plant. The plant is owned entirely 
by X. On May 27, 2010, X transfers a 60-percent qualifying interest in 
the plant to Y Corporation, a calendar year taxpayer. Before the 
transfer, X had received a schedule of ruling amounts containing an 
annual ruling amount of $10 million for the taxable years 2005 through 
2025. For 2010, neither X nor Y files a request for a revised schedule 
of ruling amounts.
    (ii) Under paragraph (e)(1)(i) of this section, X's ruling amount 
for 2010 is calculated as follows: ($10,000,000 x .40) + ($10,000,000 x 
.60 x 146/365) = $6,400,000. Under paragraph (e)(2)(i) of this section, 
Y's ruling amount for 2010 is calculated as follows: $10,000,000 x .60 x 
219/365 = $3,600,000. Under paragraphs (e)(1)(iii) and (e)(2)(ii) of 
this section, X and Y must file requests for revised schedules of ruling 
amounts by March 15, 2012.
    Example 2. Y Corporation, the sole owner of a nuclear power plant, 
is a calendar year taxpayer. In year 1, Y elects to make a special 
transfer under section 468A(f)(1) to the nuclear decommissioning fund Y 
maintains with respect to the plant. The amount of the special transfer 
is $100 x , and the remaining useful life of the plant is 20 years. Y 
obtains a schedule of deduction amounts under Sec.  1.468A-8T(c) 
permitting a $5 x deduction each year over the 20-year remaining useful 
life, and deducts $5 x of the special transfer amount in year 1, year 2, 
year 3, and year 4. On the first day of year 5, Y transfers a 25% 
interest in the plant to an unrelated party. Under paragraph (c)(1)(ii) 
of this section, Y may deduct in Year 5 the unamortized special transfer 
deduction corresponding to the portion of the plant transferred (25 
percent of $80 x or $20 x ). In addition, under paragraph (e)(1)(ii) of 
this section, Y may deduct the portion of the deduction amount for year 
5 from the schedule of deduction amounts corresponding to its retained 
interest in the plant (75 percent of $5 x or $3.75 x ). Pursuant to 
paragraph (e)(1)(iii) of this section, Y must file a request for a 
revised schedule of ruling amounts by March 15 of year 7.

    (f) Anti-abuse provision. The IRS may treat a disposition as 
satisfying the requirements of this section if the IRS determines that 
this treatment is necessary or appropriate to carry out the purposes of 
section 468A and Sec. Sec.  1.468A-1 through 1.468A-9.

[T.D. 9512, 75 FR 80701, Dec. 23, 2010, as amended by 76 FR 3837, Jan. 
21, 2011]



Sec.  1.468A-7  Manner of and time for making election.

    (a) In general. An eligible taxpayer is allowed a deduction for the 
taxable year in which the taxpayer makes a cash payment (or is deemed to 
make a cash payment) to a nuclear decommissioning fund or for a special 
transfer under Sec.  1.468A-8 only if the taxpayer elects the 
application of section 468A. A separate election is required for each 
nuclear decommissioning fund and for each taxable year with respect to 
which payments are to be deducted under section 468A or a special 
transfer is made under Sec.  1.468A-8. In the case of an affiliated 
group of corporations that join in the filing of a consolidated return 
for a taxable year, the common parent must make a separate election on 
behalf of each member whose payments to a nuclear decommissioning fund 
during such taxable year are to be deducted under section 468A and each 
member that makes a special transfer under Sec.  1.468A-8 with respect 
to such year. The election under section 468A for any taxable year is 
irrevocable and must be made by attaching a statement (Election 
Statement) and a copy of the schedule of ruling amounts provided 
pursuant to the rules of Sec.  1.468A-3 to the taxpayer's Federal income 
tax return (or, in the case of an affiliated group of corporations that 
join in the filing of a consolidated return, the consolidated return) 
for such taxable year. The return to which the Election Statement and a 
copy of the schedule of ruling amounts is attached must be filed on or 
before the time prescribed by law (including extensions) for filing the 
return for the taxable year with respect to which payments are to be 
deducted under section 468A.
    (b) Required information. The Election Statement must include the 
following information:
    (1) The legend ``Election Under Section 468A'' typed or legibly 
printed at the top of the first page.
    (2) The electing taxpayer's name, address and taxpayer 
identification number (or, in the case of an affiliated group of 
corporations that join in the filing of a consolidated return, the name, 
address and taxpayer identification number of each electing taxpayer).
    (3) The taxable year for which the election is made.
    (4) For each nuclear decommissioning fund for which an election is 
made--

[[Page 410]]

    (i) The name and location of the nuclear power plant to which the 
fund relates;
    (ii) The name and employer identification number of the nuclear 
decommissioning fund;
    (iii) The total amount of actual cash payments made to the nuclear 
decommissioning fund during the taxable year that were not treated as 
deemed cash payments under Sec.  1.468A-2(c)(1) for a prior taxable 
year;
    (iv) The total amount of cash payments deemed made to the nuclear 
decommissioning fund under Sec.  1.468A-2(c)(1) for the taxable year;
    (v) The total amount of any special transfers (whether in cash or 
property) made to the nuclear decommissioning fund under Sec.  1.468A-8 
during the taxable year that were not treated as deemed transfers under 
Sec.  1.468A-8(a)(4) for a prior taxable year;
    (vi) The total amount of any special transfers (whether in cash or 
property) deemed made to the nuclear decommissioning fund under Sec.  
1.468A-8(a)(4) for the taxable year; and
    (vii) For each item of property included in the amounts described in 
paragraph (b)(4)((v) or (vi) of this section, the amount of the item of 
property and whether the basis of the item of property is determined 
under Sec.  1.468A-8(b)(5)(iii)(A) or Sec.  1.468A-8(b)(5)(iii)(B).

[T.D. 9512, 75 FR 80701, Dec. 23, 2010]



Sec.  1.468A-8  Special transfers to qualified funds pursuant to 
section 468A(f).

    (a) General rule--(1) In general. Under section 468A(f), a taxpayer 
maintaining a qualified nuclear decommissioning fund with respect to a 
nuclear power plant may transfer cash or property into the fund (a 
special transfer). The special transfer is not subject to the ruling 
amount limitation in section 468A(b) and is not treated as a cash 
payment for purposes of that limitation. Thus, a taxpayer may, in the 
same taxable year, pay the ruling amount and make a special transfer 
into the fund. A special transfer may be made in cash, property, or both 
cash and property. The amount of a special transfer (that is, the amount 
of cash and the fair market value of property transferred) may not 
exceed the present value of the pre-2005 nonqualifying amount of nuclear 
decommissioning costs with respect to the nuclear power plant. The 
taxpayer is entitled to a deduction against income for a special 
transfer, as described in paragraph (b) of this section. A special 
transfer may not be made to a nuclear decommissioning fund before the 
first taxable year in which a deduction amount is applicable to the 
nuclear decommissioning fund (see paragraph (c) of this section).
    (2) Pre-2005 nonqualifying amount--(i) In general. The present value 
of the pre-2005 nonqualifying amount of nuclear decommissioning costs 
with respect to a nuclear power plant is the amount equal to the pre-
2005 nonqualifying percentage of the present value of the estimated 
future decommissioning costs (as defined in Sec.  1.468A-1(b)(6)) with 
respect to the nuclear power plant as of the first day of the taxable 
year of the taxpayer in which the special transfer is made or deemed 
made (or a later date that is on or before the date on which the special 
transfer is expected to be made if the taxpayer establishes to the 
satisfaction of the IRS that the determination of present value as of 
such date is reasonable and consistent with the principles and 
provisions of this section). For this purpose, the pre-2005 
nonqualifying percentage for the plant is 100 percent reduced by the sum 
of--
    (A) The qualifying percentage (within the meaning of Sec.  1.468A-
3(d)(4) as in effect on December 31, 2005) used in determining the 
taxpayer's last schedule of ruling amounts for the nuclear 
decommissioning fund under the law in effect before the enactment of the 
Energy Policy Act of 2005 (that is, the percentage of the plant's total 
nuclear decommissioning costs that were permitted to be funded through 
the fund under the law in effect before the enactment of the Energy 
Policy Act of 2005); and
    (B) The percentage of decommissioning costs transferred in any 
previous special transfer (that is, the amount transferred as a 
percentage of the present value of the estimated future costs of 
decommissioning as of the

[[Page 411]]

first day of the taxable year in which such previous transfer was made).
    (ii) Pre-2005 nonqualifying amount of transferee. If there is a 
transfer of a nuclear decommissioning fund or part or all of its assets 
and Sec.  1.468A-6 applies to the transfer, the pre-2005 nonqualifying 
amount determined with respect to the transferee is equal to the pre-
2005 nonqualifying amount (or a proportionate part of the pre-2005 
nonqualifying amount) that would have been determined with respect to 
the transferor but for such transfer.
    (3) Transfers in multiple years. A taxpayer making a special 
transfer is not required to transfer the entire eligible amount in a 
single year. The requirements of paragraph (c) of this section apply 
separately to each year in which a special transfer is made. In 
calculating the amount of any subsequent transfer, the taxpayer must 
reduce the pre-2005 nonqualifying percentage under paragraph (a)(2) of 
this section to take into account all previous transfers. For example, 
if a taxpayer has a pre-2005 nonqualifying percentage of 40 percent, and 
transfers half of the eligible amount in a special transfer, any 
subsequent transfer must be calculated on the basis of a pre-2005 
nonqualifying percentage of 20 percent.
    (4) Deemed payment rules--(i) In general. The amount of any special 
transfer (whether in cash or property) described in Sec.  1.468A-8 and 
made by an electing taxpayer to a nuclear decommissioning fund on or 
before the 15th day of the third calendar month after the close of any 
taxable year (the deemed payment deadline date) shall be deemed made 
during such taxable year if the electing taxpayer irrevocably designates 
the amount as relating to such taxable year on its timely filed Federal 
income tax return for such taxable year or, in the case of special 
transfers described in paragraph (a)(4)(ii) of this section, on an 
amended return for such taxable year (see Sec.  1.468A-7(b)(4)(v) and 
(vi) for rules relating to such designation).
    (ii) Special rule for certain special transfers. Special transfers 
that the electing taxpayer designates as relating to a taxable year 
beginning after December 31, 2005, and ending before January 1, 2010, 
which are actually made within 90 days after the electing taxpayer 
receives a ruling from the Secretary relating to the special transfer 
are deemed made during the taxable year designated as the year to which 
the special transfer relates.
    (b) Deduction for amounts transferred--(1) In general. (i) Except as 
provided in this paragraph (b), the deduction for any special transfer 
is allowed ratably over the remaining useful life of the nuclear power 
plant. The amount of the deduction for any taxable year is the deduction 
amount for such year specified in the schedule of deduction amounts 
required under paragraph (c) of this section.
    (ii) For purposes of this paragraph (b), the remaining useful life 
of the nuclear power plant is the period beginning on the first day of 
the taxable year during which the transfer is made and ending on the 
last day of the taxable year that includes the last day of the estimated 
useful life of the nuclear power plant. The last day of the estimated 
useful life of the nuclear power plant is determined for this purpose 
under the rules of Sec.  1.468A-3(c)(2).
    (2) Amount of deduction--(i) General rule. Except as provided in 
this paragraph (b)(2), the deduction for property contributed in a 
special transfer is limited to the lesser of the fair market value of 
the property contributed or the taxpayer's basis in that property.
    (ii) Election--(A) In general. If the fair market value of the 
property contributed is less than the taxpayer's adjusted basis in such 
property as of the date the property is contributed and the fund elects 
to treat the fair market value of the property as its adjusted basis in 
the property, the taxpayer may deduct an amount equal to the adjusted 
basis of the contributed property.
    (B) Manner of making election. The election described in paragraph 
(b)(2)(ii)(A) of this section is made for property contributed in a 
special transfer by attaching a description of the property and a 
statement that the fund is making an election under Sec.  1.468A-
8(b)(2)(ii) with respect to the property to the return of the fund for 
the taxable year in which the property is contributed to the fund.

[[Page 412]]

    (C) Election allowed for property transferred prior to December 23, 
2010. The election described in paragraph (b)(2)(ii)(A) of this section 
may be made and a deduction equal to adjusted basis will be allowed for 
property contributed in a special transfer prior to December 23, 2010. 
The election in such a case may be made on an amended return of the fund 
for the taxable year in which the property is contributed to the fund 
and the transferor may amend previously filed returns to claim a 
deduction calculated by reference to the adjusted basis of the property.
    (3) Denial of deduction for previously deducted amounts. If a 
deduction (other than a deduction under section 468A) has been allowed 
to the taxpayer (or a predecessor) on account of expected 
decommissioning costs for a nuclear power plant (a nonconforming 
deduction) or an amount otherwise includible in income has been excluded 
from the gross income of the taxpayer (or a predecessor) on account of 
such expected decommissioning costs (a nonconforming exclusion), the 
deduction allowed for a special transfer to the nuclear decommissioning 
fund maintained with respect to the plant is reduced. In the case of a 
single special transfer of the full eligible amount, the reduction is 
equal to the aggregate amount of all nonconforming deductions and 
nonconforming exclusions. In the case of a transfer of less than the 
full eligible amount, the reduction is a ratable portion of such 
aggregate amount.
    (4) Transfers of qualified nuclear decommissioning funds. (i) If a 
special transfer is made to any qualified nuclear decommissioning fund, 
there is a subsequent transfer of the fund or the assets of the fund (a 
fund transfer), and Sec.  1.468-6 applies to the fund transfer, any 
amount of the deduction under paragraph (b) of this section allocable to 
taxable years ending after the date of the fund transfer will be allowed 
as a current deduction to the transferor for the taxable year that 
includes the date of the fund transfer. See Sec.  468A-6(c) for 
additional rules concerning transfers of decommissioning funds, 
including the transfer of a portion of the taxpayer's interest in a 
nuclear power plant. If a taxpayer transfers only part of the fund or 
the fund's assets, the rules in this paragraph (b)(4) apply only to the 
corresponding portion of the deduction under paragraph (b) of this 
section.
    (ii) If a deduction is allowed to the transferor under paragraph 
(b)(4)(i) of this section and the transferee is related to the 
transferor, the Internal Revenue Service (IRS) will not approve the 
transferee's schedule of ruling amounts for taxable years beginning 
after the date of the transfer unless the ruling amounts are deferred in 
a manner that results in recapture of the acceleration amount. For this 
purpose--
    (A) The acceleration amount is the difference between the deduction 
allowed under this paragraph (b)(4) and the present value as of the 
beginning of the acceleration period of the deductions that, but for the 
transfer, would have been allowed under this paragraph (b) for taxable 
years during the acceleration period;
    (B) The acceleration amount is recaptured if the aggregate present 
value of the ruling amounts at the beginning of the acceleration period 
is equal to the amount by which the aggregate present value of the 
ruling amounts that would have been approved but for this paragraph 
(b)(4)(ii) exceeds the acceleration amount;
    (C) The acceleration period is the period from the first day of the 
transferor's first taxable year beginning after the date of the transfer 
until the end of the plant's remaining useful life;
    (D) Present values will be determined using the assumptions that are 
used in determining the transferee's first schedule of ruling amounts; 
and
    (E) A transferor and a transferee are related if their relationship 
is specified in section 267(b) or section 707(b)(1) or they are treated 
as a single taxpayer under section 41(f)(1)(A) or (B).
    (5) Special rules--(i) Gain or loss not recognized on transfers to 
fund. No gain or loss will be recognized on any special transfer.
    (ii) Taxpayer basis in fund. Notwithstanding any other provision of 
the Internal Revenue Code (Code) and regulations, the taxpayer's basis 
in the fund is not increased by reason of the special transfer.

[[Page 413]]

    (iii) Fund basis in transferred property--(A) In general. Except as 
provided in paragraph (b)(5)(iii)(B) of this section, the fund's basis 
in any property transferred in a special transfer is the same as the 
transferor's basis in the property immediately before the transfer.
    (B) Basis in case of election. If a fund makes the election 
described in paragraph (b)(2)(ii) of this section, the fund's basis in 
the property transferred is the fair market value of the property on the 
date of transfer.
    (c) Schedule of deductions required--(1) In general. A taxpayer may 
not make a special transfer to a qualified nuclear decommissioning fund 
unless the taxpayer requests from the IRS a schedule of deduction 
amounts in connection with such transfer. A schedule of deduction 
amounts for a nuclear decommissioning fund (schedule of deduction 
amounts) is a ruling (within the meaning of Sec.  601.201(a)(2) of this 
chapter) specifying the annual deductions (deduction amounts) that, over 
the taxable years in the remaining useful life of the nuclear power 
plant, will result in the deduction of the entire amount of the special 
transfer. Such a request may be combined with a request for a schedule 
of ruling amounts under Sec.  1.468A-3(a). In the case of a combined 
request, the schedule of deduction amounts requested under this 
paragraph (c)(1) must be stated separately from the schedule of ruling 
amounts requested under Sec.  1.468A-3(a) and approval of the schedule 
of deduction amounts under this section will constitute a separate 
ruling. A request for a schedule of deduction amounts must comply with 
all provisions of paragraph (d) of this section.
    (2) Transfers in multiple taxable years. A taxpayer making a special 
transfer in more than one taxable year pursuant to paragraph (a)(3) of 
this section must request a separate schedule of deduction amounts in 
connection with each special transfer. More than one schedule of 
deduction amounts can be requested in a single ruling request to the 
Secretary and the Secretary will provide, in a single ruling, separate 
schedules of deduction amounts for each of a series of special transfers 
provided that each request for a separate schedule of deduction amounts 
complies with all requirements of this paragraph.
    (3) Transfer of partial interest in fund. If a taxpayer transfers 
part of a fund or a fund's assets and is allowed a deduction under 
paragraph (b)(3) of this section, the taxpayer must request a new 
schedule of deduction amounts in connection with the transfer.
    (4) Special transfer permitted before receipt of schedule. If an 
electing taxpayer has filed a timely request for a schedule of deduction 
amounts in connection with a special transfer for a taxable year and 
does not receive the schedule of deduction amounts before the deemed 
payment deadline for such taxable year, the taxpayer may make a special 
transfer to the nuclear decommissioning fund on the basis of the special 
transfer amount proposed in the taxpayer's request. If the schedule of 
deduction amounts provided by the Secretary is based on a special 
transfer amount that differs from the special transfer amount proposed 
in the taxpayer's request, rules similar to the rules of Sec.  1.468A-
3(g)(2) and (3) shall apply.
    (d) Manner of requesting schedule of deduction amounts--(1) In 
general. (i) In order to receive a deduction amount for any taxable 
year, a taxpayer must file a request for a schedule of deduction amounts 
that complies with the requirements of this paragraph (d), the 
applicable procedural rules set forth in Sec.  601.201(e) of this 
chapter (Statement of Procedural Rules) and the requirements of any 
applicable revenue procedure that is in effect on the date the request 
is filed.
    (ii) A separate request for a schedule of deduction amounts is 
required for each nuclear decommissioning fund established by a taxpayer 
(see Sec.  1.468A-5(a) for rules relating to the number of nuclear 
decommissioning funds that a taxpayer can establish).
    (iii) Except as provided by Sec.  1.468A-5(a)(1)(iv) (relating to 
certain unincorporated organizations that may be taxable as 
corporations) and Sec.  1.468A-3 (relating to a request for a schedule 
of ruling amounts), a request for a schedule of deduction amounts must 
not contain a request for a ruling on any other issue, whether the issue 
involves

[[Page 414]]

section 468A or another section of the Code.
    (iv) In the case of an affiliated group of corporations that join in 
the filing of a consolidated return, the common parent of the group may 
request a schedule of deduction amounts for each member of the group 
that possesses a qualifying interest in the same nuclear power plant by 
filing a single submission with the IRS.
    (v) Except as provided in paragraph (d)(1)(vi) of this section, the 
IRS will not provide or revise a deduction amount applicable to a 
taxable year in response to a request for a schedule of deduction 
amounts that is filed after the deemed payment deadline date (as defined 
in paragraph (a)(4) of this section) for such taxable year.
    (vi) For special transfers relating to taxable years beginning after 
December 31, 2005, and before January 1, 2010, the IRS will not provide 
a deduction amount in response to a request for a schedule of deduction 
amounts that is filed after February 22, 2011.
    (vii) Except as provided in paragraph (d)(1)(viii) of this section, 
a request for a schedule of deduction amounts shall be considered filed 
only if such request complies substantially with the requirements of 
this paragraph (d). In determining the date when a request is filed, the 
principles of sections 7502 and 7503 shall apply.
    (viii) If a request does not comply substantially with the 
requirements of this paragraph (d), the IRS will notify the taxpayer of 
that fact. If the information or materials necessary to comply 
substantially with the requirements of this paragraph (d) are provided 
to the IRS within 30 days after this notification, the request will be 
considered filed on the date of the original submission. In addition, 
the request will be considered filed on the date of the original 
submission in a case in which the information and materials are provided 
more than 30 days after the notification if the IRS determines that the 
electing taxpayer made a good faith effort to provide the applicable 
information or materials within 30 days after notification and also 
determines that treating the request as filed on the date of the 
original submission is consistent with the purposes of section 468A. In 
any other case in which the information or materials necessary to comply 
substantially with the requirements of this paragraph (d) are not 
provided within 30 days after the notification, the request will be 
considered filed on the date that all information or materials necessary 
to comply with the requirements of this paragraph (d) are provided.
    (2) Information required. A request for a schedule of deduction 
amounts must contain the following information:
    (i) The taxpayer's name, address and taxpayer identification number.
    (ii) Whether the request is for an initial schedule of deduction 
amounts or a schedule of deduction amounts for a subsequent special 
transfer.
    (iii) The name and location of the nuclear power plant with respect 
to which a schedule of deduction amounts is requested.
    (iv) A description of the taxpayer's qualifying interest in the 
nuclear power plant and the percentage of such nuclear power plant that 
the qualifying interest of the taxpayer represents.
    (v) The present value of the estimated future decommissioning costs 
(as defined in Sec.  1.468A-1(b)(6)) with respect to the taxpayer's 
qualifying interest in the nuclear power plant as of the first day of 
the taxable year of the taxpayer in which a transfer is made under this 
section.
    (vi) A description of the assumptions, estimates and other factors 
that were used by the taxpayer to determine the amount of 
decommissioning costs, including each of the following if applicable:
    (A) A description of the proposed method of decommissioning the 
nuclear power plant (for example, prompt removal/dismantlement, safe 
storage entombment with delayed dismantlement, or safe storage 
mothballing with delayed dismantlement).
    (B) The estimated year in which substantial decommissioning costs 
will first be incurred.
    (C) The estimated year in which the decommissioning of the nuclear 
power plant will be substantially complete (see Sec.  1.468A-5(d)(3) for 
a definition of substantial completion of decommissioning).

[[Page 415]]

    (D) The total estimated cost of decommissioning expressed in current 
dollars (that is, based on price levels in effect at the time of the 
current determination).
    (E) The total estimated cost of decommissioning expressed in future 
dollars (that is, based on anticipated price levels when expenses are 
expected to be paid).
    (F) For each taxable year in the period that begins with the year 
specified in paragraph (d)(2)(vi)(B) of this section (the estimated year 
in which substantial decommissioning costs will first be incurred) and 
ends with the year specified in paragraph (d)(2)(vi)(C) of this section 
(the estimated year in which the decommissioning of the nuclear power 
plant will be substantially complete), the estimated cost of 
decommissioning expressed in future dollars.
    (G) A description of the methodology used in converting the 
estimated cost of decommissioning expressed in current dollars to the 
estimated cost of decommissioning expressed in future dollars.
    (H) The assumed after-tax rate of return to be earned by the amounts 
collected for decommissioning.
    (I) A copy of each engineering or cost study that was relied on or 
used by the taxpayer in determining the amount of decommissioning costs.
    (vii) The taxpayer's pre-2005 nonqualifying percentage (as defined 
in paragraph (a)(2) of this section).
    (viii) The estimated useful life of the nuclear power plant (as such 
term is defined in paragraph (b)(1)(ii) or (iii) of this section).
    (ix) If the request is for a subsequent schedule of deduction 
amounts, the amount of the previous special transfer and the present 
value of the estimated future decommissioning costs (as defined in Sec.  
1.468A-1(b)(6)) with respect to the taxpayer's qualifying interest in 
the nuclear power plant as of the first day of the taxable year of the 
taxpayer in which the previous special transfer was made.
    (x) If the request is for a subsequent schedule of deduction 
amounts, a copy of all schedules of deduction amounts that relate to the 
nuclear power plant to which the request relates and that were 
previously issued to the taxpayer making the request.
    (xi) If the request for a schedule of deduction amounts contains a 
request, pursuant to Sec.  1.468A-5(a)(1)(iv), that the IRS rule whether 
an unincorporated organization through which the assets of the fund are 
invested is an association taxable as a corporation for Federal tax 
purposes, a copy of the legal documents establishing or otherwise 
governing the organization.
    (xii) Any other information required by the IRS that may be 
necessary or useful in determining the schedule of deduction amounts.
    (3) Statement required. A taxpayer requesting a schedule of 
deduction amounts under this paragraph (d) must submit a statement that 
any nonconforming deductions and nonconforming exclusions have reduced 
the deduction allowed for the special transfer in accordance with 
paragraph (b)(2) of this section.
    (4) Administrative procedures. The IRS may prescribe administrative 
procedures that supplement the provisions of paragraphs (d)(1) and (2) 
of this section. In addition, the IRS may, in its discretion, waive the 
requirements of paragraphs (d)(1) and (2) of this section under 
appropriate circumstances.

[T.D. 9512, 75 FR 80701, Dec. 23, 2010]



Sec.  1.468A-9  Applicability dates.

    (a) In general. Except as provided in paragraph (b) of this section, 
Sec. Sec.  1.468A-1 through 1.468A-8 are effective on December 23, 2010, 
and apply with respect to taxable years ending after such date.
    (b) Special rules--(1) Taxable years ending before December 23, 
2010. Special rules that are provided for taxable years ending on or 
before December 23, 2010, such as the special rule for certain special 
transfers contained in Sec.  1.468A-8(a)(4)(ii), apply with respect to 
such taxable years. In addition, except as provided in paragraph (2) of 
this section, a taxpayer may apply the provisions of Sec. Sec.  1.468A-1 
through 1.468A-8 with respect to a taxable year ending on or before 
December 23, 2010, if all such provisions are consistently applied.
    (2) Applicability of Sec.  1.468A-1(b)(6) and Sec.  1.468A-
5(b)(2)(i), (b)(2)(v), and (d)(3)(i). The rules in Sec. Sec.  1.468A-
1(b)(6) and 1.468A-

[[Page 416]]

5(b)(2)(i), (b)(2)(v), and (d)(3)(i) apply to taxable years ending on or 
after September 4, 2020. Taxpayers may also choose to apply the rules in 
Sec.  1.468A-1(b)(6) and Sec.  1.468A-5(b)(2)(i), (b)(2)(v), and 
(d)(3)(i) to prior taxable years for which a taxpayer's deemed payment 
deadline (as defined in Sec.  1.468A-2(c)(1)) has not passed prior to 
September 4, 2020.

[T.D. 9906, 85 FR 55190, Sept. 4, 2020]



Sec.  1.468B  Designated settlement funds.

    A designated settlement fund, as defined in section 468B(d)(2), is 
taxed in the manner described in Sec.  1.468B-2. The rules for 
transferors to a qualified settlement fund described in Sec.  1.468B-3 
apply to transferors to a designated settlement fund. Similarly, the 
rules for claimants of a qualified settlement fund described in Sec.  
1.468B-4 apply to claimants of a designated settlement fund. A fund, 
account, or trust that does not qualify as a designated settlement fund 
is, however, a qualified settlement fund if it meets the requirements of 
a qualified settlement fund described in Sec.  1.468B-1.

[T.D. 8459, 57 FR 60988, Dec. 23, 1992]



Sec.  1.468B-0  Table of contents.

    This section lists the table of contents for Sec. Sec.  1.468B-1 
through 1.468B-9.

               Sec.  1.468B-1 Qualified settlement funds.

    (a) In general.
    (b) Coordination with other entity classifications.
    (c) Requirements.
    (d) Definitions.
    (1) Transferor.
    (2) Related person.
    (e) Governmental order or approval requirement.
    (1) In general.
    (2) Arbitration panels.
    (f) Resolve or satisfy requirement.
    (1) Liabilities to provide property or services.
    (2) CERCLA liabilities.
    (g) Excluded liabilities.
    (h) Segregation requirement.
    (1) In general.
    (2) Classification of fund established to resolve or satisfy 
allowable and non-allowable claims.
    (i) [Reserved]
    (j) Classification of fund prior to satisfaction of requirements in 
paragraph (c) of this section.
    (1) In general.
    (2) Relation-back rule.
    (i) In general.
    (ii) Relation-back election.
    (k) Election to treat a qualified settlement fund as a subpart E 
trust.
    (1) In general.
    (2) Manner of making grantor trust election.
    (i) In general.
    (ii) Requirements for election statement.
    (3) Effect of making the election.
    (l) Examples.

   Sec.  1.468B-2 Taxation of qualified settlement funds and related 
                      administrative requirements.

    (a) In general.
    (b) Modified gross income.
    (c) Partnership interests held by a qualified settlement fund on 
February 14, 1992.
    (1) In general.
    (2) Limitation on changes in partnership agreements and capital 
contributions.
    (d) Distributions to transferors and claimants.
    (e) Basis of property transferred to a qualified settlement fund.
    (f) Distribution of property.
    (g) Other taxes.
    (h) Denial of credits against tax.
    (i) [Reserved]
    (j) Taxable year and accounting method.
    (k) Treatment as corporation for purposes of subtitle F.
    (l) Information reporting withholding requirements.
    (1) Payments to a qualified settlement fund.
    (2) Payments and distributions by a qualified settlement fund.
    (i) In general.
    (ii) Special rules.
    (m) Request for prompt assessment.
    (n) Examples.

           Sec.  1.468B-3 Rules applicable to the transferor.

    (a) Transfer of property.
    (1) In general.
    (2) Anti-abuse rule.
    (b) Qualified appraisal requirement for transfers of certain 
property.
    (1) In general.
    (2) Provision of copies.
    (3) Qualified appraisal.
    (4) Information included in a qualified appraisal.
    (5) Effect of signature of the qualified appraiser.
    (c) Economic performance.
    (1) In general.
    (2) Right to a refund or reversion.
    (i) In general.
    (ii) Right extinguished.
    (3) Obligations of a transferor.
    (d) Payment of insurance amounts.
    (e) Statement to the qualified settlement fund and the Internal 
Revenue Service.

[[Page 417]]

    (1) In general.
    (2) Required statement.
    (i) In general.
    (ii) Combined statements.
    (f) Distributions to transferors.
    (1) In general.
    (2) Deemed distributions.
    (i) Other liabilities.
    (ii) Constructive receipt.
    (3) Tax benefit rule.
    (g) Example.

        Sec.  1.468B-4 Taxability of distributions to claimants.

   Sec.  1.468B-5 Effective dates and transition rules applicable to 
                       qualified settlement funds.

    (a) In general.
    (b) Taxation of certain pre-1996 fund income.
    (1) Reasonable method.
    (i) In general.
    (ii) Qualified settlement funds established after February 14, 1992, 
but before January 1, 1993.
    (iii) Use of cash method of accounting.
    (iv) Unreasonable position.
    (v) Waiver of penalties.
    (2) Election to apply qualified settlement fund rules.
    (i) In general.
    (ii) Election statement.
    (iii) Due date of returns and amended returns.
    (iv) Computation of interest and waiver of penalties.
    (c) Grantor trust elections under Sec.  1.468B-1(k).
    (1) In general.
    (2) Transition rules.
    (3) Qualified settlement funds established by the U.S. government on 
or before February 3, 2006.

  Sec.  1.468B-6 Escrow accounts, trusts, and other funds used during 
   deferred exchanges of like-kind property under section 1031(a)(3).

    (a) Scope.
    (b) Definitions.
    (1) In general.
    (2) Exchange funds.
    (3) Exchange facilitator.
    (4) Transactional expenses.
    (i) In general.
    (ii) Special rule for certain fees for exchange facilitator 
services.
    (c) Taxation of exchange funds.
    (1) Exchange funds generally treated as loaned to an exchange 
facilitator.
    (2) Exchange funds not treated as loaned to an exchange facilitator.
    (i) Scope.
    (ii) Earnings attributable to the taxpayer's exchange funds.
    (A) Separately identified account.
    (B) Allocation of earnings in commingled accounts.
    (C) Transactional expenses.
    (iii) Treatment of the taxpayer.
    (d) Information reporting requirements.
    (e) Examples.
    (f) Effective/applicability dates.
    (1) In general.
    (2) Transition rule.

                   Sec.  1.468B-7 Pre-closing escrows.

    (a) Scope.
    (b) Definitions.
    (c) Taxation of pre-closing escrows.
    (d) Reporting obligations of the administrator.
    (e) Examples.
    (f) Effective dates.
    (1) In general.
    (2) Transition rule.

        Sec.  1.468B-8 Contingent-at-closing escrows. [Reserved]

                Sec.  1.468B-9 Disputed ownership funds.

    (a) Scope.
    (b) Definitions.
    (c) Taxation of a disputed ownership fund.
    (1) In general.
    (2) Exceptions.
    (3) Property received by the disputed ownership fund.
    (i) Generally excluded from income.
    (ii) Basis and holding period.
    (4) Property distributed by the disputed ownership fund.
    (i) Computing gain or loss.
    (ii) Denial of deduction.
    (5) Taxable year and accounting method.
    (6) Unused carryovers.
    (d) Rules applicable to transferors that are not transferor-
claimants.
    (1) Transfer of property.
    (2) Economic performance.
    (i) In general.
    (ii) Obligations of the transferor.
    (3) Distributions to transferors.
    (i) In general.
    (ii) Exception.
    (iii) Deemed distributions.
    (e) Rules applicable to transferor-claimants.
    (1) Transfer of property.
    (2) Economic performance.
    (i) In general.
    (ii) Obligations of the transferor-claimant.
    (3) Distributions to transferor-claimants.
    (i) In general.
    (ii) Deemed distributions.
    (f) Distributions to claimants other than transferor-claimants.
    (g) Statement to the disputed ownership fund and the Internal 
Revenue Service with respect to transfers of property other than cash.
    (1) In general.
    (2) Combined statements.
    (3) Information required on the statement.
    (h) Examples.

[[Page 418]]

    (i) [Reserved]
    (j) Effective dates.
    (1) In general.
    (2) Transition rule.

[T.D. 8459, 57 FR 60988, Dec. 23, 1992, as amended by T.D. 8495, 58 FR 
58787, Nov. 4, 1993; T.D. 9249, 71 FR 6200, Feb. 7, 2006; T.D. 9413, 73 
FR 39619, July 10, 2008]



Sec.  1.468B-1  Qualified settlement funds.

    (a) In general. A qualified settlement fund is a fund, account, or 
trust that satisfies the requirements of paragraph (c) of this section.
    (b) Coordination with other entity classifications. If a fund, 
account, or trust that is a qualified settlement fund could be 
classified as a trust within the meaning of Sec.  301.7701-4 of this 
chapter, it is classified as a qualified settlement fund for all 
purposes of the Internal Revenue Code (Code). If a fund, account, or 
trust, organized as a trust under applicable state law, is a qualified 
settlement fund, and could be classified as either an association 
(within the meaning of Sec.  301.7701-2 of this chapter) or a 
partnership (within the meaning of Sec.  301.7701-3 of this chapter), it 
is classified as a qualified settlement fund for all purposes of the 
Code. If a fund, account, or trust, established for contested 
liabilities pursuant to Sec.  1.461-2(c)(1) is a qualified settlement 
fund, it is classified as a qualified settlement fund for all purposes 
of the Code.
    (c) Requirements. A fund, account, or trust satisfies the 
requirements of this paragraph (c) if--
    (1) It is established pursuant to an order of, or is approved by, 
the United States, any state (including the District of Columbia), 
territory, possession, or political subdivision thereof, or any agency 
or instrumentality (including a court of law) of any of the foregoing 
and is subject to the continuing jurisdiction of that governmental 
authority;
    (2) It is established to resolve or satisfy one or more contested or 
uncontested claims that have resulted or may result from an event (or 
related series of events) that has occurred and that has given rise to 
at least one claim asserting liability--
    (i) Under the Comprehensive Environmental Response, Compensation and 
Liability Act of 1980 (hereinafter referred to as CERCLA), as amended, 
42 U.S.C. 9601 et seq.; or
    (ii) Arising out of a tort, breach of contract, or violation of law; 
or
    (iii) Designated by the Commissioner in a revenue ruling or revenue 
procedure; and
    (3) The fund, account, or trust is a trust under applicable state 
law, or its assets are otherwise segregated from other assets of the 
transferor (and related persons).
    (d) Definitions. For purposes of this section--
    (1) Transferor. A ``transferor'' is a person that transfers (or on 
behalf of whom an insurer or other person transfers) money or property 
to a qualified settlement fund to resolve or satisfy claims described in 
paragraph (c)(2) of this section against that person.
    (2) Related person. A ``related person'' is any person who is 
related to the transferor within the meaning of sections 267(b) or 
707(b)(1).
    (e) Governmental order or approval requirement--(1) In general. A 
fund, account, or trust is ``ordered by'' or ``approved by'' a 
governmental authority described in paragraph (c)(1) of this section 
when the authority issues its initial or preliminary order to establish, 
or grants its initial or preliminary approval of, the fund, account, or 
trust, even if that order or approval may be subject to review or 
revision. Except as otherwise provided in paragraph (j)(2) of this 
section, the governmental authority's order or approval has no 
retroactive effect and does not permit a fund, account, or trust to be a 
qualified settlement fund prior to the date the order is issued or the 
approval is granted.
    (2) Arbitration panels. An arbitration award that orders the 
establishment of, or approves, a fund, account, or trust is an order or 
approval of a governmental authority described in paragraph (c)(1) of 
this section if--
    (i) The arbitration award is judicially enforceable;
    (ii) The arbitration award is issued pursuant to a bona fide 
arbitration proceeding in accordance with rules that are approved by a 
governmental authority described in paragraph (c)(1) of this section 
(such as self-regulatory organization-administered arbitration

[[Page 419]]

proceedings in the securities industry); and
    (iii) The fund, account, or trust is subject to the continuing 
jurisdiction of the arbitration panel, the court of law that has 
jurisdiction to enforce the arbitration award, or the governmental 
authority that approved the rules of the arbitration proceeding.
    (f) Resolve or satisfy requirement--(1) Liabilities to provide 
services or property. Except as otherwise provided in paragraph (f)(2) 
of this section, a liability is not described in paragraph (c)(2) of 
this section if it is a liability for the provision of services or 
property, unless the transferor's obligation to provide services or 
property is extinguished by a transfer or transfers to the fund, 
account, or trust.
    (2) CERCLA liabilities. A transferor's liability under CERCLA to 
provide services or property is described in paragraph (c)(2) of this 
section if following its transfer to a fund, account, or trust the 
transferor's only remaining liability to the Environmental Protection 
Agency (if any) is a remote, future obligation to provide services or 
property.
    (g) Excluded liabilities. A liability is not described in paragraph 
(c)(2) of this section if it--
    (1) Arises under a workers compensation act or a self-insured health 
plan;
    (2) Is an obligation to refund the purchase price of, or to repair 
or replace, products regularly sold in the ordinary course of the 
transferor's trade or business;
    (3) Is an obligation of the transferor to make payments to its 
general trade creditors or debtholders that relates to a title 11 or 
similar case (as defined in section 368(a)(3)(A)), or a workout; or
    (4) Is designated by the Commissioner in a revenue ruling or a 
revenue procedure (see Sec.  601.601(d)(2)(ii)(b) of this chapter).
    (h) Segregation requirement--(1) In general. If it is not a trust 
under applicable state law, a fund, account, or trust satisfies the 
requirements of paragraph (c)(3) of this section if its assets are 
physically segregated from other assets of the transferor (and related 
persons). For example, cash held by a transferor in a separate bank 
account satisfies the segregation requirement of paragraph (c)(3) of 
this section.
    (2) Classification of fund established to resolve or satisfy 
allowable and non-allowable claims. If a fund, account, or trust is 
established to resolve or satisfy claims described in paragraph (c)(2) 
of this section as well as other types of claims (i.e., non-allowable 
claims) arising from the same event or related series of events, the 
fund is a qualified settlement fund. However, under Sec.  1.468B-3(c), 
economic performance does not occur with respect to transfers to the 
qualified settlement fund for non-allowable claims.
    (i) [Reserved]
    (j) Classification of fund prior to satisfaction of requirements in 
paragraph (c) of this section--(1) In general. If a fund, account, or 
trust is established to resolve or satisfy claims described in paragraph 
(c)(2) of this section, the assets of the fund, account, or trust are 
treated as owned by the transferor of those assets until the fund, 
account, or trust also meets the requirements of paragraphs (c) (1) and 
(3) of this section. On the date the fund, account, or trust satisfies 
all the requirements of paragraph (c) of this section, the transferor is 
treated as transferring the assets to a qualified settlement fund.
    (2) Relation-back rule--(i) In general. If a fund, account, or trust 
meets the requirements of paragraphs (c)(2) and (c)(3) of this section 
prior to the time it meets the requirements of paragraph (c)(1) of this 
section, the transferor and administrator (as defined in Sec.  1.468B-
2(k)(3)) may jointly elect (a relation-back election) to treat the fund, 
account, or trust as coming into existence as a qualified settlement 
fund on the later of the date the fund, account, or trust meets the 
requirements of paragraphs (c)(2) and (c)(3) of this section or January 
1 of the calendar year in which all the requirements of paragraph (c) of 
this section are met. If a relation-back election is made, the assets 
held by the fund, account, or trust on the date the qualified settlement 
fund is treated as coming into existence are treated as transferred to 
the qualified settlement fund on that date.
    (ii) Relation-back election. A relation-back election is made by 
attaching a copy of the election statement, signed

[[Page 420]]

by each transferor and the administrator, to (and as part of) the timely 
filed income tax return (including extensions) of the qualified 
settlement fund for the taxable year in which the fund is treated as 
coming into existence. A copy of the election statement must also be 
attached to (and as part of) the timely filed income tax return 
(including extensions), or an amended return that is consistent with the 
requirements of Sec. Sec.  1.468B-1 through 1.468B-4, of each transferor 
for the taxable year of the transferor that includes the date on which 
the qualified settlement fund is treated as coming into existence. The 
election statement must contain--
    (A) A legend, ``Sec.  1.468B-1 Relation-Back Election'', at the top 
of the first page;
    (B) Each transferor's name, address, and taxpayer identification 
number;
    (C) The qualified settlement fund's name, address, and employer 
identification number;
    (D) The date as of which the qualified settlement fund is treated as 
coming into existence; and
    (E) A schedule describing each asset treated as transferred to the 
qualified settlement fund on the date the fund is treated as coming into 
existence. The schedule of assets does not have to identify the amount 
of cash or the property treated as transferred by a particular 
transferor. If the schedule does not identify the transferor of each 
asset, however, each transferor must include with the copy of the 
election statement that is attached to its income tax return (or amended 
return) a schedule describing each asset the transferor is treated as 
transferring to the qualified settlement fund.
    (k) Election to treat a qualified settlement fund as a subpart E 
trust--(1) In general. If a qualified settlement fund has only one 
transferor (as defined in paragraph (d)(1) of this section), the 
transferor may make an election (grantor trust election) to treat the 
qualified settlement fund as a trust all of which is owned by the 
transferor under section 671 and the regulations thereunder. A grantor 
trust election may be made whether or not the qualified settlement fund 
would be classified, in the absence of paragraph (b) of this section, as 
a trust all of which is treated as owned by the transferor under section 
671 and the regulations thereunder. A grantor trust election may be 
revoked only for compelling circumstances upon consent of the 
Commissioner by private letter ruling.
    (2) Manner of making grantor trust election--(i) In general. To make 
a grantor trust election, a transferor must attach an election statement 
satisfying the requirements of paragraph (k)(2)(ii) of this section to a 
timely filed (including extensions) Form 1041, ``U.S. Income Tax Return 
for Estates and Trusts,'' that the administrator files on behalf of the 
qualified settlement fund for the taxable year in which the qualified 
settlement fund is established. However, if a Form 1041 is not otherwise 
required to be filed (for example, because the provisions of Sec.  
1.671-4(b) apply), then the transferor makes a grantor trust election by 
attaching an election statement satisfying the requirements of paragraph 
(k)(2)(ii) of this section to a timely filed (including extensions) 
income tax return of the transferor for the taxable year in which the 
qualified settlement fund is established. See Sec.  1.468B-5(c)(2) for 
transition rules.
    (ii) Requirements for election statement. The election statement 
must include a statement by the transferor that the transferor will 
treat the qualified settlement fund as a grantor trust. The election 
statement must include the transferor's name, address, taxpayer 
identification number, and the legend, ``Sec.  1.468B-1(k) Election.'' 
The election statement and the statement described in Sec.  1.671-4(a) 
may be combined into a single statement.
    (3) Effect of making the election. If a grantor trust election is 
made--
    (i) Paragraph (b) of this section, and Sec. Sec.  1.468B-2, 1.468B-
3, and 1.468B-5(a) and (b) do not apply to the qualified settlement 
fund. However, this section (except for paragraph (b) of this section) 
and Sec.  1.468B-4 apply to the qualified settlement fund;
    (ii) The qualified settlement fund is treated, for Federal income 
tax purposes, as a trust all of which is treated as owned by the 
transferor under section 671 and the regulations thereunder;

[[Page 421]]

    (iii) The transferor must take into account in computing the 
transferor's income tax liability all items of income, deduction, and 
credit (including capital gains and losses) of the qualified settlement 
fund in accordance with Sec.  1.671-3(a)(1); and
    (iv) The reporting obligations imposed by Sec.  1.671-4 on the 
trustee of a trust apply to the administrator.
    (l) Examples. The following examples illustrate the rules of this 
section:

    Example 1. In a class action brought in a United States federal 
district court, the court holds that the defendant, Corporation X, 
violated certain securities laws and must pay damages in the amount of 
$150 million. Pursuant to an order of the court, Corporation X transfers 
$50 million in cash and transfers property with a fair market value of 
$75 million to a state law trust. The trust will liquidate the property 
and distribute the cash proceeds to the plaintiffs in the class action. 
The trust is a qualified settlement fund because it was established 
pursuant to the order of a federal district court to resolve or satisfy 
claims against Corporation X for securities law violations that have 
occurred.
    Example 2. (i) Assume the same facts as in Example 1, except that 
Corporation X and the class of plaintiffs reach an out-of-court 
settlement that requires Corporation X to establish and fund a state law 
trust before the settlement agreement is submitted to the court for 
approval.
    (ii) The trust is not a qualified settlement fund because it neither 
is established pursuant to an order of, nor has it been approved by, a 
governmental authority described in paragraph (c)(1) of this section.
    Example 3. On June 1, 1994, Corporation Y establishes a fund to 
resolve or satisfy claims against it arising from the violation of 
certain securities laws. On that date, Corporation Y transfers $10 
million to a segregated account. On December 1, 1994, a federal district 
court approves the fund. Assuming Corporation Y and the administrator of 
the qualified settlement fund do not make a relation-back election, 
Corporation Y is treated as the owner of the $10 million, and is taxable 
on any income earned on that money, from June 1 through November 30, 
1994. The fund is a qualified settlement fund beginning on December 1, 
1994.
    Example 4. (i) On September 1, 1993, Corporation X, which has a 
taxable year ending on October 31, enters into a settlement agreement 
with a plaintiff class for asserted tort liabilities. Under the 
settlement agreement, Corporation X makes two $50 million payments into 
a segregated fund, one on September 1, 1993, and one on October 1, 1993, 
to resolve or satisfy the tort liabilities. A federal district court 
approves the settlement agreement on November 1, 1993.
    (ii) The administrator of the fund and Corporation X elect to treat 
the fund as a qualified settlement fund prior to governmental approval 
under the relation-back rule of paragraph (j)(2) of this section. The 
administrator must attach the relation-back election statement to the 
fund's income tax return for calendar year 1993, and Corporation X must 
attach the election to its original or amended income tax return for its 
taxable year ending October 31, 1993.
    (iii) Pursuant to the relation-back election, the fund begins its 
existence as a qualified settlement fund on September 1, 1993, and 
Corporation X is treated as transferring $50 million to the qualified 
settlement fund on September 1, 1993, and $50 million on October 1, 
1993.
    (iv) With respect to these transfers, Corporation X must provide the 
statement described in Sec.  1.468B-3(e) to the administrator of the 
qualified settlement fund by February 15, 1994, and must attach a copy 
of this statement to its original or amended income tax return for its 
taxable year ending October 31, 1993.
    Example 5. Assume the same facts as in Example 4, except that the 
court approves the settlement on May 1, 1994. The administrator must 
attach the relation-back election statement to the fund's income tax 
return for calendar year 1994, and Corporation X must attach the 
election statement to its original or amended income tax return for its 
taxable year ending October 31, 1994. Pursuant to this election, the 
fund begins its existence as a qualified settlement fund on January 1, 
1994. In addition, Corporation X is treated as transferring to the 
qualified settlement fund all amounts held in the fund on January 1, 
1994. With respect to the transfer, Corporation X must provide the 
statement described in Sec.  1.468B-3(e) to the administrator of the 
qualified settlement fund by February 15, 1995, and must attach a copy 
of this statement to its income tax return for its taxable year ending 
October 31, 1994.
    Example 6. Corporation Z establishes a fund that meets all the 
requirements of section 468B(d)(2) for a designated settlement fund, 
except that Corporation Z does not make the election under section 
468B(d)(2)(F). Although the fund does not qualify as a designated 
settlement fund, it is a qualified settlement fund because the fund 
meets the requirements of paragraph (c) of this section.
    Example 7. Corporation X owns and operates a landfill in State A. 
State A requires Corporation X to transfer money to a trust annually 
based on the total tonnage of material placed in the landfill during the 
year. Under the laws of State A, Corporation X will be required to 
perform (either itself or through contractors) specified closure 
activities when the landfill is full, and the trust

[[Page 422]]

assets will be used to reimburse Corporation X for those closure costs. 
The trust is not a qualified settlement fund because it is established 
to secure the liability of Corporation X to perform the closure 
activities.

[T.D. 8459, 57 FR 60989, Dec. 23, 1992; 58 FR 7865, Feb. 10, 1993, as 
amended by T.D. 9249, 71 FR 6201, Feb. 7, 2006]



Sec.  1.468B-2  Taxation of qualified settlement funds and related 
administrative requirements.

    (a) In general. A qualified settlement fund is a United States 
person and is subject to tax on its modified gross income for any 
taxable year at a rate equal to the maximum rate in effect for that 
taxable year under section 1(e).
    (b) Modified gross income. The ``modified gross income'' of a 
qualified settlement fund is its gross income, as defined in section 61, 
computed with the following modifications--
    (1) In general, amounts transferred to the qualified settlement fund 
by, or on behalf of, a transferor to resolve or satisfy a liability for 
which the fund is established are excluded from gross income. However, 
dividends on stock of a transferor (or a related person), interest on 
debt of a transferor (or a related person), and payments in compensation 
for late or delayed transfers, are not excluded from gross income.
    (2) A deduction is allowed for administrative costs and other 
incidental expenses incurred in connection with the operation of the 
qualified settlement fund that would be deductible under chapter 1 of 
the Internal Revenue Code in determining the taxable income of a 
corporation. Administrative costs and other incidental expenses include 
state and local taxes, legal, accounting, and actuarial fees relating to 
the operation of the qualified settlement fund, and expenses arising 
from the notification of claimants and the processing of their claims. 
Administrative costs and other incidental expenses do not include legal 
fees incurred by, or on behalf of, claimants.
    (3) A deduction is allowed for losses sustained by the qualified 
settlement fund in connection with the sale, exchange, or worthlessness 
of property held by the fund to the extent the losses would be 
deductible in determining the taxable income of a corporation under 
section 165 (f) or (g), and sections 1211(a) and 1212(a).
    (4) A deduction is allowed for the amount of a net operating loss of 
the qualified settlement fund to the extent the loss would be deductible 
in determining the taxable income of a corporation under section 172(a). 
For purposes of this paragraph (b)(4), the net operating loss of a 
qualified settlement fund for a taxable year is the amount by which the 
deductions allowed under paragraphs (b)(2) and (b)(3) of this section 
exceed the gross income of the fund computed with the modification 
described in paragraph (b)(1) of this section.
    (c) Partnership interests held by a qualified settlement fund on 
February 14, 1992--(1) In general. For taxable years ending prior to 
January 1, 2003, a qualified settlement fund that holds a partnership 
interest it acquired prior to February 15, 1992, is allowed a deduction 
for its distributive share of that partnership's items of loss, 
deduction, or credit described in section 702(a) that would be 
deductible in determining the taxable income (or in the case of a 
credit, the income tax liability) of a corporation to the extent of the 
fund's distributive share of that partnership's items of income and gain 
described in section 702(a) for the same taxable year. For purposes of 
this paragraph (c)(1), a distributive share of a partnership credit is 
treated as a deduction in an amount equal to the amount of the credit 
divided by the rate described in paragraph (a) of this section.
    (2) Limitation on changes in partnership agreements and capital 
contributions. For purposes of paragraph (c)(1) of this section, changes 
in a qualified settlement fund's distributive share of items of income, 
gain, loss, deduction, or credit are disregarded if--
    (i) They result from a change in the terms of the partnership 
agreement on or after December 18, 1992, or a capital contribution to 
the partnership on or after December 18, 1992, unless the partnership 
agreement as in effect prior to December 18, 1992, requires the 
contribution; and
    (ii) A principal purpose of the change in the terms of the 
partnership agreement or the capital contribution is to

[[Page 423]]

circumvent the limitation described in paragraph (c)(1) of this section.
    (d) Distributions to transferors and claimants. Amounts that are 
distributed by a qualified settlement fund to, or on behalf of, a 
transferor or a claimant are not deductible by the fund.
    (e) Basis of property transferred to a qualified settlement fund. A 
qualified settlement fund's initial basis in property it receives from a 
transferor (or from an insurer or other person on behalf of a 
transferor) is the fair market value of that property on the date of 
transfer to the fund.
    (f) Distribution of property. A qualified settlement fund must treat 
a distribution of property as a sale or exchange of that property for 
purposes of section 1001(a). In computing gain or loss, the amount 
realized by the qualified settlement fund is the fair market value of 
the property on the date of distribution.
    (g) Other taxes. The tax imposed under paragraph (a) of this section 
is in lieu of any other taxation of the income of a qualified settlement 
fund under subtitle A of the Internal Revenue Code. Thus, a qualified 
settlement fund is not subject to the alternative minimum tax of section 
55, the accumulated earnings tax of section 531, the personal holding 
company tax of section 541, or the maximum capital gains rate of section 
1(h). A qualified settlement fund is, however, subject to taxes that are 
not imposed on the income of a taxpayer, such as the tax on transfers of 
property to foreign entities under section 1491.
    (h) Denial of credits against tax. The tax imposed on the modified 
gross income of a qualified settlement fund under paragraph (a) of this 
section may not be reduced or offset by any credits against tax provided 
by part IV of subchapter A of chapter 1 of the Internal Revenue Code.
    (i) [Reserved]
    (j) Taxable year and accounting method. The taxable year of a 
qualified settlement fund is the calendar year. A qualified settlement 
fund must use an accrual method of accounting within the meaning of 
section 446(c).
    (k) Treatment as corporation for purposes of subtitle F. Except as 
otherwise provided in Sec.  1.468B-5(b), for purposes of subtitle F of 
the Internal Revenue Code, a qualified settlement fund is treated as a 
corporation and any tax imposed under paragraph (a) of this section is 
treated as a tax imposed by section 11. Subtitle F rules that apply to 
qualified settlement funds include, but are not limited to--
    (1) A qualified settlement fund must file an income tax return with 
respect to the tax imposed under paragraph (a) of this section for each 
taxable year that the fund is in existence, whether or not the fund has 
gross income for that taxable year.
    (2) A qualified settlement fund is in existence for the period 
that--
    (i) Begins on the first date on which the fund is treated as a 
qualified settlement fund under Sec.  1.468B-1; and
    (ii) Ends on the earlier of the date the fund--
    (A) No longer satisfies the requirements of Sec.  1.468B-1; or
    (B) No longer has any assets and will not receive any more 
transfers. (See paragraph (m) of this section for procedures for the 
prompt assessment of tax.)
    (3) The income tax return of the qualified settlement fund must be 
filed on or before March 15 of the year following the close of the 
taxable year of the qualified settlement fund unless the fund is granted 
an extension of time for filing under section 6081. The return must be 
made by the administrator of the qualified settlement fund. The 
``administrator'' (which may include a trustee if the qualified 
settlement fund is a trust) of a qualified settlement fund is, in order 
of priority--
    (i) The person designated, or approved, by the governmental 
authority that ordered or approved the fund for purposes of Sec.  
1.468B-1(c)(1);
    (ii) The person designated in the escrow agreement, settlement 
agreement, or other similar agreement governing the fund;
    (iii) The escrow agent, custodian, or other person in possession or 
control of the fund's assets; or
    (iv) The transferor or, if there are multiple transferors, all the 
transferors, unless an agreement signed by all the transferors 
designates a single transferor as the administrator.

[[Page 424]]

    (4) The administrator of a qualified settlement fund must obtain an 
employer identification number for the fund.
    (5) A qualified settlement fund must deposit all payments of tax 
imposed under paragraph (a) of this section (including any payments of 
estimated tax) with an authorized government depositary in accordance 
with Sec.  1.6302-1.
    (6) A qualified settlement fund is subject to the addition to tax 
imposed by section 6655 in the case of an underpayment of estimated tax 
computed with respect to the tax imposed under paragraph (a) of this 
section. For purposes of section 6655(g)(2), a qualified settlement 
fund's taxable income is its modified gross income and a transferor is 
not considered a predecessor of a qualified settlement fund.
    (l) Information reporting and withholding requirements--(1) Payments 
to a qualified settlement fund. Payments to a qualified settlement fund 
are treated as payments to a corporation for purposes of the information 
reporting requirements of part III of subchapter A of chapter 61 of the 
Internal Revenue Code.
    (2) Payments and distributions by a qualified settlement fund--(i) 
In general. Payments and distributions by a qualified settlement fund 
are subject to the information reporting requirements of part III of 
subchapter A of chapter 61 of the Internal Revenue Code (Code), and the 
withholding requirements of subchapter A of chapter 3 of subtitle A and 
subtitle C of the Code.
    (ii) Special rules. The following rules apply with respect to 
payments and distributions by a qualified settlement fund--
    (A) A qualified settlement fund must make a return for, or must 
withhold tax on, a distribution to a claimant if one or more transferors 
would have been required to make a return or withhold tax had that 
transferor made the distribution directly to the claimant;
    (B) For purposes of sections 6041(a) and 6041A, if a qualified 
settlement fund makes a payment or distribution to a transferor, the 
fund is deemed to make the payment or distribution to the transferor in 
the course of a trade or business;
    (C) For purposes of sections 6041(a) and 6041A, if a qualified 
settlement fund makes a payment or distribution on behalf of a 
transferor or a claimant, the fund is deemed to make the payment or 
distribution to the recipient of that payment or distribution in the 
course of a trade or business;
    (D) With respect to a distribution or payment described in paragraph 
(1)(2)(ii)(C) of this section and the information reporting requirements 
of part III of subchapter A of chapter 61 of the Internal Revenue Code, 
the qualified settlement fund is also deemed to have made the 
distribution or payment to the transferor or claimant.
    (m) Request for prompt assessment. A qualified settlement fund is 
eligible to request the prompt assessment of tax under section 6501(d). 
For purposes of section 6501(d), a qualified settlement fund is treated 
as dissolving on the date the fund no longer has any assets (other than 
a reasonable reserve for potential tax liabilities and related 
professional fees) and will not receive any more transfers.
    (n) Examples. The following examples illustrate the rules of this 
section:

    Example 1. On June 30, 1993, a United States federal district court 
approves the settlement of a lawsuit under which Corporation X must 
transfer $10,833,000 to a qualified settlement fund on August 1, 1993. 
The $10,833,000 includes $10 million of damages incurred by plaintiffs 
on October 1, 1992, and $833,000 of interest calculated at 10 percent 
annually from October 1, 1992, to August 1, 1993. The $833,000 of 
interest is not a payment to the qualified settlement fund in 
compensation for a late or delayed transfer to the fund within the 
meaning of paragraph (b)(1) of this section because the payment of 
$10,833,000 to the fund is not due until August 1, 1993.
    Example 2. Assume the same facts as in Example 1 except that the 
settlement agreement also provides for interest to accrue at a rate of 
12 percent annually on any amount not transferred to the qualified 
settlement fund on August 1, 1993, and the only transfer Corporation X 
makes to the fund is $11,374,650 on January 1, 1994. The additional 
payment of $541,650 ($11,374,650 paid on January 1, 1994, less 
$10,833,000 due on August 1, 1993) is a payment to the qualified 
settlement fund in compensation for a late or delayed transfer to the 
fund within the meaning of paragraph (b)(1) of this section.

[T.D. 8459, 57 FR 60991, Dec. 23, 1992; 58 FR 7865, Feb. 10, 1993]

[[Page 425]]



Sec.  1.468B-3  Rules applicable to the transferor.

    (a) Transfer of property--(1) In general. A transferor must treat a 
transfer of property to a qualified settlement fund as a sale or 
exchange of that property for purposes of section 1001(a). In computing 
the gain or loss, the amount realized by the transferor is the fair 
market value of the property on the date the transfer is made (or is 
treated as made under Sec.  1.468B-1(g)) to the qualified settlement 
fund. Because the issuance of a transferor's debt, obligation to provide 
services or property in the future, or obligation to make a payment 
described in Sec.  1.461-4(g), is generally not a transfer of property 
by the transferor, it generally does not result in gain or loss to the 
transferor under this paragraph (a)(1). If a person other than the 
transferor transfers property to a qualified settlement fund, there may 
be other tax consequences as determined under general federal income tax 
principles.
    (2) Anti-abuse rule. The Commissioner may disallow a loss resulting 
from the transfer of property to a qualified settlement fund if the 
Commissioner determines that a principal purpose for the transfer was to 
claim the loss and--
    (i) The transferor places significant restrictions on the fund's 
ability to use or dispose of the property; or
    (ii) The property (or substantially similar property) is distributed 
to the transferor (or a related person).
    (b) Qualified appraisal requirement for transfers of certain 
property--(1) In general. A transferor must obtain a qualified appraisal 
to support a loss or deduction it claims with respect to a transfer to a 
qualified settlement fund of the following types of property--
    (i) Nonpublicly traded securities (as defined in Sec.  1.170A-
13(c)(7)(ix)) issued by the transferor (or a related person); and
    (ii) Interests in the transferor (if the transferor is a 
partnership) and in a partnership in which the transferor (or a related 
person) is a direct or indirect partner.
    (2) Provision of copies. The transferor must provide a copy of the 
qualified appraisal to the administrator of the qualified settlement 
fund no later than February 15 of the year following the calendar year 
in which the property is transferred. The transferor also must attach a 
copy of the qualified appraisal to (and as part of) its timely filed 
income tax return (including extensions) for the taxable year of the 
transferor in which the transfer is made.
    (3) Qualified appraisal. A ``qualified appraisal'' is a written 
appraisal that--
    (i) Is made within 60 days before or after the date the property is 
transferred to the qualified settlement fund;
    (ii) Is prepared, signed, and dated by an individual who is a 
qualified appraiser within the meaning of Sec.  1.170A-13(c)(5);
    (iii) Includes the information required by paragraph (b)(4) of this 
section; and
    (iv) Does not involve an appraisal fee of the type prohibited by 
Sec.  1.170A-13(c)(6).
    (4) Information included in a qualified appraisal. A qualified 
appraisal must include the following information--
    (i) A description of the appraised property;
    (ii) The date (or expected date) of the property's transfer to the 
qualified settlement fund;
    (iii) The appraised fair market value of the property on the date 
(or expected date) of transfer;
    (iv) The method of valuing the property, such as the comparable 
sales approach;
    (v) The specific basis for the valuation, such as specific 
comparable sales or statistical sampling, including a justification for 
using comparable sales or statistical sampling and an explanation of the 
procedure employed;
    (vi) The terms of any agreement or understanding entered into (or 
expected to be entered into) by or on behalf of the transferor (or a 
related person) or the qualified settlement fund that relates to the 
use, sale, or other disposition of the transferred property, including, 
for example, the terms of any agreement or understanding that 
temporarily or permanently--
    (A) Restricts the qualified settlement fund's right to use or 
dispose of the property; or
    (B) Reserves to, or confers upon, any person other than the 
qualified settlement fund any right (including designating another 
person as having the

[[Page 426]]

right) to income from the property, to possess the property (including 
the right to purchase or otherwise acquire the property), or to exercise 
any voting rights with respect to the property;
    (vii) The name, address, and taxpayer identification number of the 
qualified appraiser; and if the qualified appraiser is acting in his or 
her capacity as a partner in a partnership, an employee of any person, 
or an independent contractor engaged by a person other than the 
transferor, the name, address, and taxpayer identification number of the 
partnership or the person who employs or engages the qualified 
appraiser;
    (viii) The qualifications of the qualified appraiser, including the 
appraiser's background, experience, education, and membership, if any, 
in professional appraisal associations; and
    (ix) A statement that the appraisal was prepared for income tax 
purposes.
    (5) Effect of signature of the qualified appraiser. Any appraiser 
who falsely or fraudulently overstates the value of the transferred 
property referred to in a qualified appraisal may be subject to a civil 
penalty under section 6701 for aiding and abetting an understatement of 
tax liability and may have appraisals disregarded pursuant to 31 U.S.C. 
330(c).
    (c) Economic performance--(1) In general. Except as otherwise 
provided in this paragraph (c), for purposes of section 461(h), economic 
performance occurs with respect to a liability described in Sec.  
1.468B-1(c)(2) (determined with regard to Sec.  1.468B-1(f) and (g)) to 
the extent the transferor makes a transfer to a qualified settlement 
fund to resolve or satisfy the liability.
    (2) Right to a refund or reversion--(i) In general. Economic 
performance does not occur to the extent--
    (A) The transferor (or a related person) has a right to a refund or 
reversion of a transfer if that right is exercisable currently and 
without the agreement of an unrelated person that is independent or has 
an adverse interest (e.g., the court or agency that approved the fund, 
or the fund claimants); or
    (B) Money or property is transferred under conditions that allow its 
refund or reversion by reason of the occurrence of an event that is 
certain to occur, such as the passage of time, or if restrictions on its 
refund or reversion are illusory.
    (ii) Right extinguished. With respect to a transfer described in 
paragraph (c)(2)(i) of this section, economic performance is deemed to 
occur on the date, and to the extent, the transferor's right to a refund 
or reversion is extinguished.
    (3) Obligations of a transferor. Economic performance does not occur 
when a transferor transfers to a qualified settlement fund its debt (or 
the debt of a related person). Instead, economic performance occurs as 
the transferor (or related person) makes principal payments on the debt. 
Similarly, economic performance does not occur when a transferor 
transfers to a qualified settlement fund its obligation (or the 
obligation of a related person) to provide services or property in the 
future, or to make a payment described in Sec.  1.461-4(g). Instead, 
economic performance with respect to such an obligation occurs as 
services, property or payments are provided or made to the qualified 
settlement fund or a claimant.
    (d) Payment of insurance amounts. No deduction is allowed to a 
transferor for a transfer to a qualified settlement fund to the extent 
the transferred amounts represent amounts received from the settlement 
of an insurance claim and are excludable from gross income. If the 
settlement of an insurance claim occurs after a transferor makes a 
transfer to a qualified settlement fund for which a deduction has been 
taken, the transferor must include in income the amounts received from 
the settlement of the insurance claim to the extent of the deduction.
    (e) Statement to the qualified settlement fund and the Internal 
Revenue Service--(1) In general. A transferor must provide the statement 
described in paragraph (e)(2) of this section to the administrator of a 
qualified settlement fund no later than February 15 of the year 
following each calendar year in which the transferor (or an insurer or 
other person on behalf of the transferor) makes a transfer to the fund. 
The transferor must attach a copy of the statement to (and as part of) 
its

[[Page 427]]

timely filed income tax return (including extensions) for the taxable 
year of the transferor in which the transfer is made.
    (2) Required statement--(i) In general. The statement required by 
this paragraph (e) must provide the following information--
    (A) A legend, ``Sec.  1.468B-3 Statement'', at the top of the first 
page;
    (B) The transferor's name, address, and taxpayer identification 
number;
    (C) The qualified settlement fund's name, address, and employer 
identification number;
    (D) The date of each transfer;
    (E) The amount of cash transferred; and
    (F) A description of property transferred and its fair market value 
on the date of transfer.
    (ii) Combined statements. If a qualified settlement fund has more 
than one transferor, any two or more of the transferors may provide a 
combined statement to the administrator that does not identify the 
amount of cash or the property transferred by a particular transferor. 
If a combined statement is used, however, each transferor must include 
with its copy of the statement that is attached to its income tax return 
a schedule describing each asset that the transferor transferred to the 
qualified settlement fund.
    (f) Distributions to transferors--(1) In general. A transferor must 
include in gross income any distribution (including a deemed 
distribution described in paragraph (f)(2) of this section) it receives 
from a qualified settlement fund. If property is distributed, the amount 
includible in gross income and the basis in that property, is the fair 
market value of the property on the date of the distribution.
    (2) Deemed distributions--(i) Other liabilities. If a qualified 
settlement fund makes a distribution on behalf of a transferor to a 
person that is not a claimant, or to a claimant to resolve or satisfy a 
liability of the transferor (or a related person) other than a liability 
described in Sec.  1.468B-1(c)(2) for which the fund was established, 
the distribution is deemed made by the fund to the transferor. The 
transferor, in turn, is deemed to have made a payment to the actual 
recipient.
    (ii) Constructive receipt. To the extent a transferor acquires a 
right to a refund or reversion described in paragraph (c)(2) of this 
section of all or a portion of the assets of a qualified settlement fund 
subsequent to the transfer of those assets to the fund, the fund is 
deemed to distribute those assets to the transferor on the date the 
right is acquired.
    (3) Tax benefit rule. A distribution described in paragraph (f)(1) 
or (f)(2) of this section is excluded from the gross income of a 
transferor to the extent provided by section 111(a).
    (g) Example. The following example illustrates the rules of this 
section:

    Example. On March 1, 1993, Individual A transfers $1 million to a 
qualified settlement fund to resolve or satisfy claims against him 
resulting from certain violations of securities laws. Individual A uses 
the cash receipts and disbursements method of accounting. Since 
Individual A does not use the accrual method of accounting, the economic 
performance rules of paragraph (c) of this section are not applicable. 
Therefore, whether, when, and to what extent Individual A can deduct the 
transfer is determined under applicable provisions of the Internal 
Revenue Code, such as sections 162 and 461.

[T.D. 8459, 57 FR 60992, Dec. 23, 1992]



Sec.  1.468B-4  Taxability of distributions to claimants.

    Whether a distribution to a claimant is includible in the claimant's 
gross income is generally determined by reference to the claim in 
respect of which the distribution is made and as if the distribution 
were made directly by the transferor. For example, to the extent a 
distribution is in satisfaction of damages on account of personal injury 
or sickness, the distribution may be excludable from gross income under 
section 104(a)(2). Similarly, to the extent a distribution is in 
satisfaction of a claim for foregone taxable interest, the distribution 
is includible in the claimant's gross income under section 61(a)(4).

[T.D. 8459, 57 FR 60994, Dec. 23, 1992]



Sec.  1.468B-5  Effective dates and transition rules applicable to 
qualified settlement funds.

    (a) In general. Section 468B, including section 468B(g), is 
effective as provided in the Tax Reform Act of 1986 and the

[[Page 428]]

Technical and Miscellaneous Revenue Act of 1988. Except as otherwise 
provided in this section, Sec. Sec.  1.468B-1 through 1.468-4 are 
effective on January 1, 1993. Thus, the regulations apply to income of a 
qualified settlement fund earned after December 31, 1992, transfers to a 
fund after December 31, 1992, and distributions from a fund after 
December 31, 1992. For purposes of Sec.  1.468B-3(c) (relating to 
economic performance), previously transferred assets held by a qualified 
settlement fund on the date these regulations first apply to the fund 
(i.e., January 1, 1993, or the earlier date provided under paragraph 
(b)(2) of this section) are treated as transferred to the fund on that 
date, to the extent no taxpayer has previously claimed a deduction for 
the transfer.
    (b) Taxation of certain pre-1996 fund income--(1) Reasonable 
method--(i) In general. With respect to a fund, account, or trust 
established after August 16, 1986, but prior to February 15, 1992, that 
satisfies (or, if it no longer exists, would have satisfied) the 
requirements of Sec.  1.468B-1(c), the Internal Revenue Service will not 
challenge a reasonable, consistently applied method of taxation for 
transfers to the fund, income earned by the fund, and distributions made 
by the fund after August 16, 1986, but prior to January 1, 1996. A 
method is generally considered reasonable if, depending on the facts and 
circumstances, all transferors and the administrator of the fund have 
consistently treated transfers to the fund, income earned by the fund, 
and distributions made by the fund after August 16, 1986, as if the fund 
were--
    (A) A grantor trust and the transferors are the grantors;
    (B) A complex trust and the transferors are the grantors; or
    (C) A designated settlement fund.
    (ii) Qualified settlement funds established after February 14, 1992, 
but before January 1, 1993. With respect to a fund, account, or trust 
established after February 14, 1992, but prior to January 1, 1993, that 
satisfies the requirements of Sec.  1.468B-1(c), the Internal Revenue 
Service will not challenge a reasonable, consistently applied method of 
taxation as described in paragraph (b)(1)(i) of this section for 
transfers to, income earned by, and distributions made by the fund prior 
to January 1, 1993. However, pursuant to paragraph (a) of this section, 
sections 1.468B-1 through 1.468B-4 apply to transfers to, income earned 
by, and distributions made by the qualified settlement fund after 1992.
    (iii) Use of cash method of accounting. For purposes of paragraphs 
(b)(i) and (b)(ii) of this section, for taxable years beginning prior to 
January 1, 1996, the Internal Revenue Service will not challenge the use 
of the cash receipts and disbursement method of accounting by a fund, 
account, or trust.
    (iv) Unreasonable position. In no event is it a reasonable position 
to assert, pursuant to Rev. Rul. 71-119 (see Sec.  601.601(d)(2)(ii)(b) 
of this chapter), that there is no current taxation of the income of a 
fund established after August 16, 1986.
    (v) Waiver of penalties. For taxable years beginning prior to 
January 1, 1993, if a fund, account or trust is subject to section 
468B(g) and the Internal Revenue Service does not challenge the method 
of taxation for transfers to, income earned by, and distributions made 
by, the fund pursuant to paragraph (b)(1)(i) or (b)(1)(ii) of this 
section, penalties will not be imposed in connection with the use of 
such method. For example, the penalties under section 6655 for failure 
to pay estimated tax, section 6651(a)(1) for failure to file a return, 
section 6651(a)(2) for failure to pay tax, section 6656 for failure to 
make deposit of taxes, and section 6662 for accuracy-related 
underpayments will generally not be imposed.
    (2) Election to apply qualified settlement fund rules--(i) In 
general. The person that will be the administrator of a qualified 
settlement fund may elect to apply Sec. Sec.  1.468B-1 through 1.468B-4 
to transfers to, income earned by, and distributions made by, the fund 
in taxable years ending after August 16, 1986. The election is effective 
beginning on the first day of the earliest open taxable year of the 
qualified settlement fund. For purposes of this paragraph (b)(2), a 
taxable year is considered open if the period for assessment and 
collection of tax has not expired pursuant to the rules of section 6501. 
The election

[[Page 429]]

statement must provide the information described in paragraph (b)(2)(ii) 
of this section and must be signed by the person that will be the 
administrator. Such person must also provide each transferor of the 
qualified settlement fund with a copy of the election statement on or 
before March 15, 1993.
    (ii) Election statement. The election statement must provide the 
following information--
    (A) A legend, ``Sec.  1.468B-5(b)(2) Election'', at the top of the 
first page;
    (B) Each transferor's name, address, and taxpayer identification 
number;
    (C) The qualified settlement fund's name, address, and employer 
identification number; and
    (D) The date the qualified settlement fund was established within 
the meaning of Sec.  1.468B-1(j).
    (iii) Due date of returns and amended returns. The election 
statement described in paragraph (b)(2)(ii) of this section must be 
filed with, and as part of, the qualified settlement fund's timely filed 
tax return for the taxable year ended December 31, 1992. In addition, 
the qualified settlement fund must file an amended return that is 
consistent with the requirements of Sec. Sec.  1.468B-1 through 1.468B-4 
for any taxable year to which the election applies in which the fund 
took a position inconsistent with those requirements. Any such amended 
return must be filed no later than March 15, 1993, and must include a 
copy of the election statement described in paragraph (b)(2)(ii) of this 
section.
    (iv) Computation of interest and waiver of penalties. For purposes 
of section 6601 and section 6611, the income tax return for each taxable 
year of the qualified settlement fund to which the election applies is 
due on March 15 of the year following the taxable year of the fund. For 
taxable years of a qualified settlement fund ending prior to January 1, 
1993, the income earned by the fund is deemed to have been earned on 
December 31 of each taxable year for purposes of section 6655. Thus, the 
addition to tax for failure to pay estimated tax under section 6655 will 
not be imposed. The penalty for failure to file a return under section 
6651(a)(1), the penalty for failure to pay tax under section 6651(a)(2), 
the penalty for failure to make deposit of taxes under section 6656, and 
the accuracy-related penalty under section 6662 will not be imposed on a 
qualified settlement fund if the fund files its tax returns for taxable 
years ending prior to January 1, 1993, and pays any tax due for those 
taxable years, on or before March 15, 1993.
    (c) Grantor trust elections under Sec.  1.468B-1(k)--(1) In general. 
A transferor may make a grantor trust election under Sec.  1.468B-1(k) 
if the qualified settlement fund is established after February 3, 2006.
    (2) Transition rules. A transferor may make a grantor trust election 
under Sec.  1.468B-1(k) for a qualified settlement fund that was 
established on or before February 3, 2006, if the applicable period of 
limitation on filing an amended return has not expired for both the 
qualified settlement fund's first taxable year and all subsequent 
taxable years and the transferor's corresponding taxable year or years. 
A grantor trust election under this paragraph (c)(2) requires that the 
returns of the qualified settlement fund and the transferor for all 
affected taxable years are consistent with the grantor trust election. 
This requirement may be satisfied by timely filed original returns or 
amended returns filed before the applicable period of limitation 
expires.
    (3) Qualified settlement funds established by the U.S. government on 
or before February 3, 2006. If the U.S. government, or any agency or 
instrumentality thereof, established a qualified settlement fund on or 
before February 3, 2006, and the fund would have been classified as a 
trust all of which is treated as owned by the U.S. government under 
section 671 and the regulations thereunder without regard to the 
regulations under section 468B, then the U.S. government is deemed to 
have made a grantor trust election under Sec.  1.468B-1(k), and the 
election is applicable for all taxable years of the fund.

[T.D. 8459, 57 FR 60994, Dec. 23, 1992, as amended by T.D. 9249, 71 FR 
6201, Feb. 7, 2006]



Sec.  1.468B-6  Escrow accounts, trusts, and other funds used 
during deferred exchanges of like-kind property under section 1031(a)(3).

    (a) Scope. This section provides rules under section 468B(g) 
relating to the

[[Page 430]]

current taxation of escrow accounts, trusts, and other funds used during 
deferred exchanges.
    (b) Definitions. The definitions in this paragraph (b) apply for 
purposes of this section.
    (1) In general. Deferred exchange, escrow agreement, escrow holder, 
exchange agreement, qualified escrow account, qualified intermediary, 
qualified trust, relinquished property, replacement property, taxpayer, 
trust agreement, and trustee have the same meanings as in Sec.  
1.1031(k)-1; deferred exchange also includes any exchange intended to 
qualify as a deferred exchange, and qualified intermediary also includes 
any person or entity intended by a taxpayer to be a qualified 
intermediary within the meaning of Sec.  1.1031(k)-1(g)(4).
    (2) Exchange funds. Exchange funds means relinquished property, 
cash, or cash equivalent that secures an obligation of a transferee to 
transfer replacement property, or proceeds from a transfer of 
relinquished property, held in a qualified escrow account, qualified 
trust, or other escrow account, trust, or fund in a deferred exchange.
    (3) Exchange facilitator. Exchange facilitator means a qualified 
intermediary, transferee, escrow holder, trustee, or other party that 
holds exchange funds for a taxpayer in a deferred exchange pursuant to 
an escrow agreement, trust agreement, or exchange agreement.
    (4) Transactional expenses--(i) In general. Except as provided in 
paragraph (b)(4)(ii) of this section, transactional expenses means 
transactional items within the meaning of Sec.  1.1031(k)-1(g)(7)(ii).
    (ii) Special rule for certain fees for exchange facilitator 
services. The fee for the services of an exchange facilitator is not a 
transactional expense unless the escrow agreement, trust agreement, or 
exchange agreement, as applicable, provides that--
    (A) The amount of the fee payable to the exchange facilitator is 
fixed on or before the date of the transfer of the relinquished property 
by the taxpayer (either by stating the fee as a fixed dollar amount in 
the agreement or determining the fee by a formula, the result of which 
is known on or before the transfer of the relinquished property by the 
taxpayer); and
    (B) The amount of the fee is payable by the taxpayer regardless of 
whether the earnings attributable to the exchange funds are sufficient 
to pay the fee.
    (c) Taxation of exchange funds--(1) Exchange funds generally treated 
as loaned to an exchange facilitator. Except as provided in paragraph 
(c)(2) of this section, exchange funds are treated as loaned from a 
taxpayer to an exchange facilitator (exchange facilitator loan). If a 
transaction is treated as an exchange facilitator loan under this 
paragraph (c)(1), the exchange facilitator must take into account all 
items of income, deduction, and credit (including capital gains and 
losses) attributable to the exchange funds. See Sec.  1.7872-16 to 
determine if an exchange facilitator loan is a below-market loan for 
purposes of section 7872 and Sec.  1.7872-5(b)(16) to determine if an 
exchange facilitator loan is exempt from section 7872.
    (2) Exchange funds not treated as loaned to an exchange 
facilitator--(i) Scope. This paragraph (c)(2) applies if, in accordance 
with an escrow agreement, trust agreement, or exchange agreement, as 
applicable, all the earnings attributable to a taxpayer's exchange funds 
are paid to the taxpayer.
    (ii) Earnings attributable to the taxpayer's exchange funds--(A) 
Separately identified account. If an exchange facilitator holds all of 
the taxpayer's exchange funds in a separately identified account, the 
earnings credited to that account are deemed to be all the earnings 
attributable to the taxpayer's exchange funds for purposes of paragraph 
(c)(2)(i) of this section. In general, a separately identified account 
is an account established under the taxpayer's name and taxpayer 
identification number with a depository institution. For purposes of 
paragraph (c)(2)(i) of this section, a sub-account will be treated as a 
separately identified account if the master account under which the sub-
account is created is established with a depository institution, the 
depository institution identifies the sub-account by the taxpayer's

[[Page 431]]

name and taxpayer identification number, and the depository institution 
specifically credits earnings to the sub-account.
    (B) Allocation of earnings in commingled accounts. If an exchange 
facilitator commingles (for investment or otherwise) the taxpayer's 
exchange funds with other funds or assets, all the earnings attributable 
to the taxpayer's exchange funds are paid to the taxpayer if all of the 
earnings attributable to the commingled funds or assets that are 
allocable on a pro-rata basis (using a reasonable method that takes into 
account the time that the exchange funds are in the commingled account, 
actual rate or rates of return, and the respective account balances) to 
the taxpayer's exchange funds either are paid to the taxpayer or are 
treated as paid to the taxpayer under paragraph (c)(2)(ii)(C) of this 
section.
    (C) Transactional expenses. Any payment from the taxpayer's exchange 
funds, or from the earnings attributable to the taxpayer's exchange 
funds, for a transactional expense of the taxpayer (as defined in 
paragraph (b)(4) of this section) is treated as first paid to the 
taxpayer and then paid by the taxpayer to the recipient.
    (iii) Treatment of the taxpayer. If this paragraph (c)(2) applies, 
exchange funds are not treated as loaned from a taxpayer to an exchange 
facilitator. The taxpayer must take into account all items of income, 
deduction, and credit (including capital gains and losses) attributable 
to the exchange funds.
    (d) Information reporting requirements. A payor (as defined in Sec.  
1.6041-1) must report the income attributable to exchange funds to the 
extent required by the information reporting provisions of subpart B, 
Part III, subchapter A, chapter 61, Subtitle F of the Internal Revenue 
Code, and the regulations under those provisions. See Sec.  1.6041-1(f) 
for rules relating to the amount to be reported when fees, expenses or 
commissions owed by a payee to a third party are deducted from a 
payment.
    (e) Examples. The provisions of this section are illustrated by the 
following examples in which T is a taxpayer that uses a calendar taxable 
year and the cash receipts and disbursements method of accounting. The 
examples are as follows:

    Example 1. All earnings attributable to exchange funds paid to 
taxpayer. (i) T enters into a deferred exchange with R. The sales 
agreement provides that T will transfer property (the relinquished 
property) to R and R will transfer replacement property to T. R's 
obligation to transfer replacement property to T is secured by cash 
equal to the fair market value of the relinquished property, which R 
will deposit into a qualified escrow account that T establishes with B, 
a depository institution. T enters into an escrow agreement with B that 
provides that all the earnings attributable to the exchange funds will 
be paid to T.
    (ii) On November 1, 2008, T transfers property to R and R deposits 
$2,100,000 in T's qualified escrow account with B. Between November 1 
and December 31, 2008, B credits T's account with $14,000 of interest. 
During January 2009, B credits T's account with $7000 of interest. On 
February 1, 2009, R transfers replacement property worth $2,100,000 to T 
and B pays $2,100,000 from the qualified escrow account to R. 
Additionally, on February 1, 2009, B pays the $21,000 of interest to T.
    (iii) Under paragraph (b) of this section, the $2,100,000 deposited 
with B constitutes exchange funds and B is an exchange facilitator. 
Because all the earnings attributable to the exchange funds are paid to 
T in accordance with the escrow agreement, paragraph (c)(2) of this 
section applies. The exchange funds are not treated as loaned from T to 
B. T must take into account in computing T's income tax liability for 
2008 the $14,000 of earnings credited to the qualified escrow account in 
2008 and for 2009 the $7,000 of earnings credited to the qualified 
escrow account in 2009.
    Example 2. Payment of transactional expenses from earnings. (i) The 
facts are the same as in Example 1, except that the escrow agreement 
provides that, prior to paying the earnings to T, B may deduct any 
amounts B has paid to third parties for T's transactional expenses. B 
pays a third party $350 on behalf of T for a survey of the replacement 
property. After deducting $350 from the earnings attributable to T's 
qualified escrow account, B pays T the remainder ($20,650) of the 
earnings.
    (ii) Under paragraph (b)(4) of this section, the cost of the survey 
is a transactional expense. Under paragraph (c)(2)(ii)(C) of this 
section, the $350 that B pays for the survey is treated as first paid to 
T and then from T to the third party. Therefore, all the earnings 
attributable to T's exchange funds are paid or treated as paid to T in 
accordance with the escrow agreement, and paragraph (c)(2) of this 
section applies. The exchange funds are not treated as loaned from T to 
B,

[[Page 432]]

and T must take into account in computing T's income tax liability the 
$21,000 of earnings credited to the qualified escrow account.
    Example 3. Earnings retained by exchange facilitator as compensation 
for services. (i) The facts are the same as in Example 1, except that 
the escrow agreement provides that B also may deduct any outstanding 
fees owed by T for B's services in facilitating the deferred exchange. 
In accordance with paragraph (b)(4)(ii) of this section, the escrow 
agreement provides for a fixed fee of $1,200 for B's services, which is 
payable by T regardless of the amount of earnings attributable to the 
exchange funds. Because the earnings on the exchange funds in this case 
exceed $1,200, B retains $1,200 as the unpaid portion of its fee and 
pays T the remainder ($19,800) of the earnings.
    (ii) Under paragraph (b)(4) of this section, B's fee is treated as a 
transactional expense. Under paragraph (c)(2)(ii)(C) of this section, 
the $1200 that B retains for its fee is treated as first paid to T and 
then from T to B. Therefore, all the earnings attributable to T's 
exchange funds are paid or treated as paid to T in accordance with the 
escrow agreement, and paragraph (c)(2) of this section applies. The 
exchange funds are not treated as loaned from T to B, and T must take 
into account in computing T's income tax liability the $21,000 of 
earnings credited to the qualified escrow account.
    Example 4. Exchange funds deposited by exchange facilitator with 
related depository institution in account in taxpayer's name. (i) The 
facts are the same as in Example 1 except that, instead of entering into 
an escrow agreement, T enters into an exchange agreement with QI, a 
qualified intermediary. The exchange agreement provides that R will pay 
$2,100,000 to QI, QI will deposit $2,100,000 into an account with a 
depository institution under T's name and taxpayer identification number 
(TIN), and all the earnings attributable to the account will be paid to 
T.
    (ii) On May 1, 2008, T transfers property to QI, QI transfers the 
property to R, R delivers $2,100,000 to QI, and QI deposits $2,100,000 
into a money market account with depository institution B under T's name 
and TIN. B and QI are members of the same consolidated group of 
corporations within the meaning of section 1501. Between May 1 and 
September 1, 2008, the account earns $28,000 of interest at the stated 
rate established by B. During the period May 1 to September 1, 2008, B 
invests T's exchange funds and earns $40,000. On September 1, 2008, QI 
uses $2,100,000 of the funds in the account to purchase replacement 
property identified by T and transfers the replacement property to T. B 
pays to T the $28,000 of interest earned on the money market account at 
the stated rate.
    (iii) Under paragraph (b) of this section, the $2,100,000 QI 
receives from R for the relinquished property is exchange funds and QI 
is an exchange facilitator. B is not an exchange facilitator. T has not 
entered into an escrow agreement, trust agreement, or exchange agreement 
with B, and QI, not B, holds the exchange funds on behalf of T. Under 
paragraph (c)(2)(ii)(A) of this section, the $40,000 B earns from 
investing T's exchange funds are not treated as earnings attributable to 
T's exchange funds. Because all the earnings attributable to T's 
exchange funds are paid to T in accordance with the exchange agreement, 
paragraph (c)(2) of this section applies. The exchange funds are not 
treated as loaned from T to QI, and T must take into account in 
computing T's income tax liability for 2008 the $28,000 of interest 
earned on the money market account.
    Example 5. Earnings of related depository institution credited to 
exchange facilitator. (i) The facts are the same as in Example 4, except 
that at the end of each taxable year, B credits a portion of its 
earnings on deposits to QI. The amount credited is based on the total 
amount of exchange funds QI has deposited with B during the year. At the 
end of the 2008 taxable year, B credits $152,500 of B's earnings to QI.
    (ii) Under paragraph (c)(2)(ii)(A) of this section, no part of the 
$152,500 credited by B to QI is earnings attributable to T's exchange 
funds. Therefore, all of the earnings attributable to the exchange funds 
are paid to T in accordance with the exchange agreement, and paragraph 
(c)(2) of this section applies. The exchange funds are not treated as 
loaned from T to QI, and T must take into account in computing T's 
income tax liability for 2008 the $28,000 of interest earned on T's 
account.
    Example 6. Exchange funds deposited by exchange facilitator with 
unrelated depository institution in sub-account in taxpayer's name. (i) 
The facts are the same as in Example 4, except that QI and B are 
unrelated and the money market account in which QI deposits the 
$2,100,000 received from T is a sub-account within a master account QI 
maintains with B in QI's name and TIN. The master account includes other 
sub-accounts, each in the name and TIN of a taxpayer that has entered 
into an exchange agreement with QI, into which QI deposits each 
taxpayer's exchange funds. Each month, B transfers to QI's master 
account an additional amount of interest based upon the average daily 
balance of all exchange funds within the master account during the 
month. At the end of the 2008 taxable year, B has credited $152,500 of 
additional interest to QI.
    (ii) Under paragraph (c)(2)(ii)(A) of this section, no part of the 
$152,500 credited by B to QI is earnings attributable to T's exchange 
funds. Therefore, all of the earnings attributable to the exchange funds 
are paid

[[Page 433]]

to T in accordance with the exchange agreement, and paragraph (c)(2) of 
this section applies. The exchange funds are not treated as loaned from 
T to QI, and T must take into account in computing T's income tax 
liability for 2008 the $28,000 of interest earned on T's account.
    Example 7. Marketing fee paid to exchange facilitator. (i) The facts 
are the same as in Example 4, except that at the end of each taxable 
year, B pays a marketing fee to QI for using B as its depository 
institution for exchange funds. The amount of the fee is based on the 
total amount of exchange funds QI has deposited with B during the year.
    (ii) Under paragraph (c)(2)(ii)(A) of this section, no part of the 
marketing fee that B pays to QI is earnings attributable to T's exchange 
funds. Therefore, all of the earnings attributable to the exchange funds 
are paid to T in accordance with the exchange agreement, and paragraph 
(c)(2) of this section applies. The exchange funds are not treated as 
loaned from T to QI, and T must take into account in computing T's 
income tax liability for 2008 the $28,000 of interest earned on T's 
account.
    Example 8. Stated rate of interest on account less than earnings 
attributable to exchange funds. (i) The facts are the same as in Example 
4, except that the exchange agreement provides only that QI will pay T a 
stated rate of interest. QI invests the exchange funds and earns 
$40,000. The exchange funds earn $28,000 at the stated rate of interest, 
and QI pays the $28,000 to T.
    (ii) Paragraph (c)(1) of this section applies and the exchange funds 
are treated as loaned from T to QI. QI must take into account in 
computing QI's income tax liability all items of income, deduction, and 
credit (including capital gains and losses) attributable to the exchange 
funds. Paragraph (c)(2) of this section does not apply because QI does 
not pay all the earnings attributable to the exchange funds to T. See 
Sec. Sec.  1.7872-5 and 1.7872-16 for rules relating to exchange 
facilitator loans.
    Example 9. All earnings attributable to commingled exchange funds 
paid to taxpayer. (i) The facts are the same as in Example 4, except 
that the exchange agreement does not specify how the $2,100,000 QI 
receives from R must be invested.
    (ii) On May 1, 2008, QI deposits the $2,100,000 with B in a pre-
existing interest-bearing account under QI's name and TIN. The account 
has a total balance of $5,275,000 immediately thereafter. On the last 
day of each month between May and September, 2008, the account earns 
interest as follows: $17,583 in May, $17,642 in June, $18,756 in July, 
and $17,472 in August. On July 11, 2008, QI deposits $500,000 in the 
account. On August 15, 2008, QI withdraws $1,175,000 from the account.
    (iii) QI calculates T's pro-rata share of the earnings allocable to 
the $2,100,000 based on the actual return, the average daily principal 
balances, and a 30-day month convention, as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             Account's avg.     T's avg. daily       T's share*
                          Month                                daily bal.            bal.            (percent)       Monthly interest   T's end. bal.**
--------------------------------------------------------------------------------------------------------------------------------------------------------
May......................................................         $5,275,000         $2,100,000               39.8            $17,583         $2,106,998
June.....................................................          5,292,583          2,106,998               39.8             17,642          2,114,020
July.....................................................          5,643,558          2,114,020               37.5             18,756          2,121,054
August...................................................          5,035,647          2,121,054               42.1             17,472          2,128,410
--------------------------------------------------------------------------------------------------------------------------------------------------------
* T's Average Daily Balance / Account's Average Daily Balance.
** T's beginning balance + [(T's share) (Monthly Interest)].

    (iv) On September 1, 2008, QI uses $2,100,000 of the funds to 
purchase replacement property identified by T and transfers the property 
to T. QI pays $28,410, the earnings of the account allocated to T's 
exchange funds, to T.
    (v) Because QI uses a reasonable method to calculate the pro-rata 
share of account earnings allocable to T's exchange funds in accordance 
with paragraph (c)(2)(ii)(B) of this section, and pays all those 
earnings to T, paragraph (c)(2) of this section applies. The exchange 
funds are not treated as loaned from T to QI. T must take into account 
in computing T's income tax liability for 2008 the $28,410 of earnings 
attributable to T's exchange funds.

    (f) Effective/applicability dates--(1) In general. This section 
applies to transfers of relinquished property made by taxpayers on or 
after October 8, 2008.
    (2) Transition rule. With respect to transfers of relinquished 
property made by taxpayers after August 16, 1986, but before October 8, 
2008, the Internal Revenue Service will not challenge a reasonable, 
consistently applied method of taxation for income attributable to 
exchange funds.

[T.D. 9413, 73 FR 39620, July 10, 2008]



Sec.  1.468B-7  Pre-closing escrows.

    (a) Scope. This section provides rules under section 468B(g) for the 
current taxation of income of a pre-closing escrow.

[[Page 434]]

    (b) Definitions. For purposes of this section--
    (1) A pre-closing escrow is an escrow account, trust, or fund--
    (i) Established in connection with the sale or exchange of real or 
personal property;
    (ii) Funded with a down payment, earnest money, or similar payment 
that is deposited into the escrow prior to the sale or exchange of the 
property;
    (iii) Used to secure the obligation of the purchaser to pay the 
purchase price for the property;
    (iv) The assets of which, including any income earned thereon, will 
be paid to the purchaser or otherwise distributed for the purchaser's 
benefit when the property is sold or exchanged (for example, by being 
distributed to the seller as a credit against the purchase price); and
    (v) Which is not an escrow account or trust established in 
connection with a deferred exchange under section 1031(a)(3).
    (2) Purchaser means, in the case of an exchange, the intended 
transferee of the property whose obligation to pay the purchase price is 
secured by the pre-closing escrow;
    (3) Purchase price means, in the case of an exchange, the required 
consideration for the property; and
    (4) Administrator means the escrow agent, escrow holder, trustee, or 
other person responsible for administering the pre-closing escrow.
    (c) Taxation of pre-closing escrows. The purchaser must take into 
account in computing the purchaser's income tax liability all items of 
income, deduction, and credit (including capital gains and losses) of 
the pre-closing escrow. In the case of an exchange with a single pre-
closing escrow funded by two or more purchasers, each purchaser must 
take into account in computing the purchaser's income tax liability all 
items of income, deduction, and credit (including capital gains and 
losses) earned by the pre-closing escrow with respect to the money or 
property deposited in the pre-closing escrow by or on behalf of that 
purchaser.
    (d) Reporting obligations of the administrator. For each calendar 
year (or portion thereof) that a pre-closing escrow is in existence, the 
administrator must report the income of the pre-closing escrow on Form 
1099 to the extent required by the information reporting provisions of 
subpart B, Part III, subchapter A, chapter 61, Subtitle F of the 
Internal Revenue Code and the regulations thereunder. See Sec.  1.6041-
1(f) for rules relating to the amount to be reported when fees, 
expenses, or commissions owed by a payee to a third party are deducted 
from a payment.
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. P enters into a contract with S for the purchase of 
residential property owned by S for the price of $200,000. P is required 
to deposit $10,000 of earnest money into an escrow. At closing, the 
$10,000 and the interest earned thereon will be credited against the 
purchase price of the property. The escrow is a pre-closing escrow. P is 
taxable on the interest earned on the pre-closing escrow prior to 
closing.
    Example 2. X and Y enter into a contract in which X agrees to 
exchange certain construction equipment for residential property owned 
by Y. The contract requires X and Y to each deposit $10,000 of earnest 
money into an escrow. At closing, $10,000 and the interest earned 
thereon will be paid to X and $10,000 and the interest earned thereon 
will be paid to Y. The escrow is a pre-closing escrow. X is taxable on 
the interest earned prior to closing on the $10,000 of funds X deposited 
in the pre-closing escrow. Similarly, Y is taxable on the interest 
earned prior to closing on the $10,000 of funds Y deposited in the pre-
closing escrow.

    (f) Effective dates--(1) In general. This section applies to pre-
closing escrows established after February 3, 2006.
    (2) Transition rule. With respect to a pre-closing escrow 
established after August 16, 1986, but on or before February 3, 2006, 
the Internal Revenue Service will not challenge a reasonable, 
consistently applied method of taxation for income earned by the escrow 
or a reasonable, consistently applied method for reporting the income.

[T.D. 9249, 71 FR 6202, Feb. 7, 2006]



Sec.  1.468B-8  Contingent-at-closing escrows. [Reserved]



Sec.  1.468B-9  Disputed ownership funds.

    (a) Scope. This section provides rules under section 468B(g) 
relating to the current taxation of income of a disputed ownership fund.

[[Page 435]]

    (b) Definitions. For purposes of this section--
    (1) Disputed ownership fund means an escrow account, trust, or fund 
that--
    (i) Is established to hold money or property subject to conflicting 
claims of ownership;
    (ii) Is subject to the continuing jurisdiction of a court;
    (iii) Requires the approval of the court to pay or distribute money 
or property to, or on behalf of, a claimant, transferor, or transferor-
claimant; and
    (iv) Is not a qualified settlement fund under Sec.  1.468B-1, a 
bankruptcy estate (or part thereof) resulting from the commencement of a 
case under title 11 of the United States Code, or a liquidating trust 
under Sec.  301.7701-4(d) of this chapter (except as provided in 
paragraph (c)(2)(ii) of this section);
    (2) Administrator means a person designated as such by a court 
having jurisdiction over a disputed ownership fund, however, if no 
person is designated, the administrator is the escrow agent, escrow 
holder, trustee, receiver, or other person responsible for administering 
the fund;
    (3) Claimant means a person who claims ownership of, in whole or in 
part, or a legal or equitable interest in, money or property immediately 
before and immediately after that property is transferred to a disputed 
ownership fund;
    (4) Court means a court of law or equity of the United States or of 
any state (including the District of Columbia), territory, possession, 
or political subdivision thereof;
    (5) Disputed property means money or property held in a disputed 
ownership fund subject to the claimants' conflicting claims of 
ownership;
    (6) Related person means any person that is related to a transferor 
within the meaning of section 267(b) or 707(b)(1);
    (7) Transferor means, in general, a person that transfers disputed 
property to a disputed ownership fund, except that--
    (i) If disputed property is transferred by an agent, fiduciary, or 
other person acting in a similar capacity, the transferor is the person 
on whose behalf the agent, fiduciary, or other person acts; and
    (ii) A payor of interest or other income earned by a disputed 
ownership fund is not a transferor within the meaning of this section 
(unless the payor is also a claimant);
    (8) Transferor-claimant means a transferor that claims ownership of, 
in whole or in part, or a legal or equitable interest in, the disputed 
property immediately before and immediately after that property is 
transferred to the disputed ownership fund. Because a transferor-
claimant is both a transferor and a claimant, generally the terms 
transferor and claimant also include a transferor-claimant. See 
paragraph (d) of this section for rules applicable only to transferors 
that are not transferor-claimants and paragraph (e) of this section for 
rules applicable only to transferors that are also transferor-claimants.
    (c) Taxation of a disputed ownership fund--(1) In general. For 
Federal income tax purposes, a disputed ownership fund is treated as the 
owner of all assets that it holds. A disputed ownership fund is treated 
as a C corporation for purposes of subtitle F of the Internal Revenue 
Code, and the administrator of the fund must obtain an employer 
identification number for the fund, make all required income tax and 
information returns, and deposit all tax payments. Except as otherwise 
provided in this section, a disputed ownership fund is taxable as--
    (i) A C corporation, unless all the assets transferred to the fund 
by or on behalf of transferors are passive investment assets. For 
purposes of this section, passive investment assets are assets of the 
type that generate portfolio income within the meaning of Sec.  1.469-
2T(c)(3)(i); or
    (ii) A qualified settlement fund, if all the assets transferred to 
the fund by or on behalf of transferors are passive investment assets. A 
disputed ownership fund taxable as a qualified settlement fund under 
this section is subject to all the provisions contained in Sec.  1.468B-
2, except that the rules contained in paragraphs (c)(3), (4), and 
(c)(5)(i) of this section apply in lieu of the rules in Sec.  1.468B-
2(b)(1), (d), (e), (f) and (j).

[[Page 436]]

    (2) Exceptions. (i) The claimants to a disputed ownership fund may 
submit a private letter ruling request proposing a method of taxation 
different than the method provided in paragraph (c)(1) of this section.
    (ii) The trustee of a liquidating trust established pursuant to a 
plan confirmed by the court in a case under title 11 of the United 
States Code may, in the liquidating trust's first taxable year, elect to 
treat an escrow account, trust, or fund that holds assets of the 
liquidating trust that are subject to disputed claims as a disputed 
ownership fund. Pursuant to this election, creditors holding disputed 
claims are not treated as transferors of the money or property 
transferred to the disputed ownership fund. A trustee makes the election 
by attaching a statement to the timely filed Federal income tax return 
of the disputed ownership fund for the taxable year for which the 
election becomes effective. The election statement must include a 
statement that the trustee will treat the escrow account, trust, or fund 
as a disputed ownership fund and must include a legend, ``Sec.  1.468B-
9(c) Election,'' at the top of the page. The election may be revoked 
only upon consent of the Commissioner by private letter ruling.
    (3) Property received by the disputed ownership fund--(i) Generally 
excluded from income. In general, a disputed ownership fund does not 
include an amount in income on account of a transfer of disputed 
property to the disputed ownership fund. However, the accrual or receipt 
of income from the disputed property in a disputed ownership fund is not 
a transfer of disputed property to the fund. Therefore, a disputed 
ownership fund must include in income all income received or accrued 
from the disputed property, including items such as--
    (A) Payments to a disputed ownership fund made in compensation for 
late or delayed transfers of money or property;
    (B) Dividends on stock of a transferor (or a related person) held by 
the fund; and
    (C) Interest on debt of a transferor (or a related person) held by 
the fund.
    (ii) Basis and holding period. In general, the initial basis of 
property transferred by, or on behalf of, a transferor to a disputed 
ownership fund is the fair market value of the property on the date of 
transfer to the fund, and the fund's holding period begins on the date 
of the transfer. However, if the transferor is a transferor-claimant, 
the fund's initial basis in the property is the same as the basis of the 
transferor-claimant immediately before the transfer to the fund, and the 
fund = s holding period for the property is determined under section 
1223(2).
    (4) Property distributed by the disputed ownership fund--(i) 
Computing gain or loss. Except in the case of a distribution or deemed 
distribution described in paragraph (e)(3) of this section, a disputed 
ownership fund must treat a distribution of disputed property as a sale 
or exchange of that property for purposes of section 1001(a). In 
computing gain or loss, the amount realized by the disputed ownership 
fund is the fair market value of that property on the date of 
distribution.
    (ii) Denial of deduction. A disputed ownership fund is not allowed a 
deduction for a distribution of disputed property or of the net after-
tax income earned by the disputed ownership fund made to or on behalf of 
a transferor or claimant.
    (5) Taxable year and accounting method. (i) A disputed ownership 
fund taxable as a C corporation under paragraph (c)(1)(i) of this 
section may compute taxable income under any accounting method allowable 
under section 446 and is not subject to the limitations contained in 
section 448. A disputed ownership fund taxable as a C corporation may 
use any taxable year allowable under section 441.
    (ii) A disputed ownership fund taxable as a qualified settlement 
fund under paragraph (c)(1)(ii) of this section may compute taxable 
income under any accounting method allowable under section 446 and may 
use any taxable year allowable under section 441.
    (iii) Appropriate adjustments must be made by a disputed ownership 
fund or transferors to the fund to prevent the fund and the transferors 
from taking into account the same item of income, deduction, gain, loss, 
or credit (including capital gains and losses)

[[Page 437]]

more than once or from omitting such items. For example, if a transferor 
that is not a transferor-claimant uses the cash receipts and 
disbursements method of accounting and transfers an account receivable 
to a disputed ownership fund that uses an accrual method of accounting, 
at the time of the transfer of the account receivable to the disputed 
ownership fund, the transferor must include in its gross income the 
value of the account receivable because, under paragraph (c)(3)(ii) of 
this section, the disputed ownership fund will take a fair market value 
basis in the receivable and will not include the fair market value in 
its income when received from the transferor or when paid by the 
customer. If the account receivable were transferred to the disputed 
ownership fund by a transferor-claimant using the cash receipts and 
disbursements method, however, the disputed ownership fund would take a 
basis in the receivable equal to the transferor's basis, or $0, and 
would be required to report the income upon collection of the account.
    (6) Unused carryovers. Upon the termination of a disputed ownership 
fund, if the fund has an unused net operating loss carryover under 
section 172, an unused capital loss carryover under section 1212, or an 
unused tax credit carryover, or if the fund has, for its last taxable 
year, deductions in excess of gross income, the claimant to which the 
fund's net assets are distributable will succeed to and take into 
account the fund's unused net operating loss carryover, unused capital 
loss carryover, unused tax credit carryover, or excess of deductions 
over gross income for the last taxable year of the fund. If the fund's 
net assets are distributable to more than one claimant, the unused net 
operating loss carryover, unused capital loss carryover, unused tax 
credit carryover, or excess of deductions over gross income for the last 
taxable year must be allocated among the claimants in proportion to the 
value of the assets distributable to each claimant from the fund. Unused 
carryovers described in this paragraph (c)(6) are not money or other 
property for purposes of paragraph (e)(3)(ii) of this section and thus 
are not deemed transferred to a transferor-claimant before being 
transferred to the claimants described in this paragraph (c)(6).
    (d) Rules applicable to transferors that are not transferor-
claimants. The rules in this paragraph (d) apply to transferors (as 
defined in paragraph (b)(7) of this section) that are not transferor-
claimants (as defined in paragraph (b)(8) of this section).
    (1) Transfer of property. A transferor must treat a transfer of 
property to a disputed ownership fund as a sale or other disposition of 
that property for purposes of section 1001(a). In computing the gain or 
loss on the disposition, the amount realized by the transferor is the 
fair market value of the property on the date the transfer is made to 
the disputed ownership fund.
    (2) Economic performance--(i) In general. For purposes of section 
461(h), if a transferor using an accrual method of accounting has a 
liability for which economic performance would otherwise occur under 
Sec.  1.461-4(g) when the transferor makes payment to the claimant or 
claimants, economic performance occurs with respect to the liability 
when and to the extent that the transferor makes a transfer to a 
disputed ownership fund to resolve or satisfy that liability.
    (ii) Obligations of the transferor. Economic performance does not 
occur when a transferor using an accrual method of accounting issues to 
a disputed ownership fund its debt (or provides the debt of a related 
person). Instead, economic performance occurs as the transferor (or 
related person) makes principal payments on the debt. Economic 
performance does not occur when the transferor provides to a disputed 
ownership fund its obligation (or the obligation of a related person) to 
provide property or services in the future or to make a payment 
described in Sec.  1.461-4(g)(1)(ii)(A). Instead, economic performance 
occurs with respect to such an obligation as property or services are 
provided or payments are made to the disputed ownership fund or a 
claimant. With regard to interest on a debt issued or provided to a 
disputed ownership fund, economic performance occurs as determined under 
Sec.  1.461-4(e).
    (3) Distributions to transferors--(i) In general. Except as provided 
in section 111(a) and paragraph (d)(3)(ii) of this

[[Page 438]]

section, the transferor must include in gross income any distribution to 
the transferor (including a deemed distribution described in paragraph 
(d)(3)(iii) of this section) from the disputed ownership fund. If 
property is distributed, the amount includible in gross income and the 
basis in that property are generally the fair market value of the 
property on the date of distribution.
    (ii) Exception. A transferor is not required to include in gross 
income a distribution of money or property that it previously 
transferred to the disputed ownership fund if the transferor did not 
take into account, for example, by deduction or capitalization, an 
amount with respect to the transfer either at the time of the transfer 
to, or while the money or property was held by, the disputed ownership 
fund. The transferor's gross income does not include a distribution of 
money from the disputed ownership fund equal to the net after-tax income 
earned on money or property transferred to the disputed ownership fund 
by the transferor while that money or property was held by the fund. 
Money distributed to a transferor by a disputed ownership fund will be 
deemed to be distributed first from the money or property transferred to 
the disputed ownership fund by that transferor, then from the net after-
tax income of any money or property transferred to the disputed 
ownership fund by that transferor, and then from other sources.
    (iii) Deemed distributions. If a disputed ownership fund makes a 
distribution of money or property on behalf of a transferor to a person 
that is not a claimant, the distribution is deemed made by the fund to 
the transferor. The transferor, in turn, is deemed to make a payment to 
the actual recipient.
    (e) Rules applicable to transferor-claimants. The rules in this 
paragraph (e) apply to transferor-claimants (as defined in paragraph 
(b)(8) of this section).
    (1) Transfer of property. A transfer of property by a transferor-
claimant to a disputed ownership fund is not a sale or other disposition 
of the property for purposes of section 1001(a).
    (2) Economic performance--(i) In general. For purposes of section 
461(h), if a transferor-claimant using an accrual method of accounting 
has a liability for which economic performance would otherwise occur 
under Sec.  1.461-4(g) when the transferor-claimant makes payment to 
another claimant, economic performance occurs with respect to the 
liability when and to the extent that the disputed ownership fund 
transfers money or property to the other claimant to resolve or satisfy 
that liability.
    (ii) Obligations of the transferor-claimant. Economic performance 
does not occur when a disputed ownership fund transfers the debt of a 
transferor-claimant (or of a person related to the transferor-claimant) 
to another claimant. Instead, economic performance occurs as principal 
payments on the debt are made to the other claimant. Economic 
performance does not occur when a disputed ownership fund transfers to 
another claimant the obligation of a transferor-claimant (or of a person 
related to the transferor-claimant) to provide property or services in 
the future or to make a payment described in Sec.  1.461-4(g)(1)(ii)(A). 
Instead, economic performance occurs with respect to such an obligation 
as property or services are provided or payments are made to the other 
claimant. With regard to interest on a debt issued or provided to a 
disputed ownership fund, economic performance occurs as determined under 
Sec.  1.461-4(e).
    (3) Distributions to transferor-claimants--(i) In general. The gross 
income of a transferor-claimant does not include a distribution to the 
transferor-claimant (including a deemed distribution described in 
paragraph (e)(3)(ii) of this section) of money or property from a 
disputed ownership fund that the transferor-claimant previously 
transferred to the fund, or the net after-tax income earned on that 
money or property while it was held by the fund. If such property is 
distributed to the transferor-claimant by the disputed ownership fund, 
then the transferor-claimant's basis in the property is the same as the 
disputed ownership fund's basis in the property immediately before the 
distribution.
    (ii) Deemed distributions. If a disputed ownership fund makes a 
distribution of money or property to a claimant or

[[Page 439]]

makes a distribution of money or property on behalf of a transferor-
claimant to a person that is not a claimant, the distribution is deemed 
made by the fund to the transferor-claimant. The transferor-claimant, in 
turn, is deemed to make a payment to the actual recipient.
    (f) Distributions to claimants other than transferor-claimants. 
Whether a claimant other than a transferor-claimant must include in 
gross income a distribution of money or property from a disputed 
ownership fund generally is determined by reference to the claim in 
respect of which the distribution is made.
    (g) Statement to the disputed ownership fund and the Internal 
Revenue Service with respect to transfers of property other than cash--
(1) In general. By February 15 of the year following each calendar year 
in which a transferor (or other person acting on behalf of a transferor) 
makes a transfer of property other than cash to a disputed ownership 
fund, the transferor must provide a statement to the administrator of 
the fund setting forth the information described in paragraph (g)(3) of 
this section. The transferor must attach a copy of this statement to its 
return for the taxable year of transfer.
    (2) Combined statements. If a disputed ownership fund has more than 
one transferor, any two or more transferors may provide a combined 
statement to the administrator. If a combined statement is used, each 
transferor must attach a copy of the combined statement to its return 
and maintain with its books and records a schedule describing each asset 
that the transferor transferred to the disputed ownership fund.
    (3) Information required on the statement. The statement required by 
paragraph (g)(1) of this section must include the following 
information--
    (i) A legend, ``Sec.  1.468B-9 Statement,'' at the top of the first 
page;
    (ii) The transferor's name, address, and taxpayer identification 
number;
    (iii) The disputed ownership fund's name, address, and employer 
identification number;
    (iv) A statement declaring whether the transferor is a transferor-
claimant;
    (v) The date of each transfer;
    (vi) A description of the property (other than cash) transferred; 
and
    (vii) The disputed ownership fund's basis in the property and 
holding period on the date of transfer as determined under paragraph 
(c)(3)(ii) of this section.
    (h) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (i) X Corporation petitions the United States Tax Court 
in 2006 for a redetermination of its tax liability for the 2003 taxable 
year. In 2006, the Tax Court determines that X Corporation is liable for 
an income tax deficiency for the 2003 taxable year. X Corporation files 
an appellate bond in accordance with section 7485(a) and files a notice 
of appeal with the appropriate United States Court of Appeals. In 2006, 
the Court of Appeals affirms the decision of the Tax Court and the 
United States Supreme Court denies X Corporation's petition for a writ 
of certiorari.
    (ii) The appellate bond that X Corporation files with the court for 
the purpose of staying assessment and collection of deficiencies pending 
appeal is not an escrow account, trust or fund established to hold 
property subject to conflicting claims of ownership. Although X 
Corporation was found liable for an income tax deficiency, ownership of 
the appellate bond is not disputed. Rather, the bond serves as security 
for a disputed liability. Therefore, the bond is not a disputed 
ownership fund.
    Example 2. (i) The facts are the same as Example 1, except that X 
Corporation deposits United States Treasury bonds with the Tax Court in 
accordance with section 7845(c)(2) and 31 U.S.C. 9303.
    (ii) The deposit of United States Treasury bonds with the court for 
the purpose of staying assessment and collection of deficiencies while X 
Corporation prosecutes an appeal does not create a disputed ownership 
fund because ownership of the bonds is not disputed.
    Example 3. (i) Prior to A's death, A was the insured under a life 
insurance policy issued by X, an insurance company. X uses an accrual 
method of accounting. Both A's current spouse and A's former spouse 
claim to be the beneficiary under the policy and entitled to the policy 
proceeds ($1 million). In 2005, X files an interpleader action and 
deposits $1 million into the registry of the court. On June 1, 2006, a 
final determination is made that A's current spouse is the beneficiary 
under the policy and entitled to the money held in the registry of the 
court. The interest earned on the registry account is $12,000. The money 
in the registry account is distributed to A's current spouse.
    (ii) The money held in the registry of the court consisting of the 
policy proceeds and

[[Page 440]]

the earnings thereon are a disputed ownership fund taxable as if it were 
a qualified settlement fund. See paragraphs (b)(1) and (c)(1)(ii) of 
this section. The fund's gross income does not include the $1 million 
transferred to the fund by X, however, the $12,000 interest is included 
in the fund's gross income in accordance with its method of accounting. 
See paragraph (c)(3)(i) of this section. Under paragraph (c)(4)(ii) of 
this section, the fund is not allowed a deduction for a distribution to 
A's current spouse of the $1 million or the interest income earned by 
the fund.
    (iii) X is a transferor that is not a transferor-claimant. See 
paragraphs (b)(7) and (b)(8) of this section.
    (iv) Whether A's current spouse must include in income the $1 
million insurance proceeds and the interest received from the fund is 
determined under other provisions of the Internal Revenue Code. See 
paragraph (f) of this section.
    Example 4. (i) Corporation B and unrelated individual C claim 
ownership of certain rental property. B uses an accrual method of 
accounting. The rental property is property used in a trade or business. 
B claims to have purchased the property from C's father. However, C 
asserts that the purported sale to B was ineffective and that C acquired 
ownership of the property through intestate succession upon the death of 
C's father. For several years, B has maintained and received the rent 
from the property.
    (ii) Pending the resolution of the title dispute between B and C, 
the title to the rental property is transferred to a court-supervised 
registry account on February 1, 2005. On that date the court appoints R 
as receiver for the property. R collects the rent earned on the property 
and hires employees necessary for the maintenance of the property. The 
rents paid to R cannot be distributed to B or C without the court's 
approval.
    (iii) On June 1, 2006, the court makes a final determination that 
the rental property is owned by C. The court orders C to refund to B the 
purchase price paid by B to C's father plus interest on that amount from 
February 1, 2005. The court also orders that a distribution be made to C 
of all funds held in the court registry consisting of the rent collected 
by R and the income earned thereon. C takes title to the rental 
property.
    (iv) The rental property and the funds held by the court registry 
are a disputed ownership fund under paragraph (b)(1) of this section. 
The fund is taxable as if it were a C corporation because the rental 
property is not a passive investment asset within the meaning of 
paragraph (c)(1)(i) of this section.
    (v) The fund's gross income does not include the value of the rental 
property transferred to the fund by B. See paragraph (c)(3)(i) of this 
section. Under paragraph (c)(3)(ii) of this section, the fund's initial 
basis in the property is the same as B's adjusted basis immediately 
before the transfer to the fund and the fund's holding period is 
determined under section 1223(2). The fund's gross income includes the 
rents collected by R and any income earned thereon. For the period 
between February 1, 2005, and June 1, 2006, the fund may be allowed 
deductions for depreciation and for the costs of maintenance of the 
property because the fund is treated as owning the property during this 
period. See sections 162, 167, and 168. Under paragraph (c)(4)(ii) of 
this section, the fund may not deduct the distribution to C of the 
property, or the rents (or any income earned thereon) collected from the 
property while the fund holds the property. No gain or loss is 
recognized by the fund from this distribution or from the fund's 
transfer of the rental property to C pursuant to the court's 
determination that C owns the property. See paragraphs (c)(4)(i) and 
(e)(3) of this section.
    (vi) B is the transferor to the fund. Under paragraphs (b)(8) and 
(e)(1) of this section, B is a transferor-claimant and does not 
recognize gain or loss under section 1001(a) on transfer of the property 
to the disputed ownership fund. The money and property distributed from 
the fund to C is deemed to be distributed first to B and then 
transferred from B to C. See paragraph (e)(3)(ii) of this section. Under 
paragraph (e)(2)(i) of this section, economic performance occurs when 
the disputed ownership fund transfers the property and any earnings 
thereon to C. The income tax consequences of the deemed transfer from B 
to C as well as the income tax consequences of C's refund to B of the 
purchase price paid to C's father and interest thereon are determined 
under other provisions of the Internal Revenue Code.

    (i) [Reserved]
    (j) Effective dates--(1) In general. This section applies to 
disputed ownership funds established after February 3, 2006.
    (2) Transition rule. With respect to a disputed ownership fund 
established after August 16, 1986, but on or before February 3, 2006, 
the Internal Revenue Service will not challenge a reasonable, 
consistently applied method of taxation for income earned by the fund, 
transfers to the fund, and distributions made by the fund.

[T.D. 9249, 71 FR 6202, Feb. 7, 2006]



Sec.  1.469-0  Table of contents.

    This section lists the captions that appear in the regulations under 
section 469.

[[Page 441]]

                      Sec.  1.469-1 General rules.

    (a)-(c)(7) [Reserved]
    (c)(8) Consolidated groups.
    (c)(9)-(d)(1) [Reserved]
    (2) Coordination with sections 613A(d) and 1211.
    (d)(3)-(e)(1) [Reserved]
    (2) Trade or business activity.
    (e)(3)(i)-(e)(3)(ii) [Reserved]
    (iii) Average period of customer use.
    (A) In general.
    (B) Average use factor.
    (C) Average period of customer use for class of property.
    (D) Period of customer use.
    (E) Class of property.
    (F) Gross rental income and daily rent.
    (e)(3)(iv)-(e)(3)(vi)(C) [Reserved]
    (D) Lodging rented for convenience of employer.
    (E) Unadjusted basis.
    (e)(3)(vii)-(e)(4)(iii) [Reserved]
    (iv) Definition of ``working interest.''
    (e)(4)(v)-(vi) [Reserved]
    (5) Rental of dwelling unit.
    (e)(6)-(f)(3)(iii) [Reserved]
    (4) Carryover of disallowed deductions and credits.
    (i) In general.
    (ii) Operations continued through C corporations or similar 
entities.
    (iii) Examples.
    (g)(1)-(g)(4)(ii)(B) [Reserved]
    (4)(ii)(C) (no paragraph heading)
    (5) [Reserved]
    (h)(1) In general.
    (2) Definitions.
    (3) [Reserved]
    (4) Status and participation of members.
    (i) Determination by reference to status and participation of group.
    (ii) Determination of status and participation of consolidated 
group.
    (5) [Reserved]
    (6) Intercompany transactions.
    (i) In general.
    (ii) Example.
    (iii) Effective dates.
    (h)(7)-(k) [Reserved]

                Sec.  1.469-1T General rules (temporary).

    (a) Passive activity loss and credit disallowed.
    (1) In general.
    (2) Exceptions.
    (b) Taxpayers to whom these rules apply.
    (c) Cross references.
    (1) Definition of passive activity.
    (2) Passive activity loss.
    (3) Passive activity credit.
    (4) Effect of rules for other purposes.
    (5) Special rule for oil and gas working interests.
    (6) Treatment of disallowed losses and credits.
    (7) Corporations subject to section 469.
    (8) [Reserved]
    (9) Joint returns.
    (10) Material participation.
    (11) Effective date and transition rules.
    (12) Future regulations.
    (d) Effect of section 469 and the regulations thereunder for other 
purposes.
    (1) Treatment of items of passive activity income and gain.
    (2) Coordination with sections 613A(d) and 1211. [Reserved]
    (3) Treatment of passive activity losses.
    (e) Definition of ``passive activity.''
    (1) In general.
    (2) Trade or business activity. [Reserved]
    (3) Rental Activity.
    (i) In general.
    (ii) Exceptions.
    (iii) Average period of customer use. [Reserved]
    (A) In general. [Reserved]
    (B) Average use factor. [Reserved]
    (C) Average period of customer use for class of property. [Reserved]
    (D) Period of Customer use. [Reserved]
    (E) Class of property. [Reserved]
    (F) Gross rental income and daily rent. [Reserved]
    (iv) Significant personal services.
    (A) In general.
    (B) Excluded services.
    (v) Extraordinary personal services.
    (vi) Rental of property incidental to a nonrental activity of the 
taxpayer.
    (A) In general.
    (B) Property held for investment.
    (C) Property used in a trade or business.
    (D) Lodging rented for convenience of employer. [Reserved]
    (E) Unadjusted basis. [Reserved]
    (vii) Property made available for use in a nonrental activity 
conducted by a partnership, S corporation or joint venture in which the 
taxpayer owns an interest.
    (viii) Examples.
    (4) Special rules for oil and gas working interests.
    (i) In general.
    (ii) Exception for deductions attributable to a period during which 
liability is limited.
    (A) In general.
    (B) Coordination with rules governing the identification of 
disallowed passive activity deductions.
    (C) Meaning of certain terms.
    (1) Allocable deductions.
    (2) Disqualified deductions.
    (3) Net loss.
    (4) Ratable portion.
    (iii) Examples.
    (iv) Definition of ``working interest.'' [Reserved]
    (v) Entities that limit liability.
    (A) General rule.
    (B) Other limitations disregarded.
    (C) Examples.

[[Page 442]]

    (vi) Cross reference to special rule for income from certain oil or 
gas properties.
    (5) Rental of dwelling unit. [Reserved]
    (6) Activity of trading personal property.
    (i) In general.
    (ii) Personal property.
    (iii) Example.
    (f) Treatment of disallowed passive activity losses and credits.
    (1) Scope of this paragraph.
    (2) Identification of disallowed passive activity deductions.
    (i) Allocation of disallowed passive activity deductions.
    (A) General rule.
    (B) Loss from an activity.
    (C) Significant participation passive activities.
    (D) Examples.
    (ii) Allocation with loss activities.
    (A) In general.
    (B) Excluded deductions.
    (iii) Separately identified deductions.
    (3) Identification of disallowed credits from passive activities.
    (i) General rule.
    (ii) Coordination rule.
    (iii) Separately identified credits.
    (4) Carryover of disallowed deductions and credits. [Reserved]
    (i) In general.
    (ii) Operations continued through C corporations or similar 
entities.
    (iii) Examples.
    (g) Application of these rules to C corporations.
    (1) In general.
    (2) Definitions.
    (3) Participation of corporations.
    (i) Material participation.
    (ii) Significant participation.
    (iii) Participation of individual.
    (4) Modified computation of passive activity loss in the case of 
closely held corporations.
    (i) In general.
    (ii) Net active income.
    (iii) Examples.
    (5) Allowance of passive activity credit of closely held 
corporations to extent of net active income tax liability.
    (i) In general.
    (ii) Net active income tax liability.
    (h) Special rules for affiliated group filing consolidated return.
    (1)-(2) [Reserved]
    (3) Disallowance of consolidated group's passive activity loss or 
credit.
    (4) Status and participation of members. [Reserved]
    (i) Determination by reference to status and participation of group. 
[Reserved]
    (ii) Determination of status and participation of consolidated 
group. [Reserved]
    (5) Modification of rules for identifying disallowed passive 
activity deductions and credits.
    (i) Identification of disallowed deductions.
    (ii) Ratable portion of disallowed passive activity losses.
    (iii) Identification of disallowed credits.
    (6) [Reserved]
    (7) Disposition of stock of a member of an affiliated group.
    (8) Dispositions of property used in multiple activities.
    (i) [Reserved]
    (j) Spouses filing joint returns.
    (1) In general.
    (2) Exceptions of treatment as one taxpayer.
    (i) Identification of disallowed deductions and credits.
    (ii) Treatment of deductions disallowed under sections 704(d), 
1366(d) and 465.
    (iii) Treatment of losses from working interests.
    (3) Joint return no longer filed.
    (4) Participation of spouses.
    (k) Former passive activities and changes in status of corporations. 
[Reserved]

                  Sec.  1.469-2 Passive activity loss.

    (a)-(c)(2)(ii) [Reserved]
    (iii) Disposition of substantially appreciated property formerly 
used in a nonpassive activity.
    (A) In general.
    (B) Date of disposition.
    (C) Substantially appreciated property.
    (D) Investment property.
    (E) Coordination with Sec.  l.469-2T(c)(2)(ii).
    (F) Coordination with section 163(d).
    (G) Examples.
    (iv) Taxable acquisitions.
    (v) Property held for sale to customers.
    (A) Sale incidental to another activity.
    (1) Applicability.
    (i) In general.
    (ii) Principal purpose.
    (2) Dealing activity not taken into account.
    (B) Use in a nondealing activity incidental to sale.
    (C) Examples.
    (c)(3)-(c)(5) [Reserved]
    (6) Gross income from certain oil or gas properties.
    (i) In general.
    (ii) Gross and net passive income from the property.
    (iii) Property.
    (iv) Examples 1 and 2.
    (c)(6)(iv) Example 3-(c)(7)(iii) [Reserved]
    (c)(7)(iv) through (vi) (no paragraph headings)
    (d)(1)-(d)(2)(viii) [Reserved]
    (d)(2)(ix) through (d)(2)(xii) (no paragraph headings)
    (d)(3)-(d)(5)(ii) [Reserved]
    (d)(5)(iii)(A) Applicability of rules in Sec.  1.469-2T(c)(2).
    (d)(5)(iii)(B)-(d)(6)(v)(D) [Reserved]
    (d)(6)(v)(E) (no paragraph heading)

[[Page 443]]

    (d)(6)(v)(F)-(d)(7) [Reserved]
    (8) Taxable year in which item arises.
    (e)(1)-(e)(2)(i) [Reserved]
    (ii) Section 707(c).
    (iii) Payments in liquidation of a partner's interest in partnership 
property.
    (A) In general.
    (B) Payments in liquidation of a partner's interest in unrealized 
receivables and goodwill under section 736(a).
    (e)(3)(i)-(iii)(A) [Reserved]
    (e)(3)(iii)(B) (no paragraph heading)
    (e)(3)(iii)(C)-(f)(4) [Reserved]
    (5) Net income from certain property rented incidental to 
development activity.
    (i) In general.
    (ii) Commencement of use.
    (iii) Services performed for the purpose of enhancing the value of 
property.
    (iv) Examples.
    (6) Property rented to a nonpassive activity.
    (f)(7)-(f)(9)(ii) [Reserved]
    (f)(9)(iii) through (f)(9)(iv) (no paragraph heading).
    (10) Coordination with section 163(d).
    (f)(11) [Reserved]

            Sec.  1.469-2T Passive activity loss (temporary).

    (a) Scope of this section.
    (b) Definition of passive activity loss.
    (1) In general.
    (2) Cross reference.
    (c) Passive activity group income.
    (1) In general.
    (2) Treatment of gain from disposition of an interest in an activity 
or an interest in property used in an activity.
    (i) In general.
    (A) Treatment of gain.
    (B) Dispositions of partnership interest and S corporation stock.
    (C) Interest in property.
    (D) Examples.
    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition.
    (iii) Disposition of substantially appreciated property used in 
nonpassive activity. [Reserved]
    (A) In general. [Reserved]
    (B) Date of disposition. [Reserved]
    (C) Substantially appreciated property. [Reserved]
    (D) Investment property. [Reserved]
    (E) Coordination with paragraph (c)(2)(ii) of this section. 
[Reserved]
    (F) Coordination with section 163(d). [Reserved]
    (G) Examples. [Reserved]
    (iv) Taxable acquisitions. [Reserved]
    (v) Property held for sale to customers. [Reserved]
    (A) Sale incidental to another activity. [Reserved]
    (1) Applicability. [Reserved]
    (i) In general. [Reserved]
    (ii) Principal purpose. [Reserved]
    (2) Dealing activity not taken into account. [Reserved]
    (B) Use in a nondealing activity incidental to sale. [Reserved]
    (C) Examples. [Reserved]
    (3) Items of portfolio income specifically excluded.
    (i) In general.
    (ii) Gross income derived in the ordinary course of a trade or 
business.
    (iii) Special rules.
    (A) Income from property held for investment by dealer.
    (B) Royalties derived in the ordinary course of the trade or 
business of licensing intangible property.
    (1) In general.
    (2) Substantial services or costs.
    (i) In general.
    (ii) Exception.
    (iii) Expenditures taken into account.
    (3) Passthrough entities.
    (4) Cross reference.
    (C) Mineral production payments.
    (iv) Examples.
    (4) Items of personal service income specifically excluded.
    (i) In general.
    (ii) Example.
    (5) Income from section 481 adjustments.
    (i) In general.
    (ii) Positive section 481 adjustments.
    (iii) Ratable portion.
    (6) Gross income from certain oil or gas properties. [Reserved]
    (i) In general. [Reserved]
    (ii) Gross and net passive income from the properties. [Reserved]
    (iii) Property. [Reserved]
    (iv) Examples.
    (7) Other items specifically excluded.
    (d) Passive activity deductions.
    (1) In general.
    (2) Exceptions.
    (3) Interest expense.
    (4) Clearly and directly allocable expenses.
    (5) Treatment of loss from disposition.
    (i) In general.
    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition.
    (iii) Other applicable rules.
    (A) Applicability or rules in paragraph (c)(2).
    (B) Dispositions of partnership interest and S corporation stock.
    (6) Coordination with other limitations on deductions that apply 
before section 469.
    (i) In general.
    (ii) Proration of deductions disallowed under basis limitations.
    (A) Deductions disallowed under section 704(d).
    (B) Deductions disallowed under section 1366(d).

[[Page 444]]

    (iii) Proration of deductions disallowed under at-risk limitations.
    (iv) Coordination of basis and at-risk limitations.
    (v) Separately identified items of deduction and loss.
    (7) Deductions from section 481 adjustment.
    (i) In general.
    (ii) Negative section 481 adjustment.
    (iii) Ratable portion.
    (8) Taxable year in which item arises.
    (e) Special rules for partners and S corporation shareholders.
    (1) In general.
    (2) Payments under sections 707(a), 707(c), and 736(b).
    (i) Section 707(a).
    (ii) Section 707(c).
    (iii) Payments in liquidation of a partner's interest in partnership 
property.
    (A) In general.
    (B) Payments in liquidation of a partner's interest of a partnership 
property.
    (3) Sale or exchange of interest in passthrough entity.
    (i) Application of this paragraph (e)(3).
    (ii) General rule.
    (A) Allocation among activities.
    (B) Ratable portions.
    (1) Disposition on which gain is recognized.
    (2) Disposition on which loss is recognized.
    (C) Default rule.
    (D) Special rules.
    (1) Applicable valuation date.
    (i) In general.
    (ii) Exception.
    (2) Basis adjustment.
    (3) Tiered passthrough entities.
    (E) Meaning of certain terms.
    (iii) Treatment of gain allocated to certain passive activities as 
not from a passive activity.
    (iv) Dispositions occurring in taxable years beginning before 
February 19, 1988.
    (A) In general.
    (B) Exceptions.
    (v) Treatment of portfolio assets.
    (vi) Definitions.
    (vii) Examples.
    (f) Recharacterization of passive income in certain situations.
    (1) In general.
    (2) Special rule for significant participation.
    (i) In general.
    (ii) Significant participation passive activity.
    (iii) Example.
    (3) Rental of nondepreciable property.
    (4) Net interest income from passive equity-financed lending 
activity.
    (i) In general.
    (ii) Equity-financed lending activity.
    (A) In general.
    (B) Certain liabilities not taken into account.
    (iii) Equity-financed interest income.
    (iv) Net interest income.
    (v) Interest-bearing assets.
    (vi) Liabilities incurred in the activity.
    (vii) Average outstanding balance.
    (viii) Example.
    (5) Net income from certain property rented incidental to 
development activity.
    (i) In general. [Reserved]
    (ii) Commencement of use. [Reserved]
    (iii) Services performed for the purpose of enhancing the value of 
property. [Reserved]
    (iv) Examples. [Reserved]
    (6) Property rented to a nonpassive activity.
    (7) Special rules applicable to the acquisition of an interest of a 
passthrough entity engaged in the trade or business of licensing 
intangible property.
    (i) In general.
    (ii) Royalty income from property.
    (iii) Exceptions.
    (iv) Capital expenditures.
    (v) Example.
    (8) Limitation on recharacterized income.
    (9) Meaning of certain terms.
    (10) Coordination with section 163(d).
    (11) Effective date.

                 Sec.  1.469-3 Passive activity credit.

    (a)-(d) [Reserved]
    (e) Coordination with section 38(b).
    (f) Coordination with section 50.
    (g) [Reserved]

           Sec.  1.469-3T Passive activity credit (temporary).

    (a) Computation of passive activity credit.
    (b) Credits subject to section 469.
    (1) In general.
    (2) Treatment of credits attributed to qualified progress 
expenditures.
    (3) Special rule for partners and S corporations shareholders.
    (4) Exception for pre-1987 credits.
    (c) Taxable year to which credit is attributable.
    (d) Regular tax liability allocable to passive activities.
    (1) In general.
    (2) Regular tax liability.
    (e) Coordination with section 38(b). [Reserved]
    (f) Coordination with section 47. [Reserved]
    (g) Examples.

                  Sec.  1.469-4 Definition of activity.

    (a) Scope and purpose.
    (b) Definitions.
    (1) Trade or business activities.
    (2) Rental activities.
    (c) General rules for grouping activities.
    (1) Appropriate economic unit.
    (2) Facts and circumstances test.
    (3) Examples.
    (d) Limitation on grouping certain activities.

[[Page 445]]

    (1) Grouping rental activities with other trade or business 
activities.
    (i) Rule.
    (ii) Examples.
    (2) Grouping real property rentals and personal property rentals 
prohibited.
    (3) Certain activities of limited partners and limited 
entrepreneurs.
    (i) In general.
    (ii) Example.
    (4) Other activities identified by the Commissioner.
    (5) Activities conducted through section 469 entities.
    (i) In general.
    (ii) Cross reference.
    (e) Disclosure and consistency requirements.
    (1) Original groupings.
    (2) Regroupings.
    (f) Grouping by Commissioner to prevent tax avoidance.
    (1) Rule.
    (2) Example.
    (g) Treatment of partial dispositions.
    (h) Rules for grouping rental real estate activities for taxpayers 
qualifying under section 469(c)(7).

                  Sec.  1.469-5 Material participation.

    (a)-(e) [Reserved]
    (f) Participation.
    (1) In general.
    (f)(2)-(h)(2) [Reserved]
    (3) Coordination with rules governing the treatment of passthroughs 
entities.
    (i) [Reserved]
    (j) Material participation for preceding taxable years.
    (1) In general.
    (2) Material participation test for taxable years beginning before 
January 1, 1987
    (k) Examples (1)-(4). [Reserved]
    (k) Example 5.
    (k) Examples (6)-(8). [Reserved]

           Sec.  1.469-5T Material participation (temporary).

    (a) In general.
    (b) Facts and circumstances.
    (1) In general. [Reserved]
    (2) Certain participation insufficient to constitute material 
participation under this paragraph (b).
    (i) Participation satisfying standards not contained in section 469.
    (ii) Certain management activities.
    (iii) Participation less than 100 hours.
    (c) Significant participation activity.
    (1) In general.
    (2) Significant participation.
    (d) Personal service activity.
    (e) Treatment of limited partners.
    (1) General rule.
    (2) Exceptions.
    (3) Limited partnership interest.
    (i) In general.
    (ii) Limited partner holding general partner interest.
    (f) Participation. [Reserved]
    (1) In general. [Reserved]
    (2) Exceptions.
    (i) Certain work not customarily done by owners.
    (ii) participation as an investor.
    (A) In general.
    (B) Work done in individual's capacity as an investor.
    (3) Participation of spouses.
    (4) Methods of proof.
    (g) Material participation of trust and estates. [Reserved]
    (h) Miscellaneous rules.
    (1) Participation of corporations.
    (2) Treatment of certain retired farmers and surviving spouses of 
retired or disabled farmers.
    (3) Coordination with rules governing the treatment of passthroughs 
entities. [Reserved]
    (i) [Reserved]
    (j) Material participation for preceding taxable years. [Reserved]
    (1) In general. [Reserved]
    (2) Material participation for taxable years beginning before 
January 1, 1987. [Reserved]
    (k) Examples.

 Sec.  1.469-6 Treatment of losses upon certain dispositions. [Reserved]

  Sec.  1.469-7 Treatment of self-charged items of interest income and 
                               deduction.

    (a) In general.
    (1) Applicability and effect of rules.
    (2) Priority of rules in this section.
    (b) Definitions.
    (1) Passthrough entity.
    (2) Taxpayer's share.
    (3) Taxpayer's indirect interest.
    (4) Entity taxable year.
    (5) Deductions for a taxable year.
    (c) Taxpayer loans to passthrough entity.
    (1) Applicability.
    (2) General rule.
    (3) Applicable percentage.
    (d) Passthrough entity loans to taxpayer.
    (1) Applicability.
    (2) General rule.
    (3) Applicable percentage.
    (e) Identically-owned passthrough entities.
    (1) Applicability.
    (2) General rule.
    (1) Example.
    (f) Identification of properly allocable deductions.
    (g) Election to avoid application of the rules of this section.
    (1) In general.
    (2) Form of election.
    (3) Period for which election applies.
    (4) Revocation.
    (h) Examples.

[[Page 446]]

 Sec.  1.469-8 Application of section 469 to trust, estates, and their 
                        beneficiaries. [Reserved]

     Sec.  1.469-9 Rules for certain rental real estate activities.

    (a) Scope and purpose.
    (b) Definitions.
    (1) Trade or business.
    (2) Real property trade or business.
    (3) Rental real estate.
    (4) Personal services.
    (5) Material participation.
    (6) Qualifying taxpayer.
    (c) Requirements for qualifying taxpayers.
    (1) In general.
    (2) Closely held C corporations.
    (3) Requirement of material participation in the real property 
trades or businesses.
    (4) Treatment of spouses.
    (5) Employees in real property trades or businesses.
    (d) General rule for determining real property trades or businesses.
    (1) Facts and circumstances.
    (2) Consistency requirement.
    (e) Treatment of rental real estate activities of a qualifying 
taxpayer.
    (1) In general.
    (2) Treatment as a former passive activity.
    (3) Grouping rental real estate activities with other activities.
    (i) In general.
    (ii) Special rule for certain management activities.
    (4) Example.
    (f) Limited partnership interests in rental real estate activities.
    (1) In general.
    (2) De minimis exception.
    (g) Election to treat all interests in rental real estate as a 
single rental real estate activity.
    (1) In general.
    (2) Certain changes not material.
    (3) Filing a statement to make or revoke the election.
    (h) Interests in rental real estate held by certain passthrough 
entities.
    (1) General rule.
    (2) Special rule if a qualifying taxpayer holds a fifty-percent or 
greater interest in a passthrough entity.
    (3) Special rule for interests held in tiered passthrough entities.
    (i) [Reserved]
    (j) $25,000 offset for rental real estate activities of qualifying 
taxpayers.
    (1) In general.
    (2) Example.

      Sec.  1.469-10 Application of section 469 to publicly traded 
                        partnerships. [Reserved]

           Sec.  1.469-11 Effective date and transition rules.

    (a) Generally applicable effective dates.
    (b) Additional effective dates.
    (1) Application of 1992 amendments for taxable years beginning 
before October 4, 1994.
    (2) Additional transition rule for 1992 amendments.
    (3) Fresh starts under consistency rules.
    (i) Regrouping when tax liability is first determined under Project 
PS-1-89.
    (ii) Regrouping when tax liability is first determined under Sec.  
1.469-4.
    (iii) Regrouping when taxpayer is first subject to section 
469(c)(7).
    (iv) Regrouping for taxpayers subject to section 1411.
    (A) In general.
    (B) Eligibility criteria.
    (C) Consequences of amended returns and examination adjustments.
    (1) Taxpayers first subject to section 1411.
    (2) Taxpayers ceasing to be subject to section 1411.
    (3) Examples.
    (D) Effective/applicability date.
    (4) Certain investment credit property.
    (c) Special rules.
    (1) Application of certain income recharacterization rules and self-
charged rules.
    (i) Certain recharacterization rules inapplicable in 1987.
    (ii) Property rented to a nonpassive activity.
    (iii) Self-charged rules.
    (2) Qualified low-income housing projects.
    (3) Effect of events occurring in years prior to 1987.
    (d) Examples.

[T.D. 8417, 57 FR 20748, May 15, 1992, as amended by T.D. 8477, 58 FR 
11538, Feb. 26, 1993; T.D. 8495, 58 FR 58787, Nov. 4, 1993; T.D. 8565, 
59 FR 50487, Oct. 4, 1994; T.D. 8597, 60 FR 36684, July 18, 1995; T.D. 
8645, 60 FR 66498, Dec. 22, 1995; T.D. 9013, 67 FR 54089, Aug. 21, 2002; 
T.D. 9644, 78 FR 72421, Dec. 2, 2013]



Sec.  1.469-1  General rules.

    (a)-(c)(7) [Reserved]
    (c)(8) Consolidated groups. Rules relating to the application of 
section 469 to consolidated groups are contained in paragraph (h) of 
this section.
    (c)(9)-(d)(1) [Reserved]
    (d)(2) Coordination with sections 613A (d) and 1211. A passive 
activity deduction that is not disallowed for the taxable year under 
section 469 and the regulations thereunder may nonetheless be disallowed 
for the taxable year under section 613A(d) or 1211. The following 
example illustrates the application of this paragraph (d)(2):

    Example. In 1993, an individual derives $10,000 of ordinary income 
from passive activity X, no gains from the sale or exchange of capital 
assets or assets used in a trade or

[[Page 447]]

business, $12,000 of capital loss from passive activity Y, and no 
income, gain, deductions, or losses from any other passive activity. The 
capital loss from activity Y is a passive activity deduction (within the 
meaning of Sec.  1.469-2T(d)). Under section 469 and the regulations 
thereunder, the taxpayer is allowed $10,000 of the $12,000 passive 
activity deduction and has a $2,000 passive activity loss for the 
taxable year. Since the $10,000 passive activity deduction allowed under 
section 469 is a capital loss, such deduction is allowable for the 
taxable year only to the extent provided under section 1211. Therefore, 
the taxpayer is allowed $3,000 of the $10,000 capital loss under section 
1211 and has a $7,000 capital loss carryover (within the meaning of 
section 1212(b)) to the succeeding taxable year.

    (d)(3)-(e)(1) [Reserved]
    (e)(2) Trade or business activities. Trade or business activities 
are activities that constitute trade or business activities within the 
meaning of Sec.  1.469-4(b)(1).
    (e)(3)(i)-(e)(3)(ii) [Reserved]
    (e)(3)(iii) Average period of customer use--(A) In general. For 
purposes of this paragraph (e)(3), the average period of customer use 
for property held in connection with an activity (the activity's average 
period of customer use) is the sum of the average use factors for each 
class of property held in connection with the activity.
    (B) Average use factor. The average use factor for a class of 
property held in connection with an activity is the average period of 
customer use for that class of property multiplied by the fraction 
obtained by dividing--
    (1) The activity's gross rental income attributable to that class of 
property; by
    (2) The activity's gross rental income.
    (C) Average period of customer use for class of property. In 
determining an activity's average period of customer use for a taxable 
year, the average period of customer use for a class of property held in 
connection with an activity is determined by dividing--
    (1) The aggregate number of days in all periods of customer use for 
property in the class (taking into account only periods that end during 
the taxable year or that include the last day of the taxable year); by
    (2) The number of those periods of customer use.
    (D) Period of customer use. Each period during which a customer has 
a continuous or recurring right to use an item of property held in 
connection with the activity (without regard to whether the customer 
uses the property for the entire period or whether the right to use the 
property is pursuant to a single agreement or to renewals thereof) is 
treated for purposes of this paragraph (e)(3)(iii) as a separate period 
of customer use. The duration of a period of customer use that includes 
the last day of a taxable year may be determined on the basis of 
reasonable estimates.
    (E) Class of property. Taxpayers may organize property into classes 
for purposes of this paragraph (e)(3)(iii) using any method under which 
items of property for which the amount of the daily rent differs 
significantly are not included in the same class.
    (F) Gross rental income and daily rent. In determining an activity's 
average period of customer use for a taxable year--
    (1) The activity's gross rental income is the gross income from the 
activity for the taxable year taking into account only income that is 
attributable to amounts paid for the use of property;
    (2) The activity's gross rental income attributable to a class of 
property is the gross income from the activity for the taxable year 
taking into account only income that is attributable to amounts paid for 
the use of property in that class; and
    (3) The daily rent for items of property may be determined on any 
basis that reasonably reflects differences during the taxable year in 
the amounts ordinarily paid for one day's use of those items of 
property.
    (e)(3)(iv)-(e)(3)(vi)(C) [Reserved]
    (e)(3)(vi)(D) Lodging rented for convenience of employer. The 
provision of lodging to an employee or to an employee's spouse or 
dependents is treated as incidental to the activity (or activities) of 
the taxpayer in which the employee performs services if the lodging is 
furnished for the taxpayer's convenience (within the meaning of section 
119).
    (E) Unadjusted basis. For purposes of this paragraph (e)(3)(vi), the 
term unadjusted basis means adjusted basis determined without regard to 
any adjustment described in section 1016 that decreases basis.

[[Page 448]]

    (e)(3)(vii)-(e)(4)(iii) [Reserved]
    (e)(4)(iv) Definition of ``working interest.'' For purposes of 
section 469 and the regulations thereunder, the term working interest 
means a working or operating mineral interest in any tract or parcel of 
land (within the meaning of Sec.  1.612-4(a)).
    (e)(4)(v)-(f)(3) [Reserved]
    (f)(4) Carryover of disallowed deductions and credits--(i) In 
general. In the case of an activity of a taxpayer with respect to which 
any deductions or credits are disallowed for a taxable year under Sec.  
1.469-1T (f)(2) or (f)(3) (the loss activity)--
    (A) The disallowed deductions or credits is allocated among the 
taxpayer's activities for the succeeding taxable year in a manner that 
reasonably reflects the extent to which each activity continues the loss 
activity; and
    (B) The disallowed deductions or credits allocated to an activity 
under paragraph (f)(4)(i)(A) of this section shall be treated as 
deductions or credits from the activity for the succeeding taxable year.
    (ii) Business continued through C corporations or similar entities. 
If a taxpayer continues part or all of a loss activity through a C 
corporation or similar entity (C corporation entity), the taxpayer's 
interest in the C corporation entity shall be treated for purposes of 
this paragraph (f)(4) as an interest in a passive activity that 
continues that loss activity in whole or part. An entity is similar to a 
C corporation for this purpose if the owners of interests in the entity 
derive only portfolio income (within the meaning of Sec.  1.469-
2T(c)(3)(i)) from the interests.
    (iii) Examples. The following examples illustrate the application of 
this paragraph (f)(4). In each example, the taxpayer is an individual 
whose taxable year is the calendar year.

    Example 1. (i) The taxpayer owns interests in a convenience store 
and an apartment building. In each taxable year, the taxpayer's 
interests in the convenience store and the apartment building are 
treated under Sec.  1.469-4 as interests in two separate passive 
activities of the taxpayer. A $5,000 loss from the convenience-store 
activity and a $3,000 loss from the apartment-building activity are 
disallowed under Sec.  1.469-1T(f)(2) for 1993. Under Sec.  1.469-
1T(f)(2), the $5,000 loss from the convenience-store activity is 
allocated among the passive activity deductions from that activity for 
1993, and the $3,000 loss from the apartment-building activity is 
treated similarly.
    (ii) In 1994, the convenience store is continued in a single 
activity, and the section 469 activities that constituted the apartment 
building is similarly continued in a separate activity. Thus, the 
disallowed deductions from the convenience-store activity for 1993 must 
be allocated under paragraph (f)(4)(i)(A) of this section to the 
taxpayer's convenience-store activity in 1994. Similarly, the disallowed 
deductions from the apartment-building activity for 1993 must be 
allocated to the taxpayer's apartment-building activity in 1994. Under 
paragraph (f)(4)(i)(B) of this section, the disallowed deductions 
allocated to the convenience-store activity in 1994 are treated as 
deductions from that activity for 1994, and the disallowed deductions 
allocated to the apartment-building activity for 1994 are treated as 
deductions from the apartment-building activity for 1994.
    Example 2. (i) In 1993, the taxpayer acquires a restaurant and a 
catering business. Assume that in 1993 and 1994 the restaurant and the 
catering business are treated under Sec.  1.469-4 as an interest in a 
single passive activity of the taxpayer (the restaurant and catering 
activity). A $10,000 loss from the activity is disallowed under Sec.  
1.469-1T(f)(2) for 1994. Assume that in 1995, the taxpayer's interests 
in the restaurant and the catering business are treated under Sec.  
1.469-4 as interests in two separate passive activities of the taxpayer.
    (ii) Under Sec.  1.469-1T(f)(2), the $10,000 loss from the 
restaurant and catering activity is allocated among the passive activity 
deductions from that activity for 1994. In 1995, the businesses that 
constituted the restaurant and catering activity are continued, but are 
treated as two separate activities under Sec.  1.469-4. Thus, the 
disallowed deductions from the restaurant and catering activity for 1994 
must be allocated under paragraph (f)(4)(i)(A) of this section between 
the restaurant activity and the catering activity in 1995 in a manner 
that reasonably reflects the extent to which each of the activities 
continues the single restaurant and catering activity. Under paragraph 
(f)(4)(i)(B) of this section, the disallowed deductions allocated to the 
restaurant activity in 1995 are treated as deductions from the 
restaurant activity for 1995, and the disallowed deductions allocated to 
the catering activity in 1995 are treated as deductions from the 
catering activity for 1995.
    Example 3. (i) In 1993, the taxpayer acquires a restaurant and a 
catering business. Assume that in 1993 and 1994 the restaurant and the 
catering business are treated underSec.  1.469-4 as an interest in a 
single passive activity of the taxpayer (the restaurant and catering 
activity). A $10,000 loss from the activity is

[[Page 449]]

disallowed under Sec.  1.469-1T(f)(2) for 1994. Assume that in 1995, the 
taxpayer's interests in the restaurant and the catering business are 
treated under Sec.  1.469-4 as interestes in two separate passive 
activities of the taxpayer. In addition, a $20,000 loss from the 
activity was disallowed under Sec.  1.469-1T(f)(2) for 1993, and the 
gross income and deductions (including deductions that were disallowed 
for 1993 under Sec.  1.469-1T(f)(2)) from the restaurant and catering 
business for 1993 and 1994 are as follows:

------------------------------------------------------------------------
                                                               Catering
                                                 Restaurant    business
------------------------------------------------------------------------
1993:
  Gross income................................      $20,000      $60,000
  Deductions..................................       40,000       60,000
                                               --------------
      Net income (loss).......................     (20,000)  ...........
1994:
  Gross income................................       40,000       50,000
  Deductions..................................   \1\ 30,000   \2\ 70,000
                                               --------------
      Net income (loss).......................       10,000     (20,000)
------------------------------------------------------------------------
\1\ Includes $8,000 of deductions that were disallowed for 1993 ($20,000
  x $40,000/$100,000).
\2\ Includes $12,000 of deductions that were disallowed for 1993
  ($20,000 x $60,000/$100,000).

    (ii) Under paragraph (f)(4)(i)(A) of this section, the disallowed 
deductions from the restaurant and catering activity must be allocated 
among the taxpayer's activities for the succeeding year in a manner that 
reasonably reflects the extent to which those activities continue the 
restaurant and catering activity. The remainder of this example 
describes a number of allocation methods that will ordinarily satisfy 
the requirement of paragraph (f)(4)(i)(A) of this section. The 
description of specific allocation methods in this example does not 
preclude the use of other reasonable allocation methods for purposes of 
paragraph (f)(4)(i)(A) of this section.
    (iii) Ordinarily, an allocation of disallowed deductions from the 
restaurant to the restaurant activity and disallowed deductions from the 
catering business to the catering activity would satisfy the requirement 
of paragraph (f)(4)(i)(A) of this section. Under Sec.  1.469-1T 
(f)(2)(ii), a ratable portion of each deduction from the restaurant and 
catering activity is disallowed for 1994. Thus, $3,000 of the 1994 
deductions from the restaurant are disallowed ($10,000 x $30,000/
$100,000), and $7,000 of the 1994 deductions from the catering business 
are disallowed ($10,000 x $70,000/$100,000). Thus, the taxpayer can 
ordinarily treat $3,000 of the disallowed deductions as deductions from 
the restaurant activity for 1995, and $7,000 of the disallowed 
deductions as deductions from the catering activity for 1995.
    (iv) Ordinarily, an allocation of disallowed deductions between the 
restaurant activity and catering activity in proportion to the losses 
from the restaurant and from the catering business for 1994 would also 
satisfy the requirement of paragraph (f)(4)(i)(A) of this section. If 
the restaurant and the catering business had been treated as separate 
activities in 1994, the restaurant activity would have had net income of 
$10,000 and the catering activity would have had a $20,000 loss. Thus, 
the taxpayer can ordinarily treat all $10,000 of disallowed deductions 
as deductions from the catering activity for 1995.
    (v) Ordinarily, an allocation of disallowed deductions between the 
restaurant activity and catering activity in proportion to the losses 
from the restaurant and from the catering business for 1994 (determined 
as if the restaurant and the catering business had been separate 
activities for all taxable years) would also satisfy the requirement of 
paragraph (f)(4)(i)(A) of this section. If the restaurant and the 
catering business had been treated as separate activities for all 
taxable years, the entire $20,000 loss from the restaurant in 1993 would 
have been allocated to the restaurant activity in 1994, and the gross 
income and deductions from the separate activities for 1994 would be as 
follows:

------------------------------------------------------------------------
                                                               Catering
                                                 Restaurant    business
------------------------------------------------------------------------
Gross income..................................      $40,000      $50,000
Deductions....................................       42,000       58,000
                                               -------------------------
      Net income (loss).......................      (2,000)      (8,000)
------------------------------------------------------------------------

    Thus, the taxpayer can ordinarily treat $2,000 of the disallowed 
deductions as deductions from the restaurant activity for 1995, and 
$8,000 of the disallowed deductions as deductions from the catering 
activity for 1995.
    Example 4. (i) The taxpayer is a partner in a law partnership that 
acquires a building in December 1993 for use in the partnership's law 
practice. In taxable year 1993, four floors that are not needed in the 
law practice are leased to tenants; in taxable year 1994, two floors are 
leased to tenants; in taxable years after 1994, only one floor is leased 
to tenants and the rental operations are insubstantial. Assume that 
under Sec.  1.469-4, the law practice and the rental property are 
treated as a trade or business activity and a separate rental activity 
for taxable years 1993 and 1994. Assume further that the law practice 
and the rental operations are a single trade or business activity for 
taxable years after 1994 under Sec.  1.469-4. The trade or business 
activity is not a passive activity of the taxpayer. The rental activity, 
however, is a passive activity. Under Sec.  1.469-T(f)(2), a $12,000 
loss from the rental activity is disallowed for 1993 and a $9,000 loss 
from the rental activity is disallowed for 1994.
    (ii) Under Sec.  1.469-1T(f)(2), the $12,000 loss from the rental 
activity for 1993 is allocated among the passive activity deductions 
from that activity for 1993. In 1994, the business of

[[Page 450]]

the rental activity is continued in two separate activities. Only two 
floors of the building remain in the rental activity, and the other two 
floors (i.e., the floors that were leased to tenants in 1993, but not in 
1994) are used in the taxpayer's law-practice activity. Thus, the 
disallowed deductions from the rental activity for 1993 must be 
allocated under paragraph (f)(4)(i)(A) of this section between the 
rental activity and the law-practice activity in a manner that 
reasonably reflects the extent to which each of the activities continues 
business on the four floors that were leased to tenants in 1993. In 
these circumstances, the requirement of paragraph (f)(4)(i)(A) of this 
section would ordinarily be satisfied by any of the allocation methods 
illustrated in Example 3 or by an allocation of 50 percent of the 
disallowed deductions to each activity. Under paragraph (f)(4)(i)(B) of 
this section, the disallowed deductions allocated to the rental activity 
in 1994 are treated as deductions from the rental activity for 1994, and 
the disallowed deductions ($6,000) allocated to the law-practice 
activity in 1994 are treated as deductions from the law-practice 
activity for 1994.
    (iii) Under Sec.  1.469-1T(f)(2), the $9,000 loss from the rental 
activity for 1994 is allocated among the passive activity deductions 
from that activity for 1994. In 1995, the rental activity is continued 
in the taxpayer's law-practice activity. Thus, the disallowed deductions 
from the rental activity for 1994 must be allocated under paragraph 
(f)(4)(ii) of this section to the taxpayer's law-practice activity in 
1995. Under paragraph (f)(4)(i)(B) of this section, the disallowed 
deductions allocated to the law-practice activity are treated as 
deductions from the law-practice activity for 1995.
    (iv) Rules relating to former passive activities will be contained 
in paragraph (k) of this section. Under those rules, any disallowed 
deductions from the rental activity that are treated as deductions from 
the law-practice activity will be treated as unused deductions that are 
allocable to a former passive activity.
    Example 5. (i) The taxpayer owns stock in a corporation that is an S 
corporation for the taxpayer's 1993 taxable year and a C coporation 
thereafter. The only activity of the corporation is a rental activity. 
For 1993, the taxpayer's pro rata share of the corporation's loss from 
the rental activity is $5,000, and the entire loss is disallowed under 
Sec.  1.469-1T(f)(2) of this section.
    (ii) Under Sec.  1.469-1T(f)(2), the taxpayer's $5,000 loss from the 
rental activity is allocated among the taxpayer's deductions from that 
activity for 1993. In 1994, the rental activity is continued through a C 
corporation, and the taxpayer's interest in the C corporation is treated 
under paragraph (f)(4)(ii) of this section as a passive activity that 
continues the rental activity (the C corporation activity) for purposes 
of allocating the previously disallowed loss. Thus, the disallowed 
deductions from the rental activity for 1993 must be allocated under 
paragraph (f)(4)(i)(A) of this section to the taxpayer's C corporation 
activity in 1994, and are treated under paragraph (f)(4)(i)(B) of this 
section as deductions from the C corporation activity for 1994.
    (iii) Treating the taxpayer's interest in the C corporation as an 
interest in a passive activity that continues the business of the rental 
activity does not change the character of the taxpayer's dividend income 
from the C corporation. Thus, the taxpayer's dividend income is 
portfolio income (within the meaning of Sec.  1.469-2T(c)(3)(i)) and is 
not included in passive activity gross income. Accordingly, the 
taxpayer's loss from the C corporation activity for 1994 is $5,000.
    Example 6. (i) The taxpayer owns stock in a corporation that is an S 
corporation for the taxpayer's 1993 taxable year and a C corporation 
thereafter. The only activity of the corporation is a rental activity. 
For 1993, the taxpayer's pro rata share of the corporation's loss from 
the rental activity is $5,000, and the entire loss is disallowed under 
Sec.  1.469-1T(f)(2). The taxpayer has $2,000 in income from other 
passive activities for 1994, and as a result, only 60% of the taxpayer's 
loss from the C corporation activity ($3,000) is disallowed for 1994 
under Sec.  1.469-1T(f)(2).
    (ii) Under Sec.  1.469-1T(f)(2), the $3,000 disallowed loss from the 
C corporation activity is allocated among the passive activity 
deductions from that activity for 1994. In effect, therefore, 60 percent 
of each disallowed deduction from the rental activity for 1993 is again 
disallowed for 1994.
    (iii) Under paragraph (f)(4) of this section, the taxpayer's 
interest in the C corporation is treated as a loss activity and as an 
interest in a passive activity that continues the business of that loss 
activity for 1995. Thus, the disallowed deductions from the C 
corporation activity for 1994 must be allocated under paragraph 
(f)(4)(i)(A) of this section to the taxpayer's C corporation activity in 
1995, and are treated under paragraph (f)(4)(i)(B) of this section as 
deductions from that activity for 1995.

    (g)(1)-(g)(4)(ii)(B) [Reserved]
    (g)(4)(ii)(C) Portfolio income (within the meaning of Sec.  1.469-
2T(c)(3)(i)), including any gross income that is treated as portfolio 
income under any other provision of the regulations (See, e.g., Sec.  
1.469-2(c)(2)(iii)(F) (relating to gain from the disposition of 
substantially appreciated property formerly held for investment) and 
Sec.  1.469-2(f)(10) (relating to certain recharacterized passive 
activity gross income))
    (5) [Reserved]

[[Page 451]]

    (h)(1) In general. This paragraph (h) provides rules for applying 
section 469 in computing a consolidated group's consolidated taxable 
income and consolidated tax liability (and the separate taxable income 
and tax liability of each member).
    (2) Definitions. The definitions and nomenclature in the regulations 
under section 1502 apply for purposes of this paragraph (h). See, e.g., 
Sec. Sec.  1.1502-1 (definitions of group, consolidated group, member, 
subsidiary, and consolidated return year), 1.1502-2 (consolidated tax 
liability), 1.1502-11 (consolidated taxable income), 1.1502-12 (separate 
taxable income), 1.1502-13 (intercompany transactions), 1.1502-21 (net 
operating losses, and 1.1502-22 (consolidated net capital gain and 
loss).
    (3) [Reserved]
    (4) Status and participation of members--(i) Determination by 
reference to status and participation of group. For purposes of section 
469 and the regulations thereunder--
    (A) Each member of a consolidated group shall be treated as a 
closely held corporation or personal service corporation, respectively, 
for the taxable year, if and only if the consolidated group is treated 
(under the rules of paragraph (h)(4)(ii) of this section) as a closely 
held corporation or personal service corporation for that year; and
    (B) The determination of whether a trade or business activity 
(within the meaning of paragraph (e)(2) of this section) conducted by 
one or more members of a consolidated group is a passive activity of the 
members is made by reference to the consolidated group's participation 
in the activity.
    (ii) Determination of status and participation of consolidated 
group. For purposes of determining under Sec.  1.469-1T(g)(2) whether a 
consolidated group is treated as a closely held corporation or a 
personal service corporation, and determining under Sec.  1.469-1T(g)(3) 
whether the consolidated group materially or significantly participates 
in any activity conducted by one or more members of the group--
    (A) The members of the consolidated group shall be treated as one 
corporation;
    (B) Only the outstanding stock of the common parent shall be treated 
as outstanding stock of the corporation;
    (C) An employee of any member of the group shall be treated as an 
employee of the corporation; and
    (D) An activity is treated as the principal activity of the 
corporation if and only if it is the principal activity (within the 
meaning of Sec.  1.441-3(e)) of the consolidated group.
    (5) [Reserved]
    (6) Intercompany transactions--(i) In general. Section 1.1502-13 
applies to determine the treatment under section 469 of intercompany 
items and corresponding items from intercompany transactions between 
members of a consolidated group. For example, the matching rule of Sec.  
1.1502-13(c) treats the selling member (S) and the buying member (B) as 
divisions of a single corporation for purposes of determining whether 
S's intercompany items and B's corresponding items are from a passive 
activity. Thus, for purposes of applying Sec.  1.469-2(c)(2)(iii) and 
Sec.  1.469-2T(d)(5)(ii) to property sold by S to B in an intercompany 
transaction--
    (A) S and B are treated as divisions of a single corporation for 
determining the uses of the property during the 12-month period 
preceding its disposition to a nonmember, and generally have an 
aggregate holding period for the property; and
    (B) Sec.  1.469-2(c)(2)(iv) does not apply.
    (ii) Example. The following example illustrates the application of 
this paragraph (h)(6).

    Example. (i) P, a closely held corporation, is the common parent of 
the P consolidated group. P owns all of the stock of S and B. X is a 
person unrelated to any member of the P group. S owns and operates 
equipment that is not used in a passive activity. On January 1 of Year 
1, S sells the equipment to B at a gain. B uses the equipment in a 
passive activity and does not dispose of the equipment before it has 
been fully depreciated.
    (ii) Under the matching rule of Sec.  1.1502-13(c), S's gain taken 
into account as a result of B's depreciation is treated as gain from a 
passive activity even though S used the equipment in a nonpassive 
activity.
    (iii) The facts are the same as in paragraph (a) of this Example, 
except that B sells the equipment to X on December 1 of Year 3 at a 
further gain. Assume that if S and B were divisions of a single 
corporation, gain from

[[Page 452]]

the sale to X would be passive income attributable to a passive 
activity. To the extent of B's depreciation before the sale, the results 
are the same as in paragraph (ii) of this Example. B's gain and S's 
remaining gain taken into account as a result of B's sale are treated as 
attributable to a passive activity.
    (iv) The facts are the same as in paragraph (iii) of this Example, 
except that B recognizes a loss on the sale to X. B's loss and S's gain 
taken into account as a result of B's sale are treated as attributable 
to a passive activity.

    (iii) Effective dates. This paragraph (h)(6) applies with respect to 
transactions occurring in years beginning on or after July 12, 1995. For 
transactions occurring in years beginning before July 12, 1995, see 
Sec.  1.469-1T(h)(6) (as contained in the 26 CFR part 1 edition revised 
as of April 1, 1995).
    (h)(7)-(k) [Reserved]

[T.D. 8417, 57 FR 20750, May 15, 1992; 57 FR 28612, June 26, 1992, as 
amended by T.D. 8417, 59 FR 45623, Sept. 2, 1994; T.D. 8597, 60 FR 
36684, July 18, 1995; T.D. 8677, 61 FR 33322, June 27, 1996; T.D. 8823, 
64 FR 36099, July 2, 1999; T.D. 8996, 67 FR 35012, May 17, 2002]



Sec.  1.469-1T  General rules (temporary).

    (a) Passive activity loss and credit disallowed--(1) In general. 
Except as otherwise provided in paragraph (a)(2) of this section--
    (i) The passive activity loss for the taxable year shall not be 
allowed as a deduction; and
    (ii) The passive activity credit for the taxable year shall not be 
allowed.
    (2) Exceptions. Paragraph (a)(1) of this section shall not apply to 
the passive activity loss or the passive activity credit for the taxable 
year to the extent provided in--
    (i) Section 469(i) and the rules to be contained in Sec.  1.469-9T 
(relating to losses and credits attributable to certain rental real 
estate activities); and
    (ii) Section 1.469-11T (relating to losses and credits attributable 
to certain pre-enactment interests in activities).
    (b) Taxpayers to whom these rules apply. The rules of section 469 
and the regulations thereunder generally apply to--
    (1) Individuals;
    (2) Trusts (other than trusts (or portions of trusts) described in 
section 671);
    (3) Estates;
    (4) Personal service corporations (within the meaning of paragraph 
(g)(2)(i) of this section); and
    (5) Closely held corporations (within the meaning of paragraph 
(g)(2)(ii) of this section).
    (c) Cross references--(1) Definition of ``passive activity.'' Rules 
relating to the definition of the term ``passive activity'' are 
contained in paragraph (e) of this section.
    (2) Passive activity loss. Rules relating to the computation of the 
passive activity loss for the taxable year are contained in Sec.  1.469-
2T.
    (3) Passive activity credit. Rules relating to the computation of 
the passive activity credit for the taxable year are contained in Sec.  
1.469-3T.
    (4) Effect of rules for other purposes. Rules relating to the effect 
of section 469 and the regulations thereunder for other purposes under 
the Code are contained in paragraph (d) of this section.
    (5) Special rule for oil and gas working interests. Rules relating 
to the treatment of losses and credits from certain interests in oil and 
gas wells are contained in paragraph (e)(4) of this section
    (6) Treatment of disallowed losses and credits. Paragraph (f) of 
this section contains rules relating to--
    (i) The treatment of deductions from passive activities in taxable 
years in which the passive activity loss is disallowed in whole or in 
part under paragraph (a)(1)(i) of this section; and
    (ii) The treatment of credits from passive activities in taxable 
years in which the passive activity credit is disallowed in whole or in 
part under paragraph (a)(1)(ii) of this section.
    (7) Corporation subject to section 469. Rules relating to the 
application of section 469 and regulations thereunder to C corporations 
are contained in paragraph (g) of this section.
    (8) [Reserved]
    (9) Joint returns. Rules relating to the application of section 469 
and the regulations thereunder to spouses filing a joint return for the 
taxable year are contained in paragraph (j) of this section.
    (10) Material participation. Rules defining the term ``material 
participation'' are contained in Sec.  1.469-5T.

[[Page 453]]

    (11) Effective date and transition rules. Rules relating to the 
effective date of section 469 and the regulations thereunder and 
transition rules applicable to pre-enactment interests in activities are 
contained in Sec.  1.469-11T.
    (12) Future regulations. (i) Rules relating to former passive 
activities and changes in corporate status will be contained in 
paragraph (k) of this section.
    (ii) Rules relating to the definition of ``activity'' will be 
contained in Sec.  1.469-4T.
    (iii) Rules relating to the treatment of deductions from activities 
that are disposed of in certain transactions will be contained in Sec.  
1.469-6T.
    (iv) Rules relating to the treatment of self-charged items of income 
and expense will be contained in Sec.  1.469-7T.
    (v) Rules relating to the application of section 469 and the 
regulations thereunder to trusts, estates, and their beneficiaries will 
be contained in Sec.  1.469-8T.
    (vi) Rules relating to the treatment of income, deductions, and 
credits from certain rental real estate activities of individuals and 
certain estates will be contained in Sec.  1.469-9T.
    (vii) Rules relating to the application of section 469 to publicly 
traded partnerships will be contained in Sec.  1.469-10T.
    (d) Effect of section 469 and the regulations thereunder for other 
purposes--(1) Treatment of items of passive activity income and gain. 
Neither the provisions of section 469 (a)(1) and paragraph (a)(1) of 
this section nor the characterization of items of income or deduction as 
passive activity gross income (within the meaning of Sec.  1.469-2T (c)) 
or passive activity deductions (within the meaning of Sec.  1.469-2T 
(d)) affects the treatment of any item of income or gain under any 
provision of the Internal Revenue Code other than section 469. The 
following example illustrates the application of this paragraph (d)(1):

    Example. (i) In 1991, an individual's only income and loss from 
passive activities are a $10,000 capital gain from passive activity X 
and a $12,000 ordinary loss from passive activity Y. The taxpayer also 
has a $10,000 capital loss that is not derived from a passive activity.
    (ii) Under Sec.  1.469-2T (b), the taxpayer has a $2,000 passive 
activity loss for the taxable year. The only effect of section 469 and 
the regulations thereunder is to disallow a deduction for the taxpayer's 
$2,000 passive activity loss for the taxable year. Thus, the taxpayer's 
capital loss for the taxable year is allowed because the $10,000 capital 
gain from passive activity X is taken into account under section 1211 
(b) in computing the taxpayer's allowable capital loss for the year.

    (2) Coordination with sections 613A(d) and 1211. [Reserved]. See 
Sec.  1.469-1(d)(2) for rules relating to this paragraph.
    (3) Treatment of passive activity losses. Except as otherwise 
provided by regulations, a deduction that is disallowed for a taxable 
year under section 469 and the regulations thereunder is not taken into 
account as a deduction that is allowed for the taxable year in computing 
the amount subject to any tax imposed by subtitle A of the Internal 
Revenue Code. The following example illustrates the application of this 
paragraph (d)(3):

    Example. An individual has a $5,000 passive activity loss for a 
taxable year, all of which is disallowed under paragraph (a)(1) of this 
section. All of the disallowed loss is allocated under paragraph (f) of 
this section to activities that are trades or businesses (within the 
meaning of section 1402(c)). Such loss is not taken into account for the 
taxable year in computing the taxpayer's taxable income subject to tax 
under section 1. In addition, under this paragraph (d)(3), such loss is 
not taken into account for the taxable year in computing the taxpayer's 
net earnings from self-employment subject to tax under section 1401.

    (e) Definition of ``passive activity''--(1) In general. Except as 
otherwise provided in this paragraph (e), an activity is a passive 
activity of the taxpayer for a taxable year if and only if the 
activity--
    (i) Is a trade or business activity (within the meaning of paragraph 
(e)(2) of this section) in which the taxpayer does not materially 
participate for such taxable year; or
    (ii) Is a rental activity (within the meaning of paragraph (e)(3) of 
this section), without regard to whether or to what extent the taxpayer 
participates in such activity.
    (2) Trade or business activity. [Reserved]. See Sec.  1.469-1(e)(2) 
for rules relating to this paragraph.

[[Page 454]]

    (3) Rental activity--(i) In general. Except as otherwise provided in 
this paragraph (e)(3), an activity is a rental activity for a taxable 
year if--
    (A) During such taxable year, tangible property held in connection 
with the activity is used by customers or held for use by customers; and
    (B) The gross income attributable to the conduct of the activity 
during such taxable year represents (or, in the case of an activity in 
which property is held for use by customers, the expected gross income 
from the conduct of the activity will represent) amounts paid or to be 
paid principally for the use of such tangible property (without regard 
to whether the use of the property by customers is pursuant to a lease 
or pursuant to a service contract or other arrangement that is not 
denominated a lease).
    (ii) Exceptions. For purposes of this paragraph (e)(3), an activity 
involving the use of tangible property is not a rental activity for a 
taxable year if for such taxable year--
    (A) The average period of customer use for such property is seven 
days or less;
    (B) The average period of customer use for such property is 30 days 
or less, and significant personal services (within the meaning of 
paragraph (e)(3)(iv) of this section) are provided by or on behalf of 
the owner of the property in connection with making the property 
available for use by customers;
    (C) Extraordinary personal services (within the meaning of paragraph 
(e)(3)(v) of this section) are provided by or on behalf of the owner of 
the property in connection with making such property available for use 
by customers (without regard to the average period of customer use);
    (D) The rental of such property is treated as incidental to a 
nonrental activity of the taxpayer under paragraph (e)(3)(vi) of this 
section;
    (E) The taxpayer customarily makes the property available during 
defined business hours for nonexclusive use by various customers; or
    (F) The provision of the property for use in an activity conducted 
by a partnership, S corporation, or joint venture in which the taxpayer 
owns an interest is not a rental activity under paragraph (e)(3)(vii) of 
this section.
    (iii) Average period of customer use. [Reserved]. See Sec.  1.469-
1(e)(3)(iii) for rules relating to this paragraph.
    (iv) Significant personal services--(A) In general. For purposes of 
paragraph (e)(3)(ii)(B) of this section, personal services include only 
services performed by individuals, and do not include excluded services 
(within the meaning of paragraph (e)(3)(iv)(B) of this section). In 
determining whether personal services provided in connection with making 
property available for use by customers are significant, all of the 
relevant facts and circumstances shall be taken into account. Relevant 
facts and circumstances include the frequency with which such services 
are provided, the type and amount of labor required to perform such 
services, and the value of such services relative to the amount charged 
for the use of the property.
    (B) Excluded services. For purposes of paragraph (e)(3)(iv)(A) of 
this section, the term ``excluded services'' means, with respect to any 
property made available for use by customers--
    (1) Services necessary to permit the lawful use of the property;
    (2) Services performed in connection with the construction of 
improvements to the property, or in connection with the performance of 
repairs that extend the property's useful life for a period 
substantially longer than the average period for which such property is 
used by customers; and
    (3) Services, provided in connection with the use of any improved 
real property, that are similar to those commonly provided in connection 
with long-term rentals of high-grade commercial or residential real 
property (e.g., cleaning and maintenance of common areas, routine 
repairs, trash collection, elevator service, and security at entrances 
or perimeters).
    (v) Extraordinary personal services. For purposes of paragraph 
(e)(3)(ii)(C) of this section, extraordinary personal services are 
provided in connection with making property available for use by 
customers only if the services provided in connection with the use of 
the property are performed by individuals,

[[Page 455]]

and the use by customers of the property is incidental to their receipt 
of such services. For example, the use by patients of a hospital's 
boarding facilities generally is incidental to their receipt of the 
personal services provided by the hospital's medical and nursing staff. 
Similarly, the use by students of a boarding school's dormitories 
generally is incidental to their receipt of the personal services 
provided by the school's teaching staff.
    (vi) Rental of property incidental to a nonrental activity of the 
taxpayer--(A) In general. For purposes of paragraph (e)(3)(ii)(D) of 
this section, the rental of property shall be treated as incidental to a 
nonrental activity of the taxpayer only to the extent provided in this 
paragraph (e)(3)(vi).
    (B) Property held for investment. The rental of property during a 
taxable year shall be treated as incidental to an activity of holding 
such property for investment if and only if--
    (1) The principal purpose for holding the property during such 
taxable year is to realize gain from the appreciation of the property 
(without regard to whether it is expected that such gain will be 
realized from the sale or exchange of the property in its current state 
of development); and
    (2) The gross rental income from the property for such taxable year 
is less than two percent of the lesser of--
    (i) The unadjusted basis of such property; and
    (ii) The fair market value of such property.
    (C) Property used in a trade or business. The rental of property 
during a taxable year shall be treated as incidental to a trade or 
business activity (within the meaning of paragraph (e)(2) of this 
section) if and only if--
    (1) The taxpayer owns an interest in such trade or business activity 
during the taxable year;
    (2) The property was predominantly used in such trade or business 
activity during the taxable year or during at least two of the five 
taxable years that immediately precede the taxable year; and
    (3) The gross rental income from such property for the taxable year 
is less than two percent of the lesser of--
    (i) The unadjusted basis of such property; and
    (ii) The fair market value of such property.
    (D) Lodging for convenience of employer. [Reserved]. See Sec.  
1.469-1(e)(3)(vi)(D) for rules relating to this paragraph.
    (E) Unadjusted basis. [Reserved]. See Sec.  1.469-1(e)(3)(vi)(E) for 
rules relating to this paragraph.
    (vii) Property made available for use in a nonrental activity 
conducted by a partnership, S corporation, or joint venture in which the 
taxpayer owns an interest. If the taxpayer owns an interest in a 
partnership, S corporation, or joint venture conducting an activity 
other than a rental activity, and the taxpayer provides property for use 
in the activity in the taxpayer's capacity as an owner of an interest in 
such partnership, S corporation, or joint venture, the provision of such 
property is not a rental activity. Thus, if a partner contributes the 
use of property to a partnership, none of the partner's distributive 
share of partnership income is income from a rental activity unless the 
partnership is engaged in a rental activity. In addition, a partner's 
gross income attributable to a payment described in section 707(c) is 
not income from a rental activity under any circumstances (see Sec.  
1.469-2T (e)(2)). The determination of whether property used in an 
activity is provided by the taxpayer in the taxpayer's capacity as an 
owner of an interest in a partnership, S corporation, or joint venture 
shall be made on the basis of all of the facts and circumstances.
    (viii) Examples. The following examples illustrate the application 
of this paragraph (e)(3):

    Example 1. The taxpayer is engaged in an activity of leasing 
photocopying equipment. The average period of customer use for the 
equipment exceeds 30 days. Pursuant to the lease agreements, skilled 
technicians employed by the taxpayer maintain the equipment and service 
malfunctioning equipment for no additional charge. Service calls occur 
frequently (three times per week on average) and require substantial 
labor. The value of the maintenance and repair services (measured by the 
cost to the taxpayer of employees performing these services) exceeds 50 
percent of the amount charged for the use of the

[[Page 456]]

equipment. Under these facts, services performed by individuals are 
provided in connection with the use of the photocopying equipment, but 
the customers' use of the photocopying equipment is not incidental to 
their receipt of the services. Therefore, extraordinary personal 
services (within the meaning of paragraph (e)(3)(v) of this section) are 
not provided in connection with making the photocopying equipment 
available for use by customers, and the activity is a rental activity.
    Example 2. The facts are the same as in Example 1, except that the 
average period of customer use for the photocopying equipment exceeds 
seven days but does not exceed 30 days. Under these facts, significant 
personal services (within the meaning of paragraph (e)(3)(iv) of this 
section) are provided in connection with making the photocopying 
equipment available for use by customers and, under paragraph 
(e)(3)(ii)(B) of this section, the activity is not a rental activity.
    Example 3. The taxpayer is engaged in an activity of transporting 
goods for customers. In conducting the activity, the taxpayer provides 
tractor-trailers to transport goods for customers pursuant to 
arrangements under which the tractor-trailers are selected by the 
taxpayer, may be replaced at the sole option of the taxpayer, and are 
operated and maintained by drivers and mechanics employed by the 
taxpayer. The average period of customer use for the tractor-trailers 
exceeds 30 days. Under these facts, the use of tractor-trailers by the 
taxpayer's customers is incidental to their receipt of personal services 
provided by the taxpayer. Accordingly, the services performed in the 
activity are extraordinary personal services (within the meaning of 
paragraph (e)(3)(v) of this section) and, under paragraph (e)(3)(ii)(C) 
of this section, the activity is not a rental activity.
    Example 4. The taxpayer is engaged in an activity of owning and 
operating a residential apartment hotel. For the taxable year, the 
average period of customer use for apartments exceeds seven days but 
does not exceed 30 days. In addition to cleaning public entrances, 
exists, stairways, and lobbies, and collecting and removing trash, the 
taxpayer provides a daily maid and linen service at no additional 
charge. All of the services other than maid and linen service are 
excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this 
section), because such services are similar to those commonly provided 
in connection with long-term rentals of high-grade residential real 
property. The value of the maid and linen services (measured by the cost 
to the taxpayer of employees performing such services) is less than 10 
percent of the amount charged to tenants for occupancy of apartments. 
Under these facts, neither significant personal services (within the 
meaning of paragraph (e)(3)(iv) of this section) nor extraordinary 
personal services (within the meaning of paragraph (e)(3)(v) of this 
section) are provided in connection with making apartments available for 
use by customers. Accordingly, the activity is a rental activity.
    Example 5. The taxpayer owns 1,000 acres of unimproved land with a 
fair market value of $350,000 and an unadjusted basis of $210,000. The 
taxpayer holds the land for the principal purpose of realizing gain from 
appreciation. In order to defray the cost of carrying the land, the 
taxpayer leases the land to a rancher, who uses the land to graze cattle 
and pays rent of $4,000 per year. Thus, the gross rental income from the 
land is less than two percent of the lesser of the fair market value and 
the unadjusted basis of the land (.02 x $210,000 = $4,200). Accordingly, 
under paragraph (e)(3)(ii)(D) of this section, the rental of the land is 
not a rental activity because the rental is treated under paragraph 
(e)(3)(vi)(B) of this section as incidental to an activity of holding 
the property for investment.
    Example 6. (i) A calendar year taxpayer owns an interest in a 
farming activity which is a trade or business activity (within the 
meaning of paragraph (e)(2) of this section) and owns farmland which was 
used in the farming activity in 1985 and 1986. The fair market value of 
the farmland is $350,000 and its unadjusted basis is $210,000. In 1987, 
1988, and 1989, the taxpayer continues to own an interest in the farming 
activity but does not use the land in the activity. In 1987, the 
taxpayer leases the land for $4,000 to a rancher, who uses the land to 
graze cattle. In 1988, the taxpayer leases the land for $10,000 to a 
film production company, which uses the land to film scenes for a movie. 
In 1989, the taxpayer again leases the land for $4,000 to the rancher.
    (ii) For 1987 and 1989, the taxpayer owns an interest in a trade or 
business activity, and the farmland which the taxpayer leases to the 
rancher was used in such activity for two out of the five immediately 
preceding taxable years. In addition, the gross rental income from the 
land ($4,000) is less than two percent of the lesser of the fair market 
value and the unadjusted basis of the land (.02 x $210,000 = $4,200). 
Accordingly, the taxpayer's rental of the land is treated under 
paragraph (e)(3)(vi)(C) of this section as incidental to the taxpayer's 
farming activity, and is not a rental activity.
    (iii) Because the taxpayer's gross rental income from the land for 
1988 ($10,000) is not less than two percent of the lesser of the fair 
market value and the unadjusted basis of the land, the requirement of 
paragraph (e)(3)(vi)(C)(3) of this section is not met. Therefore, the 
taxpayer's rental of the land in 1988 is not treated as incidental to 
the taxpayer's farming activity and is a rental activity.

[[Page 457]]

    Example 7. (i) In 1988, the taxpayer acquires vacant land for the 
purpose of constructing a shopping mall. Before commencing construction, 
the taxpayer leases the land under a one-year lease to an automobile 
dealer, who uses the land to park cars held in its inventory. The 
taxpayer commences construction of the shopping mall in 1989.
    (ii) The taxpayer acquired the land for the principal purpose of 
constructing the shopping mall, not for the principal purpose of 
realizing gain from the appreciation of the property. Therefore, the 
rental of the property in 1988 is not treated under paragraph 
(e)(3)(vi)(B) of this section as incidental to an activity of holding 
the property for investment.
    (iii) The land has not been used in any taxable year in any trade or 
business of the taxpayer. Therefore, the rental of the property in 1988 
is not treated under paragraph (e)(3)(vi)(C) of this section as 
incidental to a trade or business activity.
    (iv) Since the rental of the land in 1988 is not treated under 
paragraph (e)(3)(vi) of this section as incidental to a nonrental 
activity of the taxpayer, the rental of the land in 1988 is a rental 
activity. See Sec.  1.469-2T(f)(3) for a special rule relating to the 
treatment of gross income from the rental of nondepreciable property.
    Example 8. The taxpayer makes farmland available to a tenant farmer 
pursuant to an arrangement designated a ``crop-share lease.'' Under the 
arrangement, the tenant is required to use the tenant's best efforts to 
farm the land and produce marketable crops. The taxpayer is obligated to 
pay 50 percent of the costs incurred in the activity (without regard to 
whether any crops are successfully produced or marketed), and is 
entitled to 50 percent of the crops produced (or 50 percent of the 
proceeds from marketing the crops). For purposes of paragraph 
(e)(3)(vii) of this section, the taxpayer is treated as providing the 
farmland for use in a farming activity conducted by a joint venture in 
the taxpayer's capacity as an owner of an interest in the joint venture. 
Accordingly, under paragraph (e)(3)(ii)(F) of this section, the taxpayer 
is not engaged in a rental activity, without regard to whether the 
taxpayer performs any services in the farming activity.
    Example 9. The taxpayer owns a taxicab which the taxpayer operates 
during the day and leases to another driver for use at night under a 
one-year lease. Under the terms of the lease, the other driver is 
charged a fixed rental for use of the taxicab. Assume that, under the 
rules to be contained in Sec.  1.469-4T, the taxpayer is engaged in two 
separate activities, an activity of operating the taxicab and an 
activity of making the taxicab available for use by the other driver. 
Under these facts, the period for which the other driver uses the 
taxicab exceeds 30 days, and the taxpayer does not provide extraordinary 
personal services in connection with making the taxicab available to the 
other driver. Accordingly, the lease of the taxicab is a rental 
activity.
    Example 10. The taxpayer operates a golf course. Some customers of 
the golf course pay green fees upon each use of the golf course, while 
other customers purchase weekly, monthly, or annual passes. The golf 
course is open to all customers from sunrise to sunset every day of the 
year except certain holidays and days on which the taxpayer determines 
that the course is too wet for play. The taxpayer thus makes the golf 
course available during prescribed hours for nonexclusive use by various 
customers. Accordingly, under paragraph (e)(3)(ii)(E) of this section, 
the taxpayer is not engaged in a rental activity, without regard to the 
average period of customer use for the golf course.

    (4) Special rule for oil and gas working interests--(i) In general. 
Except as otherwise provided in paragraph (e)(4)(ii) of this section, an 
interest in an oil or gas well drilled or operated pursuant to a working 
interest (within the meaning of paragraph (e)(4)(iv) of this section) of 
a taxpayer is not an interest in a passive activity for the taxpayer's 
taxable year (without regard to whether the taxpayer materially 
participates in such activity) if at any time during such taxable year 
the taxpayer holds such working interest either--
    (A) Directly; or
    (B) Through an entity that does not limit the liability of the 
taxpayer with respect to the drilling or operation of such well pursuant 
to such working interest.
    (ii) Exception for deductions attributable to a period during which 
liability is limited--(A) In general. If paragraph (e)(4)(i) of this 
section applies for a taxable year to the taxpayer's interest in an oil 
or gas well that would, but for the application of paragraph (e)(4)(i) 
of this section, by an interest in a passive activity for the taxable 
year, and the taxpayer has a net loss (within the meaning of paragraph 
(e)(4)(ii)(C)(3) of this section) from the well for the taxable year--
    (1) The taxpayer's disqualified deductions (within the meaning of 
paragraph (e)(4)(ii)(C)(2) of this section) from such oil or gas well 
for such year shall be treated as passive activity deductions for such 
year (within the meaning of Sec.  1.469-2T(d)); and

[[Page 458]]

    (2) A ratable portion (within the meaning of paragraph 
(e)(4)(ii)(C)(4) of this section) of the taxpayer's gross income from 
such oil or gas well for such year shall be treated as passive activity 
gross income for such year (within the meaning of Sec.  1.469-2T(c)).
    (B) Coordination with rules governing the identification of 
disallowed passive activity deductions. If gross income and deductions 
from an activity for a taxable year are treated as passive activity 
gross income and passive activity deductions under paragraph 
(e)(4)(ii)(A) of this section, such activity shall be treated as a 
passive activity for such year for purposes of applying paragraph (f) 
(2) and (4) of this section.
    (C) Meaning of certain terms. For purposes of this paragraph 
(e)(4)(ii), the following terms shall have the meanings set forth below:
    (1) Allocable deductions. The deductions allocable to a taxable year 
are any deductions that arise in such year (within the meaning of Sec.  
1.469-2T (d)(8)) and any deductions that are treated as deductions for 
such year under paragraph (f)(4) of this section.
    (2) Disqualified deductions. The taxpayer's ``disqualified 
deductions'' from an oil or gas well for a taxable year are the 
taxpayer's deductions--
    (i) That are attributable to such well and allocable to the taxable 
year; and
    (ii) With respect to which economic performance (within the meaning 
of section 461(h), without regard to section 461 (h)(3) or (i)(2)) 
occurs at a time during which the taxpayer's only interest in the 
working interest is held through an entity that limits the taxpayer's 
liability with respect to the drilling or operation of such well.
    (3) Net loss. The ``net loss'' of a taxpayer from an oil or gas well 
for a taxable year equals the amount by which the taxpayer's deductions 
that are attributable to such oil or gas well and allocable to such year 
exceeds the gross income of the taxpayer from such well for such year.
    (4) Ratable portion. The ``ratable portion'' of the taxpayer's gross 
income from an oil or gas well for a taxable year equals the total 
amount of such gross income multiplied by the fraction obtained by 
dividing--
    (i) The disqualified deductions from such oil or gas well for the 
taxable year; by
    (ii) The total amount of the deductions that are attributable to 
such oil or gas well and allocable to the taxable year.
    (iii) Examples. The following examples illustrate the application of 
paragraphs (e)(4) (i) and (ii) of this section:

    Example 1. (i) A, a calendar year individual, acquires on January 1, 
1987, a general partnership interest in P, a calendar year partnership 
that holds a working interest in an oil or gas property. Pursuant to the 
partnership agreement, A is entitled to convert the general partnership 
interest into a limited partnership interest at any time. On December 1, 
1987, pursuant to a contract with D, an independent drilling contractor, 
P commences drilling a single well pursuant to the working interest. 
Under the drilling contract, P pays D for the drilling only as the work 
is performed. All drilling costs are deducted by P in the year in which 
they are paid. At the end of 1987, A converts the general partnership 
interest into a limited partnership interest, effective immediately. The 
drilling of the well is completed on February 28, 1988. A's interest in 
the well would but for this paragraph (e)(4) be an interest in a passive 
activity.
    (ii) Throughout 1987, A holds the working interest through an entity 
that does not limit A's liability with respect to the drilling of the 
well pursuant to the working interest. In 1988, however, A holds the 
working interest through an entity that limits A's liability with 
respect to the drilling and operation of the well throughout such year. 
Accordingly, under paragraph (e)(4)(i) of this section, A's interest in 
P's well is not an interest in a passive activity for 1987 but is an 
interest in a passive activity for 1988. Moreover, since economic 
performance occurs in 1987 with respect to all items of deduction for 
drilling costs that are allocable to 1987, A has no disqualified 
deductions for 1987.
    Example 2. The facts are the same as in Example 1, except that all 
costs of drilling under the contract with D (including costs of drilling 
performed after 1987) are paid before the end of 1987 and A has a net 
loss for 1987. In addition, A has $15,000 of total deductions that are 
attributable to the well and allocable to 1987, but economic performance 
(as that term is used in paragraph (e)(4)(ii)(C)(2)(ii) of this section) 
does not occur with respect to $5,000 of those deductions until 1988. 
Under paragraph (e)(4)(ii) of this section, the $5,000 of deductions 
with respect to which economic performance occurs in 1988 are 
disqualified deductions and are treated as passive activity deductions 
for 1987. In addition, one-third ($5,000/$15,000) of

[[Page 459]]

A's gross income from the well for 1987 is treated as passive activity 
gross income.

    (iv) Definition of ``working interest.'' [Reserved]. See Sec.  
1.469-1(e)(4)(iv) for rules relating to this paragraph.
    (v) Entities that limit liability--(A) General rule. For purposes of 
paragraph (e)(4)(i)(B) of this section, an entity limits the liability 
of the taxpayer with respect to the drilling or operation of a well 
pursuant to a working interest held through such entity if the 
taxpayer's interest in the entity is in the form of--
    (1) A limited partnership interest in a partnership in which the 
taxpayer is not a general partner;
    (2) Stock in a corporation; or
    (3) An interest in any entity (other than a limited partnership or 
corporation) that, under applicable State law, limits the potential 
liability of a holder of such an interest for all obligations of the 
entity to a determinable fixed amount (for example, the sum of the 
taxpayer's capital contributions).
    (B) Other limitations disregarded. For purposes of this paragraph 
(e)(4), protection against loss through any of the following is not 
taken into account in determining whether a taxpayer holds a working 
interest through an entity that limits the taxpayer's liability:
    (1) An indemnification agreement;
    (2) A stop loss arrangement;
    (3) Insurance;
    (4) Any similar arrangement; or
    (5) Any combination of the foregoing.
    (C) Examples. The following examples illustrate the application of 
this paragraph (e)(4)(v):

    Example 1. A owns a 20 percent interest as a general partner in the 
capital and profits of P, a partnership which owns oil or gas working 
interests. The other partners of P agree to indemnify A against 
liability in excess of A's capital contribution for any of P's costs and 
expenses with respect to P's working interests. As a general partner, 
however, A is jointly and severally liable for all of P's liabilities 
and, under paragraph (e)(4)(v)(B)(1) of this section, the 
indemnification agreement is not taken into account in determining 
whether A holds the working interests through an entity that limits A's 
liability. Accordingly, the partnership does not limit A's liability 
with respect to the drilling or operation of wells pursuant to the 
working interests.
    Example 2. B owns a 10 percent interest in X, an entity (other than 
a limited partnership or corporation) created under applicable State law 
to hold working interests in oil or gas properties. Under applicable 
State law, B is liable without limitation for 10 percent of X's costs 
and expenses with respect to X's working interests but is not liable for 
the remaining 90 percent of such costs and expenses. Since B's liability 
for the obligations of X is not limited to a determinable fixed amount 
(within the meaning of paragraph (e)(4)(v)(A)(3) of this section), the 
entity does not limit B's liability with respect to the drilling or 
operation of wells pursuant to the working interests.
    Example 3. C is both a general partner and a limited partner in a 
partnership that owns a working interest in oil or gas property. Because 
C owns an interest as a general partner in each well drilled pursuant to 
the working interest, C's entire interest in each well drilled pursuant 
to the working interest is treated under paragraph (e)(4)(i) of this 
section as an interest in an activity that is not a passive activity 
(without regard to whether C materially participates in such activity).

    (vi) Cross reference to special rule for income from certain oil or 
gas properties. A special rule relating to the treatment of income from 
certain interests in oil or gas properties is contained in Sec.  1.469-
2T(c)(6).
    (5) Rental of dwelling unit. [Reserved]. See Sec.  1.469-
2(d)(2)(xii) for rules relating to this paragraph.
    (6) Activity of trading personal property--(i) In general. An 
activity of trading personal property for the account of owners of 
interests in the activity is not a passive activity (without regard to 
whether such activity is a trade or business activity (within the 
meaning of paragraph (e)(2) of this section)).
    (ii) Personal property. For purposes of this paragraph (e)(6), the 
term ``personal property'' means personal property (within the meaning 
of section 1092(d), without regard to paragraph (3) thereof).
    (iii) Example. The following example illustrates the application of 
this paragraph (e)(6):

    Example. A partnership is a trader of stocks, bonds, and other 
securities (within the meaning of section 1236(c)). The capital employed 
by the partnership in the trading activity consists of amounts 
contributed by the partners in exchange for their partnership interests, 
and funds borrowed by the partnership. The partnership derives gross 
income from the activity in the form of interest, dividends, and capital 
gains. Under

[[Page 460]]

these facts, the partnership is treated as conducting an activity of 
trading personal property for the account of its partners. Accordingly, 
under this paragraph (e)(6), the activity is not a passive activity.

    (f) Treatment of disallowed passive activity losses and credits--(1) 
Scope of this paragraph. The rules in this paragraph (f)--
    (i) Identify the passive activity deductions that are disallowed for 
any taxable year in which all or a portion of the taxpayer's passive 
activity loss is disallowed under paragraph (a)(1)(i) of this section;
    (ii) Identify the credits from passive activities that are 
disallowed for any taxable year in which all or a portion of the 
taxpayer's passive activity credit is disallowed under paragraph 
(a)(1)(i) of this section; and
    (iii) Provide for the carryover of disallowed deductions and 
credits.
    (2) Identification of disallowed passive activity deductions--(i) 
Allocation of disallowed passive activity loss among activities--(A) 
General rule. If all or any portion of the taxpayer's passive activity 
loss is disallowed for the taxable year under paragraph (a)(1)(i) of 
this section, a ratable portion of the loss (if any) from each passive 
activity of the taxpayer is disallowed. For purposes of the preceding 
sentence, the ratable portion of a loss from an activity is computed by 
multiplying the passive activity loss that is disallowed for the taxable 
year by the fraction obtained by dividing--
    (1) The loss from the activity for the taxable year; by
    (2) The sum of the losses for the taxable year from all activities 
having losses for such year.
    (B) Loss from an activity. For purposes of this paragraph (f)(2)(i), 
the term ``loss from an activity'' means--
    (1) The amount by which the passive activity deductions from the 
activity for the taxable year (within the meaning of Sec.  1.469-2T(d)) 
exceed the passive activity gross income from the activity for the 
taxable year (within the meaning of Sec.  1.469-2T(c)); reduced by
    (2) Any part of such amount that is allowed under section 469(i) and 
the rules to be contained in Sec.  1.469-9T (relating to the $25,000 
allowance for certain rental real estate activities).
    (C) Significant participation passive activities. If the taxpayer's 
passive activity gross income from significant participation passive 
activities (within the meaning of Sec.  1.469-2T(f)(2)(ii)) for the 
taxable year (determined without regard to Sec.  1.469-2T(f)(2) through 
(4)) exceeds the taxpayer's passive activity deductions from such 
activities for the taxable year, such activities shall be treated, 
solely for purposes of applying this paragraph (f)(2)(i) for the taxable 
year, as a single activity that does not have a loss for such taxable 
year.
    (D) Examples. The following examples illustrate the application of 
this paragraph (f)(2)(i):

    Example 1. An individual holds interests in three passive 
activities, A, B, and C. The gross income and deductions from these 
activities for the taxable year are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                   A            B            C          Total
----------------------------------------------------------------------------------------------------------------
Gross income................................................      $7,000       $4,000      $12,000      $23,000
Deductions..................................................     (16,000)     (20,000)      (8,000)     (44,000)
                                                             ---------------------------------------------------
    Net income (loss).......................................     ($9,000)    ($16,000)      $4,000     ($21,000)
----------------------------------------------------------------------------------------------------------------

    The taxpayer's $21,000 passive activity loss for the taxable year is 
disallowed under paragraph (a)(1)(i) of this section. Therefore, a 
ratable portion of the losses from activities A and B is disallowed. The 
disallowed portion of each loss is determined as follows:

A: $21,000 x $9,000/$25,000...................................    $7,560
B: $21,000 x $16,000/$25,000..................................   $13,440
                                                               ---------
    Total.....................................................   $21,000
 

    Example 2. An individual holds interests in four passive activities, 
A, B, C, and D. The results of operations of these activities for the 
taxable year are as follows:

----------------------------------------------------------------------------------------------------------------
                                                      A            B            C            D          Total
----------------------------------------------------------------------------------------------------------------
Gross income...................................      15,000        5,000       10,000       10,000       40,000
Deductions.....................................      (5,000)     (10,000)     (20,000)      (8,000)     (43,000)

[[Page 461]]

 
    Net income (loss)..........................      10,000       (5,000)     (10,000)       2,000       (3,000)
----------------------------------------------------------------------------------------------------------------

    Activities A and B are significant participation passive activities 
(within the meaning of Sec.  1.469-2T(f)(2)(ii)). The gross income from 
these activities for the taxable year ($20,000) exceeds the passive 
activity deductions from those activities for the taxable year ($15,000) 
by $5,000 and, under Sec.  1.469-2T(f)(2), $5,000 of gross income from 
those activities is treated as not from a passive activity. Therefore, 
solely for purposes of applying this paragraph (f)(2)(i) for the taxable 
year, activities A and B are treated as a single activity that does not 
have a loss for the taxable year. Under Sec.  1.469-2T(b), the 
taxpayer's passive activity loss for the taxable year is $8,000 ($43,000 
of passive activity deductions minus $35,000 of passive activity gross 
income). The results of treating activities A and B as a single activity 
that does not have a loss for the taxable year is that none of the 
$8,000 passive activity loss is allocated under this paragraph (f)(2)(i) 
to activity B for the taxable year, even though the taxpayer incurred a 
loss in that activity for the taxable year.

    (ii) Allocation within loss activities--(A) In general. If all or 
any portion of a taxpayer's loss from an activity is disallowed under 
paragraph (f)(2)(i) of this section for the taxable year, a ratable 
portion of each passive activity deduction (other than an excluded 
deduction (within the meaning of paragraph (f)(2)(ii)(B) of this 
section)) of the taxpayer from such activity is disallowed. For purposes 
of the preceding sentence, the ratable portion of a passive activity 
deduction of a taxpayer is the amount of the disallowed portion of the 
taxpayer's loss from the activity (within the meaning of paragraph 
(f)(2)(i)(B) of this section) for the taxable year multiplied by the 
fraction obtained by dividing--
    (1) The amount of such deduction; by
    (2) The sum of all passive activity deductions (other than excluded 
deductions (within the meaning of paragraph (f)(2)(ii)(B) of this 
section)) of the taxpayer from such activity from the taxable year.
    (B) Excluded deductions. The term ``excluded deduction'' means any 
passive activity deduction of a taxpayer that is taken into account in 
computing the taxpayer's net income from an item of property for a 
taxable year in which an amount of the taxpayer's gross income from such 
item of property is treated as not from a passive activity under Sec.  
1.469-2T(c)(6) or Sec.  1.469-2T(f) (5), (6), or (7).
    (iii) Separately identified deductions. In identifying the 
deductions from an activity that are disallowed under this paragraph 
(f)(2), the taxpayer need not account separately for a deduction unless 
such deduction may, if separately taken into account, result in an 
income tax liability for any taxable year different from that which 
would result were such deduction not taken into account separately. For 
related rules applicable to partnerships and S corporations, see Sec.  
1.702-1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Deductions 
that must be accounted for separately include (but are not limited to) 
deductions that--
    (A) Arise in a rental real estate activity (within the meaning of 
section 469(i) and the rules to be contained in Sec.  1.469-9T) in 
taxable years in which the taxpayer actively participates (within the 
meaning of section 469(i) and the rules to be contained in Sec.  1.469-
9T) in such activity;
    (B) Arise in a rental real estate activity (within the meaning of 
section 469(i) and the rules to be contained in Sec.  1.469-9T) in 
taxable years in which the taxpayer does not actively participate 
(within the meaning of section 469(i) and the rules to be contained in 
Sec.  1.469-9T) in such activity; or
    (C) Are taken into account under section 1211 (relating to the 
limitation on capital losses) or section 1231 (relating to property used 
in a trade or business and involuntary conversions).
    (3) Identification of disallowed credits from passive activities--
(i) General rule. If all or any portion of the taxpayer's passive 
activity credit is disallowed for the taxable year under paragraph 
(a)(1)(ii) of this section, a ratable portion of each credit from each 
passive activity of the taxpayer is disallowed. For purposes of the 
preceding sentence, the ratable portion of a credit of a taxpayer is 
computed by multiplying the

[[Page 462]]

portion of the taxpayer's passive activity credit that is disallowed for 
the taxable year by the fraction obtained by dividing--
    (A) The amount of the credit; by
    (B) The sum of all of the taxpayer's credits from passive activities 
for the taxable year.
    (ii) Coordination rule. For purposes of paragraph (f)(3)(i) of this 
section, the credits from a passive activity do not include any credit 
or portion of a credit that--
    (A) Is allowed for the taxable year under section 469(i) and the 
rules to be contained in Sec.  1.469-9T (relating to the $25,000 
allowance for certain rental real estate activities); or
    (B) Increases the basis of property during the taxable year under 
section 469(j)(9) and the rules to be contained in Sec.  1.469-6T 
(relating to the election to increase the basis of certain property by 
disallowed credits).
    (iii) Separately identified credits. In identifying the credits from 
an activity that are disallowed under this paragraph (f)(3), the 
taxpayer need not account separately for any credit unless such credit 
may, if separately taken into account, result in an income tax liability 
for any taxable year different from that which would result were such 
credit not taken into account separately. For related rules applicable 
to partnerships and S corporations, see Sec.  1.702-1(a)(8)(ii) and 
section 1366(a)(1)(A), respectively. Credits that must be accounted for 
separately include (but are not limited to)--
    (A) Credits (other than the low-income housing and rehabilitation 
investment credits) from a rental real estate activity (within the 
meaning of section 469(i) and the rules to be contained in Sec.  1.469-
9T) that arise in a taxable year in which the taxpayer actively 
participates (within the meaning of section 469(i) and the rules to be 
contained in Sec.  1.469-9T) in such activity;
    (B) Credits (other than the low-income housing and rehabilitation 
investment credits) from a rental real estate activity (within the 
meaning of section 469(i) and the rules to be contained in Sec.  1.469-
9T) that arise in a taxable year in which the taxpayer does not actively 
participate (within the meaning of section 469(i) and the rules to be 
contained in Sec.  1.469-9T) in such activity;
    (C) Low-income housing and rehabilitation investment credits from a 
rental real estate activity (within the meaning of section 469(i) and 
the rules to be contained in Sec.  1.469-9T); and
    (D) Any credit that is subject to the limitations of sections 26(a), 
28(d)(2), 29(b)(5), or 38(c) in a manner that differs from the manner in 
which any other credit is subject to such limitations.
    (4) Carryover of disallowed deductions and credits. [Reserved]. See 
Sec.  1.469-1(f)(4) for rules relating to this paragraph.
    (g) Application of these rules to C corporations--(1) In general. 
Except as otherwise provided in the rules to be contained in paragraph 
(k) of this section, section 469 and the regulations thereunder do not 
apply to any corporation that is not a personal service corporation or a 
closely held corporation for the taxable year. See paragraphs (g) (4) 
and (5) of this section for special rules for computing the passive 
activity loss and passive activity credit, respectively, of a closely 
held corporation.
    (2) Definitions. For purposes of section 469 and the regulations 
thereunder--
    (i) The term personal service corporation means a C corporation that 
is a personal service corporation for the taxable year (within the 
meaning of Sec.  1.441-3(c)); and
    (ii) The term closely held corporation means a C corporation that 
meets the stock ownership requirements of section 542(a)(2) (taking into 
account the modifications in section 465(a)(3)) for the taxable year and 
is not a personal service corporation for such year.
    (3) Participation of corporations--(i) Material participation. For 
purposes of section 469 and the regulations thereunder, a corporation 
described in paragraph (g)(2) of this section shall be treated as 
materially participating in an activity for a taxable year if and only 
if--
    (A) One or more individuals, each of whom is treated under paragraph 
(g)(3)(iii) of this section as materially participating in such activity 
for the taxable year, directly or indirectly hold (in the aggregate) 
more than 50

[[Page 463]]

percent (by value) of the outstanding stock of such corporation; or
    (B) In the case of a closely held corporation (within the meaning of 
paragraph (g)(2)(ii) of this section), the requirements of section 
465(c)(7)(C) (without regard to clause (iv) thereof and taking into 
account section 465(c)(7)(D)) are met with respect to such activity.
    (ii) Significant participation. For purposes of Sec.  1.469-
2T(f)(2), an activity of a corporation described in paragraph (g)(2) of 
this section shall be treated as a significant participation passive 
activity for a taxable year if and only if--
    (A) The corporation is not treated as materially participating in 
such activity for the taxable year; and
    (B) One or more individuals, each of whom is treated under paragraph 
(g)(3)(iii) of this section as significantly participating in such 
activity, directly or indirectly hold (in the aggregate) more than 50 
percent (by value) of the outstanding stock of such corporation.
    (iii) Participation of individual. Whether an individual is treated 
for purposes of this paragraph (g)(3) as materially participating or 
significantly participating in an activity of a corporation shall be 
determined under the rules of Sec.  1.469-5T, except that in applying 
such rules--
    (A) All activities of the corporation shall be treated as activities 
in which the individual holds an interest in determining whether the 
individual participates (within the meaning of Sec.  1.469-5T(f)) in an 
activity of the corporation; and
    (B) The individual's participation in all activities other than 
activities of the corporation shall be disregarded in determining 
whether the individual's participation in an activity of the corporation 
is treated as material participation under Sec.  1.469-5T(a)(4) 
(relating to material participation in significant participation 
activities).
    (4) Modified computation of passive activity loss in the case of 
closely held corporations--(i) In general. A closely held corporation's 
passive activity loss for the taxable year is the amount, if any, by 
which the corporation's passive activity deductions for the taxable year 
(within the meaning of Sec.  1.469-2T(d)) exceed the sum of--
    (A) The corporation's passive activity gross income for the taxable 
year (within the meaning of Sec.  1.469-2T(c)); and
    (B) The corporation's net active income for the taxable year.
    (ii) Net active income. For purposes of this paragraph (g)(4), a 
corporation's net active income for the taxable year is such 
corporation's taxable income for the taxable year, determined without 
regard to the following items for the year:
    (A) Passive activity gross income;
    (B) Passive activity deductions;
    (C) [Reserved]. See Sec.  1.469-1(g)(4)(ii)(C) for rules relating to 
this paragraph.
    (D) Gross income that is treated under Sec.  1.469-2T(c)(6) 
(relating to gross income from certain oil or gas properties) as not 
from a passive activity;
    (E) Gross income and deductions from any trade or business activity 
(within the meaning of paragraph (e)(2) of this section) that is 
described in paragraph (e)(6) of this section (relating to certain 
activities of trading personal property) but only if the corporation did 
not materially participate in such activity for the taxable year;
    (F) Deductions described in Sec.  1.469-2T(d)(2)(i), (ii), and (iv) 
(relating to certain deductions attributable to portfolio income); and
    (G) Interest expense allocated under Sec.  1.163-8T to a portfolio 
expenditure (within the meaning of Sec.  1.163-8T(b)(6)).
    (iii) Examples. The following examples illustrate the application of 
this paragraph (g)(4):

    Example 1. (i) For 1987, X, a closely held corporation, is engaged 
in two activities, a trade or business activity in which X materially 
participates for 1987 and a rental activity. X also holds portfolio 
investments. For 1987, X has the following gross income and deductions:

Gross income:
  Rents....................................................      $60,000
  Gross income from business...............................      100,000
  Portfolio income.........................................       35,000
                                                            ------------
    Total..................................................     $195,000
                                                            ============
Deductions:
  Rental deductions........................................   ($100,000)
  Business deductions (80,000).............................
  Interest expense allocable to portfolio expenditures          (10,000)
   under Sec.   1.163-8T...................................

[[Page 464]]

 
  Deductions (other than interest expense) clearly and           (5,000)
   directly allocable to portfolio income..................
                                                            ------------
    Total..................................................   ($195,000)
                                                            ============
 

    (ii) The corporation's net active income for 1987 is $20,000, 
computed as follows:

Gross income.....................  ...........     $195,000
Amounts not taken into account in
 computing net active income:
  Rents (see paragraph                 $60,000
   (g)(4)(ii)(A) of this section)
  Portfolio income (see paragraph      $35,000
   (g)(4)(ii)(C) of this section)
                                  --------------
                                       $95,000    ($95,000)
                                  --------------------------
Gross income taken into account    ...........     $100,000     $100,000
 in computing net active income..
                                               =============
Deductions.......................  ...........   ($195,000)
Amounts not taken into account in
 computing net active income:
  Rental deductions (see            ($100,000)
   paragraph (g)(4)(ii)(B) of
   this section).................
  Interest expense allocated to      ($10,000)
   portfolio expenditures (see
   paragraph (g)(4)(ii)(G) of
   this section).................
Other deductions clearly and          ($5,000)
 directly allocable to portfolio
 income (see paragraph
 (g)(4)(ii)(F) of this section)..
                                               -------------
                                    ($115,000)     $115,000
                                               -------------
Deductions taken into account in   ...........    ($80,000)    ($80,000)
 computing net active income.....
                                               =============
Net active income................  ...........  ...........      $20,000
                                                            ============
 

    (iii) Under paragraph (g)(4)(i) of this section, X's passive 
activity loss for 1987 is $20,000, the amount by which the passive 
activity deductions for the taxable year ($100,000) exceed the sum of 
(a) the passive activity gross income for the taxable year ($60,000) and 
(b) the net active income for the taxable year ($20,000). Under 
paragraph (f)(4) of this section, the $20,000 of deductions from X's 
rental activity that are disallowed for 1987 are treated as deductions 
from the rental activity for 1988. If computed without regard to the net 
active income for the taxable year, X's passive activity loss would be 
$40,000 ($100,000 of rental deductions minus $60,000 of rental income). 
Thus, the effect of the rule in paragraph (g)(4)(i) of this section is 
to reduce the corporation's passive activity loss for the taxable year 
by the amount of the corporation's net active income for such year.
    (iv) Under these facts, X's taxable income for 1987 is $20,000, 
computed as follows:

Gross income..................................  ...........     $195,000
Deductions:
  Total deductions............................   ($195,000)
  Passive activity loss.......................      $20,000
                                               --------------
  Allowable deductions........................   ($175,000)   ($175,000)
                                                            ------------
Taxable income................................  ...........      $20,000
                                                            ============
 

    Example 2. (i) The facts are the same as in Example 1, except that, 
in 1988, X has a loss from the trade or business activity, and a net 
operating loss (``NOL'') of $15,000 that is carried back under section 
172(b) to 1987. Since NOL carrybacks are taken into account in computing 
net active income, X's net active income for 1987 must be recomputed as 
follows:

Net active income before NOL carryback.....................      $20,000
NOL carryback..............................................    ($15,000)
                                                            ------------
Net active income..........................................       $5,000
                                                            ============
 

    (ii) Under these facts, X's disallowed passive activity loss for 
1987 is $35,000, the amount by which the passive activity deductions for 
the taxable year ($100,000) exceed the sum of (a) the passive activity 
gross income for the taxable year ($60,000) and (b) the net active 
income for the taxable year ($5,000).
    (iii) Under paragraph (f)(4) of this section, the $35,000 of 
deductions from X's rental activity that are disallowed for 1987 are 
treated as deductions from the rental activity for 1988. X's taxable 
income for 1987 is $20,000, computed as follows:

Gross income..................................  ...........     $195,000
Deductions:
  Total deductions............................   ($210,000)
  Passive activity loss.......................      $35,000
  Allowable deductions........................   ($175,000)   ($175,000)
                                                            ------------
Taxable income................................  ...........      $20,000
                                                            ============
 


Thus, taking the NOL carryback into account in computing net active 
income for 1987 does not affect X's taxable income for 1987, but 
increases the deductions treated under paragraph (f)(4) as deductions 
from X's rental activity for 1988 and decreases X's NOL carryover to 
years other than 1987.

    (5) Allowance of passive activity credit of closely held 
corporations to extent of

[[Page 465]]

net active income tax liability--(i) In general. Solely for purposes of 
determining the amount disallowed under paragraph (a)(1)(ii) of this 
section, a closely held corporation's passive activity credit for the 
taxable year shall be reduced by such corporation's net active income 
tax liability for such year.
    (ii) Net active income tax liability. For purposes of paragraph 
(g)(5)(i) of this section, a corporation's net active income tax 
liability for a taxable year is the amount (if any) by which--
    (A) The corporation's regular tax liability (within the meaning of 
section 26(b)) for the taxable year, determined by reducing the 
corporation's taxable income for such year by an amount equal to the 
excess (if any) of the corporation's passive activity gross income for 
such year over the corporation's passive activity deductions for such 
year; exceeds
    (B) The sum of--
    (1) The corporation's regular tax liability for the taxable year, 
determined by reducing the corporation's taxable income for such year by 
an amount equal to the excess (if any) of the sum of the corporation's 
net active income (within the meaning of paragraph (g)(4)(ii) of this 
section) and passive activity gross income for such year over the 
corporation's passive activity deductions for such year; and
    (2) The corporation's credits (other than credits from passive 
activities) that are allowable for the taxable year (without regard to 
the limitations contained in sections 26(a), 28(d)(2), 29(b)(5), 38(c), 
and 469).
    (h) Special rules for affiliated group filing consolidated return. 
(1)-(2) [Reserved]
    (3) Disallowance of consolidated group's passive activity loss or 
credit. A consolidated group's passive activity loss or passive activity 
credit for the taxable year shall be disallowed to the extent provided 
in paragraph (a) of this section. For purposes of the preceding 
sentence, a consolidated group's passive activity loss and passive 
activity credit shall be determined by taking into account the following 
items of each member of such group:
    (i) Passive activity gross income;
    (ii) Passive activity deductions;
    (iii) Net active income (in the case of a consolidated group treated 
as a closely held corporation under paragraph (h)(4)(ii) of this 
section); and
    (iv) Credits from passive activities.
    (4) [Reserved]. See Sec.  1.469-1(h)(4) for rules relating to this 
paragraph.
    (5) Modification of rules for identifying disallowed passive 
activity deductions and credits--(i) Identification of disallowed 
deductions. In applying paragraphs (f) (2) and (4) of this section to a 
consolidated group for purposes of identifying the passive activity 
deductions of such consolidated group and of each member of such 
consolidated group that are disallowed for the taxable year and treated 
as deductions from activities for the succeeding taxable year, the 
following rules shall apply:
    (A) A ratable portion (within the meaning of paragraph (h)(5)(ii) of 
this section) of the passive activity loss of the consolidated group 
that is disallowed for the taxable year shall be allocated to each 
member of the group;
    (B) Pararaph (f)(2) of this section shall then be applied to each 
member of the group as if--
    (1) Such member were a separate taxpayer; and
    (2) The amount allocated to such member under paragraph (h)(5)(i)(A) 
of this section were the amount of such member's passive activity loss 
that is disallowed for the taxable year; and
    (C) Paragraph (f)(4) of this section shall be applied to each member 
of the group as if it were a separate taxpayer.
    (ii) Ratable portion of disallowed passive activity loss. For 
purposes of paragraph (h)(5)(i)(A) of this section, a member's ratable 
portion of the disallowed passive activity loss of the consolidated 
group is the amount of such disallowed loss multiplied by the fraction 
obtained by dividing--
    (A) The amount of the passive activity loss of such member of the 
consolidated group that would be disallowed for the taxable year if the 
items of gross income and deduction of such member were the only items 
of the group for such year; by
    (B) The sum of the amounts described in paragraph (h)(5)(ii)(A) of 
this section for all members of the group.

[[Page 466]]

    (iii) Identification of disallowed credits. In applying paragraph 
(f)(3) of this section to a consolidated group for purposes of 
identifying the credits from passive activities of members of such 
consolidated group that are disallowed for the taxable year, the 
consolidated group shall be treated as one taxpayer. Thus, a ratable 
portion of each of the group's credits from passive activities is 
disallowed.
    (6) [Reserved]
    (7) Disposition of stock of a member of an affiliated group. Any 
gain recognized by a member on the disposition of stock of a subsidiary 
(including income resulting from the recognition of an excess loss 
account under Sec.  1.1502-19) shall be treated as portfolio income 
(within the meaning of Sec.  1.469-2T (c)(3)(i)).
    (8) Dispositions of property used in multiple activities. The 
determination of whether Sec.  1.469-2T(c)(2)(ii) or (iii) or (d)(5)(ii) 
applies to a disposition (including a deemed disposition described in 
paragraph (h)(6)(iii)(C)(1) of this section) of property by a member of 
a consolidated group shall be made by treating such member as having 
held the property for the entire period that the group has owned such 
property and as having used the property in all of the activities in 
which the group has used such property
    (i) [Reserved]
    (j) Spouses filing joint return--(1) In general. Except as otherwise 
provided in the regulations under section 469, spouses filing a joint 
return for a taxable year shall be treated for such year as one taxpayer 
for purposes of section 469 and the regulations thereunder Thus, for 
example, spouses filing a joint return are treated as one taxpayer for 
purposes of--
    (i) Section 1.469-2T (relating generally to the computation of such 
taxpayer's passive activity loss); and
    (ii) Paragraph (f) of this section (relating to the allocation of 
such taxpayer's disallowed passive activity loss and passive activity 
credit among activities and the identification of disallowed passive 
activity deductions and credits from passive activities).
    (2) Exceptions to treatment as one taxpayer--(i) Identification of 
disallowed deductions and credits. For purposes of paragraphs 
(f)(2)(iii) and (3)(iii) of this section, spouses filing a joint return 
for the taxable year must account separately for the deductions and 
credits attributable to the interests of each spouse in any activity.
    (ii) Treatment of deductions disallowed under sections 704(d), 
1366(d), and 465. Notwithstanding any other provision of this section or 
Sec.  1.469-2T, this paragraph (j) shall not affect the application of 
section 704(d), section 1366(d), or section 465 to taxpayers filing a 
joint return for the taxable year.
    (iii) Treatment of losses from working interests. Paragraph (e)(4) 
of this section (relating to losses and credits from certain interests 
in oil and gas wells) shall be applied by treating a husband and wife 
(whether or not filing a joint return) as separate taxpayers.
    (3) Joint return no longer filed. If an individual--
    (A) Does not file a joint return for the taxable years; and
    (B) Filed a joint return for the immediately preceding taxable year;


then the passive activity deductions and credits allocable to such 
individual's activities for the taxable year under paragraph (f)(4) of 
this section shall be determined by taking into account the items of 
deduction and credit attributable to such individual's interests in 
passive activities for the immediately preceding taxable year. See 
paragraph (j)(2)(i) of this section.
    (4) Participation of spouses. Rules treating an individual's 
participation in an activity as participation of such individual's 
spouse in such activity (without regard to whether the spouses file a 
joint return) are contained in Sec.  1.469-5T(f)(3).
    (k) Former passive activities and changes in status of corporations. 
[Reserved]

[T.D. 8175, 53 FR 5700, Feb. 25, 1988, as amended by T.D. 8253, 54 FR 
20535, May 12, 1989; T.D. 8319, 55 FR 49038, Nov. 26, 1990; T.D. 8417, 
57 FR 20753, May 15, 1992; 58 FR 29536, May 21, 1993; 58 FR 45059, Aug. 
26, 1993; 59 FR 17478, Apr. 13, 1994; T.D. 8560, 59 FR 41674, Aug. 15, 
1994; T.D. 8597, 60 FR 36685, July 18, 1995; T.D. 8996, 67 FR 35012, May 
17, 2002]



Sec.  1.469-2  Passive activity loss.

    (a)-(c)(2)(ii) [Reserved]
    (c)(2)(iii) Disposition of substantially appreciated property 
formerly used in

[[Page 467]]

nonpassive activity--(A) In general. If an interest in property used in 
an activity is substantially appreciated at the time of its disposition, 
any gain from the disposition shall be treated as not from a passive 
activity unless the interest in property was used in a passive activity 
for either--
    (1) 20 percent of the period during which the taxpayer held the 
interest in property; or
    (2) The entire 24-month period ending on the date of the 
disposition.
    (B) Date of disposition. For purposes of this paragraph (c)(2)(iii), 
a disposition of an interest in property is deemed to occur on the date 
that the interest in property becomes subject to an oral or written 
agreement that either requires the owner or gives the owner an option to 
transfer the interest in property for consideration that is fixed or 
otherwise determinable on that date.
    (C) Substantially appreciated property. For purposes of this 
paragraph (c)(2)(iii), an interest in property is substantially 
appreciated if the fair market value of the interest in property exceeds 
120 percent of the adjusted basis of the interest.
    (D) Investment property. For purposes of this paragraph (c)(2)(iii), 
an interest in property is treated as an interest in property used in an 
activity other than a passive activity and as an interest in property 
held for investment for any period during which the interest is held 
through a C corporation or similar entity. An entity is similar to a C 
corporation for this purpose if the owners of interests in the entity 
derive only portfolio income (within the meaning of Sec.  1.469-2T) from 
the interests.
    (E) Coordination with Sec.  1.469-2T(c)(2)(ii). If Sec.  1.469-
2T(c)(2)(ii) applies to the disposition of an interest in property, this 
paragraph (c)(2)(iii) applies only to that portion of the gain from the 
disposition of the interest in property that is characterized as gain 
from a passive activity after the application of Sec.  1.469-
2T(c)(2)(ii).
    (F) Coordination with section 163(d). Gain that is treated as not 
from a passive activity under this paragraph (c)(2)(iii) is treated as 
income described in section 469(e)(1)(A) and Sec.  1.469-2T(c)(3)(i) if 
and only if the gain is from the disposition of an interest in property 
that was held for investment for more than 50 percent of the period 
during which the taxpayer held that interest in property in activities 
other than passive activities.
    (G) Examples. The following examples illustrate the application of 
this paragraph (c)(2)(iii):

    Example 1. A acquires a building on January 1, 1993, and uses the 
building in a trade or business activity in which A materially 
participates until March 31, 2004. On April 1, 2004, A leases the 
building to B. On December 31, 2005, A sells the building. At the time 
of the sale, A's interest in the building is substantially appreciated 
(within the meaning of paragraph (c)(2)(iii)(C) of this section). 
Assuming A's lease of the building to B constitutes a rental activity 
(within the meaning of Sec.  1.469-1T(e)(3)), the building is used in a 
passive activity for 21 months (April 1, 2004, through December 31, 
2005). Thus, the building was not used in a passive activity for the 
entire 24-month period ending on the date of the sale. In addition, the 
21-month period during which the building was used in a passive activity 
is less than 20 percent of A's holding period for the building (13 
years). Therefore, the gain from the sale is treated under this 
paragraph (c)(2)(iii) as not from a passive activity.
    Example 2. (i) A, an individual, is a stockholder of corporation X. 
X is a C corporation until December 31, 1993, and is an S corporation 
thereafter. X acquires a building on January 1, 1993, and sells the 
building on March 1, 1994. At the time of the sale, A's interest in the 
building held through X is substantially appreciated (within the meaning 
of paragraph (c)(2)(iii)(C) of this section). The building is leased to 
various tenants at all times during the period in which it is held by X. 
Assume that the lease of the building would constitute a rental activity 
(within the meaning of Sec.  1.469-1T(e)(3)) with respect to a person 
that holds the building directly or through an S corporation.
    (ii) Paragraph (c)(2)(iii)(D) of this section provides that an 
interest in property is treated for purposes of this paragraph 
(c)(2)(iii) as used in an activity other than a passive activity and as 
held for investment for any period during which the interest is held 
through a C corporation. Thus, for purposes of determining the character 
of A's gain from the sale of the building, A's interest in the building 
is treated as an interest in property held for investment for the period 
from January 1, 1993, to December 31, 1993, and as an interest in 
property used in a passive activity for the period from January 1, 1994, 
to February 28, 1994.
    (iii) A's interest in the building was not used in a passive 
activity for the entire 24-month period ending on the date of the sale.

[[Page 468]]

In addition, the 2-month period during which A's interest in the 
building was used in a passive activity is less than 20 percent of the 
period during which A held an interest in the building (14 months). 
Therefore, the gain from the sale is treated under this paragraph 
(c)(2)(iii) as not from a passive activity.
    (iv) Under paragraph (c)(2)(iii)(F) of this section, gain that is 
treated as nonpassive under this paragraph (c)(2)(iii) is treated as 
portfolio income (within the meaning of Sec.  1.469-2T(c)(3)(i)) if the 
gain is from the disposition of an interest in property that was held 
for investment for more than 50 percent of the period during which the 
taxpayer held the interest in activities other than passive activities. 
In this case, A's interest in the building was treated as held for 
investment for the entire period during which it was used in activities 
other than passive activities (i.e., the 12-month period from January 1, 
1993, to December 31, 1993). Accordingly, A's gain from the sale is 
treated under this paragraph (c)(2)(iii) as portfolio income.

    (iv) Taxable acquisitions. If a taxpayer acquires an interest in 
property in a transaction other than a nonrecognition transaction 
(within the meaning of section 7701(a)(45)), the ownership and use of 
the interest in property before the transaction is not taken into 
account for purposes of applying this paragraph (c)(2) to any subsequent 
disposition of the interest in property by the taxpayer.
    (v) Property held for sale to customers--(A) Sale incidental to 
another activity--(1) Applicability--(i) In general. This paragraph 
(c)(2)(v)(A) applies to the disposition of a taxpayer's interest in 
property if and only if--
    (A) At the time of the disposition, the taxpayer holds the interest 
in property in an activity that, for purposes of section 1221(1), 
involves holding the property or similar property primarily for sale to 
customers in the ordinary course of a trade or business (a dealing 
activity);
    (B) One or more other activities of the taxpayer do not involve 
holding similar property for sale to customers in the ordinary course of 
a trade or business (nondealing activities) and the interest in property 
was used in the nondealing activity or activities for more than 80 
percent of the period during which the taxpayer held the interest in 
property; and
    (C) The interest in property was not acquired and held by the 
taxpayer for the principal purpose of selling the interest to customers 
in the ordinary course of a trade or business.
    (ii) Principal purpose. For purposes of this paragraph (c)(2)(v)(A), 
a taxpayer is rebuttably presumed to have acquired and held an interest 
in property for the principal purpose of selling the interest to 
customers in the ordinary course of a trade or business if--
    (A) The period during which the interest in property was used in 
nondealing activities of the taxpayer does not exceed the lesser of 24 
months or 20 percent of the recovery period (within the meaning of 
section 168) applicable to the property; or
    (B) The interest in property was simultaneously offered for sale to 
customers and used in a nondealing activity of the taxpayer for more 
than 25 percent of the period during which the interest in property was 
used in nondealing activities of the taxpayer.
    For purposes of the preceding sentence, an interest in property is 
not considered to be offered for sale to customers solely because a 
lessee of the property has been granted an option to purchase the 
property.
    (2) Dealing activity not taken into account. If paragraph 
(c)(2)(v)(A) applies to the disposition of a taxpayer's interest in 
property, holding the interest in the dealing activity is treated, for 
purposes of Sec.  1.469-2T(c)(2), as the use of the interest in the last 
nondealing activity of the taxpayer in which the interest in property 
was used prior to its disposition.
    (B) Use in a nondealing activity incidental to sale. If paragraph 
(c)(2)(v)(A) of this section does not apply to the disposition of a 
taxpayer's interest in property that is held in a dealing activity of 
the taxpayer at the time of disposition, the use of the interest in 
property in a nondealing activity of the taxpayer for any period during 
which the interest in property is also offered for sale to customers is 
treated, for purposes of Sec.  1.469-2T(c)(2), as the use of the 
interest in property in the dealing activity of the taxpayer.
    (C) Examples. The following examples illustrate the application of 
this paragraph (c)(2)(v):

    Example 1. (i) The taxpayer acquires a residential apartment 
building on January 1,

[[Page 469]]

1993, and uses the building in a rental activity. In January 1996, the 
taxpayer converts the apartments into condominium units. After the 
conversion, the taxpayer holds the condominium units for sale to 
customers in the ordinary course of a trade or business of dealing in 
condominium units. (Assume that these are dealing operations treated as 
separate activities under Sec.  1.469-4, and that the taxpayer 
materially participates in the activity.) In addition, the taxpayer 
continues to use the units in the rental activity until they are sold. 
The units are first held for sale on January 1, 1996, and the last unit 
is sold on December 31, 1996.
    (ii) This paragraph (c)(2)(v) provides that holding an interest in 
property in a dealing activity (the marketing of the property) is 
treated for purposes of Sec.  1.469-2T(c)(2) as the use of the interest 
in a nondealing activity if the marketing of the property is incidental 
to the nondealing use. Under paragraph (c)(2)(v)(A)(2) of this section, 
the interests in property are treated as used in the last nondealing 
activity in which they were used prior to their disposition. In 
addition, paragraph (c)(2)(v)(A)(1) of this section provides rules for 
determining whether the marketing of the property is incidental to the 
use of an interest in property in a nondealing activity. Under these 
rules, the marketing of the property is treated as incidental to the use 
in a nondealing activity if the interest in property was used in 
nondealing activities for more than 80 percent of the taxpayer's holding 
period in the property (the holding period requirement) and the taxpayer 
did not acquire and hold the interest in property for the principal 
purpose of selling it to customers in the ordinary course of a trade or 
business (a dealing purpose).
    (iii) In this case, the apartments were used in a rental activity 
for the entire period during which they were held by the taxpayer. Thus, 
the apartments were used in a nondealing activity for more than 80 
percent of the taxpayer's holding period in the property, and the 
marketing of the property satisfies the holding period requirement.
    (iv) Paragraph (c)(2)(v)(A)(1)(ii) of this section provides that a 
taxpayer is rebuttably presumed to have a dealing purpose unless the 
interest in property was used in nondealing activities for more than 24 
months or 20 percent of the property's recovery period (whichever is 
less). The same presumption applies if the interest in property was 
offered for sale to customers during more than 25 percent of the period 
in which the interest was held in nondealing activities. In this case, 
the taxpayer used each apartment in a nondealing activity (the rental 
activity) for a period of 36 to 48 months (i.e., from January 1, 1993, 
to the date of sale in the period from January through December 1996). 
Thus, the apartments were used in nondealing activities for more than 24 
months, and the first of the rebuttable presumptions described above 
does not apply. In addition, the apartments were offered for sale to 
customers for up to 12 months (depending on the month in which the 
apartment was sold) during the period in which the apartments were used 
in a nondealing activity. The percentage obtained by dividing the period 
during which an apartment was held for sale to customers by the period 
during which the apartment was used in nondealing activities ranges from 
zero in the case of apartments sold on January 1, 1996, to 25 percent 
(i.e., 12 months/48 months) in the case of apartments sold on December 
31, 1996. Thus, no apartment was offered for sale to customers during 
more than 25 percent of the period in which it was used in nondealing 
activities, and the second rebuttable presumption does not apply.
    (v) Because neither of the rebuttable presumptions in paragraph 
(c)(2)(v)(A)(1)((ii) of this section applies in this case, the taxpayer 
will not be treated as having a dealing purpose unless other facts and 
circumstances establish that the taxpayer acquired and held the 
apartments for the principal purpose of selling the apartments to 
customers in the ordinary course of a trade or business. Assume that 
none of the facts and circumstances suggest that the taxpayer had such a 
purpose. If that is the case, the taxpayer does not have a dealing 
purpose.
    (vi) The marketing of the property satisfies the holding period 
requirement, and the taxpayer does not have a dealing purpose. Thus, 
holding the apartments in the taxpayer's dealing activity is treated for 
purposes of this paragraph (c)(2) as the use of the apartments in a 
nondealing activity. In this case, the rental activity is the only 
nondealing activity in which the apartments were used prior to their 
disposition. Thus, the apartments are treated under paragraph 
(c)(2)(v)(A)(2) of this section as interests in property that were used 
only in the rental activity for the entire period during which the 
taxpayer held the interests. Accordingly, the rules in Sec.  1.469-
2T(c)(2)(ii) and paragraph (c)(2)(iii) of this section do not apply, and 
all gain from the sale of the apartments is treated as passive activity 
gross income.
    Example 2. (i) The taxpayer acquires a residential apartment 
building on January 1, 1993, and uses the building in a rental activity. 
The taxpayer converts the apartments into condominium units on July 1, 
1993. After the conversion, the taxpayer holds the condominium units for 
sale to customers in the ordinary course of a trade or business of 
dealing in condominium units. (Assume that these are dealing operations 
treated as separate activities under Sec.  1.469-4, and that the 
taxpayer materially participates in the activities.) In addition, the 
taxpayer continues to use the units in the rental activity until

[[Page 470]]

they are sold. The first unit is sold on January 1, 1994, and the last 
unit is sold on December 31, 1996.
    (ii) In this case, all of the apartments were simultaneously offered 
for sale to customers and used in a nondealing activity of the taxpayer 
for more than 25 percent of the period during which the apartments were 
used in nondealing activities. Thus, the taxpayer is rebuttably presumed 
to have acquired the apartments (including apartments that are used in 
the rental activity for at least 24 months) for the principal purpose of 
selling them to customers in the ordinary course of a trade or business. 
Assume that the facts and circumstances do not rebut this presumption. 
If that is the case, the taxpayer has a dealing purpose, and paragraph 
(c)(2)(v)(A) of this section does not apply to the disposition of the 
apartments.
    (iii) Paragraph (c)(2)(v)(B) of this section provides that if 
paragraph (c)(2)(v)(A) of this section does not apply to the disposition 
of a taxpayer's interest in property that is held in a dealing activity 
of the taxpayer at the time of the disposition, the use of the interest 
in property in any nondealing activity of the taxpayer for any period 
during which the interest is also offered for sale to customers is 
treated as incidental to the use of the interest in the dealing 
activity. Accordingly, for purposes of applying the rules of Sec.  
1.469-2T(c)(2) to the disposition of the apartments, the rental of the 
apartments after July 1, 1993, is treated as the use of the apartments 
in the taxpayer's dealing activity.
    Example 3. (i) The taxpayer acquires a residential apartment 
building on January 1, 1993, and uses the building in a rental activity. 
In January 1996, the taxpayer converts the apartments into condominium 
units. After the conversion, the taxpayer holds the condominium units 
for sale to customers in the ordinary course of a trade or business of 
dealing in condominium units. (Assume that these are dealing operations 
treated as separate activities under Sec.  1.469-4, and that the 
taxpayer materially participates in the activities.) In addition, the 
taxpayer continues to use the units in the rental activity until they 
are sold. The units are first held for sale on January 1, 1996, and the 
last unit is sold in 1997.
    (ii) The treatment of apartments sold in 1996 is the same as in 
Example 1. The apartments sold in 1997, however, were simultaneously 
offered for sale to customers and used in a nondealing activity for more 
than 25 percent of the period during which the apartments were used in 
nondealing activities. (For example, an apartment that is sold on 
January 31, 1997, has been offered for sale for 13 months or 26.1 
percent of the 49-month period during which it was used in nondealing 
activities.) Thus, the taxpayer is rebuttably presumed to have acquired 
the apartments sold in 1997 for the principal purpose of selling them to 
customers in the ordinary course of a trade of business. Assume that the 
facts and circumstances do not rebut this presumption. In that case, the 
marketing of the apartments sold in 1997 does not satisfy the principal 
purpose requirement, and paragraph (c)(2)(v)(A) of this section does not 
apply to the disposition of those apartments. Accordingly, for purposes 
of applying the rules of Sec.  1.469-2T(c)(2) to the disposition of the 
apartments sold in 1997, the rental of the apartments after January 1, 
1996, is treated, under paragraph (c)(2)(v)(B) of this section, as the 
use of the apartments in the taxpayer's dealing activity.

    (c)(3)-(c)(5) [Reserved]
    (c)(6) Gross income from certain oil or gas properties--(i) In 
general. Notwithstanding any other provision of the regulations under 
section 469, passive activity gross income for any taxable year does not 
include an amount of the taxpayer's gross passive income for the year 
from a property described in this paragraph (c)(6)(i) equal to the 
taxpayer's net passive income from the property for the year. Property 
is described in this paragraph (c)(6)(i) if the property is--
    (A) An oil or gas property that includes an oil or gas well if, for 
any prior taxable year beginning after December 31, 1986, any of the 
taxpayer's loss from the well was treated, solely by reason of Sec.  
1.469-1T(e)(4) (relating to a special rule for losses from oil and gas 
working interests), and not by reason of the taxpayer's material 
participation in the activity, as a loss that is not from a passive 
activity; or
    (B) Any property the basis of which is determined in whole or in 
part by reference to the basis of property described in paragraph 
(c)(6)(i)(A) of this section.
    (ii) Gross and net passive income from the property. For purposes of 
this paragraph (c)(6)--
    (A) The taxpayer's gross passive income for any taxable year from 
any property described in paragraph (c)(6)(i) of this section is any 
passive activity gross income for the year (determined without regard to 
this paragraph (c)(6) and Sec.  1.469-2T(f)) from the property;
    (B) The taxpayer's net passive income for any taxable year from any 
property described in paragraph

[[Page 471]]

(c)(6)(i) of this section is the excess, if any, of--
    (1) The taxpayer's gross passive income for the taxable year from 
the property; over
    (2) Any passive activity deductions for the taxable year (including 
any deduction treated as a deduction for the year under Sec.  1.469-
1T(f)(4)) that are reasonably allocable to the income; and
    (C) if any oil or gas well or other item of property (the item) is 
included in two or more properties described in paragraph (c)(6)(i) of 
this section (the properties), the taxpayer must allocate the passive 
activity gross income (determined without regard to this paragraph 
(c)(6) and Sec.  1.469-2T(f) from the item and the passive activity 
deductions reasonably allocable to the item among the properties.
    (iii) Property. For purposes of paragraph (c)(6)(i)(A) of this 
section, the term ``property'' does not have the meaning given the term 
by section 614(a) or the regulations thereunder, and an oil or gas 
property that includes an oil or gas well is--
    (A) The well; and
    (B) Any other item of property (including any oil or gas well) the 
value of which is directly enhanced by any drilling, logging, seismic 
testing, or other activities the costs of which were taken into account 
in determining the amount of the taxpayer's income or loss from the 
well.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(6):

    Example 1. A is a general partner in partnership P and a limited 
partner in partnership R. P and R own oil and gas working interests in 
two separate tracts of land acquired from two separate landowners. In 
1993, P drills a well on its tract, and A's distributive share of P's 
losses from drilling the well are treated under Sec.  1.469-1T(e)(4) as 
not from a passive activity. In the course of selecting the drilling 
site and drilling the well, P develops information indicating that the 
reservior in which the well was drilled underlies R's tract as well as 
P's. Under these facts, P's and R's tracts are treated as one property 
for purposes of this paragraph (c)(6), even if A's interests in the 
mineral deposits in the tracts are treated as separate properties under 
section 614(a). Accordingly, in 1994 and subsequent years, A's 
distributive share of both P's and R's income and expenses from their 
respective tracts is taken into account in computing A's net passive 
income from the property for purposes of this paragraph (c)(6).
    Example 2. B is a general partner in partnership S. S owns an oil 
and gas working interest in a single tract of land. In 1993, S drills a 
well, and B's distributive share of S's losses from drilling the well is 
treated under Sec.  1.469-1T(e)(4) as not from a passive activity. In 
the course of drilling the well, S discovers two oil-bearing formations, 
one underlying the other. On December 1, 1993, S completes the well in 
the underlying formation. On January 1, 1994, B converts B's entire 
general partnership interest in S into a limited partnership interest. 
In 1994, S completes in, and commences production from, the shallow 
formation. Under these facts, the two mineral deposits in S's tract are 
treated as one property for purposes of this paragraph (c)(6), even if 
they are treated as separate properties under section 614(a). 
Accordingly, B's distributive share of S's income and expenses from both 
the underlying formation and from recompletion in and production from 
the shallow formation is taken into account in computing B's net passive 
income from the property for purposes of this paragraph (c)(6).

    (c)(6)(iv) Example 3--(c)(7)(iii) [Reserved]
    (c)(7)(iv) Gross income of an individual from a covenant by such 
individual not to compete;
    (v) Gross income that is treated as not from a passive activity 
under any provision of the regulations under section 469, including but 
not limited to Sec.  1.469-1T(h)(6) (relating to income from 
intercompany transactions of members of an affiliated group of 
corporations filing a consolidated return) and Sec.  1.469-2T(f) and 
paragraph (f) of this section (relating to recharacterized passive 
income);
    (vi) Gross income attributable to the reimbursement of a loss from 
fire, storm, shipwreck, or other casualty, or from theft (as such terms 
are used in section 165(c)(3)) if--
    (A) The reimbursement is included in gross income under Sec.  1.165-
1(d)(2)(iii) (relating to reimbursements of losses that the taxpayer 
deducted in a prior taxable year); and
    (B) The deduction for the loss was not a passive activity deduction; 
and
    (c)(7)(vii) Gross income or gain allocable to business or rental use 
of a dwelling unit for any taxable year in which section 280A(c)(5) 
applies to such business or rental use.

[[Page 472]]

    (d)(1)-(d)(2)(viii) [Reserved]
    (ix) An item of loss or deduction that is carried to the taxable 
year under section 172(a), section 613A(d), section 1212(a)(1) (in the 
case of corporations), or section 1212(b) (in the case of taxpayers 
other than corporations);
    (x) An item of loss or deduction that would have been allowed for a 
taxable year beginning before January 1, 1987, but for section 704(d), 
1366, or 465;
    (xi) A deduction for a loss from fire, storm, shipwreck, or other 
casualty, or from theft (as such terms are used in section 165(c)(3)) if 
losses that are similar in cause and severity do not recur regularly in 
the conduct of the activity; and
    (xii) A deduction or loss allocable to business or rental use of a 
dwelling unit for any taxable year in which section 280A(c)(5) applies 
to such business or rental use.
    (d)(3)-(d)(5)(ii) [Reserved]
    (d)(5)(iii) Other applicable rules--(A) Applicability of rules in 
Sec.  1.469-2T(c)(2). For purposes of this paragraph (d)(5), a 
taxpayer's interests in property used in an activity and the amounts 
allocated to the interests shall be determined under Sec.  1.469-
2T(c)(2)(i)(C). In addition, the rules contained in paragraph (c)(2)(iv) 
and (v) of this section apply in determining for purposes of this 
paragraph (d)(5) the activity (or activities) in which an interest in 
property is used at the time of its disposition and during the 12-month 
period ending on the date of its disposition.
    (d)(5)(iii)(B)-(d)(6)(v)(D) [Reserved]
    (d)(6)(v)(E) Are taken into account under section 613A(d) (relating 
to limitations on certain depletion deductions), section 1211 (relating 
to the limitation on capital losses), or section 1231 (relating to 
property used in a trade or business and involuntary conversions); or
    (d)(6)(v)(F)-(d)(7) [Reserved]
    (d)(8) Taxable year in which item arises. For purposes of Sec.  
1.469-2T(d), an item of deduction arises in the taxable year in which 
the item would be allowable as a deduction under the taxpayer's method 
of accounting if taxable income for all taxable years were determined 
without regard to sections 469, 613A(d) and 1211.
    (e)(1)-(e)(2)(i) [Reserved]
    (e)(2)(ii) Section 707(c). Except as provided in paragraph 
(e)(2)(iii)(B) of this section, any payment to a partner for services or 
the use of capital that is described in section 707(c), including any 
payment described in section 736(a)(2) (relating to guaranteed payments 
made in liquidation of the interest of a retiring or deceased partner), 
is characterized as a payment for services or as the payment of 
interest, respectively, and not as a distributive share of partnership 
income.
    (iii) Payments in liquidation of a partner's interest in partnership 
property--(A) In general. If any gain or loss is taken into account by a 
retiring partner (or any other person that owns (directly or indirectly) 
an interest in the partner if the partner is a passthrough entity) or a 
deceased partner's successor in interest as a result of a payment to 
which section 736(b) (relating to payments made in exchange for a 
retired or deceased partner's interest in partnership property) applies, 
the gain or loss is treated as passive activity gross income or a 
passive activity deduction only to the extent that the gain or loss 
would have been passive activity gross income or a passive activity 
deduction of the retiring or deceased partner (or the other person) if 
it had been recognized at the time the liquidation of the partner's 
interest commenced.
    (B) Payments in liquidation of a partner's interest in unrealized 
receivables and goodwill under section 736(a). (1) If a payment is made 
in liquidation of a retiring or deceased partner's interest, the payment 
is described in section 736(a), and any income--
    (i) Is taken into account by the retiring partner (or any other 
person that owns (directly or indirectly) an interest in the partner if 
the partner is a passthrough entity) or the deceased partner's successor 
in interest as a result of the payment; and
    (ii) Is attributable to the portion (if any) of the payment that is 
allocable to the unrealized receivables (within the meaning of section 
751(c)) and goodwill of the partnership;

the percentage of the income that is treated as passive activity gross 
income shall not exceed the percentage of passive activity gross income 
that would be included in the gross income

[[Page 473]]

that the retiring or deceased partner (or the other person) would have 
recognized if the unrealized receivables and goodwill had been sold at 
the time that the liquidation of the partner's interest commenced.
    (2) For purposes of this paragarph (e)(2)(iii)(B), the portion (if 
any) of a payment under section 736(a) that is allocable to unrealized 
receivables and goodwill of a partnership shall be determined in 
accordance with the principles employed under Sec.  1.736-1(b) for 
determining the portion of a payment made under section 736 that is 
treated as a distribution under section 736(b).
    (e)(3)(i)-(iii)(A) [Reserved]
    (B) An amount of gain that would have been treated as gain that is 
not from a passive activity under paragraph (c)(2)(iii) of this section 
(relating to substantially appreciated property formerly used in a 
nonpassive activity), paragraph (c)(6) of this section (relating to 
certain oil or gas properties), Sec.  1.469-2T(f)(5) (relating to 
certain property rented incidental to development), paragraph (f)(6) of 
this section (relating to property rented to a nonpassive activity), or 
Sec.  1.469-2T(f)(7) (relating to certain interests in a passthrough 
entity engaged in the trade or business of licensing intangible 
property) would have been allocated to the holder (or such other person) 
with respect to the interest if all of the property used in the passive 
activity had been sold immediately prior to the disposition for its fair 
market value on the applicable valuation date (within the meaning of 
Sec.  1.469-2T(e)(3)(ii)(D)(1)); and
    (e)(3)(iii)(C)-(f)(4) [Reserved]
    (f)(5) Net income from certain property rented incidental to 
development activity--(i) In general. An amount of the taxpayer's gross 
rental activity income for the taxable year from an item of property 
equal to the net rental activity income for the year from the item of 
property shall be treated as not from a passive activity if--
    (A) Any gain from the sale, exchange, or other disposition of the 
item of property is included in the taxpayer's income for the taxable 
year;
    (B) The taxpayer's use of the item of property in an activity 
involving the rental of the property commenced less than 12 months 
before the date of the disposition (within the meaning of paragraph 
(c)(2)(iii)(B) of this section) of such property; and
    (C) The taxpayer materially participated (within the meaning of 
Sec.  1.469-5T) or significantly participated (within the meaning of 
Sec.  1.469-5T(c)(2)) for any taxable year in an activity that involved 
for such year the performance of services for the purpose of enhancing 
the value of such item of property (or any other item of property if the 
basis of the item of property that is sold, exchanged, or otherwise 
disposed of is determined in whole or in part by reference to the basis 
of such other item of property).
    (ii) Commencement of use--(A) In general. For purposes of paragraph 
(f)(5)(i)(B) of this section, a taxpayer's use of an item of property in 
an activity involving the rental of the property commences on the first 
date on which--
    (1) The taxpayer owns an interest in the property;
    (2) Substantially all of the property is rented (or is held out for 
rent and is in a state of readiness for rental); and
    (3) No significant value-enhancing services (within the meaning of 
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
    (B) Value-enhancing services. For purposes of this paragraph 
(f)(5)(ii), the term value-enhancing services means the services 
described in paragraphs (f)(5) (i)(C) and (iii) of this section, except 
that the term does not include lease-up. Thus, in cases in which this 
paragraph (f)(5) applies solely because substantial lease-up remains to 
be performed (see paragraph (f)(5)(iii)(C) of this section), the twelve 
month period described in paragraph (f)(5)(i)(B) of this section will 
begin when the taxpayer acquires an interest in the property if 
substantially all of the property is held out for rent and is in a state 
of readiness for rental on that date.
    (iii) Services performed for the purpose of enhancing the value of 
property. For purposes of paragraph (f)(5)(i)(C) of this section, 
services that are treated as performed for the purpose of enhancing the 
value of an item of property include but are not limited to--
    (A) Construction;
    (B) Renovation; and

[[Page 474]]

    (C) Lease-up (unless more than 50 percent of the property is leased 
on the date that the taxpayer acquires an interest in the property).
    (iv) Examples. The following examples illustrate the application of 
this paragraph (f)(5):

    Example 1. (i) A, a calendar year individual, is a partner in P, a 
calendar year partnership, which develops real estate. In 1993, P 
acquires an interest in undeveloped land and arranges for the financing 
and construction of an office building on the land. Construction is 
completed in February 1995, and substantially all of the building is 
either rented or held out for rent and in a state of readiness for 
rental beginning on March 1, 1995. Twenty percent of the building is 
leased as of March 1, 1995.
    (ii) P rents the building (or holds it out for rent) for the 
remainder of 1995 and all of 1996, and sells the building on February 1, 
1997, pursuant to a contract entered into on January 15, 1996. P did not 
hold the building (or any other buildings) for sale to customers in the 
ordinary course of P's trade or business (see paragraph (c)(2)(v) of 
this section). A's distributive share of P's taxable losses from the 
rental of the building is $50,000 for 1995 and $30,000 for 1996. All of 
A's losses from the rental of the building are disallowed under 1.469-
1(a)(1)(i) (relating to the disallowance of the passive activity loss 
for the taxable year). A's distributive share of P's gain from the sale 
of the building is $150,000. A has no other gross income or deductions 
from the activity of renting the building.
    (iii) The real estate development activity that A holds through P in 
1993, 1994, and 1995 involves the performance of services (e.g., 
construction) for the purpose of enhancing the value of the building. 
Accordingly, an amount equal to A's net rental activity income from the 
building may be treated as gross income that is not from a passive 
activity if A's use of the building in an activity involving the rental 
of the building commenced less that 12 months before the date of the 
disposition of the building. In this case, the date of the disposition 
of the building is January 15, 1996, the date of the binding contract 
for its sale.
    (iv)(A) A taxpayer's use of an item of property in an activity 
involving the rental of the property commences on the first date on 
which--
    (1) The taxpayer owns an interest in the item of property;
    (2) Substantially all of the property is rented (or is held out for 
rent and is in a state of readiness for rental); and
    (3) No significant value-enhancing services (within the meaning of 
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
    (B) In this case, A's use of the building in an activity involving 
the rental of the building commenced on March 1, 1995, less than 12 
months before January 15, 1996, the date of disposition. Accordingly, if 
A materially (or significantly) participated in the real estate 
development activity in 1993, 1994, or 1995 (without regard to whether A 
materially participated in the activity in more than one of those 
years), an amount of A's gross rental activity income from the building 
for 1997 equal to A's net rental activity income from the building for 
1997 is treated under this paragraph (f)(5) as gross income that is not 
from a passive activity. Under paragraph (f)(9)(iv) of this section, A's 
net rental activity income from the building for 1997 is $70,000 
($150,000 distributive share of gain from the disposition of the 
building minus $80,000 of reasonably allocable passive activity 
deductions).
    Example 2. (i) X, a calendar year taxpayer subject to section 469, 
acquires a building on February 1, 1994, when the building is 25 percent 
leased. During 1994, X rents the building (or holds it out for rent) and 
materially participates in an activity that involves the lease-up of the 
building. X's activities do not otherwise involve the performance of 
construction or other services for the purpose of enhancing the value of 
the building, and X does not hold the building (or any other building) 
for sale to customers in the ordinary course of X's trade or business. X 
sells the building on December 1, 1994.
    (ii)(A) Under paragraph (f)(5)(iii)(C) of this section, lease-up is 
considered a service performed for the purpose of enhancing the value of 
property unless more than 50 percent of the property is leased on the 
date the taxpayer acquires an interest in the property. Under paragraph 
(f)(5)(ii)(B) of this section, however, lease-up is not considered a 
value-enhancing service for purposes of determining when the taxpayer 
commences using an item of property in an activity involving the rental 
of the property. Accordingly, X's acquisition of the building 
constitutes a commencement of X's use of the building in a rental 
activity, because February 1, 1994, is the first date on which--
    (1) The taxpayer owns an interest in the item of property;
    (2) Substantially all of the property is held out for rent; and
    (3) No significant value-enhancing services (within the meaning of 
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
    (B) In this case, X disposes of the property within 12 months of the 
date X commenced using the building in a rental activity. Accordingly, 
an amount of X's gross rental activity income for 1994 equal to X's net 
rental activity income from the building for 1994 is treated under this 
paragraph (f)(5) as gain that is not from a passive activity.

[[Page 475]]

    Example 3. The facts are the same as in Example 2, except that at 
the time X acquires the building it is 60 percent leased. Under 
paragraph (f)(5)(iii)(C) of this section, lease-up is not considered a 
service performed for the purpose of enhancing the value of property if 
more than 50 percent of the property is leased on the date the taxpayer 
acquires an interest in the property. Therefore, additional lease-up 
performed by X is not taken into account under this paragraph (f)(5). 
Since X's activities do not otherwise involve the performance of 
services for the purpose of enhancing the value of the building, none of 
X's gross rental activity income from the building will be treated as 
income that is not from a passive activity under this paragraph (f)(5).

    (f)(6) Property rented to a nonpassive activity. An amount of the 
taxpayer's gross rental activity income for the taxable year from an 
item of property equal to the net rental activity income for the year 
from that item of property is treated as not from a passive activity if 
the property--
    (i) Is rented for use in a trade or business activity (within the 
meaning of paragraph (e)(2) of this section) in which the taxpayer 
materially participates (within the meaning of Sec.  1.469-5T) for the 
taxable year; and
    (ii) Is not described in Sec.  1.469-2T(f)(5).
    (f)(7)-(f)(9)(ii) [Reserved]
    (f)(9)(iii) The gross rental activity income for a taxable year from 
an item of property is any passive activity gross income (determined 
without regard to Sec.  1.469-2T(f)(2) through (f)(6)) that--
    (A) Is income for the year from the rental or disposition of such 
item of property; and
    (B) In the case of income from the disposition of such item of 
property, is income from an activity that involved the rental of such 
item of property during the 12-month period ending on the date of the 
disposition (see Sec.  1.469-2T(c)(2)(ii)); and
    (iv) The net rental activity income from an item of property for the 
taxable year is the excess, if any, of--
    (A) The gross rental activity income from the item of property for 
the taxable year; over
    (B) Any passive activity deductions for the taxable year (including 
any deduction treated as a deduction for the year under Sec.  1.469-
1(f)(4)) that are reasonably allocable to the income.
    (10) Coordination with section 163(d). Gross income that is treated 
as not from a passive activity under Sec.  1.469-2T(f)(3), (4), or (7) 
is treated as income described in section 469(e)(1)(A) and Sec.  1.469-
2T(c)(3)(i) except in determining whether--
    (i) Any property is treated for purposes of section 
469(e)(1)(A)(ii)(I) and Sec.  1.469-2T(c)(3)(i)(C) as property that 
produces income of a type described in Sec.  1.469-2T(c)(3)(i)(A);
    (ii) Any property is treated for purposes of section 
469(e)(1)(A)(ii)(II) and Sec.  1.469-2T(c)(3)(i)(D) as property held for 
investment;
    (iii) An expense (other than interest expense) is treated for 
purposes of section 469(e)(1)(A)(i)(II) and Sec.  1.469-2T(d)(4) as 
clearly and directly allocable to portfolio income (within the meaning 
of Sec.  1.469-2T(c)(3)(i); and
    (iv) Interest expense is allocated under Sec.  1.163-8T to an 
investment expenditure (within the meaning of Sec.  1.163-8T(b)(3)) or 
to a passive activity expenditure (within the meaning of Sec.  1.163-
8T(b)(4)).
    (11) [Reserved]

[T.D. 8417, 57 FR 20754, May 15, 1992, as amended by T.D. 8477, 58 FR 
11538, Feb. 26, 1993; 58 FR 13706, Mar. 15, 1993; 58 FR 29536, May 21, 
1993; T.D. 8495, 58 FR 58787, Nov. 4, 1993; T.D. 8417, 59 FR 45623, 
Sept. 2, 1994]



Sec.  1.469-2T  Passive activity loss (temporary).

    (a) Scope of this section. This section contains rules for 
determining the amount of the taxpayer's passive activity loss for the 
taxable year for purposes of section 469 and the regulations thereunder. 
The rules contained in this section--
    (1) Provide general guidance for identifying items of income and 
deduction that are taken into account in determining the amount of the 
passive activity loss for the taxable year;
    (2) Specify particular items of income and deduction that are not 
taken into account in determining the amount of the passive activity 
loss for the taxable year; and
    (3) Specify the manner in which provisions of the Internal Revenue 
Code and the regulations, other than section 469 and the regulations 
thereunder, are applied for purposes of determining the

[[Page 476]]

extent to which items of deduction are taken into account for a taxable 
year in computing the amount of the passive activity loss for such year.
    (b) Definition of passive activity loss--(1) In general. In the case 
of a taxpayer other than a closely held corporation (within the meaning 
of Sec.  1.469-1T(g)(2)(ii)), the passive activity loss for the taxable 
year is the amount, if any, by which the passive activity deductions for 
the taxable year exceed the passive activity gross income for the 
taxable year.
    (2) Cross references. See paragraph (c) of this section for the 
definition of ``passive activity gross income,'' paragraph (d) of this 
section for the definition of ``passive activity deduction,'' and Sec.  
1.469-1T(g)(4) for the computation of the passive activity loss of a 
closely held corporation.
    (c) Passive activity gross income--(1) In general. Except as 
otherwise provided in the regulations under section 469, passive 
activity gross income for a taxable year includes an item of gross 
income if and only if such income is from a passive activity.
    (2) Treatment of gain from disposition of an interest in an activity 
or an interest in property used in an activity--(i) In general--(A) 
Treatment of gain. Except as otherwise provided in the regulations under 
section 469, any gain recognized upon the sale, exchange or other 
disposition (a ``disposition'') of an interest in property used in an 
activity at the time of the disposition or of an interest in an activity 
held through a partnership or S corporation is treated in the following 
manner:
    (1) The gain is treated as gross income from such activity for the 
taxable year or years in which it is recognized;
    (2) If the activity is a passive activity of the taxpayer for the 
taxable year of the disposition, the gain is treated as passive activity 
gross income for the taxable year or years in which it is recognized; 
and
    (3) If the activity is not a passive activity of the taxpayer for 
the taxable year of the disposition, the gain is treated as not from a 
passive activity.
    (B) Dispositions of partnership interests and S corporation stock. A 
partnership interest or S corporation stock is not property used in an 
activity for purposes of this paragraph (c)(2). See paragraph (e)(3) of 
this section for rules treating the gain recognized upon the disposition 
of a partnership interest or S corporation stock as gain from the 
disposition of interests in the activities in which the partnership or S 
corporation has an interest.
    (C) Interest in property. For purposes of applying this paragraph 
(c)(2) to a disposition of property--
    (1) Any material portion of the property that was used, at any time 
before the disposition, in any activity at a time when the remainder of 
the property was not used in such activity shall be treated as a 
separate interest in property; and
    (2) The amount realized from the disposition and the adjusted basis 
of the property must be allocated among the separate interests in a 
reasonable manner.
    (D) Examples. The following examples illustrate the application of 
this paragraph (c)(2)(i):

    Example 1. A owns an interest in a trade or business activity in 
which A has never materially participated. In 1987, A sells equipment 
that was used exclusively in the activity and realizes a gain on the 
sale. Under paragraph (c)(2)(i)(A)(2) of this section, the gain is 
passive activity gross income.
    Example 2. B owns an interest in a trade or business activity in 
which B materially participates for 1987. In 1987, B sells a building 
used in the activity in an installment sale and realizes a gain on the 
sale. B does not materially participate in the activity for 1988 or any 
subsequent year. Under paragraph (c)(2)(i)(A)(3) of this section, none 
of B's gain from the sale (including gain taken into account after 1987) 
is passive activity gross income.
    Example 3. C enters into a contract to acquire property used by the 
seller in a rental activity. Before acquiring the property pursuant to 
the contract, C sells all rights under the contract and realizes a gain 
on the sale. Since C's rights under the contract are not property used 
in a rental activity, the gain is not income from a rental activity. The 
result would be the same if C owned an option to acquire the property 
and sold the option.
    Example 4. D sells a ten-floor office building. D owned the building 
for three years preceding the sale and at all times during that period 
used seven floors of the building in a trade or business activity and 
three floors in a rental activity. The fair market value per square foot 
is substantially the same throughout the building, and D did not

[[Page 477]]

maintain a separate adjusted basis for any part of the building. Under 
paragraph (c)(2)(i)(C)(1) of this section, the seven floors used in the 
trade or business activity and the three floors used in the rental 
activity are treated as separate interests in property. Under paragraph 
(c)(2)(i)(C)(2) of this section, the amount realized and the adjusted 
basis of the building must be allocated between the separate interests 
in a reasonable manner. Under these facts, an allocation based on the 
square footage of the parts of the building used in each activity would 
be reasonable.
    Example 5. The facts are the same as in Example 4, except that two 
of the seven floors used in the trade or business activity were used in 
the rental activity until five months before the sale. Under paragraph 
(c)(2)(i)(C)(1) of this section, the five floors used exclusively in the 
trade or business activity and the two floors used first in the rental 
activity and then in the trade or business activity are treated as 
separate interests in property. See paragraph (c)(2)(ii) of this section 
for rules for allocating amount realized and adjusted basis upon a 
disposition of an interest in property used in more than one activity 
during the 12-month period ending on the date of the disposition.

    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition. In the case of a disposition of an 
interest in property that is used in more than one activity during the 
12-month period ending on the date of the disposition, the amount 
realized from the disposition and the adjusted basis of such interest 
must be allocated among such activities on a basis that reasonably 
reflects the use of such interest in property during such 12-month 
period. For purposes of this paragraph (c)(2)(ii), an allocation of the 
amount realized and adjusted basis solely to the activity in which an 
iterest in property is predominantly used during the 12-month period 
ending on the date of the disposition reasonably reflects the use of 
such interest in property if the fair market value of such interest does 
not exceed the lesser of--
    (A) $10,000; and
    (B) 10 percent of the sum of the fair market value of such interest 
and the fair market value of all other property used in such activity 
immediately before the disposition.

The following examples illustrate the application of this paragraph 
(c)(2)(ii):

    Example 1. The facts are the same as in Example 5 of paragraph 
(c)(2)(i)(D) of this section. Under paragraph (c)(2)(i)(C)(2) of this 
section, D allocates the amount realized and adjusted basis of the 
building 30 percent to the three floors used exclusively in the rental 
activity, 50 percent to the five floors used exclusively in the trade or 
business activity, and 20 percent to the two floors used first in the 
rental activity and then in the trade or business activity. Under this 
paragraph (c)(2)(ii), the amount realized and adjusted basis allocated 
to the two floors that were used in both activities during the 12-month 
period ending on the date of the disposition must also be allocated 
between such activities. Under these facts, an allocation of \7/12\ of 
such amounts to the rental activity and \5/12\ of such amounts to the 
trade or business activity would reasonably reflect the use of the two 
floors during the 12-month period ending on the date of the disposition.
    Example 2. B is a limited partner in a partnership that sells a 
tractor-trailer. During the 12-month period ending on the date of the 
sale, the tractor-trailer was used in several activities, and the 
partnership allocates the amount realized from the disposition and the 
adjusted basis of the tractor-trailer among the activities based on the 
number of days during the 12-month period that the partnership used the 
tractor-trailer in each activity. Under these facts, the partnership's 
allocation reasonably reflects the use of the tractor-trailer during the 
12-month period ending on the date of the sale.
    Example 3. C sells a personal computer for $8,000. During the 12-
month period ending on the date of the sale, 70 percent of C's use of 
the computer was in a passive activity. Immediately before the sale, the 
fair market value of all property used in the passive activity 
(including the personal computer) was $200,000. Under these facts, the 
computer was predominatly used in the passive activity during the 12-
month period ending on the date of the sale, and the value of the 
computer, as measured by its sale price ($8,000), does not exceed the 
lesser of (a) $10,000, and (b) 10 percent of the value of all property 
used in the activity immediately before the sale ($20,000). C allocates 
the amount realized and the adjusted basis solely to the passive 
activity. Under this paragraph (c)(2)(ii), C's allocation reasonably 
reflects the use of the computer during the 12-month period ending on 
the date of the sale.

    (iii) Disposition of substantially appreciated property formerly 
used in nonpassive activity. [Reserved]. See Sec.  1.469-4(c)(2)(iii) 
for rules relating to this paragraph.
    (iv) Taxable acquisitions. [Reserved]. See Sec.  1.469-2(c)(iv) for 
rules relating to this paragraph.

[[Page 478]]

    (v) Property held for sale to customers. [Reserved]. See Sec.  
1.469-2(c)(v) for rules relating to this paragraph.

    (3) Items of portfolio income specifically excluded--(i) In general. 
Passive activity gross income does not include portfolio income. For 
purposes of the preceding sentence, portfolio income includes all gross 
income, other than income derived in the ordinary course of a trade or 
business (within the meaning of paragraph (c)(3)(ii) of this section), 
that is attributable to--
    (A) Interest (including amounts treated as interest under paragraph 
(e)(2)(ii) of this section, relating to certain payments to partners for 
the use of capital); annuities; royalties (including fees and other 
payments for the use of intangible property); dividends on C corporation 
stock; and income (including dividends) from a real estate investment 
trust (within the meaning of section 856), regulated investment company 
(within the meaning of section 851), real estate mortgage investment 
conduit (within the meaning of section 860D), common trust fund (within 
the meaning of section 584), controlled foreign corporation (within the 
meaning of section 957), qualified electing fund (within the meaning of 
section 1295(a)), or cooperative (within the meaning of section 
1381(a));
    (B) Dividends on S corporation stock (within the meaning of section 
1368(c)(2);
    (C) The disposition of property that produces income of a type 
described in paragraph (c)(3)(i)(A) of this section; and
    (D) The disposition of property held for investment (within the 
meaning of section 163 (d)).
    (ii) Gross income derived in the ordinary course of a trade or 
business. Solely for purposes of paragraph (c)(3)(i) of this section, 
gross income derived in the ordinary course of a trade or business 
includes only--
    (A) Interest income on loans and investments made in the ordinary 
course of a trade or business of lending money;
    (B) Interest on accounts receivable arising from the performance of 
services or the sale of property in the ordinary course of a trade or 
business of performing such services or selling such property, but only 
if credit is customarily offered to customers of the business;
    (C) Income from investments made in the ordinary course of a trade 
or business of furnishing insurance or annuity contracts or reinsuring 
risks underwritten by insurance companies;
    (D) Income or gain derived in the ordinary course of an activity of 
trading or dealing in any property if such activity constitutes a trade 
or business (but see paragraph (c)(3)(iii)(A) of this section);
    (E) Royalties derived by the taxpayer in the ordinary course of a 
trade or business of licensing intangible property (within the meaning 
of paragraph (c)(3)(iii)(B) of this section);
    (F) Amount included in the gross income of a patron of a cooperative 
(within the meaning of section 1381(a), without regard to paragraph 
(2)(A) or (C) thereof) by reason of any payment or allocation to the 
patron based on patronage occurring with respect to a trade or business 
of the patron; and
    (G) Other income identified by the Commissioner as income derived by 
the taxpayer in the ordinary course of a trade or business.
    (iii) Special rules--(A) Income from property held for investment by 
dealer. For purposes of paragraph (c)(3)(i) of this section, a dealer's 
income or gain from an item of property is not dervied by the dealer in 
the ordinary course of a trade or business of dealing in such property 
if the dealer held the property for investment at any time before such 
income or gain is recognized.
    (B) Royalties derived in the ordinary course of the trade or 
business of licensing intangible property--(1) In general. Royalties 
received by any person with respect to a license or other transfer of 
any rights in intangible property shall be considered to be derived in 
the ordinary course of the trade or business of licensing such property 
only if such person--
    (i) Created such property; or
    (ii) Performed substantial services or incurred substantial costs 
with respect to the development or marketing of such property.
    (2) Substantial services or costs--(i) In general. Except as 
provided in paragraph (c)(3)(iii)(B)(2)(ii) of this section,

[[Page 479]]

the determination of whether a person has performed substantial services 
or incurred substantial costs with respect to the development or 
marketing of an item of intangible property shall be made on the basis 
of all the facts and circumstances.
    (ii) Exception. A person has performed substantial services or 
incurred substantial costs for a taxable year with respect to the 
development or marketing of an item of intangible property if--
    (a) The expenditures reasonably incurred by such person in such 
taxable year with respect to the development or marketing of the 
property exceed 50 percent of the gross royalties from licensing such 
property that are includible in such person's gross income for the 
taxable year; or
    (b) The expenditures reasonably incurred by such person in such 
taxable year and all prior taxable years with respect to the development 
or marketing of the property exceed 25 percent of the aggregate capital 
expenditures (without any adjustment of amortization) made by such 
person with respect to the property in all such taxable years.
    (iii) Expenditures taken into account. For purposes of paragraph 
(c)(3)(iii)(B)(2)(ii) of this section, expenditures in a taxable year 
include amounts chargeable to capital account for such year without 
regard to the year or years (if any) in which any deduction for such 
expenditure is allowed.
    (3) Passthrough entities. For purposes of this paragraph 
(c)(3)(iii)(B), in the case of any intangible property held by a 
partnership, S corporation, estate, or trust, the determination of 
whether royalties from such property are derived in the ordinary course 
of a trade or business shall be made by applying the rules of this 
paragraph (c)(3)(iii)(B) to such entity and not to any holder of an 
interest in such entity.
    (4) Cross reference. For special rules applicable to certain gross 
income from a trade or business of licensing intangible property, see 
paragraph (f)(7) of this section.
    (C) Mineral production payments. For purposes of section 469 and the 
regulations thereunder--
    (1) If a mineral production payment is treated as a loan under 
section 636, the portion of any payment in discharge of the production 
payment that is the equivalent of interest shall be treated as interest; 
and
    (2) If a mineral production payment is not treated as a loan under 
section 636, payments in discharge of the production payment shall be 
treated as royalties.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(3):

    Example 1. A, an individual engaged in the trade or business of 
farming, disposes of farmland in an installment sale. A is not engaged 
in a trade or business of selling farmland. Therefore, A's interest 
income from the installment note is not gross income derived in the 
ordinary course of a trade or business.
    Example 2. P, a partnership, operates a rental apartment building 
for low-income tenants in City Y. Under Y's laws relating to the 
operation of low-income housing, P is required to maintain a reserve 
fund to pay for the maintenance and repair of the building. P invests 
the reserve fund in short-term interest-bearing deposits. Because P's 
interest income from the investment of the reserve fund is not interest 
income described in paragraph (c)(3)(ii) of this section, such income is 
not treated as derived in the ordinary course of a trade or business. 
Accordingly, P's interest income from the deposits is portfolio income 
(within the meaning of paragraph (c)(3)(i) of this section).
    Example 3. (i) B is a partner in a partnership that is engaged in an 
activity involving the conduct of a trade or business of dealing in 
securities. On February 1, the partnership acquires certain securities 
for investment (within the meaning of section 163(d)). On February 2, 
before recognizing any income with respect to the securities, the 
partnership determines that it would be advisable to hold the securities 
primarily for sale to customers and subsequently sells them to customers 
in the ordinary course of its business.
    (ii) Under paragraph (c)(3)(iii)(A) of this section, income or gain 
from any security (including any security acquired pursuant to an 
investment of working capital) held by a dealer for investment at any 
time before such income or gain is recognized is not treated for 
purposes of paragraph (c)(3)(i) of this section as derived by the dealer 
in the ordinary course of its trade or business of dealing in 
securities. Accordingly, B's distributive share of the partnership's 
interest, dividends, or gains from the securities acquired by the 
partnership for investment on February 1 is portfolio income of B, 
notwithstanding that such securities were held by

[[Page 480]]

the partnership, subsequent to February 1, primarily for sale to 
customers in the ordinary course of the partnership's trade or business 
of dealing in securities.
    Example 4. C is a partner in a partnership that is engaged in an 
activity of trading or dealing in royalty interests in mineral 
properties. The partnership derives royalty income from royalty 
interests held in the activity. If the activity is a trade or business 
activity, C's distributive share of the partnership's royalty income 
from such royalty interests is treated under paragraph (c)(3)(ii)(D) of 
this section as derived in the ordinary course of the partnership's 
trade or business.
    Example 5. (i) D, a calendar year individual, is a partner in a 
calendar year partnership that is engaged in an activity of developing 
and marketing a design for a system that reduces air pollution in office 
buildings. D has a 10 percent distributive share of all items of 
partnership income, gain, loss, deduction, and credit. In 1987, the 
partnership acquired the rights to the design for $100,000. In 1987, 
1988, and 1989, the partnership incurs expenditures with respect to the 
development and marketing of the design, and derives gross royalties 
from licensing the design, in the amounts set forth in the table below. 
The expenditures incurred in 1987 and 1988 are currently deductible 
expenses. The expenditures incurred in 1989 are capitalized and may be 
deducted only in subsequent taxable years.

------------------------------------------------------------------------
                                                            Cumulative
              Year                 Gross    Expenditures      capital
                                 royalties                 expenditures
------------------------------------------------------------------------
1987...........................    $20,000      $8,000          $100,000
1988...........................     20,000      12,000           100,000
1989...........................     60,000      15,000           115,000
1990...........................    120,000           0           115,000
------------------------------------------------------------------------

    (ii) Under paragraph (c)(3)(iii)(B)(3) of this section, the 
determination of whether royalties from intangible property are derived 
in the ordinary course of a trade or business of a partnership is made 
by applying the rules of paragraph (c)(3)(iii)(B) of this section to the 
partnership rather than the partners. The expenditures reasonably 
incurred by the partnership in 1987 with respect to the development or 
marketing of the design ($8,000) do not exceed 50 percent of the 
partnership's gross royalties for such year from licensing the design 
($20,000). In addition, the sum of such expenditures incurred in 1987 
and all prior taxable years ($8,000) does not exceed 25 percent of the 
aggregate capital expenditures made by the partnership in all such 
taxable years with respect to the design ($100,000). Accordingly, for 
1987, the partnership is not treated under paragraph 
(c)(3)(iii)(B)(2)(ii) of this section as performing substantial services 
or incurring substantial costs with respect to the development or 
marketing of the design. Therefore, unless all of the facts and 
circumstances indicate that the partnership performed substantial 
services or incurred substantial costs with respect to the development 
or marketing of the design, D's distributive share of the partnership's 
royalty income for 1987 is portfolio income.
    (iii) As of the end of 1988, the sum of the expenditures reasonably 
incurred by the partnership during such taxable year and all prior 
taxable years with respect to the development or marketing of the design 
($20,000) does not exceed 25 percent of the aggregate capital 
expenditures made by the partnership in all such years with respect to 
the design ($100,000). However, the amount of such expenditures incurred 
by the partnership in 1988 ($12,000) exceeds 50 percent of the 
partnership's gross royalties for such year from licensing the design 
($20,000). Accordingly, for 1988, under paragraph 
(c)(3)(iii)(B)(2)(ii)(a) of this section, the partnership is treated as 
performing substantial services or incurring substantial costs with 
respect to the development or marketing of the design, and D's 
distributive share of the partnership's royalty income for 1988 is 
considered for purposes of paragraph (c)(3)(i) of this section to be 
derived in the ordinary course of a trade or business and therefore is 
not portfolio income.
    (iv) The expenditures reasonably incurred by the partnership in 1989 
with respect to the development or marketing of the design ($15,000) do 
not exceed 50 percent of the partnership's gross royalties for such year 
from licensing the design ($60,000). However, the sum of such 
expenditures incurred by the partnership in 1989 and all prior taxable 
years ($35,000) exceeds 25 percent of the partnership's aggregate 
capital expenditures made in all such years with respect to the design 
($115,000). Accordingly, for 1989, under paragraph 
(c)(3)(iii)(B)(2)(ii)(b) of this section, the partnership is treated as 
performing substantial services or incurring substantial costs with 
respect to the development or marketing of the design, and D's 
distributive share of the partnership's royalty income in 1989 is 
considered for purposes of paragraph (c)(3)(i) of this section to be 
derived in the ordinary course of a trade or business and therefore is 
not portfolio income.
    (v) The result for 1990 is the same as for 1989, notwithstanding 
that the partnership incurs no expenditures in 1990 with respect to the 
development or marketing of the design.
    Example 6. The facts are the same as in Example 5, except that, for 
1987, D's distributive share of the partnership's development and 
marketing costs is 15 percent, while D's distributive share of the 
partnership's gross royalties is 10 percent. Although D's distributive 
share of the expenditures reasonably incurred by the partnership during 
1987

[[Page 481]]

with respect to the development and marketing of the design ($1,200) is 
more than 50 percent of D's distributive share of the partnership's 
gross royalties from licensing the design ($2,000), D is not treated as 
performing substantial services or incurring substantial costs with 
respect to the development or marketing of the design for 1987 under 
paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. This is because, 
under paragraph (c)(3)(iii)(B)(3) of this section, the determination of 
whether the royalties are derived in the ordinary course of a trade or 
business is made by applying paragraph (c)(3)(iii)(B) of this section to 
the partnership, and not to D.

    (4) Items of personal service income specifically excluded--(i) In 
general. Passive activity gross income does not include compensation 
paid to or on behalf of an individual for personal services performed or 
to be performed by such individual at any time. For purposes of this 
paragraph (c)(4), compensation for personal services includes only--
    (A) Earned income (within the meaning of section 911(d)(2)(A)), 
including gross income from a payment described in paragraph (e)(2) of 
this section that represents compensation for the performance of 
services by a partner;
    (B) Amounts includible in gross income under section 83;
    (C) Amounts includible in gross income under sections 402 and 403;
    (D) Amounts (other than amounts described in paragraph (c)(4)(i)(C) 
of this section) paid pursuant to retirement, pension, and other 
arrangements for deferred compensation for services;
    (E) Social security benefits (within the meaning of section 86(d)) 
includible in gross income under section 86; and
    (F) Other income identified by the Commissioner as income derived by 
the taxpayer from personal services;


provided, however, that no portion of a partner's distributive share of 
partnership income (within the meaning of section 704(b)) or a 
shareholder's pro rata share of income from an S corporation (within the 
meaning of section 1377(a)) shall be treated as compensation for 
personal services.
    (ii) Example. The following example illustrates the application of 
this paragraph (c)(4):

    Example. C owns 50 percent of the stock of X, an S corporation. X 
owns rental real estate, which it manages. X pays C a salary for 
services performed by C on behalf of X in connection with the management 
of X's rental properties. Under this paragraph (c)(4), although C's pro 
rata share of X's gross rental income is passive activity gross income 
(even if the salary paid to C is less than the fair market value of C's 
services), the salary paid to C does not constitute passive activity 
gross income.

    (5) Income from section 481 adjustment--(i) In general. If a change 
in accounting method results in a positive section 481 adjustment with 
respect to an activity, a ratable portion (within the meaning of 
paragraph (c)(5)(iii) of this section) of the amount taken into account 
for a taxable year as a net positive section 481 adjustment by reason of 
such change shall be treated as gross income from the activity for such 
taxable year, and such gross income shall be treated as passive activity 
gross income if and only if such activity is a passive activity for the 
year of the change (within the meaning of section 481(a)).
    (ii) Positive section 481 adjustments. For purposes of applying this 
paragraph (c)(5)--
    (A) The term ``net positive section 481 adjustment'' means the 
increase (if any) in taxable income taken into account under section 
481(a) to prevent amounts from being duplicated or omitted by reason of 
a change in accounting method; and
    (B) The term ``positive section 481 adjustment with respect to an 
activity'' means the increase (if any) in taxable income that would be 
taken into account under section 481(a) to prevent only the duplication 
or omission of amounts from such activity by reason of the change in 
accounting method.
    (iii) Ratable portion. The ratable portion of the amount taken into 
account as a net positive section 481 adjustment for a taxable year by 
reason of a change in accounting method is determined with respect to an 
activity by multiplying such amount by the fraction obtained by 
dividing--
    (A) The positive section 481 adjustment with respect to the 
activity; by
    (B) The sum of the positive section 481 adjustments with respect to 
all of the activities of the taxpayer.
    (6) Gross income from certain oil or gas properties--(i) In general. 
[Reserved]. See Sec.  1.469-2(c)(6)(i) for rules relating to this 
paragraph.

[[Page 482]]

    (ii) Gross and net passive income from the property. [Reserved]. See 
Sec.  1.469-2(c)(6)(ii) for rules relating to this paragraph.
    (iii) Property. [Reserved]. See 1.469-2(c)(6)(iii) for rules 
relating to this paragraph.
    (iv) Examples. The following examples illustrate the application of 
this (c)(6):

    Example 1. [Reserved]. See Sec.  1.469-2(c)(6)(iv) Example 1.
    Example 2. [Reserved]. See Sec.  1.469-2(c)(6)(iv) Example 2.
    Example 3. C is a general partner in partnership T and a limited 
partner in partnership U. T and U both own oil and gas working interests 
in tracts of land in County X. In 1987, T drills a well, and C's 
distributive share of T's losses from drilling the well is treated under 
Sec.  1.469-1T(e)(4) as not from a passive activity. In the course of 
selecting the drilling site and drilling the well, T develops 
information indicating a significant probability that substantial oil 
and gas reserves underlie most portions of County X. As a result, the 
value of all oil and gas properties in County X is enhanced. The 
information developed by T does not, however, indicate that the 
reservoir in which T's well is drilled underlies U's tract. Under these 
facts, T's and U's tracts are not treated as one property for purposes 
of this paragraph (c)(6), because the value of U's tract is not directly 
enhanced by T's activities.

    (7) Other items specifically excluded. Notwithstanding any other 
provision of the regulations under section 469, passive activity gross 
income does not include the following:
    (i) Gross income of an individual from intangible property, such as 
a patent, copyright, or literary, musical, or artistic composition, if 
the taxpayer's personal efforts significantly contributed to the 
creation of such property;
    (ii) Gross income from a qualified low-income housing project 
(within the meaning of section 502 of the Tax Reform Act of 1986) for 
any taxable year in the relief period (within the meaning of section 
502(b) of such Act;
    (iii) Gross income attributable to a refund of any state, local, or 
foreign income, war profits, or excess profits tax;
    (iv) [Reserved]. See Sec.  1.469-2(c)(7)(iv) for rules relating to 
this paragraph (c)(7)(iv).
    (v) [Reserved]. See Sec.  1.469-2(c)(7)(v) for rules relating to 
this paragraph (c)(7)(v).
    (vi) [Reserved]. See Sec.  1.469-2(c)(7)(vi) for rules relating to 
this paragraph (c)(7)(vi).
    (d) Passive activity deductions--(1) In general. Except as otherwise 
provided in section 469 and the regulations thereunder, a deduction is a 
passive activity deduction for a taxable year if and only if such 
deduction--
    (i) Arises (within the meaning of paragraph (d)(8) of this section) 
in connection with the conduct of an activity that is a passive activity 
for the taxable year; or
    (ii) Is treated as a deduction from an activity under Sec.  1.469-
1T(f)(4) for the taxable year.

The following example illustrates the application of this paragraph 
(d)(1):

    Example. (i) In 1987, A, a calendar year individual, acquires a 
partnership interest in R, a calendar year partnership. R's only 
activity is a trade or business activity in which A materially 
participates for 1987. R incurs a loss in 1987. A's distributive share 
of R's 1987 loss is $1,000. However, A's basis in the partnership 
interest at the end of 1987 (without regard to A's distributive share of 
partnership loss) is $600; accordingly, section 704(d) disallows any 
deduction in 1987 for $400 of A's distributive share of R's loss. The 
remainder of A's distributive share of R's loss would be allowed as a 
deduction for 1987 if taxable income for all taxable years were 
determined without regard to sections 469, 613A(d), and 1211. See 
paragraph (d)(8) of this section.
    (ii) A does not materially participate in R's activity for 1988. In 
1988, R again incurs a loss, and A's distributive share of the loss is 
again $1,000. At the end of 1988, A's basis in the partnership interest 
(without regard to A's distributive share of partnership loss) is 
$2,000; accordingly, in 1988 section 704(d) does not limit A's deduction 
for either A's $1,000 distributive share of R's 1988 loss or the $400 
loss carried over from 1987 under the second sentence of section 704(d). 
These losses would be allowed as a deduction for 1988 if taxable income 
for all taxable years were determined without regard to sections 469, 
613A(d) and 1211. See paragraph (d)(8) of this section.
    (iii) Under these facts, only $400 of A's distributive share of R's 
deductions from the activity are disallowed under section 704(d) in 
1987. A's remaining deductions from the activity are treated as 
deductions that arise in connection with the activity for 1987 under 
paragraph (d)(8) of this section. Because A materially participates in 
the activity for 1987, the activity is not a passive activity (within 
the meaning of Sec.  1.469-1T(e)(1)) of A for such year. Accordingly, 
the deductions that are not disallowed in 1987 are not passive activity 
deductions.

[[Page 483]]

    (iv) A does not materially participate in R's activity for 1988. 
Accordingly, the activity is a passive activity of A for such year. No 
portion of A's distributive share of R's deductions from the activity is 
disallowed under section 704(d) in 1988. Accordingly, A's distributive 
share of R's deductions for 1988 and the $400 of deductions carried over 
from 1987 are both treated under paragraph (d)(8) of this section as 
deductions that arise in 1988. Since the activity is a passive activity 
for 1988, such deductions are passive activity deductions.

    (2) Exceptions. Passive activity deductions do not include--
    (i) A deduction for an item of expense (other than interest) that is 
clearly and directly allocable (within the meaning of paragraph (d)(4) 
of this section) to portfolio income (within the meaning of paragraph 
(c)(3)(i) of this section);
    (ii) A deduction allowed under section 243, 244, or 245 with respect 
to any dividend that is not included in passive activity gross income;
    (iii) Interest expense (other than interest expense described in 
paragraph (d)(3) of this section);
    (iv) A deduction for a loss from the disposition of property of a 
type that produces portfolio income (within the meaning of paragraph 
(c)(3)(i) of this section);
    (v) A deduction that, under section 469(g) and Sec.  1.469-6T 
(relating to the allowance of passive activity losses upon certain 
dispositions of interests in passive activities), is treated as a 
deduction that is not a passive activity deduction;
    (vi) A deduction for any state, local, or foreign income, war 
profits, or excess profits tax;
    (vii) A miscellaneous itemized deduction (within the meaning of 
section 67(b)) that is subject to disallowance in whole or in part under 
section 67(a) (without regard to whether any amount of such deduction is 
disallowed under section 67);
    (viii) A deduction allowed under section 170 for a charitable 
contribution;
    (ix) [Reserved]. See Sec.  1.469-2(d)(2)(ix) for rules relating to 
this paragraph.
    (x) [Reserved]. See Sec.  1.469-2(d)(2)(x) for rules relating to 
this paragraph (d)(2)(x).
    (xi) [Reserved]. See Sec.  1.469-2(d)(2)(xi) for rules relating to 
this paragraph (d)(2)(xi).
    (xii) [Reserved]. See Sec.  1.469-2(d)(2)(xii) for rules relating to 
this paragraph (d)(2)(xii).
    (3) Interest expense. Except as otherwise provided in the 
regulations under section 469, interest expense is taken into account as 
a passive activity deduction if and only if such interest expense--
    (i) Is allocated under Sec.  1.163-8T to a passive activity 
expenditure (within the meaning of Sec.  1.163-8T(b)(4)); and
    (ii) Is not--
    (A) Qualified residence interest (within the meaning of Sec.  1.163-
10T); or
    (B) Capitalized pursuant to a capitalization provision (within the 
meaning of Sec.  1.163-8T(m)(7)(i)).
    (4) Clearly and directly allocable expenses. For purposes of section 
469 and the regulations thereunder, an expense (other than interest 
expense) is clearly and directly allocable to portfolio income (within 
the meaning of paragraph (c)(3)(i) of this section) if and only if such 
expense is incurred as a result of, or incident to, an activity in which 
such gross income is derived or in connection with property from which 
such gross income is derived. For example, general and administrative 
expenses and compensation paid to officers attributable to the 
performance of services that do not directly benefit or are not incurred 
by reason of a particular activity or particular property are not 
clearly and directly allocable to portfolio income (within the meaning 
of paragraph (c)(3)(i) of this section).
    (5) Treatment of loss from disposition--(i) In general. Except as 
otherwise provided in the regulations under section 469--
    (A) Any loss recognized in any year upon the sale, exchange, or 
other disposition (a ``disposition'') of an interest in property used in 
an activity at the time of the disposition or of an interest in an 
activity held through a partnership or S corporation and any deduction 
allowed on account of the abandonment or worthlessness of such an 
interest is treated as a deduction from such activity; and

[[Page 484]]

    (B) Any such deduction is a passive activity deduction if and only 
if the activity is a passive activity of the taxpayer for the taxable 
year of the disposition (or other event giving rise to the deduction).
    (ii) Disposition of property used in more than one activity in 12-
month period preceding disposition. In the case of a disposition of an 
interest in property that is used in more than one activity during the 
12-month period ending on the date of the disposition, the amount 
realized from the disposition and the adjusted basis of such interest 
must be allocated among such activities in the manner described in 
paragraph (c)(2)(ii) of this section.
    (iii) Other applicable rules--(A) Applicability of rules in 
paragraph (c)(2). [Reserved]. See Sec.  1.469-2(d)(5)(iii)(A) for rules 
relating to this paragraph.
    (B) Dispositions of partnership interests and S corporation stock. A 
partnership interest or S corporation stock is not property used in an 
activity for purposes of this paragraph (d)(5). See paragraph (e)(3) of 
this section for rules treating the loss recognized upon the disposition 
of a partnership interest or S corporation stock as loss from the 
disposition of interests in the activities in which the partnership or S 
corporation has an interest.
    (6) Coordination with other limitations on deductions that apply 
before section 469--(i) In general. An item of deduction from a passive 
activity that is disallowed for a taxable year under section 704(d), 
1366(d), or 465 is not a passive activity deduction for the taxable 
year. Paragraphs (d)(6) (ii) and (iii) of this section provide rules for 
determining the extent to which items of deduction from a passive 
activity are disallowed for a taxable year under sections 704(d), 
1366(d), and 465.
    (ii) Proration of deductions disallowed under basis limitations--(A) 
Deductions disallowed under section 704(d). If any amount of a partner's 
distributive share of a partnership's loss for the taxable year is 
disallowed under section 704(d), a ratable portion of the partner's 
distributive share of each item of deduction or loss of the partnership 
is disallowed for the taxable year. For purposes of the preceding 
sentence, the ratable portion of an item of deduction or loss is the 
amount of such item multiplied by the fraction obtained by dividing--
    (1) The amount of the partner's distributive share of partnership 
loss that is disallowed for the taxable year; by
    (2) The sum of the partner's distributive shares of all items of 
deduction and loss of the partnership for the taxable year.
    (B) Deductions disallowed under section 1366(d). If any amount of an 
S corporation shareholder's pro rata share of an S corporation's loss 
for the taxable year is disallowed under section 1366(d), a ratable 
portion of the taxpayer's pro rata share of each item of deduction or 
loss of the S corporation is disallowed for the taxable year. For 
purposes of the preceding sentence, the ratable portion of an item of 
deduction or loss is the amount of such item multiplied by the fraction 
obtained by dividing--
    (1) The amount of the shareholder's pro rata share of S corporation 
loss that is disallowed for the taxable year; by
    (2) The sum of the shareholder's pro rata shares of all items of 
deduction and loss of the corporation for the taxable year.
    (iii) Proration of deductions disallowed under at-risk limitation. 
If any amount of the taxpayer's loss from an activity (within the 
meaning of section 465(c)) is disallowed under section 465 for the 
taxable year, a ratable portion of each item of deduction or loss from 
the activity is disallowed for the taxable year. For purposes of the 
preceding sentence, the ratable portion of an item of deduction or loss 
is the amount of such item multiplied by the fraction obtained by 
dividing--
    (1) The amount of the loss from the activity that is disallowed for 
the taxable year; by
    (2) The sum of all deductions from the activity for the taxable 
year.
    (iv) Coordination of basis and at-risk limitations. The portion of 
any item of deduction or loss that is disallowed for the taxable year 
under section 704(d) or 1366(d) is not taken into account for the 
taxable year in determining the loss from an activity (within the 
meaning of section 465(c)) for purposes of applying section 465.

[[Page 485]]

    (v) Separately identified items of deduction and loss. In 
identifying the items of deduction and loss from an activity that are 
not disallowed under sections 704(d), 1366(d), and 465 (and that 
therefore may be treated as passive activity deductions), the taxpayer 
need not account separately for any item of deduction or loss unless 
such item may, if separately taken into account, result in an income tax 
liability different from that which would result were such item of 
deduction or loss taken into account separately. For related rules 
applicable to partnerships and S corporations, see Sec.  1.702-
1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Items of deduction 
or loss that must be accounted for separately include (but are not 
limited to) items of deduction or loss that--
    (A) Are attributable to separate activities (within the meaning of 
the rules to be contained in Sec.  1.469-4T);
    (B) Arise in a rental real estate activity (within the meaning of 
section 469(i) and the rules to be contained in Sec.  1.469-9T) in 
taxable years in which the taxpayer activity participates (within the 
meaning of section 469(i) and the rules to be contained in Sec.  1.469-
9T) in such activity;
    (C) Arise in a rental real estate activity (within the meaning of 
section 469(i) and the rules to be contained in Sec.  1.469-9T) in 
taxable years in which the taxpayer does not actively participate 
(within the meaning of section 469(i) and the rules to be contained in 
Sec.  1.469-9T) in such activity;
    (D) Arose in a taxable year beginning before 1987 and were not 
allowed for such taxable year under section 704(d), 1366(d), or 
465(a)(2);
    (E) [Reserved]. See Sec.  1.469-2(d)(6)(v)(E) for rules relating to 
this paragraph.
    (F) Are attributable to pre-enactment interests in activities 
(within the meaning of Sec.  1.469-11T(c)).
    (7) Deductions from section 481 adjustment--(i) In general. If a 
change in accounting method results in a negative section 481 adjustment 
with respect to an activity, a ratable portion (within the meaning of 
paragraph (d)(7)(iii) of this section) of the amount taken into account 
for a taxable year as a net negative section 481 adjustment by reason of 
such change shall be treated as a deduction from the activity for such 
taxable year, and such deduction shall be treated as a passive activity 
deduction if and only if such activity is a passive activity for the 
year of the change (within the meaning of section 481(a)). See the rules 
to be contained in Sec.  1.469-1T(k) for the treatment of passive 
activity deductions from an activity in taxable years in which the 
activity is a former passive activity.
    (ii) Negative section 481 adjustments. For purposes of applying this 
paragraph (d)(7)--
    (A) The term ``net negative section 481 adjustment'' means the 
decrease (if any) in taxable income taken into account under section 
481(a) to prevent amounts from being duplicated or omitted by reason of 
a change in accounting method; and
    (B) The term ``negative section 481 adjustment with respect to an 
activity'' means the decrease (if any) in taxable income that would be 
taken into account under section 481(a) to prevent only the duplication 
or omission of amounts from such activity by reason of the change in 
accounting method.
    (iii) Ratable portion. The ratable portion of the amount taken into 
account as a net negative section 481 adjustments for a taxable year by 
reason of a change in accounting method is determined with respect to an 
activity by multiplying such amount by the fraction obtained by 
dividing--
    (A) The negative section 481 adjustment with respect to the 
activity; by
    (B) The sum of the negative section 481 adjustments with respect to 
all of the activities of the taxpayer.
    (8) Taxable year in which item arises. [Reserved]. See Sec.  1.469-
2(d)(8) for rules relating to this paragraph.
    (e) Special rules for partners and S corporation shareholders--(1) 
In general. For purposes of section 469 and the regulations thereunder, 
the character (as an item of passive activity gross income or passive 
activity deduction) of each item of gross income and deduction allocated 
to a taxpayer from a partnership or S corporation (a ``passthrough 
entity'') shall be determined, in any case in which participation is 
relevant, by reference to the participation of the taxpayer in the 
activity (or activities) that generated such item.

[[Page 486]]

Such participation is determined for the taxable year of the passthrough 
entity (and not the taxable year of the taxpayer). The following example 
illustrates the application of this paragraph (e)(1):

    Example. A, a calendar year individual, is a partner in a 
partnership that has a taxable year ending January 31. During its 
taxable year ending on January 31, 1988, the partnership engages in a 
single trade or business activity. For the period from February 1, 1987, 
through January 31, 1988, A does not materially participate in this 
activity. In A's calendar year 1988 return, A's distributive share of 
the partnership's gross income and deductions from the activity must be 
treated as passive activity gross income and passive activity 
deductions, without regard to A's participation in the activity from 
February 1, 1988, through December 31, 1988. See also Sec.  1.469-
11T(a)(4) (relating to the effective date of, and transition rules 
under, section 469 and the regulations thereunder).

    (2) Payments under sections 707(a), 707(c), and 736(b). Items of 
gross income and deduction attributable to a transaction described in 
section 707(a), 707(c), or 736(b) shall be characterized for purposes of 
section 469 and the regulations thereunder in accordance with the 
following rules:
    (i) Section 707(a). Any item of gross income or deduction 
attributable to a transaction that is treated under section 707(a) as a 
transaction between a partnership and a partner acting in a capacity 
other than as a member of such partnership shall be characterized for 
purposes of section 469 and the regulations thereunder in a manner that 
is consistent with the treatment of such transaction under section 
707(a).
    (ii) Section 707(c). [Reserved]. See Sec.  1.469-2(e)(ii) for rules 
relating to this paragraph.
    (iii) Payments in liquidation of a partner's interest in partnership 
property. [Reserved]. See Sec.  1.469-2(e)(iii) for rules relating to 
this paragraph.
    (3) Sale or exchange of interest in passthrough entity--(i) 
Application of this paragraph (e)(3). In the case of the sale, exchange, 
or other disposition (a ``disposition'') of an interest in a passthrough 
entity, the amount of the seller's gain or loss from each activity in 
which such entity has an interest is determined, for purposes of section 
469 and the regulations thereunder, under this paragraph (e)(3). In the 
case of any such disposition, except as otherwise provided in paragraph 
(e)(3)(iii) or (iv) of this section, paragraph (e)(3)(ii) of this 
section shall apply. See paragraphs (c)(2) and (d)(5) of this section 
for rules for determining the character of gain or loss, respectively, 
recognized upon a disposition of an interest in an activity held through 
a passthrough entity.
    (ii) General rule--(A) Allocation among activities. Except as 
otherwise provided in this paragraph (e)(3)(ii) or in paragraph (e)(3) 
(iii) or (iv) of this section, if a holder of an interest in a 
passthrough entity disposes of such interest, a ratable portion (within 
the meaning of paragraph (e)(3)(ii)(B) of this section) of any gain or 
loss from such disposition shall be treated as gain or loss from the 
disposition of an interest in each trade or business, rental, or 
investment activity in which such passthrough entity owns an interest on 
the applicable valuation date.
    (B) Ratable portion--(1) Dispositions on which gain is recognized. 
The ratable portion of any gain from the disposition of an interest in a 
passthrough entity that is allocable to an activity described in 
paragraph (e)(3)(ii)(A) of this section is determined by multiplying the 
amount of such gain by the fraction obtained by dividing--
    (i) The amount of net gain (within the meaning of paragraph 
(e)(3)(ii)(E)(3) of this section) that would have been allocated to the 
holder of such interest with respect thereto if the passthrough entity 
had sold its entire interest in such activity for its fair market value 
on the applicable valuation date; by
    (ii) The sum of the amounts of net gain that would have been 
allocated to the holder of such interest with respect thereto if the 
passthrough entity had sold its entire interest in each appreciated 
activity (within the meaning of paragraph (e)(3)(ii)(E)(1) of this 
section) described in paragraph (e)(3)(ii)(A) of this section for the 
fair market value of each such activity on the applicable valuation 
date.
    (2) Dispositions on which loss is recognized. The ratable portion of 
any loss from the disposition of an interest in a passthrough entity 
that is allocable to

[[Page 487]]

an activity described in paragraph (e)(3)(ii)(A) of this section is 
determined by multiplying the amount of such loss by the fraction 
obtained by dividing--
    (i) The amount of net loss (within the meaning of paragraph 
(e)(3)(ii)(E)(4) of this section) that would have been allocated to the 
holder of such interest with respect thereto if the passthrough entity 
had sold its entire interest in such activity for its fair market value 
on the applicable valuation date; by
    (ii) The sum of the amounts of net loss that would have been 
allocated to the holder of such interest with respect thereto if the 
passthrough entity had sold its entire interest in each depreciated 
activity (within the meaning of paragraph (e)(3)(ii)(E)(2) of this 
section) described in paragraph (e)(3)(ii)(A) of this section for the 
fair market value of each such activity on the applicable valuation 
date.
    (C) Default rule. If the gain or loss recognized upon the 
disposition of an interest in a passthrough entity cannot be allocated 
under paragraph (e)(3)(ii)(A) of this section, such gain or loss shall 
be allocated among the activities described in paragraph (e)(3)(ii)(A) 
of this section in proportion to the respective fair market values of 
the passthrough entity's interests in such activities at the applicable 
valuation date, and the gain or loss allocated to each activity of the 
passthrough entity shall be treated as gain or loss from the disposition 
of an interest in such activity.
    (D) Special rules. For purposes of this paragraph (e)(3)(ii), the 
following rules shall apply:
    (1) Applicable valuation date--(i) In general. Except as otherwise 
provided in paragraph (e)(3)(ii)(D)(1)(ii) of this section, the 
applicable valuation date with respect to any disposition of an interest 
in a passthrough entity is whichever one of the following dates is 
selected by the passthrough entity:
    (a) The beginning of the taxable year of the passthrough entity in 
which such disposition occurs; or
    (b) The date on which such disposition occurs.
    (ii) Exception. If, after the beginning of a passthrough entity's 
taxable year in which a holder's disposition of an interest in such 
passthrough entity occurs and before the time of such disposition--
    (a) The passthrough entity disposes of more than 10 percent of its 
interest (by value as of the beginning of such taxable year) in any 
activity;
    (b) More than 10 percent of the property (by value as of the 
beginning of such taxable year) used in any activity of the passthrough 
entity is disposed of; or
    (c) The holder of such interest contributes to the passthrough 
entity substantially appreciated property or substantially depreciated 
property with a total fair market value or adjusted basis, respectively, 
which exceeds 10 percent of the total fair market value of the holder's 
interest in the passthrough entity as of the beginning of such taxable 
year;

then the applicable valuation date shall be the date immediately 
preceding the date on which such disposition occurs.
    (2) Basis adjustments. Any adjustment to the basis of partnership 
property under section 743(b) made with respect to the holder of an 
interest in a partnership shall be taken into account in computing the 
net gain or net loss that would have been allocated to the holder with 
respect to such interest if the partnership had sold its entire interest 
in an activity.
    (3) Tiered passthrough entities. In the case of a disposition of an 
interest in a passthrough entity (the ``subsidiary passthrough entity'') 
by a holder that is also a passthrough entity, any gain or loss from 
such disposition that is taken into account by any person that owns 
(directly or indirectly) an interest in such holder shall be allocated 
among the activities of the subsidiary passthrough entity by applying 
the rules of this paragraph (e)(3)(ii) to the person taking such gain or 
loss into account as if such person has been the holder of an interest 
in such subsidiary passthrough entity and had recognized such gain or 
loss as a result of a disposition of such interest.
    (E) Meaning of certain terms. For purposes of this paragraph 
(e)(3)(ii)--
    (1) An activity is an appreciated activity with respect to a holder 
that has

[[Page 488]]

disposed of an interest in a passthrough entity if a net gain would have 
been allocated to the holder with respect to such interest if the 
passthrough entity has sold its entire interest in such activity for its 
fair market value on the applicable valuation date;
    (2) An activity is a depreciated activity with respect to a holder 
that has disposed of an interest in a passthrough entity if a net loss 
would have been allocated to the holder with respect to such interest if 
the passthrough entity had sold its entire interest in such activity for 
its fair market value on the applicable valuation date;
    (3) The term ``net gain'' means, with respect to the sale of a 
passthrough entity's entire interest in an activity, the amount by which 
the gains from the sale of all of the property used by (or representing 
the interest of) the passthrough entity in such activity exceed the 
losses (if any) from such sale;
    (4) The term ``net loss'' means, with respect to the sale of a 
passthrough entity's entire interest in an activity, the amount by which 
the losses from the sale of all of the property used by (or representing 
the interest of) the passthrough entity in such activity exceed the 
gains (if any) from such sale.
    (iii) Treatment of gain allocated to certain passive activities as 
not from a passive activity. If, in the case of a disposition of an 
interest in a passthrough entity--
    (A) An amount of gain recognized on account of such disposition by 
the holder of such interest (or any other person that owns (directly or 
indirectly) an interest in such holder if such holder is a passthrough 
entity) is allocated to a passive activity of such holder (or such other 
person) under paragraph (e)(3)(ii) of this section;
    (B) [Reserved]. See Sec.  1.469-2(e)(3)(iii)(B) for rules relating 
to this paragraph.
    (C) The amount of the gain of the holder (or such other person) 
described in paragraph (e)(3)(iii)(B) of this section exceeds 10 percent 
of the amount of the gain of the holder (or such other person) described 
in paragraph (e)(3)(iii)(A) of this section;

then the gain of the holder (or such other person) that is described in 
paragraph (e)(3)(iii)(A) of this section shall be treated as gain that 
is not from a passive activity to the extent that such gain does not 
exceed the amount of the gain of the holder (or such other person) 
described in paragraph (e)(3)(iii)(B) of this section. For purposes of 
applying the preceding sentence to the disposition of an interest in a 
partnership, the amount of gain that would have been allocated to the 
holder (or such other person) if all of the property used in an activity 
had been sold shall be determined by taking into account any adjustment 
to the basis of partnership property made with respect to such holder 
(or such other person) under section 743(b).
    (iv) Dispositions occurring in taxable years beginning before 
February 19, 1988--(A) In general. Except as otherwise provided in this 
paragraph (e)(3)(iv), if the holder of an interest in a passthrough 
entity sells, exchanges, or otherwise disposes of all or part of such 
interest during a taxable year of such entity beginning prior to 
February 19, 1988, any gain or loss recognized from such disposition 
shall be allocated among the activities of the passthrough entity under 
any reasonable method selected by the passthrough entity, and the gain 
or loss allocated to each activity of the passthrough entity shall be 
treated as gain or loss from the disposition of an interest in such 
activity. For purposes of the preceding sentence, a reasonable method 
shall include the method prescribed by paragraph (e)(3)(ii) of this 
section. In addition, a method that allocates gain or loss among the 
passthrough entity's activities on the basis of the fair market value, 
cost, or adjusted basis of the property used in such activities shall 
generally be considered a reasonable method for purposes of this 
paragraph (e)(3)(iv).
    (B) Exceptions. This paragraph (e)(3)(iv) shall not apply to any 
disposition of an interest in a passthrough entity occurring after 
February 19, 1988, if after such date, but before the holder's 
disposition of such interest, the holder (or any other person that owns 
(directly or indirectly) an interest in

[[Page 489]]

such holder if such holder is a passthrough entity) contributes to the 
passthrough entity substantially appreciated portfolio assets or any 
other substantially appreciated property that was used in any trade or 
business activity (within the meaning of Sec.  1.469-1T(e)) of the 
holder (or such other person) during--
    (1) The taxable year of such person in which such contribution 
occurs; or
    (2) The immediately preceding taxable year of such person;

but only if such person materially participated (within the meaning of 
Sec.  1.469-5T) in the activity for such year.
    (v) Treatment of portfolio assets. For purposes of the paragraph 
(e)(3), all portfolio assets owned by a passthrough entity shall be 
treated as held in a single investment activity.
    (vi) Definitions. For purposes of this paragraph (e)(3)--
    (A) The term ``portfolio asset'' means any property of a type that 
produces portfolio income (within the meaning of paragraph (c)(3)(i) of 
this section);
    (B) The term ``substantially appreciated property'' means property 
with a fair market value that exceeds 120 percent of its adjusted basis; 
and
    (C) The term ``substantially depreciated property'' means property 
with an adjusted basis that exceeds 120 percent of its fair market 
value.
    (vii) Examples. The following examples illustrate the application of 
this paragraph (e)(3):

    Example 1. (i) A owns a one-half interest in P, a calendar year 
partnership. In 1993, A sells 50 percent of such interest for $50,000. 
A's adjusted basis for the interest sold is $30,000. Thus, A recognizes 
$20,000 of gain from the sale. P is engaged in three trade or business 
activities, X, Y, and Z, and owns marketable securities that are 
portfolio assets. For 1993, A materially participates in activity Z, but 
does not participate in activities X and Y. Paragraph (c)(2)(iii) of 
this section would not have applied to any of the gain that A would have 
been allocated if, immediately before A's sale, P had disposed of all of 
the property used in its trade or business activities. During the 
portion of 1993 preceding A's sale, P did not sell any of the property 
used in its activities, and A did not contribute any property to P.
    (ii) Under paragraph (e)(3)(ii) of this section, a ratable portion 
of A's $20,000 gain is allocated to each appreciated activity in which P 
owned an interest on the applicable valuation date (within the meaning 
of paragraph (e)(3)(ii)(D)(1) of this section). For this purpose, 
paragraph (e)(3)(v) of this section treats the marketable securities 
owned by P as a single investment activity.
    (iii) P selects the beginning of 1993 as the applicable valuation 
date pursuant to paragraph (e)(3)(ii)(D)(1)(i) of this section. P is not 
required to use the date of A's sale as the applicable valuation date 
under paragraph (e)(3)(ii)(D)(1)(ii) of this section because during the 
portion of 1993 preceding A's sale, P did not sell any of its property 
and A did not contribute any property to P. At the beginning of 1993, 
the fair market value and adjusted basis of the property used in P's 
activities are as follows:

------------------------------------------------------------------------
                                                                  Fair
                                                     Adjusted    market
                                                      basis      value
------------------------------------------------------------------------
X.................................................    $68,000    $48,000
Y.................................................     30,000     62,000
Z.................................................     20,000     80,000
Marketable securities.............................      2,000     10,000
                                                   ---------------------
      Total.......................................    120,000    200,000
------------------------------------------------------------------------

    (iv) Under paragraph (e)(3)(ii)(B) of this section, the portion of 
A's $20,000 gain that is allocated to an appreciated activity of P 
(i.e., activities Y and Z and the marketable securities) is the amount 
of such gain multiplied by the fraction obtained by dividing (a) the net 
gain that would have been allocated to A with respect to the interest 
sold by A if P had sold its entire interest in such activity at the 
beginning of 1993 by (b) the sum of the amounts of net gain that would 
have been allocated to A with respect to the interest sold by A if P had 
sold its entire interest in each appreciated activity at the beginning 
of 1993.
    (v) If P had sold its entire interest in activities Y and Z and the 
marketable securities at the beginning of 1993, A would have been 
allocated the following amounts of net gain with respect to the interest 
in P that A sold in 1993:

------------------------------------------------------------------------
                           Activity                             Net gain
------------------------------------------------------------------------
Y............................................................     $8,000
Z............................................................     15,000
Marketable securities........................................      2,000
                                                              ----------
      Total..................................................     25,000
------------------------------------------------------------------------

    (vi) Accordingly, under paragraph (e)(3)(ii) of this section, $6,400 
of A's $20,000 gain ($20,000 x $8,000/$25,000) is allocated to activity 
Y, $12,000 of A's $20,000 gain ($20,000 x $15,000/$25,000) is allocated 
to activity Z, and $1,600 of A's $20,000 gain ($20,000 x $2,000/$25,000) 
is allocated to the marketable securities. The gain allocated to 
activity Y is passive activity gross income. None of that gain is 
treated as gain that is not from a passive activity under paragraph 
(e)(3)(iii) of this section because paragraph (c)(2)(iii) of

[[Page 490]]

this section would not have applied to any of the gain that A would have 
been allocated if P had sold all of the property used in activity Y 
immediately prior to A's sale.
    Example 2. (i) B and C, calendar year individuals, are equal 
partners in calendar year partnership R, which they formed on January 1, 
2005, with contributions of property and money. The only item of 
property (other than money) contributed by B was a building that B had 
used for 12 years preceding the contribution in an activity that was not 
a passive activity during such period. At the time of its contribution, 
the building had an adjusted basis of $40,000 and a fair market value of 
$66,000. R is engaged in a single activity: the sale of equipment to 
customers in the ordinary course of the business of dealing in such 
property. R uses the building contributed by B in the dealership 
activity. B did not materially participate in the dealership activity 
during 2005. On July 1, 2005, D purchases one-half of B's interest in R 
for $37,500 in cash. At the time of the sale, the balance sheet of R, 
which uses the accrual method of accounting, is as follows:

------------------------------------------------------------------------
                                                     Adjusted     Fair
                                                    basis per    market
                                                      books      value
------------------------------------------------------------------------
                                 Assets
------------------------------------------------------------------------
Cash..............................................    $30,000    $30,000
Accounts receivable:
  Dealership......................................     20,000     18,000
Inventory:
  Dealership......................................     52,000     66,000
Building..........................................     40,000     66,000
                                                   ---------------------
      Total.......................................    142,000    180,000
------------------------------------------------------------------------
                         Liabilities and Capital
------------------------------------------------------------------------
Liabilities.......................................    $30,000    $30,000
Capital:
  B...............................................     47,000     75,000
  C...............................................     65,000     75,000
                                                   ---------------------
      Total.......................................    142,000    180,000
------------------------------------------------------------------------


Thus, B's gain from the sale is $14,000 ($45,000 amount realized from 
the sale (consisting of $37,500 of cash and $7,500 of liabilities 
assumed by the purchaser) minus B's $31,000 adjusted basis for the 
interest sold (one-half of B's total adjusted basis of $62,000)).
    (ii) Under paragraph (e)(3)(ii) of this section, all $14,000 of B's 
gain from the sale is allocated to R's dealership activity, which is a 
passive activity of B for 2005. If, however, R had sold its interest in 
the building immediately prior to B's sale for its fair market value on 
the applicable valuation date (the valuation date selected by R is 
irrelevant since the building had a fair market value of $66,000 at the 
beginning of 2005 and at the time of the sale), B would have been 
allocated $13,000 of gain under section 704(c) with respect to the 
interest in R that B sold to D. This gain would have been treated as 
gain that is not from a passive activity under paragraph (c)(2)(iii) of 
this section and would have exceeded 10 percent of the total amount of 
B's gain that is allocated to the dealership activity under paragraph 
(e)(3)(ii) of this section. Accordingly, under paragraph (e)(3)(iii) of 
this section, B's gain from the sale ($14,000) is treated as gain that 
is not from a passive activity to the extent that such gain does not 
exceed the amount of gain subject to paragraph (c)(2)(iii) of this 
section that B would have been allocated with respect to the interest 
sold to D if R had sold all of the property used in the dealership 
activity immediately prior to B's sale ($13,000). Thus, $13,000 of B's 
gain from the sale is treated as gain that is not from a passive 
activity.

    (f) Recharacterization of passive income in certain situations--(1) 
In general. This paragraph (f) sets forth rules that require income from 
certain passive activities to be treated as income that is not from a 
passive activity (regardless of whether such income is treated as 
passive activity gross income under section 469 or any other provision 
of the regulations thereunder). For definitions of certain terms used in 
this paragraph (f), see paragraph (f)(9) of this section.
    (2) Special rule for significant participation--(i) In general. An 
amount of the taxpayer's gross income from each significant 
participation passive activity for the taxable year equal to a ratable 
portion of the taxpayer's net passive income from such activity for the 
taxable year shall be treated as not from a passive activity if the 
taxpayer's passive activity gross income from all significant 
participation passive activities for the taxable year (determined 
without regard to paragraphs (f) (2) through (4) of this section) 
exceeds the taxpayer's passive activity deductions from all such 
activities for such year. For purposes of this paragraph (f)(2), the 
ratable portion of the net passive income from an activity is determined 
by multiplying the amount of such income by the fraction obtained by 
dividing--
    (A) The amount of the excess described in the preceding sentence; by
    (B) The amount of the excess described in the preceding sentence 
taking into account only significant participation passive activities 
from which the taxpayer has net passive income for the taxable year.

[[Page 491]]

    (ii) Significant participation passive activity. For purposes of 
this paragraph (f)(2), the term ``significant participation passive 
activity'' means any trade or business activity (within the meaning of 
Sec.  1.469-1T(e)(2)) in which the taxpayer significantly participates 
(within the meaning of Sec.  1.469-5T(c)(2)) for the taxable year but in 
which the taxpayer does not materially participate (within the meaning 
of Sec.  1.469-5T) for such year.
    (iii) Example. The following example illustrates the application of 
this paragraph (f)(2):

    Example. (i) A owns interests in three trade or business activities, 
X, Y, and Z. A does not materially participate in any of these 
activities for the taxable year, but participates in activity X for 110 
hours, in activity Y for 160 hours, and in activity Z for 125 hours. A 
owns no interest in any other trade or business activity in which A does 
not materially participate for the taxable year but in which A 
participates for more than 100 hours during the taxable year. A's net 
passive income (or loss) for the taxable year from activities X, Y, and 
Z is as follows:

------------------------------------------------------------------------
                                                   X        Y        Z
------------------------------------------------------------------------
Passive activity gross income.................   $600      $700    $900
Passive activity deductions...................   (200)   (1,000)   (300)
                                               -------------------------
Net passive income............................    400      (300)    600
------------------------------------------------------------------------

    (ii) Under paragraph (f)(2)(ii) of this section, activities X, Y, 
and Z are A's only significant participation passive activities for the 
taxable year. A's passive activity gross income from significant 
participation passive activities ($2,200) exceeds A's passive activity 
deductions from significant participation passive activities ($1,500) by 
$700 for such year. Therefore, under paragraph (f)(2)(i) of this 
section, a ratable portion of A's gross income from activities X and Z 
(A's significant participation passive activities with net passive 
income for the taxable year) is treated as gross income that is not from 
a passive activity. The ratable portion is determined by dividing (a) 
the amount by which A's passive activity gross income from significant 
participation passive activities exceeds A's passive activity deductions 
from significant participation passive activities for the taxable year 
($700) by (b) such excess taking into account only A's significant 
participation passive activities having net passive income for the 
taxable year ($1,000). Accordingly, $280 of gross income from activity X 
($400 x 700/1000) and $420 of gross income from activity Z ($600 x 700/
1000) is treated as gross income that is not from a passive activity.

    (3) Rental of nondepreciable property. If less than 30 percent of 
the unadjusted basis of the property used or held for use by customers 
in a rental activity (within the meaning of Sec.  1.469-1T(e)(3)) during 
the taxable year is subject to the allowance for depreciation under 
section 167, an amount of the taxpayer's gross income from the activity 
equal to the taxpayer's net passive income from the activity shall be 
treated as not from a passive activity. For purposes of this paragraph 
(f)(3), the term ``unadjusted basis'' means adjusted basis determined 
without regard to any adjustment described in section 1016 that 
decreases basis. The following example illustrates the application of 
this paragraph (f)(3):

    Example. C is a limited partner in a partnership. The partnership 
acquires vacant land for $300,000, constructs improvements on the land 
at a cost of $100,000, and leases the land and improvements to a tenant. 
The partnership then sells the land and improvements for $600,000, 
thereby realizing a gain on the disposition. The unadjusted basis of the 
improvements ($100,000) equals 25 percent of the unadjusted basis of all 
property ($400,000) used in the rental activity. Therefore, under this 
paragraph (f)(3), an amount of C's gross income from the activity equal 
to the net passive income from the activity (which is computed by taking 
into account the gain from the disposition, including gain allocable to 
the improvements) is treated as not from a passive activity.

    (4) Net interest income from passive equity-financed lending 
activity--(i) In general. An amount of the taxpayer's gross income for 
the taxable year from any equity-financed lending activity equal to the 
lesser of--
    (A) The taxpayer's equity-financed interest income from the activity 
for such year; and
    (B) The taxpayer's net passive income from the activity for such 
year

shall be treated as not from a passive activity.
    (ii) Equity-financed lending activity--(A) In general. For purposes 
of this paragraph (f)(4), an activity is an equity-financed lending 
activity for a taxable year if--
    (1) The activity involves a trade or business of lending money; and
    (2) The average outstanding balance of the liabilities incurred in 
the activity for the taxable year does not exceed

[[Page 492]]

80 percent of the average outstanding balance of the interest-bearing 
assets held in the activity for such year.
    (B) Certain liabilities not taken into account. For purposes of 
paragraph (f)(4)(ii)(A)(2) of this section, liabilities incurred 
principally for the purpose of increasing the percentage described in 
paragraph (f)(4)(ii)(A)(2) of this section shall not be taken into 
account in computing such percentage.
    (iii) Equity-financed interest income. For purposes of this 
paragraph (f)(4), the taxpayer's equity-financed interest income from an 
activity for a taxable year is the amount of the taxpayer's net interest 
income from the activity for such year multiplied by the fraction 
obtained by dividing--
    (A) The excess of the average outstanding balance for such year of 
the interest-bearing assets held in the activity over the average 
outstanding balance for such year of the liabilities incurred in the 
activity; by
    (B) The average outstanding balance for such year of the interest-
bearing assets held in the activity.
    (iv) Net interest income. For purposes of this paragraph (f)(4), the 
net interest income from an activity for a taxable year is--
    (A) The gross interest income from the activity for such year; 
reduced by
    (B) Expenses from the activity (other than interest on liabilities 
described in paragraph (f)(4)(vi) of this section) for such year that 
are reasonably allocable to such gross interest income.
    (v) Interest-bearing assets. For purposes of this paragraph (f)(4), 
the interest-bearing assets held in an activity include all assets that 
produce interest income, including loans to customers.
    (vi) Liabilities incurred in the activity. For purposes of this 
paragraph (f)(4), liabilities incurred in an activity include all fixed 
and determinable liabilities incurred in the activity that bear interest 
or are issued with original issue discount other than debts secured by 
tangible property used in the activity. In the case of an activity 
conducted by an entity in which the taxpayer owns an interest, 
liabilities incurred in an activity include only liabilities with 
respect to which the entity is the borrower.
    (vii) Average outstanding balance. For purposes of this paragraph 
(f)(4), the average outstanding balance of liabilities incurred in an 
activity or of the interest-bearing assets held in an activity may be 
computed on a daily, monthly, or quarterly basis at the option of the 
taxpayer.
    (viii) Example. The following example illustrates the application of 
this paragraph (f)(4):

    Example: (i) A, a calendar year individual, acquires on January 1, 
1988, a limited partnership interest in P, a calendar year partnership. 
Under the partnership agreement, A has a one percent share of each item 
of income, gain, loss, deduction, and credit of P. A acquires the 
partnership interest for $90,000, using $50,000 of unborrowed funds and 
$40,000 of proceeds of a loan bearing interest at an annual rate of 10 
percent. A pays $4,000 of interest on the loan in 1988.
    (ii) P's sole activity is a trade or business of lending money. A 
does not materially participate in the activity for 1988. During 1988, 
the average outstanding balance of P's interest-bearing assets 
(including loans to customers, temporary deposits with other lending 
institutions, and government and corporate securities) is $20 million. P 
incurs numerous interest-bearing liabilities in connection with its 
lending activity, including liabilities for deposits taken from 
customers, unsecured short-term and long-term loans from other lending 
institutions, and a mortgage loan secured by the building, owned by P, 
in which P conducts its business. For 1988, the average outstanding 
balance of all of these liabilities (other than the mortgage loan) is 
$11 million. None of these liabilities was incurred by P principally for 
the purpose of increasing the percentage described in paragraph 
(f)(4)(ii)(A)(2) of this section.
    (iii) The interest income derived by P for 1988 from its interest-
bearing assets is $2.2 million. The interest expense paid by P for 1988 
with respect to the liabilities incurred in connection with its lending 
activity (other than the mortgage loan) is $990,000. P's other expenses 
for 1988 that are reasonably allocable to P's gross interest income 
(including expenses for advertising, loan processing and servicing, and 
insurance, and depreciation on P's building) total $250,000. P's 
interest expense for 1988 on the mortgage loan secured by the building 
used in P's lending activity is $50,000. All of the interest expense 
paid or incurred by P for 1988 is allocated under Sec.  1.63-8T to 
expeditures in connection with P's lending activity.
    (iv) Under paragraph (f)(4)(ii) of this section, P's activity is an 
equity-financed lending activity for 1988, since, for 1988, the activity 
involves a trade or business of lending money and the average 
outstanding balance

[[Page 493]]

of the liabilities incurred in the activity ($11 million) does not 
exceed 80 percent of the average outstanding balance of the interest-
bearing assets held in the activity ($20 million). Accordingly, under 
paragraph (f)(4)(i) of this section, an amount of A's gross income from 
the activity equal to the lesser of (a) A's equity-financed interest 
income from the activity for 1988, or (b) A's net passive income from 
the activity for 1988, is treated as income that is not from a passive 
activity.
    (v) Under paragraph (f)(4)(iii) of this section, A's equity-financed 
interest income from the activity for 1988 is determined by multiplying 
A's net interest income from the activity for 1988 by the fraction 
obtained by dividing $9 million (the excess of the average interest-
bearing assets for 1988 over the average interest-bearing liabilities 
for 1988) by $20 million (the average interest-bearing assets for 1988). 
Under paragraph (f)(4)(iv) of this section, A's net interest income from 
the activity for 1988 is $19,000 (A's distributive share of $2.2 million 
of gross interest income less A's distributive share of $300,000 of 
expenses described in paragraph (f)(4)(iv)(B) of this section, including 
interest expense on the mortgage loan). A's distributive share of P's 
other interest expense ($990,000) is not taken into account in computing 
A's net interest income for 1988. Accordingly, A's equity-financed 
interest income from the activity for 1988 is $8,550 ($19,000 x $9 
million/$20 million).
    (vi) Under paragraph (f)(9)(i) of this section, A's net passive 
income from the activity for 1988 is determined by taking into account 
A's distributive share of P's gross income and deductions from the 
activity for 1988, as well as any interest expense incurred by A 
individually that is taken into account under Sec.  1.163-8T in 
determining A's income or loss from the activity for 1988. Assuming that 
for 1988 all $4,000 of interest expense on the loan that A used to 
finance the acquisition of A's interest in P is allocated under Sec.  
1.163-8T to expenditures of A in connection with the lending activity 
for 1988, A's net passive income from the activity for 1988 is $5,100, 
computed as set forth in the following table:

Gross income:
  Interest income..........................................     $22,000
Deductions:
  Distributive share of P's expenses from the activity.....     (12,900)
  Interest expense on A's acquisition debt.................      (4,000)
                                                            ------------
  Net passive income.......................................       5,100
 

    (vii) A's net passive income from the activity for 1988 ($5,100) is 
less than A's equity-financed income from the activity for 1988 
($8,550). Accordingly, under this paragraph (f)(4), $5,100 of A's gross 
income from the activity for 1988 is treated as not from a passive 
activity.

    (5) Net income from certain property rented incidental to 
development activity--
    (i) In general. [Reserved]. See Sec.  1.469-2(f)(5)(i) for rules 
relating to this paragraph.
    (ii) Commencement. [Reserved]. See Sec.  1.469-2(f)(5)(ii) for rules 
relating to this paragraph (f)(5)(ii).
    (iii) Services performed for the purpose of enhancing the value of 
property. [Reserved]. See Sec.  1.469-2(f)(5)(iii) for rules relating to 
this paragraph (f)(5)(iii).
    (iv) Examples. [Reserved]. See Sec.  1.469-2(f)(5)(iv) for examples 
relating to this paragraph (f)(5)(iv).
    (6) Property rented to a nonpassive activity. [Reserved]. See Sec.  
1.469-2(f)(6) for rules relating to this paragraph.
    (7) Special rules applicable to the acquisition of an interest in a 
passthrough entity engaged in the trade or business of licensing 
intangible property--(i) In general. If a taxpayer acquires an interest 
in an entity described in paragraph (c)(3)(iii)(B)(3) of this section 
(the ``development entity'') after the development entity has created an 
item of intangible property or performed substantial services or 
incurred substantial costs with respect to the development or marketing 
of an item of intangible property, an amount of the taxpayer's gross 
royalty income for the taxable year from such item of property equal to 
the taxpayer's net royalty income for the year from such item of 
property shall be treated as not from a passive activity.
    (ii) Royalty income from property. For purposes of this paragraph 
(f)(7)--
    (A) A taxpayer's gross royalty income for a taxable year from an 
item of property is the taxpayer's share of passive activity gross 
income for such year (determined without regard to paragraphs (f)(2) 
through (7) of this section) from the licensing or transfer of any right 
in such property; and
    (B) A taxpayer's net royalty income for a taxable year from an item 
of property is the excess, if any, of--
    (1) The taxpayer's gross royalty income for the taxable year from 
such item of property; over
    (2) Any passive activity deductions for such taxable year (including 
any deduction treated as a deduction for such year under Sec.  1.469-1T 
(f)(4)) that

[[Page 494]]

are reasonably allocable to such item of property.
    (iii) Exceptions. Paragraph (f)(7)(i) of this section shall not 
apply to a taxpayer's gross royalty income for a taxable year from the 
licensing of an item of intangible property if--
    (A) The expenditures reasonably incurred by the development entity 
for the taxable year of the entity ending with or within the taxpayer's 
taxable year with respect to the development or marketing of such 
property satisfy paragraph (c)(3)(iii)(B)(2)(ii) (a) of this section; or
    (B) The taxpayer's share of the expenditures reasonably incurred by 
the development entity with respect to the development or marketing of 
such property for all taxable years of the entity beginning with the 
taxable year of the entity in which the taxpayer acquired the interest 
in the entity and ending with the taxable year of the entity ending with 
or within the taxpayer's current taxable year exceeds 25 percent of the 
fair market value of the taxpayer's interest in such property at the 
time the taxpayer acquired the interest in the entity.
    (iv) Capital expenditures. For purposes of paragraph (f)(7)(iii)(B) 
of this section, a capital expenditure shall be taken into account for 
the taxable year of the entity in which such expenditure is chargeable 
to capital account, and the taxpayer's share of such expenditure shall 
be determined as though such expenditure were allowed as a deduction for 
such year.
    (v) Example. The following example illustrates the application of 
this paragraph (f)(7):

    Example. (i) The facts are the same as in Example 5 in paragraph 
(c)(3)(iv) of this section, except that, in 1988, D's 10 percent 
partnership interest is sold to F for $13,000, all of which is 
attributable to the design licensed by the partnership.
    (ii) For 1988, the expenditures reasonably incurred by the 
partnership with respect to the development or marketing of the design 
satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. Accordingly, 
under paragraph (f)(7)(iii)(A) of this section, paragraph (f)(7)(i) of 
this section does not apply to F's distributive share of the 
partnership's gross income from licensing the design.
    (iii) For 1989, the expenditures reasonably incurred by the 
partnership with respect to the development or marketing of the design 
do not satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. 
Moreover, F's distributive share of such expenditures reasonably 
incurred by the partnership for 1988 and 1989 ($27,000 x .10 = $2,700) 
does not exceed 25 percent of the fair market value of F's interest in 
the design at the time F acquired the partnership interest ($13,000). 
Accordingly, neither of the exceptions provided in paragraph (f)(7)(iii) 
of this section applies for 1989 and, under paragraph (f)(7)(i) of this 
section, an amount of F's gross royalty income from the design equal to 
F's net royalty income from the design is treated as not from a passive 
activity.

    (8) Limitation on recharacterized income. The amount of gross income 
from an activity that is treated as not from a passive activity for the 
taxable year under subparagraphs (f) (2) through (4) of this paragraph 
(f) shall not exceed the greatest amount of gross income treated as not 
from a passive activity under any one of such subparagraphs.
    (9) Meaning of certain terms. For purposes of this paragraph (f), 
the terms set forth below shall have the following meanings:
    (i) The net passive income from an activity for a taxable year is 
the amount by which the taxpayer's passive activity gross income from 
the activity for the taxable year (determined without regard to 
paragraphs (f) (2) through (4) of this section) exceeds the taxpayer's 
passive activity deductions from the activity for such year;
    (ii) The net passive loss from an activity for a taxable year is the 
amount by which the taxpayer's passive activity deductions from the 
activity for the taxable year exceeds the taxpayer's passive activity 
gross income from the activity for such year (determined without regard 
to paragraphs (f) (2) through (4) of this section).
    (iii) [Reserved]. See Sec.  1.469-2(f)(9)(iii) for rules relating to 
this paragraph.
    (iv) [Reserved]. See Sec.  1.469-2(f)(9)(iv) for rules relating to 
this paragraph.
    (10) Coordination with section 163(d). [Reserved]. See paragraph 
1.469-2(f)(10) for rules relating to this paragraph.
    (11) Effective date. For the effective date of the rules in this 
paragraph (f),

[[Page 495]]

see Sec.  1.469-11T (relating to effective date and transition rules).

[T.D. 8175, 53 FR 5711, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988, as 
amended by T.D. 8253, 54 FR 20538, May 12, 1989; T.D. 8290, 55 FR 6981, 
Feb. 28, 1990; T.D. 8318, 55 FR 48108, Nov. 19, 1990; 55 FR 51688, Dec. 
17, 1990; T.D. 8417, 57 FR 20758, May 15, 1992; T.D. 8477, 58 FR 11538, 
Feb. 26, 1993; T.D. 8495, 58 FR 58788, Nov. 4, 1993]



Sec.  1.469-3  Passive activity credit.

    (a)-(d) [Reserved]
    (e) Coordination with section 38(b). Any credit described in section 
38(b) (1) through (5) is taken into account in computing the current 
year business credit for the first taxable year in which the credit is 
subject to section 469 and is not disallowed by section 469 and the 
regulations thereunder.
    (f) Coordination with section 50. In the case of any cessation 
described in section 50(a) (1) or (2), the credits allocable to the 
taxpayer's activities under Sec.  1.469-1(f)(4) shall be adjusted by 
reason of the cessation.
    (g) [Reserved]

[T.D. 8417, 57 FR 20758, May 15, 1992]



Sec.  1.469-3T  Passive activity credit (temporary).

    (a) Computation of passive activity credit. The taxpayer's passive 
activity credit for the taxable year is the amount (if any) by which--
    (1) The sum of all of the taxpayer's credits that are subject to 
section 469 for such year; exceeds
    (2) The taxpayer's regular tax liability allocable to all passive 
activities for such year.
    (b) Credits subject to section 469--(1) In general. Except as 
otherwise provided in this paragraph (b), a credit is subject to section 
469 for a taxable year if and only if--
    (i) Such credit--
    (A) Is attributable to such taxable year and arises in connection 
with the conduct of an activity that is a passive activity for such 
taxable year; and
    (B) Is described in--
    (1) Section 38(b) (1) through (5) (relating to general business 
credits);
    (2) Section 27(b) (relating to corporations described in section 
936);
    (3) Section 28 (relating to clinical testing of certain drugs); or
    (4) Section 29 (relating to fuel from nonconventional sources); or
    (ii) Such credit is allocable to an activity for such taxable year 
under Sec.  1.469-1T(f)(4).
    (2) Treatment of credits attributable to qualified progress 
expenditures. Any credit attributable to an increase in qualified 
investment under section 46(d)(1)(A) (relating to qualified progress 
expenditures) with respect to progress expenditure property (as defined 
in section 46(d)(2)) is subject to section 469 for a taxable year if--
    (i) Such credit is attributable to such taxable year;
    (ii) Such credit is described in paragraph (b)(1)(i)(B) of this 
section; and
    (iii) It is reasonable to believe that such progress expenditure 
property will be used in a passive activity of the taxpayer when it is 
placed in service.
    (3) Special rule for partners and S corporation shareholders. The 
character of a credit of a taxpayer arising in connection with an 
activity conducted by a partnership or S corporation (as a credit 
subject to section 469) shall be determined, in any case in which 
participation is relevant, by reference to the participation of the 
taxpayer in such activity. Such participation is determined for the 
taxable year of the partnership or S corporation (and not the taxable 
year of the taxpayer). See Sec.  1.469-2T(e)(1).
    (4) Exception for pre-1987 credits. A credit is not subject to 
section 469 if it is attributable to a taxable year of the taxpayer 
beginning prior to January 1, 1987.
    (c) Taxable year to which credit is attributable. A credit is 
attributable to the taxable year in which such credit would be (or would 
have been) allowed if the credits regard to the limitations contained in 
sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469.
    (d) Regular tax liability allocable to passive activities--(1) In 
general. For purposes of paragraph (a)(2) of this section, the 
taxpayer's regular tax liability allocable to all passive activities for 
the taxable year is the excess (if any) of--
    (i) The taxpayer's regular tax liability for such taxable year; over
    (ii) The amount of such regular tax liability determined by reducing 
the

[[Page 496]]

taxpayer's taxable income for such year by the excess (if any) of the 
taxpayer's passive activity gross income for such year over the 
taxpayer's passive activity deductions for such year.
    (2) Regular tax liability. For purposes of this section, the term 
``regularly tax liability'' has the meaning given such term in section 
26(b).
    (e) Coordination with section 38(b). [Reserved]. See Sec.  1.469-
3(e) for rules relating to this paragraph.
    (f) Coordination with section 50. [Reserved]. See Sec.  1.469-3(f) 
for rules relating to this paragraph.
    (g) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) A, a calendar year individual, is a general partner 
in calendar year partnership P. P purchases a building in 1987 and, in 
1987, 1988, and 1989, incurs rehabilitation costs with respect to the 
building. The building is placed in service in the rental activity in 
1989. P's rehabilitation costs are qualified rehabilitation expenditures 
(within the meaning of section 48(g)(2)) and are taken into account in 
determining the amount of the investment credit for rehabilitation 
expenditures. P's qualified rehabilitation expenditures are not 
qualified progress expenditures (within the meaning of section 46(d)).
    (ii) Because, under section 46(c)(1), the credit is allowable for 
the taxable year in which the rehabilitated property is placed in 
service, the credit allowable for P's qualified rehabilitation 
expenditures arises in connection with the activity in which the 
property is placed in service. In addition, the credit is attributable 
to 1989, the year in which the property is placed in service, because it 
would be allowed for such year if A's credits allowed for all taxable 
years were determined without regard to the limitations contained in 
sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469. Accordingly, under 
paragraph (b)(1) of this section, A's distributive share of the credit 
is subject to section 469 for 1989 because the credit arises in 
connection with a rental activity for such year.
    Example 2. The facts are the same as in Example 1, except that the 
rehabilitation costs are incurred in anticipation of placing the 
building in service in a rental activity, the qualified rehabilitation 
expenditures in 1987 and 1988 are qualified progress expenditures 
(``QPEs'') (within the meaning of section 46(d)(3)), the improvements 
resulting from the expenditures are progress expenditure property 
(within the meaning of paragraph (d)(2) of this section), and it is 
reasonable to expect that such property will be transition property 
(within the meaning of section 49(e)) when the property is placed in 
service. Therefore, under section 46(d)(1)(A), the qualified investment 
for 1987 and 1988 is increased by an amount equal to the aggregate of 
the applicable percentage of the qualified rehabilitation expenditures 
incurred in such years. The credits that are based on these expenditures 
are attributable (under paragraph (c) of this section) to 1987 and 1988, 
respectively. It is reasonable to believe in 1987 and 1988 that the 
progress expenditure property will be used in a rental activity when it 
is placed in service. Accordingly, under paragraph (b)(2) of this 
section, A's distributive share of the credit for 1987 and 1988 is 
subject to section 469. Under paragraph (b)(1) of this section (as in 
Example 1), A's distributive share of the credit for 1989 is also 
subject to section 469.
    Example 3. (i) B, a single individual, acquires an interest in a 
partnership that, in 1988, rehabilitates a building and places it in 
service in a trade or business activity in which B does not materially 
participate. For 1988, B has the following items of gross income, 
deduction, and credit:

Gross income:
  Income other than passive activity gross income.   $110,000
  Passive activity gross income...................     20,000   $130,000
                                                   -----------
Deductions:
  Deductions other than passive activity               23,950
   deductions.....................................
  Passive activity deductions.....................     18,000   (41,950)
                                                   -----------==========
  Taxable income..................................  .........     88,050
                                                              ==========
Credits:
  Rehabilitation credit from the passive activity.  .........      8,000
 

    (ii) For 1988, the amount by which B's passive activity gross income 
exceeds B's passive activity deductions (B's net passive income) is 
$2,000. Under paragraph (d) of this section, B's regular tax liability 
allocable to passive activities for 1988 is determined as follows:

  (A) Taxable income.............................   $88,050
  (B) Regular tax liability......................  ........   $24,578.50
  (C) Taxable income minus net passive income....    86,050
  (D) Regular tax liability for taxable income of  ........    23,918.50
   $86,050.00....................................
                                                            ------------
  (E) Regular tax liability allocable to passive   ........      $660.00
   activities ((B) minus (D))....................
 

    (iii) Under paragraph (a) of this section, B's passive activity 
credit for 1988 is the amount by which B's credits that are subject to 
section 469 for 1988 ($8,000) exceed B's regular tax liability allocable 
to passive activities for 1988 ($660.00). Accordingly, B's passive 
activity credit for 1988 is $7,340.
    Example 4. (i) The facts are the same as in Example 3 except that, 
in 1988, B also has additional deductions of $100,000 from a trade or 
business activity in which B materially

[[Page 497]]

participates for 1988. Thus, B has a taxable loss for 1988 of $11,950, 
determined as follows:

Gross income:
  Income other than passive activity gross income   $110,000
  Passive activity gross income..................     20,000   $130,000
                                                  -----------
Deductions:
  Deductions other than passive activity             123,950
   deductions....................................
  Passive activity deductions....................     18,000   (141,950)
                                                  ----------------------
  Taxable income.................................  .........    (11,950)
 

    (ii) Under section 26(b) and paragraph (d)(2) of this section, the 
regular tax liability for a taxable year cannot exceed the tax imposed 
by chapter 1 of subtitle A of the Internal Revenue Code for the taxable 
year. Therefore, under paragraph (d)(1) of this section, B's regular tax 
liability allocable to passive activities for 1988 is zero. Although B's 
net operating loss for the taxable year is reduced by B's net passive 
income, and B's regular tax liability for other taxable years may 
increase as a result of the reduction, such an increase does not change 
B's regular tax liability allocable to passive activities for 1988. 
Accordingly, B's passive activity credit for 1988 is $8,000.

[T.D. 8175, 53 FR 5724, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988; T.D. 
8253, 54 FR 20542, May 12, 1989; T.D. 8417, 57 FR 20758, May 15, 1992]



Sec.  1.469-4  Definition of activity.

    (a) Scope and purpose. This section sets forth the rules for 
grouping a taxpayer's trade or business activities and rental activities 
for purposes of applying the passive activity loss and credit limitation 
rules of section 469. A taxpayer's activities include those conducted 
through C corporations that are subject to section 469, S corporations, 
and partnerships.
    (b) Definitions. The following definitions apply for purposes of 
this section--
    (1) Trade or business activities. Trade or business activities are 
activities, other than rental activities or activities that are treated 
under Sec.  1.469-1T(e)(3)(vi)(B) as incidental to an activity of 
holding property for investment, that--
    (i) Involve the conduct of a trade or business (within the meaning 
of section 162);
    (ii) Are conducted in anticipation of the commencement of a trade or 
business; or
    (iii) Involve research or experimental expenditures that are 
deductible under section 174 (or would be deductible if the taxpayer 
adopted the method described in section 174(a)).
    (2) Rental activities. Rental activities are activities that 
constitute rental activities within the meaning of Sec.  1.469-1T(e)(3).
    (c) General rules for grouping activities--(1) Appropriate economic 
unit. One or more trade or business activities or rental activities may 
be treated as a single activity if the activities constitute an 
appropriate economic unit for the measurement of gain or loss for 
purposes of section 469.
    (2) Facts and circumstances test. Except as otherwise provided in 
this section, whether activities constitute an appropriate economic unit 
and, therefore, may be treated as a single activity depends upon all the 
relevant facts and circumstances. A taxpayer may use any reasonable 
method of applying the relevant facts and circumstances in grouping 
activities. The factors listed below, not all of which are necessary for 
a taxpayer to treat more than one activity as a single activity, are 
given the greatest weight in determining whether activities constitute 
an appropriate economic unit for the measurement of gain or loss for 
purposes of section 469--
    (i) Similarities and differences in types of trades or businesses;
    (ii) The extent of common control;
    (iii) The extent of common ownership;
    (iv) Geographical location; and
    (v) Interdependencies between or among the activities (for example, 
the extent to which the activities purchase or sell goods between or 
among themselves, involve products or services that are normally 
provided together, have the same customers, have the same employees, or 
are accounted for with a single set of books and records).
    (3) Examples. The following examples illustrate the application of 
this paragraph (c).

    Example 1. Taxpayer C has a significant ownership interest in a 
bakery and a movie theater at a shopping mall in Baltimore and in a 
bakery and a movie theater in Philadelphia. In this case, after taking 
into account all the relevant facts and circumstances, there may be more 
than one reasonable method for grouping C's activities. For instance, 
depending on the relevant facts and circumstances, the following 
groupings may

[[Page 498]]

or may not be permissible: a single activity; a movie theater activity 
and a bakery activity; a Baltimore activity and a Philadelphia activity; 
or four separate activities. Moreover, once C groups these activities 
into appropriate economic units, paragraph (e) of this section requires 
C to continue using that grouping in subsequent taxable years unless a 
material change in the facts and circumstances makes it clearly 
inappropriate.
    Example 2. Taxpayer B, an individual, is a partner in a business 
that sells non-food items to grocery stores (partnership L). B also is a 
partner in a partnership that owns and operates a trucking business 
(partnership Q). The two partnerships are under common control. The 
predominant portion of Q's business is transporting goods for L, and Q 
is the only trucking business in which B is involved. Under this 
section, B appropriately treats L's wholesale activity and Q's trucking 
activity as a single activity.

    (d) Limitation on grouping certain activities. The grouping of 
activities under this section is subject to the following limitations:
    (1) Grouping rental activities with other trade or business 
activities--(i) Rule. A rental activity may not be grouped with a trade 
or business activity unless the activities being grouped together 
constitute an appropriate economic unit under paragraph (c) of this 
section and--
    (A) The rental activity is insubstantial in relation to the trade or 
business activity;
    (B) The trade or business activity is insubstantial in relation to 
the rental activity; or
    (C) Each owner of the trade or business activity has the same 
proportionate ownership interest in the rental activity, in which case 
the portion of the rental activity that involves the rental of items of 
property for use in the trade or business activity may be grouped with 
the trade or business activity.
    (ii) Examples. The following examples illustrate the application of 
paragraph (d)(1)(i) of this section:

    Example 1. (i) H and W are married and file a joint return. H is the 
sole shareholder of an S corporation that conducts a grocery store trade 
or business activity. W is the sole shareholder of an S corporation that 
owns and rents out a building. Part of the building is rented to H's 
grocery store trade or business activity (the grocery store rental). The 
grocery store rental and the grocery store trade or business are not 
insubstantial in relation to each other.
    (ii) Because they file a joint return, H and W are treated as one 
taxpayer for purposes of section 469. See Sec.  1.469-1T(j). Therefore, 
the sole owner of the trade or business activity (taxpayer H-W) is also 
the sole owner of the rental activity. Consequently, each owner of the 
trade or business activity has the same proportionate ownership interest 
in the rental activity. Accordingly, the grocery store rental and the 
grocery store trade or business activity may be grouped together (under 
paragraph (d)(1)(i) of this section) into a single trade or business 
activity, if the grouping is appropriate under paragraph (c) of this 
section.
    Example 2. Attorney D is a sole practitioner in town X. D also 
wholly owns residential real estate in town X that D rents to third 
parties. D's law practice is a trade or business activity within the 
meaning of paragraph (b)(1) of this section. The residential real estate 
is a rental activity within the meaning of Sec.  1.469-1T(e)(3) and is 
insubstantial in relation to D's law practice. Under the facts and 
circumstances, the law practice and the residential real estate do not 
constitute an appropriate economic unit under paragraph (c) of this 
section. Therefore, D may not treat the law practice and the residential 
real estate as a single activity.

    (2) Grouping real property rentals and personal property rentals 
prohibited. An activity involving the rental of real property and an 
activity involving the rental of personal property (other than personal 
property provided in connection with the real property or real property 
provided in connection with the personal property) may not be treated as 
a single activity.
    (3) Certain activities of limited partners and limited 
entrepreneurs--(i) In general. Except as provided in this paragraph, a 
taxpayer that owns an interest, as a limited partner or a limited 
entrepreneur (as defined in section 464(e)(2)), in an activity described 
in section 465(c)(1), may not group that activity with any other 
activity. A taxpayer that owns an interest as a limited partner or a 
limited entrepreneur in an activity described in the preceding sentence 
may group that activity with another activity in the same type of 
business if the grouping is appropriate under the provisions of 
paragraph (c) of this section.
    (ii) Example. The following example illustrates the application of 
this paragraph (d)(3):


[[Page 499]]


    Example. (i) Taxpayer A, an individual, owns and operates a farm. A 
is also a member of M, a limited liability company that conducts a 
cattle-feeding business. A does not actively participate in the 
management of M (within the meaning of section 464(e)(2)(B)). In 
addition, A is a limited partner in N, a limited partnership engaged in 
oil and gas production.
    (ii) Because A does not actively participate in the management of M, 
A is a limited entrepreneur in M's activity. M's cattle-feeding business 
is described in section 465(c)(1)(B) (relating to farming) and may not 
be grouped with any other activity that does not involve farming. 
Moreover, A's farm may not be grouped with the cattle-feeding activity 
unless the grouping constitutes an appropriate economic unit for the 
measurement of gain or loss for purposes of section 469.
    (iii) Because A is a limited partner in N and N's activity is 
described in section 465(c)(1)(D) (relating to exploring for, or 
exploiting, oil and gas resources), A may not group N's oil and gas 
activity with any other activity that does not involve exploring for, or 
exploiting, oil and gas resources. Thus, N's activity may not be grouped 
with A's farm or with M's cattle-feeding business.

    (4) Other activities identified by the Commissioner. A taxpayer that 
owns an interest in an activity identified in guidance issued by the 
Commissioner as an activity covered by this paragraph (d)(4) may not 
group that activity with any other activity, except as provided in the 
guidance issued by the Commissioner.
    (5) Activities conducted through section 469 entities--(i) In 
general. A C corporation subject to section 469, an S corporation, or a 
partnership (a section 469 entity) must group its activities under the 
rules of this section. Once the section 469 entity groups its 
activities, a shareholder or partner may group those activities with 
each other, with activities conducted directly by the shareholder or 
partner, and with activities conducted through other section 469 
entities, in accordance with the rules of this section. A shareholder or 
partner may not treat activities grouped together by a section 469 
entity as separate activities.
    (ii) Cross reference. An activity that a taxpayer conducts through a 
C corporation subject to section 469 may be grouped with another 
activity of the taxpayer, but only for purposes of determining whether 
the taxpayer materially or significantly participates in the other 
activity. See Sec.  1.469-2T(c)(3)(i)(A) and (c)(4)(i) for the rules 
regarding dividends on C corporation stock and compensation paid for 
personal services.
    (6) Activities described in section 163(d)(5)(A)(ii). With respect 
to any taxpayer that is an individual, trust, estate, closely held C 
corporation or personal service corporation, an activity described in 
Sec.  1.469-1T(e)(6) and subject to section 163(d)(5)(A)(ii) that 
involves the conduct of a trade or business which is not a passive 
activity of the taxpayer and with respect to which the taxpayer does not 
materially participate may not be grouped with any other activity or 
activities of the taxpayer, including any other activity described in 
Sec.  1.469-1T(e)(6) and subject to section 163(d)(5)(A)(ii).
    (e) Disclosure and consistency requirements--(1) Original groupings. 
Except as provided in paragraph (e)(2) of this section and Sec.  1.469-
11, once a taxpayer has grouped activities under this section, the 
taxpayer may not regroup those activities in subsequent taxable years. 
Taxpayers must comply with disclosure requirements that the Commissioner 
may prescribe with respect to both their original groupings and the 
addition and disposition of specific activities within those chosen 
groupings in subsequent taxable years.
    (2) Regroupings. If it is determined that a taxpayer's original 
grouping was clearly inappropriate or a material change in the facts and 
circumstances has occurred that makes the original grouping clearly 
inappropriate, the taxpayer must regroup the activities and must comply 
with disclosure requirements that the Commissioner may prescribe.
    (f) Grouping by Commissioner to prevent tax avoidance--(1) Rule. The 
Commissioner may regroup a taxpayer's activities if any of the 
activities resulting from the taxpayer's grouping is not an appropriate 
economic unit and a principal purpose of the taxpayer's grouping (or 
failure to regroup under paragraph (e) of this section) is to circumvent 
the underlying purposes of section 469.
    (2) Example. The following example illustrates the application of 
this paragraph (f):


[[Page 500]]


    Example. (i) Taxpayers D, E, F, G, and H are doctors who operate 
separate medical practices. D invested in a tax shelter several years 
ago that generates passive losses and the other doctors intend to invest 
in real estate that will generate passive losses. The taxpayers form a 
partnership to engage in the trade or business of acquiring and 
operating X-ray equipment. In exchange for equipment contributed to the 
partnership, the taxpayers receive limited partnership interests. The 
partnership is managed by a general partner selected by the taxpayers; 
the taxpayers do not materially participate in its operations. 
Substantially all of the partnership's services are provided to the 
taxpayers or their patients, roughly in proportion to the doctors' 
interests in the partnership. Fees for the partnership's services are 
set at a level equal to the amounts that would be charged if the 
partnership were dealing with the taxpayers at arm's length and are 
expected to assure the partnership a profit. The taxpayers treat the 
partnership's services as a separate activity from their medical 
practices and offset the income generated by the partnership against 
their passive losses.
    (ii) For each of the taxpayers, the taxpayer's own medical practice 
and the services provided by the partnership constitute an appropriate 
economic unit, but the services provided by the partnership do not 
separately constitute an appropriate economic unit. Moreover, a 
principal purpose of treating the medical practices and the 
partnership's services as separate activities is to circumvent the 
underlying purposes of section 469. Accordingly, the Commissioner may 
require the taxpayers to treat their medical practices and their 
interests in the partnership as a single activity, regardless of whether 
the separate medical practices are conducted through C corporations 
subject to section 469, S corporations, partnerships, or sole 
proprietorships. The Commissioner may assert penalties under section 
6662 against the taxpayers in appropriate circumstances.

    (g) Treatment of partial dispositions. A taxpayer may, for the 
taxable year in which there is a disposition of substantially all of an 
activity, treat the part disposed of as a separate activity, but only if 
the taxpayer can establish with reasonable certainty--
    (1) The amount of deductions and credits allocable to that part of 
the activity for the taxable year under Sec.  1.469-1(f)(4) (relating to 
carryover of disallowed deductions and credits); and
    (2) The amount of gross income and of any other deductions and 
credits allocable to that part of the activity for the taxable year.
    (h) Rules for grouping rental real estate activities for taxpayers 
qualifying under section 469(c)(7). See Sec.  1.469-9 for rules for 
certain rental real estate activities.

[T.D. 8565, 59 FR 50487, Oct. 4, 1994, as amended by T.D. 8645, 60 FR 
66499, Dec. 22, 1995; T.D. 9943, 86 FR 5540, Jan. 19, 2021]



Sec.  1.469-4T  Definition of activity (temporary).

    (a) Overview--(1) Purpose and effect of overview. This paragraph (a) 
contains a general description of the rules contained in this section 
and is intended solely as an aid to readers. The provisions of this 
paragraph (a) are not a substitute for the more detailed rules contained 
in the remainder of this section and cannot be relied upon in cases in 
which those rules qualify the general description contained in this 
paragraph (a).
    (2) Scope and structure of Sec.  1.469-4T. This section provides 
rules under which a taxpayer's business and rental operations are 
treated as one or more activities for purposes of section 469 and the 
regulations thereunder. (See paragraph (b)(2)(ii) of this section for 
the definition of business and rental operations.) In general, these 
rules are divided into three groups:
    (i) Rules that identify the business and rental operations that 
constitute an undertaking (the undertaking rules).
    (ii) Rules that identify the undertaking or undertakings that 
constitute an activity (the activity rules).
    (iii) Rules that apply only under certain special circumstances (the 
special rules).
    (3) Undertaking rules--(i) In general. The undertaking is generally 
the smallest unit that can constitute an activity. (See paragraph (b)(1) 
of this section for the general rule and paragraph (k)(2)(iii) of this 
section for a special rule that permits taxpayers to treat a single 
rental real estate undertaking as multiple activities.) An undertaking 
may include diverse business and rental operations.
    (ii) Basic undertaking rule. The basic undertaking rule identifies 
the business and rental operations that constitute an undertaking by 
reference to their location and ownership. Under

[[Page 501]]

this rule, business and rental operations that are conducted at the same 
location and are owned by the same person are generally treated as part 
of the same undertaking. Conversely, business and rental operations 
generally constitute separate undertakings to the extent that they are 
conducted at different locations or are not owned by the same person. 
(See paragraph (c)(2)(i) of this section.)
    (iii) Circumstances in which location is disregarded. In some 
circumstances, the undertaking in which business and rental operations 
are included does not depend on the location at which the operations are 
conducted. Operations that are not conducted at any fixed place of 
business or that are conducted at the customer's place of business are 
treated as part of the undertaking with which the operations are most 
closely associated (see paragraph (c)(2)(iii)(C) of this section). In 
addition, operations that are conducted at a location but do not relate 
to the production of property at that location or to the transaction of 
business with customers at that location are treated, in effect, as part 
of the undertaking or undertakings that the operations support (see 
paragraph (c)(2)(ii) of this section).
    (iv) Rental undertakings. The basic undertaking rule is also 
modified if the undertaking determined under that rule includes both 
rental and nonrental operations. In such cases, the rental operations 
and the nonrental operations generally must be treated as separate 
undertakings (see paragraph (d)(1) of this section). This rule does not 
apply if more than 80 percent of the income of the undertaking 
determined under the basic rule is attributable to one class of 
operations (i.e., rental or nonrental) or if the rental operations would 
not be treated as part of a rental activity because of the exceptions 
contained in Sec.  1.469-1T(e)(3)(ii) (see paragraph (d)(2) of this 
section). In applying the rental undertaking rules, short-term rentals 
of real property (e.g., hotel-room rentals) are generally treated as 
nonrental operations (see paragraph (d)(3)(ii) of this section).
    (v) Oil and gas wells. Another exception to the basic undertaking 
rule treats oil and gas wells that are subject to the working-interest 
exception in Sec.  1.469-1T(e)(4) as separate undertakings (see 
paragraph (e) of this section).
    (4) Activity rules--(i) In general. The basic activity rule treats 
each undertaking in which a taxpayer owns an interest as a separate 
activity of the taxpayer (see paragraph (b)(1) of this section). In the 
case of trade or business undertakings, professional service 
undertakings, and rental real estate undertakings, additional rules may 
either require or permit the aggregation of two or more undertakings 
into a single activity.
    (ii) Aggregation of trade or business undertakings--(A) Trade or 
business undertakings. Trade or business undertakings include all 
nonrental undertakings other than oil and gas undertakings described in 
paragraph (a)(3)(v) of this section and professional service 
undertakings described in paragraph (a)(4)(iii) of this section (see 
paragraph (f)(1)(ii) of this section).
    (B) Similar, commonly-controlled undertakings treated as a single 
activity. An aggregation rule treats trade or business undertakings that 
are both similar and controlled by the same interests as part of the 
same activity. This rule is, however, generally inapplicable to small 
interests held by passive investors in such undertakings, except to the 
extent such interests are held through the same passthrough entity. (See 
paragraph (f)(2) of this section.) Undertakings are similar for purposes 
of this rule if more than half (by value) of their operations are in the 
same line of business (as defined in a revenue procedure issued pursuant 
to paragraph (f)(4)(iv) of this section) or if the undertakings are 
vertically integrated (see paragraph (f)(4)(iii) of this section). All 
the facts and circumstances are taken into account in determining 
whether undertakings are controlled by the same interests for purposes 
of the aggregation rule (see paragraph (j)(1) of this section). If, 
however, each member of a group of five or fewer persons owns a 
substantial interest in each of the undertakings, the undertakings may 
be rebuttably presumed to be controlled by the same interests (see 
paragraph (j) (2) and (3) of this section).
    (C) Integrated businesses treated as a single activity. Trade or 
business undertakings (including undertakings that

[[Page 502]]

have been aggregated because of their similarity and common control) are 
subject to a second aggregation rule. Under this rule undertakings that 
constitute an integrated business and are controlled by the same 
interests must be treated as part of the same activity. (See paragraph 
(g) of this section.)
    (iii) Aggregation of professional service undertakings. Professional 
service undertakings are nonrental undertakings that predominantly 
involve the provision of services in the fields of health, law, 
engineering, architecture, accounting, actuarial science, performing 
arts, or consulting (see paragraph (h)(1)(ii) of this section). In 
general, professional service undertakings that are either similar, 
related, or controlled by the same interests must be treated as part of 
the same activity (see paragraph (h)(2) of this section). The rules for 
determining whether trade or business undertakings are controlled by the 
same interests also apply with respect to professional service 
undertakings. Professional service undertakings are similar, however, if 
more than 20 percent (by value) of their operations are in the same 
field, and two professional service undertakings are related if one of 
the undertakings derives more than 20 percent of its gross income from 
persons who are customers of the other undertaking (see paragraph (h)(3) 
of this section).
    (iv) Rules for rental real estate--(A) Taxpayers permitted to 
determine rental real estate activities. The rules for aggregating 
rental real estate undertakings are generally elective. They permit 
taxpayers to treat any combination of rental real estate undertakings as 
a single activity. Taxpayers may also divide their rental real estate 
undertakings and then treat portions of the undertakings as separate 
activities or recombine the portions into activities that include parts 
of different undertakings. (See paragraph (k)(2) (i) and (iii) of this 
section.)
    (B) Limitations on fragmentation and aggregation of rental real 
estate. Taxpayers may not fragment their rental real estate in a manner 
that is inconsistent with their treatment of such property in prior 
taxable years or with the treatment of such property by the passthrough 
entity through which it is held (see paragraph (k) (2)(ii) and (3) of 
this section). There are no comparable limitations on the aggregation of 
rental real estate into a single activity. If however, the income or 
gain from a rental real estate undertaking is subject to 
recharacterization under Sec.  1.469-2T(f)(3) (relating to the rental of 
nondepreciable property), a coordination rule provides that the 
undertaking must be treated as a separate activity (see paragraph (k)(6) 
of this section.)
    (v) Election to treat nonrental undertakings as separate activities. 
Another elective rule permits taxpayers to treat a nonrental undertaking 
as a separate activity even if the undertaking would be treated as part 
of a larger activity under the aggregation rules applicable to the 
undertaking (see paragraph (o)(2) of this section). This elective rule 
is limited by consistency requirements similar to those that apply to 
rental real estate operations (see paragraph (o) (3) and (4) of this 
section). Moreover, in cases in which a taxpayer elects to treat a 
nonrental undertaking as a separate activity, the taxpayer's level of 
participation (i.e., material, significant, or otherwise) in the 
separate activity is the same as the taxpayer's level of participation 
in the larger activity in which the undertaking would be included but 
for the election (see paragraph (o)(6) of this section).
    (5) Special rules--(i) Consolidated groups and publicly traded 
partnerships. Special rules apply to the business and rental operations 
of consolidated groups of corporations and publicly traded partnerships. 
Under these rules, a consolidated group is treated as one taxpayer in 
determining its activities and those of its members (see paragraph (m) 
of this section), and business and rental operations owned through a 
publicly traded partnership cannot be aggregated with operations that 
are not owned through the partnership (see paragraph (n) of this 
section).
    (ii) Transitional rule. A special rule applies for taxable years 
ending before August 10, 1989. In those years, taxpayers may organize 
business and rental operations into activities under any reasonable 
method (see paragraph (p)(1) of this section). A taxpayer will also be 
permitted to use any reasonable

[[Page 503]]

method to allocate disallowed deductions and credits among activities 
for the first taxable year in which the taxpayer's activities are 
determined under the general rules of Sec.  1.469-4T (see paragraph 
(p)(3) of this section).
    (b) General rule and definitions of general application--(1) General 
rule. Except as otherwise provided in this section, each undertaking in 
which a taxpayer owns an interest shall be treated as a separate 
activity of the taxpayer. See paragraphs (f), (g), and (h) of this 
section for rules requiring certain nonrental undertakings to be treated 
as part of the same activity and paragraph (k) of this section for rules 
identifying the rental real estate undertakings (or portions thereof) 
that are included in an activity.
    (2) Definitions of general application. The following definitions 
set forth the meaning of certain terms for purposes of this section:
    (i) Passthrough entity. The term ``passthrough entity'' means a 
partnership, S corporation, estate, or trust.
    (ii) Business and rental operations--(A) In general. Except as 
provided in paragraph (b)(2)(ii)(B) of this section, the term ``business 
and rental operations'' means all endeavors that are engaged in for 
profit or the production of income and satisfy one or more of the 
following conditions for the taxable year:
    (1) Such endeavors involve the conduct of a trade or business 
(within the meaning of section 162) or are conducted in anticipation of 
such endeavors becoming a trade or business;
    (2) Such endeavors involve making tangible property available for 
use by customers; or
    (3) Research or experimental expenditures paid or incurred with 
respect to such endeavors are deductible under section 174 (or would be 
deductible if the taxpayer adopted the method described in section 
174(a)).
    (B) Operations conducted through nonpassthrough entities. For 
purposes of applying section 469 and the regulations thereunder, a 
taxpayer's activities do not include operations that a taxpayer conducts 
through one or more entities (other than passthrough entities). The 
following example illustrates the operation of this paragraph 
(b)(2)(ii)(B):

    Example. (i) A, an individual, owns stock of X, a closely held 
corporation (within the meaning of Sec.  1.469-1T(g)(2)(ii) that is 
directly engaged in the conduct of a real estate development business. A 
participates in X's real estate development business, but does not own 
any interest in the business other than through ownership of the stock 
of X.
    (ii) X is subject to section 469 (see Sec.  1.469-1T(b)(5)) and does 
not hold the real estate development business through another entity. 
Accordingly, for purposes of section 469 and the regulations thereunder, 
the operations of X's real estate development business are treated as 
part of X's activities.
    (iii) A is also subject to section 469 (see Sec.  1.469-1T(b)(1)), 
but A's only interest in the real estate development business is held 
through X. X is a C corporation and therefore is not a passthrough 
entity. Thus, for purposes of section 469 and the regulations 
thereunder, A's activities do not include the operations of X's real 
estate development business. Accordingly, A's participation in X's 
busines is not participation in an activity of A, and is not taken into 
account in determining whether A materially participates (within the 
meaning of Sec.  1.469-5T) or significantly participates (within the 
meaning of Sec.  1.469-1T(c)(2)) in any activity. (See, however, Sec.  
1.469-1T(g)(3) for rules under which a shareholder's participation is 
taken into account for purposes of determining whether a corporation 
materially or significantly participates in an activity.

    (c) Undertaking--(1) In general. Except as otherwise provided in 
paragraphs (d), (e), and (k)(2)(iii) of this section, business and 
rental operations that constitute a separate source of income production 
shall be treated as a single undertaking that is separate from other 
undertakings.
    (2) Operations treated as a separate source of income production--
(i) In general. Except as otherwise provided in this paragraph (c)(2), 
business and rental operations shall be treated for purposes of this 
paragraph (c) as a separate source of income production if and only if--
    (A) Such operations are conducted at the same location (within the 
meaning of paragraph (c)(2)(iii) of this section) and are owned by the 
same person (within the meaning of paragraph (c)(2)(v) of this section); 
and
    (B) Income-producing operations (within the meaning of paragraph 
(c)(2)(iv) of this section) owned by such person are conducted at such 
location.

[[Page 504]]

    (ii) Treatment of support operations--(A) In general. For purposes 
of section 469 and the regulations thereunder--
    (1) The support operations conducted at a location shall not be 
treated as part of an undertaking under paragraph (c)(2)(i) of this 
section; and
    (2) The income and expenses that are attributable to such operations 
and are reasonably allocable to an undertaking conducted at a different 
location shall be taken into account in determining the income or loss 
from the activity or activities that include such undertaking.
    (B) Support operations. For purposes of this paragraph (c)(2), the 
business and rental operations conducted at a location are treated as 
support operations to the extent that--
    (1) Such operations and an undertaking that is conducted at a 
different location are owned by the same person (within the meaning of 
paragraph (c)(2)(v) of this section);
    (2) Such operations involve the provision of property or services to 
such undertaking; and
    (3) Such operations are not income-producing operations (within the 
meaning of paragraph (c)(2)(iv) of this section).
    (iii) Location. For purposes of this paragraph (c)(2)--
    (A) The term ``location'' means, with respect to any business and 
rental operations, a fixed place of business at which such operations 
are regularly conducted;
    (B) Business and rental operations are conducted at the same 
location if they are conducted in the same physical structure or within 
close proximity of one another;
    (C) Business and rental operations that are not conducted at a fixed 
place of business or that are conducted on the customer's premises shall 
be treated as operations that are conducted at the location (other than 
the customer's premises) with which they are most closely associated;
    (D) All the facts and circumstances (including, in particular, the 
factors listed in paragraph (c)(3) of this section) are taken into 
account in determining the location with which business and rental 
operations are most closely associated; and
    (E) Oil and gas operations that are conducted for the development of 
a common reservoir are conducted within close proximity of one another.
    (iv) Income-producing operations. For purposes of this paragraph 
(c)(2), the term ``income-producing operations'' means business and 
rental operations that are conducted at a location and relate to (or are 
conducted in reasonable anticipation of)--
    (A) The production of property at such location;
    (B) The sale of property to customers at such location;
    (C) The performance of services for customers at such location;
    (D) Transactions in which customers take physical possession at such 
location of property that is made available for their use; or
    (E) Any other transactions that involve the presence of customers at 
such location.
    (v) Ownership by the same person. For purposes of this paragraph 
(c)(2), business and rental operations are owned by the same person if 
and only if one person (within the meaning of section 7701(a)(1)) is the 
direct owner of such operations.
    (3) Facts and circumstances determinations. In determining whether a 
location is the location with which business and rental operations are 
most closely associated for purposes of paragraph (c)(2)(iii)(D) of this 
section, the following relationships between operations that are 
conducted at such location and other operations are generally the most 
significant:
    (i) The extent to which other persons conduct similar operations at 
one location;
    (ii) Whether such operations are treated as a unit in the primary 
accounting records reflecting the results of such operations;
    (iii) The extent to which other persons treat similar operations as 
a unit in the primary accounting records reflecting the results of such 
similar operations;
    (iv) The extent to which such operations involve products or 
services that are commonly provided together;
    (v) The extent to which such operations serve the same customers;

[[Page 505]]

    (vi) The extent to which the same personnel, facilities, or 
equipment are used to conduct such operations;
    (vii) The extent to which such operations are conducted in 
coordination with or reliance upon each other;
    (viii) The extent to which the conduct of any such operations is 
incidental to the conduct of the remainder of such operations;
    (ix) The extent to which such operations depend on each other for 
their economic success; and
    (x) Whether such operations are conducted under the same trade name.
    (4) Examples. The following examples illustrate the application of 
this paragraph (c). In each example that does not state otherwise, the 
taxpayer is an individual and the facts, analysis, and conclusion relate 
to a single taxable year.

    Example 1. The taxpayer is the sole owner of a department store and 
a restaurant and conducts both businesses in the same building. Thus, 
the department store and restaurant operations are conducted at the same 
location (within the meaning of paragraph (c)(2)(iii) of this section) 
and are owned by the same person (i.e., the taxpayer is the direct owner 
of the operations). In addition, the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the location (i.e., property is sold to customers and services are 
performed for customers on the premises of the department store). 
Accordingly, the department store and restaurant operations are treated 
as a separate source of income production (see paragraph (c)(2) of this 
section) and as a single undertaking that is separate from other 
undertakings (see paragraph (c)(1) of this section).
    Example 2. (i) The facts are the same as in Example 1, except that 
the taxpayer is also the sole owner of an automotive center that 
services automobiles and sells tires, batteries, motor oil, and 
accessories. The taxpayer operates the automotive center in a separate 
structure in the shopping mall in which the department store is located. 
Although the automotive center operations and the department store and 
restaurant operations are not conducted in the same physical structure, 
they are conducted within close proximity (within the meaning of 
paragraph (c)(2)(iii)(B) of this section) of one another. Thus, the 
department store, restaurant, and automotive center operations are 
conducted at the same location (within the meaning of paragraph 
(c)(2)(iii) of this section).
    (ii) As in Example 1, the operations conducted at the same location 
are owned by the same person, and the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the location. Accordingly, the department store, restaurant, and 
automotive center operations are treated as a separate source of income 
production (see paragraph (c)(2) of this section) and as a single 
undertaking that is separate from other undertakings (see paragraph 
(c)(1) of this section).
    Example 3. (i) The facts are the same as in Example 2, except that 
the automotive center is located several blocks from the shopping mall. 
As in Example 1, the department store and restaurant operations are 
treating as a single undertaking that is separate from other 
undertakings. Because, however, the automotive center operations are not 
conducted within close proximity (within the meaning of paragraph 
(c)(2)(iii)(B) of this section) of the department store and restaurant 
operations, all of the taxpayer's operations are not conducted at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section).
    (ii) All of the automotive center operations are conducted at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). In addition, the taxpayer conducts 
income producing operations (within the meaning of paragraph (c)(2)(iv) 
of this section) at the location (i.e., property is sold to customers 
and services are performed for customers on the premises of the 
automotive center). Accordingly, the automotive center operations are 
also treated as a separate source of income production (see paragraph 
(c)(2) of this section) and as a single undertaking that is separate 
from other undertakings (see paragraph (c)(1) of this section). See, 
however, paragraph (g) of this section for rules under which certain 
trade or business activities are treated as a single activity.
    Example 4. The taxpayer is the sole owner of a building and rents 
residential, office, and retail space in the building to various 
tenants. The taxpayer manages these rental operations from an office 
located in the building. The rental operations are conducted at the same 
location (within the meaning of paragraph (c)(2)(iii) of this section) 
and are owned by the same person (i.e., the taxpayer is the direct owner 
of the operations). In addition, the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the location (i.e., customers take physical possession in the 
building of property made available for their use). Accordingly, the 
rental operations are treated as a separate source of income production 
(see

[[Page 506]]

paragraph (c)(2) of this section) and as a single undertaking that is 
separate from other undertakings (see paragraph (c)(1) of this section). 
See paragraph (d) of this section for rules for determining whether this 
undertaking is a rental undertaking and paragraph (k) of this section 
for rules for identifying rental real estate activities.
    Example 5. (i) The facts are the same as in Example 4, except that 
the taxpayer also uses the rental office in the building (``Building 
1'') to manage rental operations in another building (``Building 2'') 
that the taxpayer owns. The rental operations conducted in Building 2 
are treated as a separate source of income production under paragraph 
(c)(2) of this section and as a single undertaking that is separate from 
other undertakings (the ``Building 2 undertaking'') under paragraph 
(c)(1) of this section.
    (ii) The operations conducted at the rental office in Building 1 
and the Building 2 undertaking are owned by the same person (i.e., the 
taxpayer is the direct owner of the operations). In addition, the 
operations conducted at the rental office with respect to the Building 
2 undertaking relate to transactions in which customers take physical 
possession at another location of property that is made available for 
their use (i.e., the operations are not income-producing operations 
(within the meaning of paragraph (c)(2)(iv) of this section)). Thus, to 
the extent the operations conducted at the rental office involve the 
management of the Building 2 undertaking, they are support operations 
(within the meaning of paragraph (c)(2)(ii)(B) of this section) with 
respect to the Building 2 undertaking.
    (iii) Paragraph (c)(2)(ii)(A)(1) of this section provides that 
support operations are not treated as part of an undertaking under 
paragraph (c)(2)(i) of this section. Therefore, the support operations 
conducted at the rental office are not treated as part of the 
undertaking that consists of the rental operations conducted in Building 
1 (the ``Building 1 undertaking''). Paragraph (c)(2)(ii)(A)(2) of this 
section provides that the income and expenses that are attributable to 
support operations and are reasonably allocable to an undertaking 
conducted at a different location shall be taken into account in 
determining the income or loss from the activity that includes such 
undertaking. Accordingly, the income and expenses of the rental office 
that are reasonably allocable to the Building 2 undertaking are taken 
into account in determining the income or loss from the activity or 
activities that include the Building 2 undertaking. See paragraph (k) 
of this section for rules for identifying rental real estate activities.
    (iv) Rental office operations that involve the management of rental 
operations conducted in Building 1 are not support operations (within 
the meaning of paragraph (c)(2)(ii)(B) of this section) because they 
relate to an undertaking that is conducted at the same location (the 
``Building 1 undertaking''). Thus, the rules for support operations in 
paragraph (c)(2)(ii)(A) of this section do not apply to such operations, 
and they are treated as part of the Building 1 undertaking.
    Example 6. (i) The taxpayer conducts business and rental operations 
at eleven different locations (within the meaning of paragraph 
(c)(2)(iii) of this section). At ten of the locations the taxpayer owns 
grocery stores, and at the eleventh location the taxpayer owns a 
warehouse that receives goods and supplies them to the taxpayer's 
stores. The operations of each store are conducted at the same location 
(within the meaning of paragraph (c)(2)(iii) of this section) and are 
owned by the same person (i.e., the taxpayer is the direct owner of the 
operations). In addition, the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at each location (i.e., property is sold to customers on the store 
premises, and customers take physical possession on the store premises 
of property made available for their use). Accordingly, the operations 
of each of the ten grocery stores are treated as a separate source of 
income production (see paragraph (c)(2) of this section), and each store 
is treated as a single undertaking (a ``grocery store undertaking'') 
that is separate from other undertakings (see paragraph (c)(1) of this 
section). The operations conducted at the warehouse, however, do not 
include any income-producing operations (within the meaning of paragraph 
(c)(2)(iv) of this section). Accordingly, the warehouse operations do 
not satisfy the requirements of paragraph (c)(2)(i) of this section and 
are not treated as a separate undertaking under paragraph (c)(1) of this 
section.
    (ii) The warehouse operations and the grocery store undertakings are 
owned by the same person (i.e., the taxpayer is the direct owner of the 
operations), the operations conducted at the warehouse involve the 
provision of property to the grocery store undertakings, and the 
warehouse operations are not income-producing operations (within the 
meaning of paragraph (c)(2)(iv) of this section). Thus, the warehouse 
operations are support operations (within the meaning of paragraph 
(c)(2)(ii)(B) of this section) with respect to the grocery store 
undertakings. Paragraph (c)(2)(ii)(A)(2) of this section provides that 
the income and expenses that are attributable to support operations and 
are reasonably allocable to an undertaking conducted at a different 
location shall be taken into account in determining the income or

[[Page 507]]

loss from the activity or activities that include such undertaking. 
Accordingly, the income and expenses of the warehouse operations that 
are reasonably allocable to a grocery store undertaking are taken into 
account in determining the income or loss from the activity or 
activities that include such undertaking. See paragraph (f) of this 
section for rules under which certain similar, commonly-controlled 
undertakings are treated as a single activity.
    Example 7. (i) The facts are the same as in Example 6, except that 
the warehouse operations also include the sale of goods to grocery 
stores that the taxpayer does not own (``other grocery stores''). 
Because of these sales, the taxpayer conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the warehouse. The warehouse operations are conducted at the same 
location (within the meaning of paragraph (c)(2)(iii) of this section) 
and are owned by the same person (i.e., the taxpayer is the direct owner 
of the operations). Accordingly, prior to the application of the rules 
for support operations in paragraph (c)(2)(ii) of this section, the 
warehouse operations are treated as a separate source of income 
production (see paragraph (c)(2) of this section) and as a single 
undertaking (the ``separate warehouse undertaking'') that is separate 
from other undertakings (see paragraph (c)(1) of this section).
    (ii) As in Example 6, the warehouse operations that involve 
supplying goods to the taxpayer's grocery store undertakings are support 
operations with respect to those undertakings. Therefore, those 
operations are not treated as part of the separate warehouse undertaking 
(see paragraph (c)(2)(ii)(A)(1) of this section), and the income and 
expenses of such operations are taken into account, as in Example 6, in 
determining the income or loss from the activity or activities that 
include the taxpayer's grocery store undertakings.
    Example 8. (i) A partnership is formed to acquire real property and 
construct a building on the property. The partnership hires brokers to 
locate a suitable parcel of land, lawyers to negotiate zoning variances, 
easements, and building permits, and architects and engineers to design 
the improvements. After the architects and engineers have designed the 
improvements and other preliminaries have been completed, the 
partnership hires a general contractor who hires subcontractors and 
oversees construction. During the construction process and after 
construction has been completed, the partnership leases out space in the 
building. The partnership then operates the building as a rental 
property. The operations of acquiring the real property, negotiating 
contracts, overseeing the designing and construction of the 
improvements, leasing up the building, and operating the building are 
conducted at an office (the ``management office'') that is not at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section) as the building.
    (ii) The operations conducted at the building site (e.g., excavating 
the land, pouring the concrete for the foundation, erecting the frame of 
the building, completing the exterior of the building, and building out 
the interior of the building) are conducted at the same location (within 
the meaning of paragraph (c)(2)(iii) of this section) and are owned by 
the same person (i.e., the partnership is the direct owner of the 
operations). In addition, the partnership conducts income-producing 
operations (within the meaning of paragraph (c)(2)(iv) of this section) 
at the location (i.e., during the construction period property (the 
building) is produced at the building site, and during the rental period 
customers take physical possession in the building of property made 
available for their use). Accordingly, the operations conducted at the 
building site are treated as a separate source of income production (see 
paragraph (c)(2) of this section) and as a single undertaking that is 
separate from other undertakings (see paragraph (c)(1) of this section).
    (iii) The operations conducted at the management office and the 
undertaking conducted at the building site are owned by the same person 
(i.e., the partnership is the direct owner of the operations). In 
addition, the operations conducted at the management office relate to 
transactions in which customers take physical possession at another 
location of property that is made available for their use (i.e., the 
operations are not income-producing operations (within the meaning of 
paragraph (c)(2)(iv) of this section)). Thus, to the extent the 
operations conducted at the management office involve the provision of 
services to the undertaking conducted at the building site, they are 
support operations (within the meaning of paragraph (c)(2)(ii)(B) of 
this section) with respect to such undertaking.
    (iv) Paragraph (c)(2)(ii)(A)(2) of this section provides that the 
income and expenses of support operations that are reasonably allocable 
to an undertaking conducted at a different location shall be taken into 
account in determining the income or loss from the activity that 
includes such undertaking. Accordingly, the income and expenses of the 
management office that are reasonably allocable to the undertaking 
conducted at the building site are taken into account in determining the 
income or loss from the activity or activities that include such 
undertaking.
    (v) Until the building is first held out for rent and is in a state 
of readiness for rental, the undertaking conducted at the building site 
is a trade or business undertaking (within the meaning of paragraph 
(f)(1)(ii) of this section). See paragraph (d) of this section for

[[Page 508]]

rules for determining whether the undertaking is a rental undertaking 
for periods after the building is first held out for rent and is in a 
state of readiness for rental and paragraph (k) of this section for 
rules for identifying rental real estate activities.
    Example 9. The taxpayer owns 15 oil wells pursuant to a single 
working interest (within the meaning of Sec.  1.469-1T (e)(4)(iv). All 
of the wells are drilled and operated for the development of a common 
reservoir. Thus, all of the wells are at the same location (see 
paragraph (c)(2)(iii)(E) of this section). All of the wells are owned by 
the same person (i.e., the taxpayer is the direct owner of the 
operations), and the taxpayer conducts income-producing operations 
(within the meaning of paragraph (c)(2)(iv) of this section) at the 
location (i.e., oil wells are drilled in reasonable anticipation of 
producing oil at the location). Accordingly, the operations of the wells 
are treated as a separate source of income production (see paragraph 
(c)(2) of this section) and as a single undertaking that is separate 
from other undertakings (see paragraph (c)(1) of this section). See 
paragraph (e) of this section for rules under which certain oil and gas 
operations are treated as multiple undertakings even if they would be 
part of the same undertaking under the rules of this paragraph (c).
    Example 10. (i) Partnership X owns an automobile dealership and 
partnership Y owns an automobile repair shop. The dealership and repair 
shop operations are conducted in the same physical structure. 
Individuals A, B, and C are the only partners in partnerships X and Y, 
and each of the partners owns a one-third interest in both partnerships.
    (ii) The dealership operations and the repair-shop operations are 
conducted at the same location (within the meaning of paragraph 
(c)(2)(iii) of this section), but are owned by different persons (i.e., 
X is the direct owner of the dealership operations, and Y is the direct 
owner of the repair-shop operations). Moreover, indirect ownership of 
the operations is not taken into account under paragraph (c)(2)(v) of 
this section. Thus, it is irrelevant that the two partnerships are owned 
by the same persons in identical proportions. Accordingly, the 
dealership and repair-shop operations are not treated as part of the 
same source of income production (see paragraph (c)(2) of this section) 
or as a single undertaking that is separate from other undertakings (see 
paragraph (c)(1) of this section). See, however, paragraph (g) of this 
section for rules under which certain trade or business activities are 
treated as a single activity.
    Example 11. (i) The taxpayer owns and operates a delivery service. 
The business consists of a central office, retail establishments, and 
messengers who transport packages from one place to another. Customers 
may bring their packages to a retail establishment for delivery 
elsewhere or, by calling the central office, may have packages picked up 
at their homes or offices. The central office dispatches messengers and 
coordinates all pickups and deliveries. Customers may pay for deliveries 
when they drop off or pick up packages at a retail establishment, or the 
central office will bill the customer for services rendered. In 
addition, many packages are routed through the central office.
    (ii) The operations conducted at the central office are conducted at 
the same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). The operations actually conducted at 
the central office, however, do not include any income-producting 
operations (within the meaning of paragraph (c)(2)(iv) of this section).
    (iii) Under paragraph (c)(2)(iii) (C) and (D) of this section, 
business and rental operations that are not conducted at a fixed place 
of business or that are conducted on the customer's premises are treated 
as operations that are conducted at the location (other than the 
customer's premises) with which they are most closely associated, and 
all the facts and circumstances are taken into account in determining 
the location with which business and rental operations are most closely 
associated. The facts and circumstances in this case (including the 
facts that the central office dispatches messengers, coordinates all 
pickups and deliveries, and is the transshipment point for many 
packages) establish that the operations of delivering packages from one 
location to another are most closely associated with the central office. 
Thus, the delivery operations are treated as operations that are 
conducted at the central office, and the deliveries are treated as 
income-producing operations (i.e., the performance of services for 
customers) that the taxpayer conducts at the central office. 
Accordingly, the operations conducted at the central office are treated 
as a separate source of income production (see paragraph (c)(2) of this 
section) and as a single undertaking that is separate from other 
undertakings (see paragraph (c)(1) of this section).
    (iv) The operations conducted at each retail establishment are 
conducted at the same location (within the meaning of paragraph 
(c)(2)(iii) of this section) and are owned by the same person (i.e., the 
taxpayer is the direct owner of the operations). At each retail 
establishment, the taxpayer's operations include transactions that 
involve the presence of customers at the establishment. Thus, the 
taxpayer conducts income-producing operations (within the meaning of 
paragraph (c)(2)(iv)(E) of this section) at the retail establishments. 
Accordingly, the operations of each retail establishment are treated as 
a separate source of income production (see

[[Page 509]]

paragraph (c)(2) of this section) and as a single undertaking that is 
separate from other undertakings (see paragraph (c)(1) of this section). 
See, however, paragraph (f) of this section for rules under which 
certain similar, commonly-controlled undertakings are treated as a 
single activity.
    Example 12. (i) The taxpayer is the sole owner of a saw mill and a 
lumber yard. The taxpayer's business operations consist of converting 
timber into lumber and other wood products and selling the resulting 
products. The timber is processed at the saw mill, and the resulting 
products are transported to the lumber yard where they are sold. The saw 
mill and the lumber yard are at different locations (within the meaning 
of paragraph (c)(2)(iii) of this section). The transportation operations 
are managed at the saw mill.
    (ii) The operations conducted at the saw mill are conducted at the 
same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). In addition, the taxpayer conducts 
income-producing operations (within the meaning of paragraph (c)(2)(iv) 
of this section) at the location (i.e., lumber is produced at the mill). 
Similarly, the selling operations at the lumber yard are conducted at 
the same location (within the meaning of paragraph (c)(2)(iii) of this 
section) and are owned by the same person (i.e., the taxpayer is the 
direct owner of the operations). In addition, the taxpayer conducts 
income-producing operations (within the meaning of paragraph (c)(2)(iv) 
of this section) at the location (i.e., lumber is sold to customers at 
the lumber yard). Thus, the milling operations and the selling 
operations are treated as separate sources of income production (see 
paragraph (c)(2) of this section) and as separate undertakings (see 
paragraph (c)(1) of this section).
    (iii) The operations conducted at the mill involve the provision of 
property to the lumber-yard undertaking. Nonetheless, the milling 
operations are income-producing operations because they relate to the 
production of property at the mill, and an undertaking's income-
producing operations are not treated as support operations (see 
paragraph (c)(2)(ii)(B)(3) of this section). Accordingly, the milling 
operations are not support operations with respect to the lumber-yard 
undertaking. See, however, paragraph (f) of this section for rules under 
which certain vertically-integrated undertakings are treated as part of 
the same activity.
    (iv) The operations of transporting finished products from the saw 
mill to the lumber yard are not conducted at a fixed location. Under 
paragraphs (c)(2)(iii) (C) and (D) of this section, business and rental 
operations that are not conducted at a fixed place of business or that 
are conducted on the customer's premises are treated as operations that 
are conducted at the location (other than the customer's premises) with 
which they are most closely associated, and all the facts and 
circumstances are taken into account in determining the location with 
which business and rental operations are most closely associated. The 
facts and circumstances in this case (including the fact that the 
transportation operations are managed at the saw mill) establish that 
the transportation operations are most closely associated with the saw 
mill. Thus, the transportation operations are treated as operations that 
are conducted at the mill and as part of the undertaking that consists 
of the milling operations.

    (d) Rental undertaking--(1) In general. This paragraph (d) applies 
to operations that are treated, under paragraph (c) of this section and 
before the application of paragraph (d)(1)(i) of this section, as a 
single undertaking that is separate from other undertakings (a 
``paragraph (c) undertaking''). For purposes of this section--
    (i) A paragraph (c) undertaking's rental operations and its 
operations other than rental operations shall be treated, except as 
otherwise provided in paragraph (d)(2) of this section, as two separate 
undertakings;
    (ii) The income and expenses that are reasonably allocable to an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) shall be taken into account in determining the income or 
loss from the activity or activities that include such undertaking; and
    (iii) An undertaking (determined after the application of paragraph 
(d)(1)(i) of this section) shall be treated as a rental undertaking if 
and only if such undertaking, considered as a separate activity, would 
constitute a rental activity (within the meaning of Sec.  1.469-
1T(e)(3)).
    (2) Exceptions. Paragraph (d)(1)(i) of this section shall not apply 
to a paragraph (c) undertaking for any taxable year in which--
    (i) The rental operations of the paragraph (c) undertaking, 
considered as a separate activity, would not constitute a rental 
activity (within the meaning of Sec.  1.469-1T(e)(3));
    (ii) Less than 20 percent of the gross income of the paragraph (c) 
undertaking is attributable to rental operations; or

[[Page 510]]

    (iii) Less than 20 percent of the gross income of the paragraph (c) 
undertaking is attributable to operations other than rental operations.
    (3) Rental operations. For purposes of this paragraph (d), a 
paragraph (c) undertaking's rental operations are determined under the 
following rules:
    (i) General rule. Except as otherwise provided in paragraph (d)(3) 
(ii) or (iii) of this section, a paragraph (c) undertaking's rental 
operations are all of the undertaking's business and rental operations 
that involve making tangible property available for use by customers and 
the provision of property and services in connection therewith.
    (ii) Real property provided for short-term use. A paragraph (c) 
undertaking's operations that involve making short-term real property 
available for use by customers and the provision of property and 
services in connection therewith shall not be treated as rental 
operations if such operations, considered as a separate activity, would 
not constitute a rental activity. An item of property is treated as 
short-term real property for this purpose if and only if such item is 
real property that the paragraph (c) undertaking makes available for use 
by customers and the average period of customer use (within the meaning 
of Sec.  1.469-1T(e)(3)(iii)) for all of the paragraph (c) undertaking's 
real property of the same type as such item is 30 days or less.
    (iii) Property made available to licensees. A paragraph (c) 
undertaking's operations that involve making tangible property available 
during defined business hours for nonexclusive use by various customers 
shall not be treated as rental operations. (See Sec.  1.469-
1T(e)(3)(ii)(E).)
    (4) Examples. The following examples illustrate the application of 
this paragraph (d). In each example that does not state otherwise, the 
taxpayer is an individual and the facts, analysis, and conclusions 
relate to a single taxable year.

    Example 1. (i) The taxpayer owns a building in which the taxpayer 
rents office space to tenants and operates a parking garage that is used 
by tenants and other persons. (Assume that, under paragraph (c)(1) of 
this section, the operations conducted in the building are treated as a 
single paragraph (c) undertaking.) The taxpayer's tenants typically 
occupy an office for at least one year, and the services provided to 
tenants are those customarily provided in office buildings. Some persons 
(including tenants) rent spaces in the parking garage on a monthly or 
annual basis. In general, however, spaces are rented on an hourly or 
daily basis, and the average period for which all customers (including 
tenants) use the parking garage is less than 24 hours. The paragraph (c) 
undertaking derives 75 percent of its gross income from office-space 
rentals and 25 percent of its gross income from the parking garage. The 
operations conducted in the building are not incidental to any other 
activity of the taxpayer (within the meaning of Sec.  1.469-
1T(e)(3)(vi)).
    (ii) The parking spaces are real property and the average period of 
customer use (within the meaning of Sec.  1.469-1T(e)(3)(iii)) for the 
parking spaces is 30 days or less. Thus, the parking spaces are short-
term real properties (within the meaning of paragraph (d)(3)(ii) of this 
section). (For this purpose, individual parking spaces that are rented 
on a monthly or annual basis are, nevertheless, short-term real 
properties because all the parking spaces are property of the same type, 
and the average rental period taking all parking spaces into account is 
30 days or less.) In addition, the parking-garage operations involve 
making short-term real properties available for use by customers and the 
provision of property and services in connection therewith.
    (iii) Paragraph (d)(3) (i) and (ii) of this section provides, in 
effect, that a paragraph (c) undertaking's operations that involve 
making short-term real properties available for use by customers and the 
provision of property and services in connection therewith are treated 
as rental operations if and only if the operations, considered as a 
separate activity, would constitute a rental activity (within the 
meaning of Sec.  1.469-1T(e)(3)). In this case, the parking-garage 
operations, if considered as a separate activity, would not constitute a 
rental activity because the average period of customer use for the 
parking spaces is seven days or less (see Sec.  1.469-1T(e)(3)(ii)(A)). 
Accordingly, the parking-garage operations are not treated as rental 
operations.
    (iv) The paragraph (c) undertaking's remaining operations involve 
the provision of tangible property (the office spaces) for use by 
customers and the provision of property and services in connection 
therewith. The average period of customer use for the office spaces 
exceeds 30 days. Thus, the office spaces are not short-term real 
properties, and the undertaking's operations involving the rental of 
office spaces are rental operations.
    (v) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations

[[Page 511]]

and its operations other than rental operations are treated as two 
separate undertakings. In this case, at least 20 percent of the 
paragraph (c) undertaking's gross income is attributable to rental 
operations (the office-space operations) and at least 20 percent is 
attributable to operations other than rental operations (the parking-
garage operations). Thus, the exceptions in paragraph (d)(2) (ii) and 
(iii) of this section do not apply. In addition, the average period of 
customer use for the office spaces exceeds 30 days, extraordinary 
personal services (within the meaning of Sec.  1.469-1T(e)(3)(v)) are 
not provided, and the rental of the office spaces is not treated as 
incidental to a nonrental activity under Sec.  1.469-1T(e)(3)(vi) 
(relating to incidental rentals that are not treated as a rental 
activity). Thus, the rental operations, if considered as a separate 
activity, would constitute a rental activity, and the exception in 
paragraph (d)(2)(i) of this section does not apply. Accordingly, the 
rental operations and the parking-garage operations are treated as two 
separate undertakings (the ``office-space undertaking'' and the 
``parking-garage undertaking'').
    (vi) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the office-space undertaking, if 
considered as a separate activity, would constitute a rental activity 
(see (v) above), and the parking-garage undertaking, if considered as a 
separate activity, would not constitute a rental activity (see (iii) 
above). Accordingly, the office-space undertaking is treated as a rental 
undertaking, and the parking-garage undertaking is not.
    Example 2. (i) The taxpayer owns a building in which the taxpayer 
rents apartments to tenants and operates a restaurant. (Assume that, 
under paragraph (c)(1) of this section, the operations conducted in the 
building are treated as a single paragraph (c) undertaking.) The 
taxpayer's tenants typically occupy an apartment for at least one year, 
and the services provided to tenants are those customarily provided in 
residential apartment buildings. The paragraph (c) undertaking derives 
85 percent of its gross income from apartment rentals and 15 percent of 
its gross income from the restaurant. The operations conducted in the 
building are not incidental to any other activity of the taxpayer 
(within the meaning of Sec.  1.469-1T(e)(3)(vi)).
    (ii) The operations with respect to apartments (the ``apartment 
operations'') involve the provision of tangible property (the 
apartments) for use by customers and the provision of property and 
services in connection therewith. In addition, the apartments are not 
short-term real properties (within the meaning of paragraph (d)(3)(ii) 
of this section) because the average period of customer use (within the 
meaning of Sec.  1.469-1T(e)(3)(iii)) for the apartments exceeds 30 
days. Accordingly, the apartment operations are rental operations 
(within the meaning of paragraph (d)(3) of this section). The restaurant 
operations do not involve the provision of tangible property for use by 
customers or the provision of property or services in connection 
therewith. Thus, the restaurant operations are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the exception in paragraph 
(d)(2)(iii) of this section applies because less than 20 percent of the 
paragraph (c) undertaking's gross income is attributable to operations 
other than rental operations (the restaurant operations). Accordingly, 
the rental operations and the restaurant operations are not treated as 
two separate undertakings under paragraph (d)(1)(i) of this section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the undertaking (determined after the 
application of paragraph (d)(1)(i) of this section) includes both the 
apartment operations and the restaurant operations, and the gross income 
of this undertaking represents amounts paid principally for the use of 
tangible property (the apartments). Moreover, the average period of 
customer use for the apartments exceeds 30 days, extraordinary personal 
services (within the meaning of Sec.  1.469-1T(e)(3)(v)) are not 
provided, and the rental of the apartments is not treated as incidental 
to a nonrental activity under Sec.  1.469-1T(e)(3)(vi) (relating to 
incidental rentals that are not treated as a rental activity). Thus, the 
undertaking, if considered as a separate activity, would constitute a 
rental activity. Accordingly, the undertaking is treated as a rental 
undertaking.
    Example 3. (i) The taxpayer owns a building in which the taxpayer 
rents hotel rooms, meeting rooms, and parking spaces to customers, rents 
space to various retailers, and operates a restaurant and health club. 
(Assume that, under paragraph (c)(1) of this section, the operations 
conducted in the building are treated as a single paragraph (c) 
undertaking.) Although some customers occupy hotel rooms for extended 
periods (including some customers who reside in the hotel), customers 
use hotel rooms for an average period of two days and meeting rooms for 
an average period of one day. The services provided to persons using the 
hotel rooms and

[[Page 512]]

meeting rooms are those customarily provided in hotels (including wake-
up calls, valet services, and delivery of food and beverages to rooms). 
Some customers rent spaces in the parking garage on a monthly or annual 
basis. In general, however, parking spaces are rented on an hourly or 
daily basis, and the average period for which customers use the parking 
garage is less than 24 hours. Retail tenants typically occupy their 
space for at least one year, and the services provided to retail tenants 
are those customarily provided in commercial buildings. The paragraph 
(c) undertaking derives 45 percent of its gross income from renting 
hotel rooms, meeting rooms, and parking spaces, 35 percent of its gross 
income from renting retail space, and 20 percent of its gross income 
from the restaurant and health club. The operations conducted in the 
building are not incidental to any other activity of the taxpayer 
(within the meaning of Sec.  1.469-1T(e)(3)(vi)).
    (ii) The parking spaces, hotel rooms, and meeting rooms are real 
property of three different types, but the average period of customer 
use (within the meaning of Sec.  1.469-1T (e)(3)(iii)) for property of 
each type is 30 days or less. Thus, the parking spaces, hotel rooms, and 
meeting rooms are short-term real properties. (For this purpose, 
individual parking spaces or hotel rooms that are rented for extended 
periods are, nevertheless, short-term real properties if the average 
rental period for all parking spaces is 30 days or less and the average 
rental period for all hotel rooms is 30 days or less.) In addition, the 
parking garage operations, the operations with respect to hotel rooms 
(the ``hotel-room operations''), and the operations with respect to 
meeting rooms (the ``meeting-room operations'') involve making short-
term real properties available for use by customers and the provision of 
property and services in connection therewith.
    (iii) Paragraph (d)(3) (i) and (ii) of this section provides, in 
effect, that a paragraph (c) undertaking's operations that involve 
making short-term real properties available for use by customers and the 
provision of property and services in connection therewith are treated 
as rental operations if and only if the operations, considered as a 
separate activity, would constitute a rental activity (within the 
meaning of Sec.  1.469-1T (e)(3)). In this case the parking-garage, 
hotel-room and meeting-room operations, if considered as separate 
activities, would not constitute rental activities because the average 
period of customer use for parking spaces, hotel rooms, and meeting 
rooms does not exceed seven days (see Sec.  1.469-1T (e)(3)(ii)(A)). 
Accordingly, the parking-garage, hotel-room, and meeting-room operations 
are not treated as rental operations.
    (iv) The operations with respect to retail space in the building 
(the ``retail-space operations'') involve the provision of tangible 
property (the retail spaces) for use by customers and the provision of 
property and services in connection therewith. In addition, the retail 
spaces are not short-term real properties (within the meaning of 
paragraph (d)(3)(ii) of this section) because the average period of 
customer use (within the meaning of Sec.  1.469-1T (e)(3)(iii)) for the 
retail spaces exceeds 30 days. Accordingly, the retail-space operations 
are rental operations.
    (v) The health-club operations involve making tangible property 
available for use by customers, but the property is customarily made 
available during defined business hours for nonexclusive use by various 
customers. Accordingly, the health-club operations are not rental 
operations (see paragraph (d)(3)(iii) of this seciton). The restaurant 
operations do not involve the provision of tangible property for use by 
customers or the provision of property or services in connection 
therewith. Accordingly, the restaurant operations also are not rental 
operations.
    (vi) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, at least 20 percent of the paragraph (c) 
undertaking's gross income is attributable to rental operations (35 
percent of the paragraph (c) undertaking's gross income is from the 
retail-space operations) and at least 20 percent is attributable to 
operations other than rental operations (45 percent from the hotel-room, 
meeting-room and parking-garage operations and 20 percent from the 
restaurant and health-club operations). Thus, the exceptions in 
paragraph (d)(2) (ii) and (iii) of this section do not apply. In 
addition, the average period of customer use for the retail space 
exceeds 30 days, extraordinary personal services (within the meaning of 
Sec.  1.469-1T (e)(3)(v)) are not provided, and the rental of the retail 
space is not treated as incidental to a nonrental activity under Sec.  
1.469-1T (e)(3)(vi) (relating to incidental rentals that are not treated 
as a rental activity). Thus, the retail-space operations, if considered 
as a separate activity, would constitute a rental activity, and the 
exception in paragraph (d)(2)(i) of this section does not apply. 
Accordingly, the retail-space operations are treated as an undertaking 
(the ``retail-space undertaking'') and all the other operations 
conducted in the building (i.e., renting hotel and meeting rooms and 
parking spaces and operating the restaurant and health club) are treated 
as a separate undertaking (the ``hotel undertaking'').
    (vii) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of

[[Page 513]]

this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the retail-space undertaking, if 
considered as a separate activity, would constitute a rental activity 
(see (iv) above). Accordingly, the retail-space undertaking is treated 
as a rental undertaking. The hotel undertaking, if considered as a 
separate activity, would not constitute a rental activity because all 
tangible property provided for the use of customers in the hotel 
undertaking is either property for which the average period of customer 
use is seven days or less (see Sec.  1.469-1T (e)(3)(ii)(A)) or property 
customarily made available during defined business hours for 
nonexclusive use by various customers (see Sec.  1.469-1T 
(e)(3)(ii)(E)). Accordingly, the hotel undertaking is not treated as a 
rental undertaking.
    Example 4. (i) A law partnership owns a ten-story building. The 
partnership uses eight floors of the building in its law practice and 
leases two floors to one or more tenants. (Assume that, under paragraph 
(c)(1) of this section, the operations conducted in the building are 
treated as a single paragraph (c) undertaking.) Tenants typically occupy 
space on the two rented floors for at least one year, and the services 
provided to tenants are those customarily provided in office buildings. 
The paragraph (c) undertaking derives 90 percent of its gross income 
from rendering legal services and 10 percent of its gross income from 
renting space. The operations conducted in the building are not 
incidental to any other activity of the taxpayer (within the meaning of 
Sec.  1.469-1T (e)(3)(vi)).
    (ii) The operations with respect to the office space leased to 
tenants (the ``office-space operations'') involve the provision of 
tangible property (the office space) for use by customers and the 
provision of property and services in connection therewith. In addition, 
the office spaces are not short-term real properties (within the meaning 
of paragraph (d)(3)(ii) of this section) because the average period of 
customer use (within the meaning of Sec.  1.469-1T(e)(3)(iii)) for the 
office space exceeds 30 days. Accordingly, the office-space operations 
are rental operations (within the meaning of paragraph (d)(3) of this 
section).
    (iii) The operations that involve the performance of legal services 
(the ``law-practice operations'') do not involve the provision of 
tangible property for use by customers or the provision of property or 
services in connection therewith. Accordingly, the law-practice 
operations are not rental operations.
    (iv) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the exception in paragraph 
(d)(2)(ii) of this section applies because less than 20 percent of the 
paragraph (c) undertaking's gross income is attributable to rental 
operations (the office-space operations). Accordingly, the law-practice 
operations and the office-space operations are not treated as two 
separate undertakings under paragraph (d)(1)(i) of this section.
    (v) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the undertaking (determined after the 
application of paragraph (d)(1)(i) of this section) includes both the 
law-practice operations and the office-space operations, and the gross 
income of this undertaking does not represent amounts paid principally 
for the use of tangible property. Thus, the undertaking, if considered 
as a separate activity, would not constitute a rental activity. 
Accordingly, the undertaking is not treated as a rental undertaking.
    Example 5. (i) The facts are the same as in Example 4, except that 
the building is owned by a separate partnership (the ``real estate 
partnership''), which leases eight floors of the building to the law 
partnership for use in its law practice and two floors to one or more 
other tenants. The law partnership and real estate partnership are owned 
by the same individuals in identical proportions.
    (ii) The operations conducted in the building are owned by two 
different persons (i.e., the law partnership and the real estate 
partnership). (See paragraph (c)(2)(v) of this section.) Thus, the 
operations conducted in the building are not treated as a single 
undertaking under paragraph (c)(1) of this section. Instead, each 
partnership's share of such operations is treated as a separate 
paragraph (c) undertaking (the ``law-practice undertaking'' and the 
``office-space undertaking'').
    (iii) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the office-space undertaking, if 
considered as a separate activity, would constitute a rental activity 
because all of the undertaking's gross income (including rents paid by 
the law partnership) represents amounts paid principally for the use of 
tangible property (the office space), the average period of customer use 
for the office space exceeds 30 days, extraordinary personal services 
(within the meaning of Sec.  1.469-1T(e)(3)(v)) are not provided, and 
the rental of the office space is not treated as incidental to a 
nonrental activity under Sec.  1.469-1T(e)(3)(vi) (relating to 
incidental

[[Page 514]]

rentals that are not treated as a rental activity). Accordingly, the 
office-space undertaking is treated as a rental undertaking. See, 
however, Sec.  1.469-2T(f)(6) (relating to certain rentals of property 
to a trade or business activity in which the taxpayer materially 
participates).
    (iv) The law-practice undertaking, if considered as a separate 
activity, would not constitute a rental activity because none of the 
undertaking's gross income represents amounts paid principally for the 
use of tangible property. Accordingly, the law-practice undertaking is 
not treated as a rental undertaking.
    Example 6. (i) The taxpayer owns a building in which the taxpayer 
operates a nursing home and a medical clinic. (Assume that, under 
paragraph (c)(1) of this section, the operations conducted in the 
building are treated as a single paragraph (c) undertaking.) The 
nursing-home operations consist of renting apartments in the nursing 
home to elderly and handicapped persons and providing medical care, 
meals, and social activities. (Assume that these services are 
extraordinary personal services (within the meaning of Sec.  1.469-
1T(e)(3)(v)). The medical clinic provides medical care to nursing-home 
residents and other individuals. Nursing-home residents typically occupy 
an apartment for at least one year. The paragraph (c) undertaking 
derives 55 percent of its gross income from nursing-home operations 
(including the provision of medical services to nursing-home residents) 
and 45 percent of its gross income from medical-clinic operations. The 
operations conducted in the building are not incidental to any other 
activity of the taxpayer (within the meaning of Sec.  1.469-
1T(e)(3)(vi)).
    (ii) The paragraph (c) undertaking's nursing-home operations involve 
the provision of tangible property (the apartments) for use by customers 
and the provision of property and services in connection therewith. In 
addition, the apartments are not short-term real properties (within the 
meaning of paragraph (d)(3)(ii) of this section) because the average 
period of customer use (within the meaning of Sec.  1.469-1T(e)(3)(iii)) 
for the apartments exceeds 30 days. Accordingly, the nursing-home 
operations are rental operations (within the meaning of paragraph (d)(3) 
of this section). The medical-clinic operations do not involve the 
provision of tangible property for use by customers or the provision of 
property or services in connection therewith. Thus, the medical-clinic 
operations are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the nursing-home operations, if 
considered as a separate activity, would not constitute a rental 
activity because extraordinary personal services are provided in 
connection with making nursing-home apartments available for use by 
customers (see Sec.  1.469-T(e)(3)(ii)(C)). Thus, the exception in 
paragraph (d)(2)(i) of this section applies, and the nursing-home 
operations and the medical-clinic operations are not treated as two 
separate undertakings under paragraph (d)(1)(i) of this section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the nursing-home operations, if 
considered as a separate activity, would not constitute a rental 
activity (see (iii) above). Thus, an undertaking that includes no rental 
operations other than the nursing-home operations would not, if 
considered as a separate activity, constitute a rental activity. 
Accordingly, the undertaking is not treated as a rental undertaking.
    Example 7. (i) The taxpayer rents and sells videocassettes. (Assumes 
that, under paragraph (c)(1) of this section, the videocassette 
operations are treated as a single paragraph (c) undertaking.) Renters 
of videocassettes typically keep the videocassettes for one or two days, 
and do not receive any other property or services in connection with 
videocassette rentals. The paragraph (c) undertaking derives 70 percent 
of its gross income from renting videocassettes and 30 percent of its 
gross income from selling videocassettes. The videocassette operations 
are not incidental to any other activity of the taxpayer (within the 
meaning of Sec.  1.469-1T(e)(3)(vi)).
    (ii) The rental of videocassettes involves the provision of tangible 
property (the videocassettes) for use by customers. In addition, the 
special rules for short-term real properties contained in paragraph 
(d)(3)(ii) of this section do not apply in this case because the 
videocassettes are not real property. Thus, the operations that involve 
videocassette rentals are rental operations (within the meaning of 
paragraph (d)(3) of this section). The sale of videocassettes does not 
involve the provision of tangible property for use by customers or the 
provision of property or services in connection therewith. Thus, the 
operations that involve videocassette sales are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the rental operations, if 
considered as a separate activity, would not constitute a rental 
activity because the average period of customer use for rented 
videocassettes does not exceed seven

[[Page 515]]

days (see Sec.  1.469-1T(e)(3)(ii)(A)). Accordingly, the exception in 
paragraph (d)(2)(i) of this section applies, and the videocassette-
rental operations and videocassette-sales operations are not treated as 
two separate undertakings under paragraph (d)(1)(i) of this section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the videocassette-rental operations, if 
considered as a separate activity, would not constitute a rental 
activity (see (iii) above). Thus, an undertaking that includes no rental 
operations other than the videocassette-rental operations would not, if 
considered as a separate activity, constitute a rental activity. 
Accordingly, the undertaking is not treated as a rental undertaking.
    Example 8. (i) The taxpayer owns a building in which the taxpayer 
sells, leases, and services automobiles. (Assume that, under paragraph 
(c)(1) of this section, the operations conducted in the building are 
treated as a single paragraph (c) undertaking.) The minimum lease term 
for any leased automobile is 31 days, and the services provided to 
lessees (including periodic oil changes, lubrication, and routine 
services and repairs) are those customarily provided in long-term 
automobile leases. The paragraph (c) undertaking derives 75 percent of 
its gross income from selling automobiles, 15 percent of its gross 
income from servicing automobiles other than leased automobiles, and 10 
percent of its gross income from leasing automobiles. The taxpayer's 
automobile operations are not incidental to any other activity of the 
taxpayer (within the meaning of Sec.  1.469-1T(e)(3)(vi)).
    (ii) The paragraph (c) undertaking's automobile-leasing operations 
involve the provision of tangible property (the automobiles) for use by 
customers and the provision of services in connection therewith. In 
addition, the special rules for short-term real properties contained in 
paragraph (d)(3)(ii) of this section do not apply in this case because 
the automobiles are not real property. Accordingly, the automobile-
leasing operations are rental operations (within the meaning of 
paragraph (d)(3) of this section). The paragraph (c) undertaking's 
automobile-sales operations and servicing operations for automobiles 
other than leased automobiles (the ``selling-and-servicing operations'') 
do not involve the provision of tangible property for use by customers 
or the provision of property or services in connection therewith. Thus, 
the selling-and-servicing operations are not rental operations.
    (iii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, however, the exception in paragraph 
(d)(2)(ii) of this section applies because less than 20 percent of the 
paragraph (c) undertaking's gross income is attributable to rental 
operations (the ``automobile-leasing operations''). Accordingly, the 
rental operations and the selling-and-servicing operations are not 
treated as two separate undertakings under paragraph (d)(1)(i) of this 
section.
    (iv) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the undertaking (determined after the 
application of paragraph (d)(1)(i) of this section) includes both the 
selling-and-servicing operations and the automobile-leasing operations, 
and the gross income of the undertaking does not represent amounts paid 
principally for the use of tangible property. Thus, the undertaking, if 
considered as a separate activity, would not constitute a rental 
activity. Accordingly, the undertaking is not treated as a rental 
undertaking.
    Example 9. (i) The facts are the same as in Example 8, except that 
the paragraph (c) undertaking derives 60 percent of its gross income 
from selling automobiles, 15 percent of its gross income from servicing 
automobiles other than leased automobiles, and 25 percent of its gross 
income from leasing automobiles.
    (ii) Paragraph (d)(1)(i) of this section provides, with certain 
exceptions, that a paragraph (c) undertaking's rental operations and its 
operations other than rental operations are treated as two separate 
undertakings. In this case, more than 20 percent of the paragraph (c) 
undertaking's gross income is attributable to rental operations (the 
automobile-leasing operations), and more than 20 percent is attributable 
to operations other than rental operations (the selling-and-servicing 
operations). Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of 
this section do not apply. In addition, the average period of customer 
use for leased automobiles exceeds 30 days, extraordinary personal 
services (within the meaning of Sec.  1.469-1T(e)(3)(v)) are not 
provided, and the leasing of the automobiles is not treated as 
incidental to a nonrental activity under Sec.  1.469-1T(e)(3)(vi) 
(relating to incidental rentals that are not treated as a rental 
activity). Thus, the leasing operations, if considered as a separate 
activity, would constitute a rental activity, and the exception in 
paragraph (d)(2)(i) of this section does not apply. Accordingly, the 
rental operations and the selling-and-servicing operations are treated 
as

[[Page 516]]

two separate undertakings (the ``automobile-leasing undertaking'' and 
the ``automobile selling-and-servicing undertaking'').
    (iii) Paragraph (d)(1)(iii) of this section provides that an 
undertaking (determined after the application of paragraph (d)(1)(i) of 
this section) is treated as a rental undertaking if and only if the 
undertaking, considered as a separate activity, would constitute a 
rental activity. In this case, the automobile-leasing undertaking would, 
if considered as a separate activity, constitute a rental activity, and 
the automobile selling-and-servicing undertaking would not, if 
considered as a separate activity, constitute a rental activity (see 
Example 8 and (ii) above). Accordingly, the automobile-leasing 
undertaking is treated as a rental undertaking, and the automobile 
selling-and-servicing undertaking is not.

    (e) Special rules for certain oil and gas operations--(1) Wells 
treated as nonpassive under Sec.  1.469-1T(e)(4)(i). An oil or gas well 
shall be treated as an undertaking that is separate from other 
undertakings in determining the activities of a taxpayer for a taxable 
year if the following conditions are satisfied:
    (i) The well is drilled or operated pursuant to a working interest 
(within the meaning of Sec.  1.469-1T(e)(4)(iv)) and at any time during 
such taxable year the taxpayer holds such working interest either--
    (A) Directly; or
    (B) Through an entity that does not limit the liability of the 
taxpayer with respect to the drilling or operation of such well pursuant 
to such working interest; and
    (ii) The taxpayer would not be treated as materially participating 
(within the meaning of Sec.  1.469-5T) for the taxable year in the 
activity in which such well would be included if the taxpayer's 
activities were determined without regard to this paragraph (e).
    (2) Business and rental operations that constitute an undertaking. 
In any case in which an oil or gas well is treated under this paragraph 
(e) as an undertaking that is separate from other undertakings, the 
business and rental operations that constitute such undertaking are the 
business and rental operations that are attributable to such well.
    (3) Examples. The following examples illustrate the application of 
this paragraph (e). In each example, the taxpayer is an individual whose 
taxable year is the calendar year.

    Example 1. During 1989, A directly owns an undivided interest in a 
working interest (within the meaning of Sec.  1.469-1T(e)(4)(iv)) in two 
oil wells. A does not participate in the activity in which the wells 
would be included if A's activities were determined without regard to 
this paragraph (e). Under paragraph (e)(1) of this section, each well is 
treated as a separate undertaking in determining A's activities for 1989 
because A holds the working interest directly and would not be treated 
as materially participating for 1989 in the activity in which the wells 
would be included if A's activities were determined without regard to 
this paragraph (e). The aggregation rules in paragraph (f) of this 
section do not apply to these undertakings (see paragraph (f)(1)(ii)(B) 
of this section). Thus, each of the undertakings is treated as a 
separate activity under paragraph (b)(1) of this section. The result is 
the same even if A has net income from one or both wells for 1989 and 
even if the wells would otherwise be treated as part of the same 
undertaking under paragraph (c) of this section. The result would also 
be the same if A held the working interest through an entity, such as a 
general partnership, that does not limit A's liability with respect to 
the drilling or operation of the wells pursuant to the working interest.
    Example 2. (i) During 1989, B is a general partner in a partnership 
that owns a working interest (within the meaning of Sec.  1.469-
1T(e)(4)(iv)) in an oil well. B does not own any interest in the well 
other than through the partnership. At the end of 1989, however, B's 
partnership interest is converted into a limited partnership interest, 
and during 1990 B holds the working interest only as a limited partner. 
B does not participate in the activity in which the well would be 
included if B's activities were determined without regard to this 
paragraph (e).
    (ii) Under paragraph (e)(1) of this section, the well is treated as 
a separate undertaking in determining B's activities for 1989 because B 
holds the working interest during 1989 through an entity that does not 
limit B's liability with respect to the drilling or operation of the 
well pursuant to the working interest, and B would not be treated as 
materially participating for 1989 in the activity in which the well 
would be included if B's activities were determined without regard to 
this paragraph (e). Throughout 1990, however, B's liability with respect 
to the drilling and operation of the well is limited by the entity 
through which B holds the working interest (i.e., the limited 
partnership). Accordingly, paragraph (e)(1) of this section does not 
apply to the well in 1990, and the well may be included under paragraph 
(c) of this section in an undertaking that includes other operations.

[[Page 517]]

    Example 3. The facts are the same as in Example 2, except that B's 
partnership interest is converted into a limited partnership interest at 
the end of November 1989. An oil or gas well may be treated as a 
separate undertaking under paragraph (e)(1) of this section if at any 
time during the taxable year the taxpayer holds a working interest in 
the well directly or through an entity that does not limit the 
taxpayer's liability with respect to the drilling or operation of the 
well pursuant to the working interest (see Sec.  1.469-1T(e)(4)(i)). 
Thus, although B's liability with respect to the drilling and operation 
of the well is limited during December 1989, the result in both 1989 and 
1990 is the same as in Example 2. In 1989, however, disqualified 
deductions and a ratable portion of the gross income from the well may 
be treated under Sec.  1.469-1T(e)(4)(ii) as passive activity deductions 
and passive activity gross income, respectively.

    (f) Certain trade or business undertakings treated as part of the 
same activity--(1) Applicability--(i) In general. This paragraph (f) 
applies to a taxpayer's interests in trade or business undertakings 
(within the meaning of paragraph (f)(1)(ii) of this section).
    (ii) Trade or business undertaking. For purposes of this paragraph 
(f), the term ``trade or business undertaking'' means any undertaking in 
which a taxpayer has an interest, other than--
    (A) A rental undertaking (within the meaning of paragraph (d) of 
this section);
    (B) An oil or gas well treated as an undertaking that is separate 
from other undertakings under paragraph (e) of this section; or
    (C) A professional service undertaking (within the meaning of 
paragraph (h) of this section).
    (2) Treatment as part of the same activity. A taxpayer's interests 
in two or more trade or business undertakings that are similar (within 
the meaning of paragraph (f)(4) of this section) and controlled by the 
same interests (within the meaning of paragraph (j) of this section) 
shall be treated as part of the same activity of the taxpayer for any 
taxable year in which the taxpayer--
    (i) Owns interests in each such undertaking through the same 
passthrough entity;
    (ii) Owns a direct or substantial indirect interest (within the 
meaning of paragraph (f)(3) of this section) in each such undertaking; 
or
    (iii) Materially or significantly participates (within the meaning 
of Sec.  1.469-5T) in the activity that would result if such 
undertakings were treated as part of the same activity.
    (3) Substantial indirect interest--(i) In general. For purposes of 
this paragraph (f), a taxpayer owns a substantial indirect interest in 
an undertaking for a taxable year if at any time during such taxable 
year the taxpayer's ownership percentage (determined in accordance with 
paragraph (j)(3) of this section) in a passthrough entity that directly 
owns such undertaking exceeds ten percent.
    (ii) Coordination rule. A taxpayer shall be treated for purposes of 
this paragraph (f) as owning a substantial indirect interest in each of 
two or more undertakings for any taxable year in which--
    (A) Such undertakings are treated as part of the same activity of 
the taxpayer under paragraph (f)(2)(i) of this section; and
    (B) The taxpayer owns a substantial indirect interest (within the 
meaning of paragraph (f)(3)(i) of this section) in any such undertaking.
    (4) Similar undertakings--(i) In general. Except as provided in 
paragraph (f)(4)(iii) of this section, two undertakings are similar for 
purposes of this paragraph (f) if and only if--
    (A) There are predominant operations in each such undertaking; and
    (B) The predominant operations of both undertakings are in the same 
line of business.
    (ii) Predominant operations. For purposes of paragraph (f)(4)(i)(A) 
of this section, there are predominant operations in an undertaking if 
more than 50 percent of the undertaking's gross income is attributable 
to operations in a single line of business.
    (iii) Vertically-integrated undertakings. If an undertaking (the 
``supplier undertaking'') provides property or services to other 
undertakings (the ``recipient undertakings''), the following rules apply 
for purposes of this paragraph (f):
    (A) Supplier undertaking similar to recipient undertaking. If the 
supplier undertaking predominantly involves the provision of property 
and services to a recipient undertaking that is controlled by the same 
interests (within

[[Page 518]]

the meaning of paragraph (j) of this section), the supplier undertaking 
shall be treated as similar to the recipient undertaking. For purposes 
of applying the preceding sentence--
    (1) If a supplier undertaking and two or more recipient undertakings 
that are similar (within the meaning of paragraph (f)(4)(i) of this 
section) are controlled by the same interests, such recipient 
undertakings shall be treated as a single undertaking; and
    (2) A supplier undertaking predominantly involves the provision of 
property and services to a recipient undertaking for any taxable year in 
which such recipient undertaking obtains more than 50 percent (by value) 
of all property and services provided by the supplier undertaking.
    (B) Recipient undertaking similar to supplier undertaking. If the 
supplier undertaking is the predominant provider of property and 
services to a recipient undertaking that is controlled by the same 
interests (within the meaning of paragraph (j) of this section), the 
recipient undertaking shall be treated, except as otherwise provided in 
paragraph (f)(4)(iii)(C) of this section, as similar to the supplier 
undertaking. For purposes of the preceding sentence, a supplier 
undertaking is the predominant provider of property and services to a 
recipient undertaking for any taxable year in which the supplier 
undertaking provides more than 50 percent (by value) of all property and 
services obtained by the recipient undertaking.
    (C) Coordination rules. (1) Paragraph (f)(4)(iii)(B) of this section 
does not apply if, under paragraph (f)(4)(iii)(A) of this section--
    (i) The supplier undertaking is treated as an undertaking that is 
similar to any recipient undertaking;
    (ii) The recipient undertaking is treated as a supplier undertaking 
that is similar to another recipient undertaking; or
    (iii) Another supplier undertaking is treated as an undertaking that 
is similar to the recipient undertaking.
    (2) If paragraph (f)(4)(iii)(A) of this section applies to a 
supplier undertaking, the supplier undertaking shall be treated as 
similar to undertakings that are similar to the recipient undertaking 
and shall not otherwise be treated as similar to undertakings to which 
the supplier undertaking would be similar without regard to paragraph 
(f)(4)(iii) of this section.
    (3) If paragraph (f)(4)(iii)(B) of this section applies to a 
recipient undertaking, the recipient undertaking shall be treated as 
similar to undertakings that are similar to the supplier undertaking and 
shall not otherwise be treated as similar to undertakings to which the 
recipient undertaking would be similar without regard to paragraph 
(f)(4)(iii) of this section.
    (iv) Lines of business. The Commissioner shall establish, by revenue 
procedure, lines of business for purposes of this paragraph (f)(4). 
Business and rental operations that are not included in the lines of 
business established by the Commissioner shall nonetheless be included 
in a line of business for purposes of this paragraph (f)(4). Such 
operations shall be included in a single line of business or in multiple 
lines of business on a basis that reasonably reflects--
    (A) Similarities and differences in the property or services 
provided pursuant to such operations and in the markets to which such 
property or services are offered; and
    (B) The treatment within the lines of business established by the 
Commissioner of operations that are comparable in their similarities and 
differences.
    (5) Examples. The following examples illustrate the application of 
this paragraph (f). In each example that does not state otherwise, the 
taxpayer is an individual and the facts, analysis, and conclusions 
relate to a single taxable year.

    Example 1. (i) The taxpayer is a partner in partnerships A, B, C, 
and D and owns a five-percent interest in each partnership. Each 
partnership owns a single undertaking (undertakings A, B, C, and D), and 
the undertakings are trade or business undertakings (within the meaning 
of paragraph (f)(1)(ii) of this section) that are controlled by the same 
interests (within the meaning of paragraph (j) of this section). In 
addition, undertakings A, B, and D are similar (within the meaning of 
paragraph (f)(4) of this section). The taxpayer is not related to any of 
the other partners, and does not participate in any of the undertakings.
    (ii) In general, each undertaking in which a taxpayer owns an 
interest is treated as a

[[Page 519]]

single activity that is separate from other activities of the taxpayer 
(see paragraph (b)(1) of this section). This paragraph (f) provides 
aggregation rules for trade or business undertakings that are similar 
and controlled by the same interests. These aggregation rules do not 
apply, however, unless the taxpayer owns interests in the undertakings 
through the same passthrough entity, owns direct or substantial indirect 
interests in the undertakings, or materially or significantly 
participates in the undertakings. In this case, the taxpayer does not 
satisfy any of these conditions, and the aggregation rules in this 
paragraph (f) do not apply. Accordingly, except as otherwise provided in 
paragraph (g) of this section (relating to an aggregation rule for 
integrated businesses), undertakings A, B, C, and D are treated as 
separate activities of the taxpayer under paragraph (b)(1) of this 
section.
    Example 2. (i) The facts are the same as in Example 1, except that 
the taxpayer owns a 25-percent interest in partnership A, a 15-percent 
interest in partnership B, and a 40-percent interest in partnership C.
    (ii) Paragraph (f)(2)(ii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns a direct or substantial indirect interest in each such 
undertaking. In this case, the taxpayer owns more than ten percent of 
partnerships A, B, and C, and these partnerships directly own 
undertakings A, B, and C. Thus, the taxpayer owns a substantial indirect 
interest in undertakings A, B, and C (see paragraph (f)(3)(i) of this 
section). Of these undertakings, only undertakings A and B are both 
similar and controlled by the same interests. Accordingly, the 
taxpayer's interests in undertakings A and B are treated as part of the 
same activity. As in Example 1, the aggregation rules in this paragraph 
(f) do not apply to undertakings C and D, and except as otherwise 
provided in paragraph (g) of this section, undertakings C and D are 
treated as separate activities.
    Example 3. (i) The facts are the same as in Example 1, except that 
the taxpayer participates (within the meaning of Sec.  1.469-5T(f)) for 
60 hours in undertaking A and for 60 hours in undertaking B.
    (ii) Paragraph (f)(2)(iii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer materially or significantly participates (within the 
meaning of Sec.  1.469-5T) in the activity that would result from the 
treatment of similar, commonly-controlled undertakings as part of the 
same activity. In this case, the activity that would result from 
treating the similar, commonly-controlled undertakings as part of the 
same activity consists of undertakings A, B, and D, and the taxpayer 
participates for 120 hours in the activity that results from this 
treatment. Accordingly, undertakings A, B, and D are treated as part of 
the same activity because the taxpayer significantly participates 
(within the meaning of Sec.  1.469-5T(c)(2)) in the activity that 
results from this treatment. The result is the same whether the taxpayer 
participates in one, two, or all three of the similar, commonly-
controlled undertakings, so long as the taxpayer's aggregate 
participation in undertakings A, B, and D exceeds 100 hours. As in 
Example 1, the aggregation rules in this paragraph (f) do not apply to 
undertaking C, and except as otherwise provided in paragraph (g) of this 
section, undertaking C is treated as a separate activity.
    Example 4. (i) The taxpayer owns a 5-percent interest in partnership 
A. Partnership A owns interests in partnerships B and C, each of which 
owns a single undertaking (undertakings B and C). In addition, the 
taxpayer is a partner in partnerships C and D and directly owns a 15-
percent interest in each partnership. Partnership D also owns a single 
undertaking (undertaking D). Undertakings B, C, and D are trade or 
business undertakings (within the meaning of paragraph (f)(1)(ii) of 
this section) that are similar (within the meaning of paragraph (f)(4) 
of this section) and controlled by the same interests (within the 
meaning of paragraph (j) of this section). The taxpayer does not 
participate in undertaking B, C, or D.
    (ii) Paragraph (f)(2)(i) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns interests in the undertakings through the same 
passthrough entity. In this case, the taxpayer owns interests in 
undertakings B and C through partnership A. Thus, the taxpayer's 
interests in undertakings B and C are treated as part of the same 
activity.
    (iii) Paragraph (f)(2)(ii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns a direct or substantial indirect interest in each such 
undertaking. In this case, the taxpayer owns more than ten percent of 
partnerships C and D, and these partnerships directly own undertakings C 
and D. Thus, the taxpayer owns a substantial indirect interest in 
undertakings C and D (see paragraph (f)(3)(i) of this section).
    (iv) The coordination rule in paragraph (f)(3)(ii) of this section 
applies to undertakings B and C because they are treated as part of the 
same activity under paragraph (f)(2)(i) of this section, and the 
taxpayer owns a substantial indirect interest in undertaking C. Under 
the coordination rule,

[[Page 520]]

the taxpayer is treated as owning a substantial indirect interest in 
undertaking B as well as undertaking C. Accordingly, the taxpayer's 
interests in undertakings B, C, and D are treated as part of the same 
activity.
    Example 5. (i) Undertakings A, B, C, and D are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section), each of which involves the operation of a department store, 
restaurants, and movie theaters. The following table shows, for each 
undertaking, the percentages of gross income attributable to the various 
operations of the undertaking.

------------------------------------------------------------------------
                                       Department                 Movie
                                          store    Restaurants  Theaters
------------------------------------------------------------------------
Undertaking A........................        70%         20%         10%
Undertaking B........................        60%         20%         20%
Undertaking C........................        35%         35%         30%
Undertaking D........................        35%         10%         55%
------------------------------------------------------------------------

    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if and only 
if there are predominant operations in each undertaking and the 
predominant operations of the two undertakings are in the same line of 
business. (Assume that the applicable revenue procedure provides that 
``general merchandise stores,'' ``eating and drinking places,'' and 
``motion picture services'' are three separate lines of business.)
    (iii) Undertaking A and undertaking B each derives more than 50 
percent of its gross income from department-store operations, which are 
in the general-merchandise-store line of business. Thus, there are 
predominant operations in undertaking A and undertaking B, and the 
predominant operations of the two undertakings are in the same line of 
business. Accordingly, undertakings A and B are similar.
    (iv) Undertaking C does not derive more than 50 percent of its gross 
income from operations in any single line of business. Thus, there are 
no predominant operations in undertaking C, and undertaking C is not 
similar to any of the other undertakings.
    (v) Undertaking D derives more than 50 percent of its gross income 
from movie-theater operations, which are in the motion-picture-services 
line of business. Thus, there are predominant operations in undertaking 
D. The predominant operations of undertaking D, however, are not in the 
same line of business as those of undertakings A and B. Accordingly, 
undertaking D is not similar to undertakings A and B.
    Example 6. (i) Undertakings A and B are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) that derive all of their gross income from the sale of 
automobiles. Undertakings C and D derive all of their gross income from 
the rental of automobiles. Undertaking C is not a rental undertaking 
(within the meaning of paragraph (d)(1)(iii) of this section) because 
the average period of customer use (within the meaning of Sec.  1.469-
1T(e)(3)(iii)) for its automobiles does not exceed seven days (see Sec.  
1.469-1T(e)(3)(ii)(A)). Undertaking D, on the other hand, leases 
automobiles for periods of one year or more and is a rental undertaking.
    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if and only 
if there are predominant operations in each undertaking and the 
predominant operations of the two undertakings are in the same line of 
business. (Assume that the applicable revenue procedure provides that 
(a) ``automotive dealers and service stations'' (automotive retail) and 
(b) ``auto repair, services (including rentals), and parking'' 
(automotive services) are two separate lines of business.)
    (iii) Undertakings A and B both derive more than 50 percent of their 
gross income from operations in the automotive-retail line of business 
(the automobile-sales operations). Similarly, undertakings C and D both 
derive more than 50 percent of their gross income from operations in the 
automotive-services line of business (the automobile-rental operations). 
Thus, there are predominant operations in each undertaking, the 
predominant operations of undertakings A and B are in the same line of 
business, and the predominant operations of undertakings C and D are in 
the same line of business. Accordingly, undertakings A and B are 
similar, undertakings C and D are similar, and undertakings A and B are 
not similar to undertakings C and D.
    (iv) Paragraph (f)(1) of this section provides that this paragraph 
(f) applies only to trade or business undertakings and that a rental 
undertaking is not a trade or business undertaking. Accordingly, this 
paragraph (f) does not apply to undertaking D, and undertakings C and D, 
although similar, are not treated, under this paragraph (f), as part of 
the same activity.
    Example 7. (i) Undertakings A, B, and C are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) that involve real estate operations. Undertaking A derives all 
of its gross income from the development of real property, undertaking B 
derives all of its gross income from the management of real property and 
the performance of services as a leasing agent with respect to real 
property, and undertaking C derives all of its gross income from buying, 
selling, or arranging purchases and sales of real property. Undertaking 
D derives all of its gross income from the rental of residential 
apartments and is a rental undertaking (within the meaning of paragraph 
(d)(1)(iii) of this section).

[[Page 521]]

    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if there are 
predominant operations in each undertaking and the predominant 
operations of the two undertakings are in the same line of business. 
(Assume that the applicable revenue procedure provides that real estate 
development and services (including the development and management of 
real property, dealing in real property, and the performance of services 
as a leasing agent with respect to real property) is a single line of 
business (the ``real-estate'' line of business).)
    (iii) Undertakings A, B, and C all derive more than 50 percent of 
their gross income from operations in the real-estate line of business. 
Thus, there are predominant operations in undertakings A, B, and C, and 
the predominant operations of the three undertakings are in the same 
line of business. Accordingly, undertakings A, B, and C are similar.
    (iv) Undertaking D also derives more than 50 percent of its gross 
income from operations in the real-estate line of business. Thus, there 
are predominant operations in undertaking D, and the predominant 
operations of undertaking D are in the same line of business as those of 
undertakings A, B, and C. Paragraph (f)(1) of this section provides, 
however, that this paragraph (f) applies only to trade or business 
undertakings and that a rental undertaking is not a trade or business 
undertaking. Accordingly, this paragraph (f) does not apply to 
undertaking D, and undertaking D, although similar to undertakings A, B, 
and C, is not treated, under this paragraph (f), as part an activity 
that includes undertaking A, B, or C.
    Example 8. (i) Undertakings A and B are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section), both of which involve the provision of moving services. 
Undertaking A derives its gross income principally from local moves, and 
undertaking B derives its gross income principally from long-distance 
moves.
    (ii) Paragraph (f)(4)(i) of this section provides that two 
undertakings are similar for purposes of this paragraph (f) if there are 
predominant operations in each undertaking and the predominant 
operations of the two undertakings are in the same line of business. 
Under paragraph (f)(4)(iv) of this section, operations that are not in 
the lines of business established by the applicable revenue procedure 
are nonetheless included in a line of business. In addition, such 
operations are included in a single line of business or in multiple 
lines of business on a basis that reasonably reflects (a) similarities 
and differences in the property or services provided pursuant to such 
operations and in the markets to which such property or services are 
offered, and (b) the treatment within the lines of business established 
by the Commissioner of operations that are comparable in their 
similarities and differences. (Assume that the provision of moving 
services is not in any line of business established by the Commissioner 
and that within the lines of business established by the Commissioner 
services that differ only in the distance over which they are performed 
(e.g., local and long-distance telephone services) are generally treated 
as part of the same line of business.)
    (iii) Undertakings A and B provide the same types of services to 
similar customers, and the only significant difference in the services 
provided is the distance over which they are performed. Thus, treating 
local and long-distance moving services as a single line of business 
(the ``moving-services'' line of business) reasonably reflects the 
treatment within the lines of business established by the Commissioner 
of operations that are comparable in their similarities and differences.
    (iv) Each undertaking derives more than 50 percent of its gross 
income from operations in the moving-services line of business. Thus, 
there are predominant operations in each undertaking, and the 
predominant operations of the two undertakings are in the same line of 
business. Accordingly, undertakings A and B are similar.
    Example 9. (i) Undertakings A, B, C, D, and E are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) and are controlled by the same interests (within the meaning of 
paragraph (j) of this section). Undertakings A, B, and C derive all of 
their gross income from retail sales of dairy products, and undertakings 
D and E derive all of their gross income from the processing of dairy 
products. Undertakings D and E sell less than ten percent of their dairy 
products to undertakings A, B, and C, and sell the remainder to 
unrelated undertakings. Undertakings A, B, and C purchase less than ten 
percent of their inventory from undertakings D and E and purchase the 
remainder from unrelated undertakings.
    (ii) Paragraph (f)(4)(i) of this section provides that, except as 
provided in paragraph (f)(4)(iii) of this section, undertakings are 
similar for purposes of this paragraph (f) if and only if there are 
predominant operations in each undertaking and the predominant 
operations of the undertakings are in the same line of business. (Assume 
that the applicable revenue procedure provides that (a) ``food stores'' 
and (b) ``manufacturing--food and kindred products'' are two separate 
lines of business.)
    (iii) Undertakings A, B, and C all derive more than 50 percent of 
their gross income from operations in the food-store line of business 
(the dairy-sales operations). Thus,

[[Page 522]]

there are predominant operations in undertakings A, B, and C, and the 
predominant operations of the three undertakings are in the same line of 
business. Accordingly, undertakings A, B, and C are similar.
    (iv) Undertakings D and E both derive more than 50 percent of their 
gross income from operations in the food-manufacturing line of business 
(the dairy-processing operations). Thus, there are predominant 
operations in undertakings D and E, and the predominant operations of 
the two undertakings are in the same line of business. Accordingly, 
undertakings D and E are similar. The predominant operations of 
undertakings D and E are not in the same line of business as those of 
undertakings A, B, and C. Accordingly, undertakings D and E are not 
similar to undertakings A, B, and C.
    (v) Paragraph (f)(4)(iii) of this section provides rules under which 
certain undertakings whose operations are not in the same line of 
business nevertheless are similar to one another if one of the 
undertakings (the ``supplier undertaking'') provides property or 
services to the other undertaking (the ``recipient undertaking''), and 
the undertakings are controlled by the same interests. These rules 
apply, however, only if the supplier undertaking predominantly involves 
the provision of property and services to the recipient undertaking (see 
paragraph (f)(4)(iii)(A) of this section), or the supplier undertaking 
is the predominant provider of property and services to the recipient 
undertaking (see paragraph (f)(4)(iii)(B) of this section). In this 
case, undertakings D and E are supplier undertakings, and undertakings 
A, B, and C are recipient undertakings. Undertakings D and E, however, 
sell less than ten percent of their dairy products to undertakings A, B, 
and C and thus do not predominantly involve the provision of property 
and services to recipient undertakings. Similarly, undertakings D and E 
are not the predominant providers of property and services to 
undertakings A, B, and C. Thus, the rules for vertically-integrated 
undertakings in paragraph (f)(4)(iii) of this section do not apply in 
this case.
    Example 10. (i) The facts are the same as in Example 9, except that 
undertaking D sells 75 percent of its dairy products to undertakings A, 
B, and C.
    (ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier 
undertaking predominantly involves the provision of property to a 
recipient undertaking that is controlled by the same interests. 
Paragraph (f)(4)(iii)(A)(2) of this section provides that a supplier 
undertaking predominantly involves the provision of property to a 
recipient undertaking if the supplier undertaking provides more than 50 
percent of its property to such recipient undertaking. In addition, 
paragraph (f)(4)(iii)(A)(1) of this section provides that if a supplier 
undertaking and two or more similar recipient undertakings are 
controlled by the same interests, the recipient undertakings are treated 
as a single undertaking for purposes of applying paragraph 
(f)(4)(iii)(A) of this section. Undertakings D and E both provide dairy 
products to undertakings A, B, and C. Thus, for purposes of paragraph 
(f)(4)(iii) of this section, undertakings D and E are supplier 
undertakings and undertakings A, B, and C are recipient undertakings. 
Undertaking D predominantly involves the provision of property to 
undertakings A, B, and C. Moreover, undertakings A, B, and C are treated 
as a single undertaking under paragraph (f)(4)(iii)(A)(1) of this 
section because undertakings A, B, and C are similar to one another 
under paragraph (f)(4)(i) of this section, and undertakings A, B, C, and 
D are controlled by the same interests. Accordingly, paragraph 
(f)(4)(iii)(A) of this section applies to undertakings A, B, C, and D.
    (iii) If paragraph (f)(4)(iii)(A) of this section applies to 
supplier and recipient undertakings, the supplier undertaking is treated 
under paragraph (f)(4)(iii) (A) and (C)(2) of this section as an 
undertaking that is similar to the recipient undertakings and to 
undertakings to which the recipient undertakings are similar. 
Accordingly, undertaking D is similar, for purposes of this paragraph 
(f), to undertakings A, B, and C.
    (iv) Undertaking E does not predominantly involve the provision of 
property to undertakings A, B, and C, or to any other related 
undertakings. Thus, paragraph (f)(4)(iii)(A) of this section does not 
apply to undertaking E, and undertaking E is not similar to undertakings 
A, B, and C. Moreover, undertakings D and E are not similar because, 
under paragraph (f)(4)(iii)(C)(2) of this section, undertaking D is not 
similar to any undertaking that is not similar to undertakings A, B, and 
C.
    Example 11. (i) The facts are the same as in Example 10, except that 
75 percent of undertaking D's dairy products are sold to undertakings A 
and B, and none are sold to undertaking C.
    (ii) In this case, undertaking D is a supplier undertaking only with 
respect to undertakings A and B. Accordingly, paragraph (f)(4)(iii)(A) 
applies only to undertakings A, B, and D. As in Example 10, undertaking 
D is similar to undertakings A and B, and is not similar to undertaking 
E. In addition, if paragraph (f)(4)(iii)(A) of this section applies to 
supplier and recipient undertakings, the supplier undertaking is treated 
under paragraph (f)(4)(iii)(C)(2) of this section as an undertaking that 
is similar to the recipient undertakings and undertakings to which the 
recipient undertakings are similar. Accordingly, even though undertaking 
D does not

[[Page 523]]

provide any property or services to undertaking C, undertaking D is 
similar to undertaking C because undertaking C is similar to 
undertakings A and B.
    Example 12. (i) The facts are the same as in Example 9, except that 
undertakings A and B purchase 80 percent of their inventory from 
undertaking D.
    (ii) Paragraph (f)(4)(iii)(B) of this section applies, except as 
provided in paragraph (f)(4)(iii)(C) of this section, if a supplier 
undertaking is the predominant provider of property to a recipient 
undertaking that is controlled by the same interests. Undertakings D and 
E both provide dairy products to undertakings A, B, and C. Thus, for 
purposes of paragraph (f)(4)(iii) of this section, undertakings D and E 
are supplier undertakings, and undertakings A, B, and C are recipient 
undertakings. In addition, undertaking D is the predominant provider of 
property and services to undertakings A and B, and undertakings A, B and 
D are controlled by the same interests. Thus, except as provided in 
paragraph (f)(4)(iii)(C) of this section, paragraph (f)(4)(iii)(B) of 
this section applies to undertakings A, B, and D.
    (iii) The coordination rules in paragraph (f)(4)(iii)(C)(1) of this 
section provide that paragraph (f)(4)(iii)(B) of this section does not 
apply in certain cases to which paragraph (f)(4)(iii)(A) of this section 
applies. These coordination rules would apply if undertaking D or E (or 
any other undertaking that is controlled by the interests that control 
undertakings A, B, and C) predominantly involved the provision of 
property and services to undertakings A, B, and C. The coordination 
rules in paragraph (f)(4)(iii)(C)(1) of this section would also apply if 
undertaking A, B, or D predominantly involved the provision of property 
or services to a recipient undertaking that is controlled by the same 
interests. Assume that these coordination rules do not apply in this 
case.
    (iv) If paragraph (f)(4)(iii)(B) of this section applies to supplier 
and recipient undertakings, the recipient undertakings are treated under 
paragraph (f)(4)(iii) (B) and (C)(3) of this section as undertakings 
that are similar to the supplier undertaking and to undertakings to 
which the supplier undertaking is similar. Accordingly, undertakings A 
and B are similar, for purposes of this paragraph (f), to undertaking D 
and, because undertakings D and E are similar, to undertaking E.
    (v) The principal providers of property and services to undertaking 
C are unrelated undertakings. Thus, paragraph (f)(4)(iii)(B) of this 
section does not apply to undertaking C, and undertaking C is not 
similar to undertakings D and E. Moreover, undertaking C is not similar 
to undertakings A and B because, under paragraph (f)(4)(iii)(C)(3) of 
this section, undertakings A and B are not similar to any undertaking 
that is not similar to undertaking D.
    Example 13. (i) Undertakings A through Z are trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) and are controlled by the same interests (within the meaning of 
paragraph (j) of this section). Undertaking A derives all of its gross 
income from the manufacture and sale of men's and women's clothing, 
undertaking B derives all of its gross income from sales of men's and 
women's clothing to retail stores, and undertakings C through Z derive 
all of their gross income from retail sales of men's and women's 
clothing. Undertaking A sells clothing exclusively to undertaking B. 
Undertaking B sells 75 percent of its clothing to undertakings C through 
Z, and sells the remainder to unrelated retail stores. Undertaking B 
purchases 80 percent of its inventory from undertaking A, and 
undertakings C through Z purchase 60 to 90 percent of their inventory 
from undertaking B.
    (ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier 
undertaking predominantly involves the provision of property to a 
recipient undertaking that is controlled by the same interests. In 
addition, paragraph (f)(4)(iii)(A)(1) of this section provides that if a 
supplier undertaking and two or more similar recipient undertakings are 
controlled by the same interests, the recipient undertaking are treated 
as a single undertaking for this purpose. Undertaking B provides men's 
and women's clothing to undertaking C through Z. Thus, for purposes of 
paragraph (f)(4)(iii) of this section, undertaking B is a supplier 
undertaking and undertakings C through Z are recipient undertakings. In 
addition, undertaking B predominantly involves the provision of property 
to undertakings C through Z, and undertakings C through Z are treated as 
a single undertaking for purposes of paragraph (f)(4)(iii)(A) of this 
section. Accordingly, paragraph (f)(4)(iii)(A) of this section applies 
to undertakings B and C through Z.
    (iii) If paragraph (f)(4)(iii)(A) of this section applies to 
supplier and recipient undertakings, the supplier undertaking is treated 
under paragraph (f)(4)(iii)(A) of this section as an undertaking that is 
similar to the recipient undertakings. Accordingly, undertaking B is 
similar, for purposes of this paragraph (f), to undertakings C through 
Z.
    (iv) Undertaking A provides men's and women's clothing to 
undertaking B. Thus, for purposes of paragraph (f)(4)(iii) of this 
section, undertaking A is a supplier undertaking and undertaking B is a 
recipient undertaking. In addition, undertaking A predominantly involves 
the provision of property to undertaking B, and undertakings A and B are 
controlled by the same interests. Accordingly, paragraph (f)(4)(iii)(A) 
of this section applies to undertakings A and B, and undertaking A is 
similar to undertaking B.

[[Page 524]]

    (v) If paragraph (f)(4)(iii)(A) of this section applies to supplier 
and recipient undertakings, the supplier undertaking is treated under 
paragraph (f)(4)(iii)(C)(2) of this section as an undertaking that is 
similar to undertakings to which the recipient undertakings are similar. 
Accordingly, undertaking A is also similar, for purposes of this 
paragraph (f), to undertakings C through Z.
    (vi) The coordination rule in paragraph (f)(4)(iii)(C)(1)(i) of this 
section provides that paragraph (f)(4)(iii)(B) of this section does not 
apply if, as described above, the supplier undertaking predominantly 
involves the provision of property to recipient undertakings and is 
treated under paragraph (f)(4)(iii)(A) of this section as an undertaking 
that is similar to such recipient undertakings. Accordingly, paragraph 
(f)(4)(iii)(B) of this section does not apply to undertakings B through 
Z, even though undertaking B is the predominant provider of property and 
services to undertakings C through Z, and undertakings B through Z are 
controlled by the same interests. For the same reason, paragraph 
(f)(4)(iii)(B) of this section does not apply to undertaking A and B. 
(Paragraph (f)(4)(iii)(B) of this section is also inapplicable to 
undertakings A and B because the coordination rule in paragraph 
(f)(4)(iii)(C)(1)(ii) of this section applies if the recipient 
undertaking (undertaking B) is itself a supplier undertaking that is 
treated under paragraph (f)(4)(iii)(A) of this section as an undertaking 
that is similar to its recipient undertakings (undertakings C through 
Z).)

    (g) Integrated businesses--(1) Applicability--(i) In general. This 
paragraph (g) applies to a taxpayer's interests in trade or business 
activities (within the meaning of paragraph (g)(1)(ii) of this section).
    (ii) Trade or business activity. For purposes of this paragraph (g), 
the term ``trade or business activity'' means any activity (determined 
without regard to this paragraph (g)) that consists of interests in one 
or more trade or business undertakings (within the meaning of paragraph 
(f)(1)(ii) of this section).
    (2) Treatment as a single activity. A taxpayer's interests in two or 
more trade or business activities shall be treated as a single activity 
if and only if--
    (i) The operations of such trade or business activities constitute a 
single integrated business, activities constitute a single integrated 
business; and
    (ii) Such activities are controlled by the same interests (within 
the meaning of paragraph (j) of this section).
    (3) Facts and circumstances test. In determining whether the 
operations of two or more trade or business activities constitute a 
single integrated business for purposes of this paragraph (g), all the 
facts and circumstances are taken into account, and the following 
factors are generally the most significant:
    (i) Whether such operations are conducted at the same location;
    (ii) The extent to which other persons conduct similar operations at 
one location;
    (iii) Whether such operations are treated as a unit in the primary 
accounting records reflecting the results of such operations;
    (iv) The extent to which other persons treat similar operations as a 
unit in the primary accounting records reflecting the results of such 
similar operations;
    (v) Whether such operations are owned by the same person (within the 
meaning of paragraph (c)(2)(v) of this section);
    (vi) The extent to which such operations involve products or 
services that are commonly provided together;
    (vii) The extent to which such operations serve the same customers;
    (viii) The extent to which the same personnel, facilities, or 
equipment are used to conduct such operations;
    (ix) The extent to which such operations are conducted in 
coordination with or reliance upon each other;
    (x) The extent to which the conduct of any such operations is 
incidental to the conduct of the remainder of such operations;
    (xi) The extent to which such operations depend on each other for 
their economic success; and
    (xii) Whether such operations are conducted under the same trade 
name.
    (4) Examples. The following examples illustrate the application of 
this paragraph (g). The facts, analysis, and conclusion in each example 
relate to a single taxable year, and the trade or business activities 
described in each example are controlled by the same interests (within 
the meaning of paragraph (j) of this section).


[[Page 525]]


    Example 1. (i) The taxpayer owns a number of department stores and 
auto-supply stores. Some of the taxpayer's department stores include 
auto-supply departments. In other cases, the taxpayer operates a 
department store and an auto-supply store at the same location (within 
the meaning of paragraph (c)(2)(iii) of this section), or at different 
locations from which the same group of customers can be served. In cases 
in which a department store and an auto-supply store are operated at the 
same location, the department-store operations are the predominant 
operations (within the meaning of paragraph (f)(4)(ii) of this section), 
and the undertaking that includes the stores is treated as a department-
store undertaking for purposes of paragraph (f) of this section. Under 
paragraph (f) of this section, the department-store undertakings are all 
treated as part of the same activity of the taxpayer (the ``department-
store activity''). Similarly, the auto-supply undertakings (i.e., the 
auto-supply stores that are not operated at a department-store location) 
are all treated as part of the same activity (the ``auto-supply 
activity''). (Assume that department-store undertakings and auto-supply 
undertakings are not similar and are not treated as part of the same 
activity under paragraph (f) of this section.)
    (ii) The department stores and auto-supply stores use a common trade 
name and coordinate their marketing activities (e.g., the stores 
advertise in the same catalog and the same newspaper supplements, honor 
the same credit cards (including credit cards issued by the department 
stores), and jointly conduct sales and other promotional activities). 
Although sales personnel generally work only in a particular store or in 
a particular department within a store, other employees (e.g., cashiers, 
janitorial and maintenance workers, and clerical staff) may work in or 
perform services for various stores, including both department and auto-
supply stores. In addition, the management of store operations is 
organized on a geographical basis, and managers above the level of the 
individual store generally supervise operations in both types of store. 
A central office provides payroll, financial, and other support services 
to all stores and establishes pricing and other business policies. Most 
inventory for both types of stores is acquired through a central 
purchasing department and inventory for all stores in an area is stored 
in a common warehouse.
    (iii) Based on the foregoing facts and circumstances, the operations 
of the department-store activity and the auto-supply activity constitute 
an integrated business. Paragraph (g)(3) of this section provides that 
the factors relevant to this determination include the conduct of 
department-store and auto-supply operations at the same location, the 
location of department and auto-supply stores at sites where the same 
group of customers can be served, the treatment of all such operations 
as a unit in the taxpayer's financial statements, the taxpayer's 
ownership and the common management of all such operations, the use of 
the same personnel, facilities, and equipment to conduct and support the 
operations, the use of a common trade name, and the coordination (as 
evidenced by the coordinated marketing activities) of department-store 
and auto-supply operations.
    (iv) Paragraph (g)(2) of this section provides that a taxpayer's 
interests in two or more trade or business activities (within the 
meaning of paragraph (g)(1)(ii) of this section) are treated as a single 
activity of the taxpayer if the operations of such activities constitute 
an integrated business and the activities are controlled by the same 
interests. The department-store activity and the auto-supply activity 
consist of trade or business undertakings and, thus, are trade or 
business activities. In addition, the activities are controlled by the 
same interests (the taxpayer), and the operations of the activities 
constitute an integrated business. Accordingly, the department-store 
activity and the auto-supply activity are treated as a single activity 
of the taxpayer.
    Example 2. (i) The taxpayer owns a number of stores that sell stereo 
equipment and a repair shop that services stereo equipment. Under 
paragraph (f) of this section, the stores are all treated as part of the 
same activity of the taxpayer (the ``store activity''). The repair shop 
does not sell stereo equipment, does not predominantly involve the 
provision of services to the taxpayer's stores, and is treated as a 
separate activity (the ``repair-shop activity''). (Assume that stereo-
sales undertakings and stereo-repair undertakings are not similar and 
are not treated as part of the same activity under paragraph (f) of this 
section.)
    (ii) The stores sell stereo equipment produced by manufacturers for 
which the stores are an authorized distributor. The repair shop's 
operations principally involve the servicing of stereo equipment 
produced by the same manufacturers. These operations include repairs on 
equipment under warranty for which reimbursement is received from the 
manufacturer and reconditioning of equipment taken as trade-ins by the 
taxpayer's stores. The majority of the operations, however, involve 
repairs that are performed for customers and are not covered by a 
warranty. The taxpayer's distribution agreements with manufacturers 
generally require the taxpayer to repair and service equipment produced 
by the manufacturer both during and after the warranty period. In some 
cases, the distribution agreements require that the taxpayer's repair 
facility meet the manufacturer's standards and provide for

[[Page 526]]

periodic inspections to ensure that these standards are met.
    (iii) The stores and the repair shop use a common trade name. Sales 
personnel generally work only in a particular store and stereo 
technicians work only in the repair shop. The stores and the repair shop 
are, however, managed from a central office, which supervises both store 
and repair-shop operations, provides payroll, financial, and other 
support services to the stores and the repair shop, and establishes 
pricing and other business policies. In addition, inventory for the 
stores and supplies for the repair shop are acquired through a central 
purchasing department and are stored in a single warehouse.
    (iv) Based on the foregoing facts and circumstances, the operations 
of the store activity and the repair-shop activity constitute an 
integrated business. Paragraph (g)(3) of this section provides that the 
factors relevant to this determination include the treatment of all such 
operations as a unit in the taxpayer's financial statements, the 
taxpayer's ownership and the common management of all such operations, 
the use of the same personnel and facilities to support the operations, 
the use of a common trade name, the extent to which the same customers 
patronize both the stores and the repair shop, the similarity of the 
products (i.e., stereo equipment) involved in both store and repair-shop 
operations, and the extent to which the provision of repair services 
contributes to the taxpayer's ability to obtain the stereo equipment 
sold in store operations.
    (v) Paragraph (g)(2) of this section provides that a taxpayer's 
interests in two or more trade or business activities (within the 
meaning of paragraph (g)(1)(ii) of this section) are treated as a single 
activity of the taxpayer if the operations of such activities constitute 
an integrated business and the activities are controlled by the same 
interests. The store activity and repair-shop activity consist of trade 
or business undertakings and thus are trade or business activities. In 
addition, the activities are controlled by the same interests (the 
taxpayer), and the operations of the activities constitute an integrated 
business. Accordingly, the store activity and the repair-shop activity 
are treated as a single activity of the taxpayer.
    Example 3. (i) The taxpayer owns interests in three partnerships. 
One partnership owns a television station, the second owns a 
professional sports franchise, and the third owns a motion-picture 
production company. The operations of the partnerships are treated as 
three separate undertakings. Although other persons own interests in the 
partnerships, all three undertakings are controlled (within the meaning 
of paragraph (j) of this section) by the taxpayer. The operations of the 
partnerships are treated as three separate activities (the ``television 
activity,'' the ``sports activity,'' and the ``motion-picture 
activity''). (Assume that the undertakings are not similar and are not 
treated as part of the same activity under paragraph (f) of this 
section.)
    (ii) Each partnership prepares financial statements that reflect 
only the results of that partnership's operations, and each of the 
activities is conducted under its own trade name. The taxpayer 
participates extensively in the management of each partnership and makes 
the major business decisions for all three partnerships. Each 
partnership, however, employs separate management and other personnel 
who conduct its operations on a day-to-day basis. The taxpayer generally 
arranges the partnerships' financing and often obtains loans for two, or 
all three, partnerships from the same source. Although the assets of one 
partnership are not used as security for loans to another partnership, 
the taxpayer's interest in a partnership may secure loans to the other 
partnerships. The television station broadcasts the sports franchise's 
games, and the motion-picture production company occasionally prepares 
programming for the television station. In addition, support staff of 
one partnership may, during periods of peak activity or in the case of 
emergency, be made available to another partnership on a temporary 
basis. There are no other significant transactions between the 
partnerships. Moreover, all transactions between the partnerships 
involve essentially the same terms as would be provided in transactions 
between unrelated persons.
    (iii) Based on the foregoing facts and circumstances, the television 
activity, the sports activity, and the motion-picture activity 
constitute three separate businesses. Paragraph (g)(3) of this section 
provides that the factors relevant to this determination include the 
treatment of the activities as separate units in the partnerships' 
financial statements, the use of a different trade name for each 
activity, the separate day-to-day management of the activities, and the 
limited extent to which the activities contribute to or depend on each 
other (as evidenced by the small number of significant transactions 
between the partnerships and the arm's length nature of those 
transactions). The taxpayer's participation in management and financing 
are taken into account in this determination, as are the transactions 
between the partnerships, but these factors do not of themselves support 
a determination that the activities constitute an integrated business.
    (iv) Paragraph (g)(2) of this section provides that a taxpayer's 
interests in two or more trade or business activities (within the 
meaning of paragraph (g)(1)(ii) of this section) are treated as a single 
activity of the taxpayer only if the operations of such activities 
constitute an integrated business

[[Page 527]]

and the activities are controlled by the same interests. In this case, 
the taxpayer's activities do not constitute an integrated business, and 
the aggregation rule in paragraph (g)(2) of this section does not apply. 
Accordingly, the television activity, the sports activity, and the 
motion-picture activity are treated as three separate activities of the 
taxpayer.

    (h) Certain professional service undertakings treated as a single 
activity--(1) Applicability--(i) In general. This paragraph (h) applies 
to a taxpayer's interests in professional service undertakings (within 
the meaning of paragraph (h)(1)(ii) of this section).
    (ii) Professional service undertaking. For purposes of this 
paragraph (h), an undertaking is treated as a professional service 
undertaking for any taxable year in which the undertaking derives more 
than 50 percent of its gross income from the provision of services that 
are treated, for purposes of section 448 (d)(2)(A) and the regulations 
thereunder, as services performed in the fields of health, law, 
engineering, architecture, accounting, actuarial science, performing 
arts, or consulting.
    (2) Treatment as a single activity--(i) Undertakings controlled by 
the same interest. A taxpayer's interests in two or more professional 
service undertakings that are controlled by the same interests (within 
the meaning of paragraph (j) of this section) shall be treated as part 
of the same activity of the taxpayer.
    (ii) Undertakings involving significant similar or significant 
related services. A taxpayer's interests in two or more professional 
service undertakings that involve the provision of significant similar 
services or significant related services shall be treated as part of the 
same activity of the taxpayer.
    (iii) Coordination rule. (A) Except as provided in paragraph 
(h)(2)(iii)(B) of this section, a taxpayer's interests in two or more 
undertakings (the ``original undertakings'') that are treated as part of 
the same activity of the taxpayer under the provisions of paragraph 
(h)(2) (i) or (ii) of this section shall be treated as interests in a 
single professional service undertaking (the ``aggregated undertaking'') 
for purposes of reapplying such provisions.
    (B) If any original undertaking included in an aggregated 
undertaking and any other undertaking that is not included in such 
aggregated undertaking involve the provision of significant similar or 
related services, the aggregated undertaking and such other undertaking 
shall be treated as undertakings that involve the provision of 
significant similar or related services for purposes of reapplying the 
provisions of paragraph (h)(2)(ii) of this section.
    (3) Significant similar or significant related services. For 
purposes of this paragraph (h)--
    (i) Services (other than consulting services) in any field described 
in paragraph (h)(1)(ii) of this section are similar to all other 
services in the same field;
    (ii) All the facts and circumstances are taken into account in 
determining whether consulting services are similar;
    (iii) Two professional service undertakings involve the provision of 
significant similar services if and only if--
    (A) Each such undertaking provides significant professional 
services; and
    (B) Significant professional services provided by one such 
undertaking are similar to significant professional services provided by 
the other such undertaking;
    (iv) Services are significant professional services if and only if 
such services are in a field described in paragraph (h)(1)(ii) of this 
section and more than 20 percent of the undertaking's gross income is 
attributable to services in such field (or, in the case of consulting 
services, to similar services in such field); and
    (v) Two professional service undertakings involve the provision of 
significant related services if and only if more than 20 percent of the 
gross income of one such undertaking is derived from customers that are 
also customers of the other such undertaking.
    (4) Examples. The following examples illustrate the application of 
this paragraph (h). In each example that does not state otherwise, the 
taxpayer is an individual, and the facts, analysis, and conclusions 
relate to a single taxable year.

    Example 1. (i) The taxpayer is a partner in a law partnership that 
has offices in various

[[Page 528]]

cities. Some of the partnership's offices provide a full range of legal 
services. Other offices, however, specialize in a particular area or 
areas of the law (e.g., litigation, tax law, corporate law, etc.). In 
either case, substantially all of the office's gross income is derived 
from the provision of legal services. Under paragraph (c)(1) of this 
section, each of the law partnership's offices is treated as a single 
undertaking that is separate from other undertakings (a ``law-office 
undertaking'').
    (ii) Each law-office undertaking derives more than 50 percent of its 
gross income from the provision of services in the field law. Thus, each 
such undertaking is treated as a professional service undertaking 
(within the meaning of paragraph (h)(1)(ii) of this section).
    (iii) Each law-office undertaking derives more than 20 percent of 
its gross income from services in the field of law. Thus, each such 
undertaking involves significant professional services (within the 
meaning of paragraph (h)(3)(iv) of this section) in the field of law. In 
addition, all services in the field of law are treated as similar 
services under paragraph (h)(3)(i) of this section. Thus, the law-office 
undertakings involve the provision of significant similar services 
(within the meaning of paragraph (h)(3)(iii) of this section).
    (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interest in professional service undertakings that involve the provision 
of significant similar services are treated as part of the same activity 
of the taxpayer. Accordingly, the taxpayer's interests in the law-office 
undertakings are treated as part of the same activity of the taxpayer 
under paragraph (h)(2)(ii) of this section even if the undertakings are 
not controlled by the same interests (within the meaning of paragraph 
(j) of this section).
    Example 2. (i) The taxpayer is a partner in medical partnerships A 
and B. Both partnerships derive all of their gross income from the 
provision of medical services, but partnership A specializes in internal 
medicine and partnership B operates a radiology laboratory. Under 
paragraph (c)(1) of this section, the medical-service business of each 
partnership is treated as a single undertaking that is separate from 
other undertakings (a ``medical-service undertaking''). Partnerships A 
and B are not controlled by the same interests (within the meaning of 
paragraph (j) of this section).
    (ii) Each partnership's medical-service undertaking derives more 
than 50 percent of its gross income from the provision of services in 
the field of health. Thus, each partnership's medical-service 
undertaking is treated as a professional service undertaking (within the 
meaning of paragraph (h)(1)(ii) of this section).
    (iii) Each partnership's medical-service undertaking derives more 
than 20 percent of its gross income from services in the field of 
health. Thus, each such undertaking involves significant professional 
services (within the meaning of paragraph (h)(3)(iv) of this section) in 
the field of health. In addition, all services in the field of health 
are treated as similar services under paragraph (h)(3)(i) of this 
section. Thus, the medical-services undertakings of partnerships A and B 
involve the provision of significant similar services (within the 
meaning of paragraph (h)(3)(iii) of this section).
    (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interests in professional service undertakings that involve the 
provision of significant similar services are treated as part of the 
same activity of the taxpayer. Accordingly, the taxpayer's interests in 
the medical-service undertakings of partnerships A and B are treated as 
part of the same activity of the taxpayer under paragraph (h)(2)(ii) of 
this section even though the undertakings are not controlled by the same 
interests.
    Example 3. (i) The facts are the same as in Example 2, except that 
the taxpayer withdraws from partnership A in 1989 and becomes a partner 
in partnership B in 1990. In addition, the taxpayer was a full-time 
participant in the operations of partnership A from 1970 through 1989, 
but does not participate in the operations of partnership B.
    (ii) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interests in professional service undertakings that involve the 
provision of significant similar services are treated as part of the 
same activity of the taxpayer. This rule is not limited to cases in 
which the taxpayer holds such interests simultaneously. Thus, as in 
Example 2, the taxpayer's interests in the medical-service undertakings 
of partnerships A and B are treated as part of the same activity of the 
taxpayer.
    (iii) The activity that includes the taxpayer's interests in the 
medical-service undertakings of partnerships A and B is a personal 
service activity (within the meaning of Sec.  1.469-5T(d)) because it 
involves the performance of personal services in the field of health. In 
addition, the taxpayer materially participated in the activity for three 
or more taxable years preceding 1990 (see Sec.  1.469-5T(j)(1)). Thus, 
even if the taxpayer does not work in the activity after 1989, the 
taxpayer is treated, under Sec.  1.469-5T(a)(6), as materially 
participating in the activity for 1990 and subsequent taxable years.
    Example 4. (i) The taxpayer is a partner in an accounting 
partnership that has offices in various cities (partnership A) and in a 
management-consulting partnership that has a single office (partnership 
B). Each of partnership A's offices derives substantially all of its 
gross income from services in the field

[[Page 529]]

of accounting, and partnership B derives substantially all of its gross 
income from services in the field of consulting. Under paragraph (c)(1) 
of this section, partnership B's consulting business is treated as a 
single undertaking that is separate from other undertakings (the 
``consulting undertaking'') and each of partnership A's offices is 
similarly treated (the ``accounting undertakings''). The accounting 
undertakings are controlled by the same interests, but partnerships A 
and B are not controlled by the same interests (within the meaning of 
paragraph (j) of this section). Partnership B's consulting business 
derives 50 percent of its gross income from customers of partnership A's 
accounting undertakings, but does not derive more than 20 percent of its 
gross income from the customers of any single accounting undertaking.
    (ii) Each accounting undertaking derives more than 50 percent of its 
gross income from the provision of services in the field of accounting, 
and the consulting undertaking derives more than 50 percent of its gross 
income from the provision of services in the field of consulting. Thus, 
each accounting undertaking is treated as a professional service 
undertaking (within the meaning of paragraph (h)(1)(ii) of this 
section), and the consulting undertaking is also treated as a 
professional service undertaking.
    (iii) Each accounting undertaking derives more than 20 percent of 
its gross income from services in the field of accounting. Thus, each 
such undertaking involves significant professional services (within the 
meaning of paragraph (h)(3)(iv) of this section) in the field of 
accounting. In addition, all services in the field of accounting are 
treated as similar services under paragraph (h)(3)(i) of this section. 
Thus, the accounting undertakings involve the provision of significant 
similar services (within the meaning of paragraph (h)(3)(iii) of this 
section).
    (iv) Paragraph (h)(2) (i) and (ii) of this section provides that a 
taxpayer's interests in professional service undertakings that are 
controlled by the same interests or that involve the provision of 
significant similar services are treated as part of the same activity of 
the taxpayer. The accounting undertakings are controlled by the same 
interests (see (i) above) and involve the provision of significant 
similar services (see (iii) above). Accordingly, the taxpayer's 
interests in the accounting undertakings are treated as part of the same 
activity under paragraph (h)(2) (i) and (ii) of this section.
    (v) The consulting undertaking derives more than 20 percent of its 
gross income from services in the field of consulting. If, based on all 
the facts and circumstances, these services are determined to be similar 
consulting services under paragraph (h)(3)(ii) of this section, the 
consulting undertaking involves significant professional services 
(within the meaning of paragraph (h)(3)(iv) of this section). In this 
case, however, the consulting undertaking and the accounting 
undertakings do not involve the provision of significant similar 
services (within the meaning of paragraph (h)(3)(iii) of this section) 
because consulting services and accounting services are not treated as 
similar services under paragraph (h)(3)(i) of this section.
    (vi) The consulting undertaking does not derive more than 20 percent 
of its gross income from the customers of any single accounting 
undertaking of partnership A. If, however, partnership A's accounting 
undertakings are aggregated, the consulting undertaking derives more 
than 20 percent of its gross income from customers of the aggregated 
undertakings. Paragraph (h)(3)(v) of this section provides that two 
professional service undertakings involve the provision of significant 
related services if more than 20 percent of the gross income of one 
undertaking is derived from customers of the other undertaking. For 
purposes of applying this rule, partnership A's accounting undertakings 
are treated as a single undertaking under paragraph (h)(2)(iii) of this 
section because the accounting undertakings are treated as part of the 
same activity under paragraph (h)(2)(i) and (ii) of this section. Thus, 
the consulting undertaking and the accounting undertakings involve the 
provision of significant related services.
    (vii) Paragraph (h)(2)(ii) of this section provides that a 
taxpayer's interests in professional service undertakings that involve 
the provision of significant related services are treated as part of the 
same activity of the taxpayer. Accordingly, the taxpayer's interests in 
the consulting undertaking and the accounting undertakings are treated 
as part of the same activity of the taxpayer under paragraph (h)(2)(ii) 
of this section.
    Example 5. (i) The facts are the same as in Example 4, except that 
partnership B's consulting business derives only 15 percent of its gross 
income from customers of partnership A's accounting undertakings.
    (ii) As in Example 4, the taxpayer's interests in the accounting 
undertakings are treated as part of the same activity under paragraph 
(h)(2)(i) and (ii) of this section and are treated under paragraph 
(h)(2)(iii) of this section as a single undertaking for purposes of 
reapplying those provisions. In this case, however, the consulting 
undertaking does not derive more than 20 percent of its gross income 
from the customers of partnership A's accounting undertakings. Thus, the 
consulting undertaking and the accounting undertakings do not involve 
the provision of significant related services. Accordingly, the 
accounting undertakings and the consulting undertaking are not treated 
as part of the same activity under paragraph (h)(2)(i) or (ii)

[[Page 530]]

of this section because they are not controlled by the same interests 
and do not involve the provision of significant similar or related 
services.
    Example 6. (i) The taxpayer is a partner in partnerships A, B, and 
C. Partnership A derives substantially all of its gross income from the 
provision of engineering services, partnership B derives substantially 
all of its gross income from the provision of architectural services, 
and partnership C derives 40 percent of its gross income from the 
provision of engineering services and the remainder from the provision 
of architectural services. Under paragraph (c)(1) of this section, each 
partnership's service business is treated as a single undertaking that 
is separate from other undertakings. Partnerships A, B, and C are not 
controlled by the same interests (within the meaning of paragraph (j) of 
this section).
    (ii) Each partnership's undertaking derives more than 50 percent of 
its gross income from the provision of services in the fields of 
architecture and engineering. Thus, each such undertaking is treated as 
a professional service undertaking (within the meaning of paragraph 
(h)(1)(ii) of this section).
    (iii) Partnership A's undertaking (``undertaking A'') derives more 
than 20 percent of its gross income from services in the field of 
engineering, partnership B's undertaking (``undertaking B'') derives 
more than 20 percent of its gross income from services in the field of 
architecture, and partnership C's undertaking (``undertaking C'') 
derives more than 20 percent of its gross income from services in the 
field of engineering and more than 20 percent of its gross income from 
services in the field of architecture. Thus, undertaking A involves 
significant services in the field of engineering, undertaking B involves 
significant services in the field of architecture, and undertaking C 
involves significant services in both fields. Under paragraph (h)(3)(i) 
of this section, all services within each field are treated as similar 
services, but engineering services and architectural services are not 
treated as similar services. Thus, undertakings A and C, and 
undertakings B and C, involve the provision of significant similar 
services (within the meaning of paragraph (h)(3)(iii) of this section).
    (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's 
interests in professional service undertakings that involve the 
provision of significant similar services are treated as part of the 
same activity of the taxpayer. Accordingly, the taxpayer's interests in 
undertakings A and C are treated as part of the same activity of the 
taxpayer.
    (v) Under paragraph (h)(2)(iii)(A) of this section, undertakings A 
and C are also treated as a single undertaking for purposes of 
determining whether undertaking B involves the provision of significant 
similar services. Paragraph (h)(2)(iii)(B) of this section in effect 
provides that treating undertakings A and C as a single undertaking does 
not affect the conclusion that the architectural services provided by 
undertakings B and C are significant similar services. Thus, undertaking 
B and the single undertaking in which undertakings A and C are included 
under paragraph (h)(3)(iii) of this section involve the provision of 
significant similar services, and the taxpayer's interests in 
undertakings A, B, and C are treated as part of the same activity of the 
taxpayer under paragraph (h)(2)(ii) of this section.

    (i) [Reserved]
    (j) Control by the same interests and ownership percentage--(1) In 
general. Except as otherwise provided in paragraph (j)(2) of this 
section, all the facts and circumstances are taken into account in 
determining, for purposes of this section, whether undertakings are 
controlled by the same interests. For this purpose, control includes any 
kind of control, direct or indirect, whether legally enforceable, and 
however exercisable or exercised. It is the reality of control that is 
determinative, and not its form or mode of exercise.
    (2) Presumption--(i) In general. Undertakings are rebuttably 
presumed to be controlled by the same interests if such undertakings are 
part of the same common-ownership group.
    (ii) Common-ownership group. Except as provided in paragraph 
(j)(2)(iii) of this section, two or more undertakings of a taxpayer are 
part of the same common-ownership group for purposes of this paragraph 
(j)(2) if and only if the sum of the common-ownership percentages of any 
five or fewer persons (within the meaning of section 7701(a)(1), but not 
including passthrough entities) with respect to such undertakings 
exceeds 50 percent. For this purpose, the common-ownership percentage of 
a person with respect to such undertakings is the person's smallest 
ownership percentage (determined in accordance with paragraph (j)(3) of 
this section) in any such undertaking.
    (iii) Special aggregation rule. If, without regard to this paragraph 
(j)(2)(iii), an undertaking of a taxpayer is part of two or more common-
ownership groups, any undertakings of the taxpayer that are part of any 
such common-ownership group shall be treated for purposes of this 
paragraph (j)(2) as part of a single common-ownership

[[Page 531]]

group in determining the activities of such taxpayer.
    (3) Ownership percentage--(i) In general. For purposes of this 
section, a person's ownership percentage in an undertaking or in a 
passthrough entity shall include any interest in such undertaking or 
passthrough entity that the person holds directly and the person's share 
of any interest in such undertaking or passthrough entity that is held 
through one or more passthrough entities.
    (ii) Passthrough entities. The following rules apply for purposes of 
applying paragraph (j)(3)(i) of this section:
    (A) A partner's interest in a partnership and share of any interest 
in a passthrough entity or undertaking held through a partnership shall 
be determined on the basis of the greater of such partner's percentage 
interest in the capital (by value) of such partnership or such partner's 
largest distributive share of any item of income or gain (disregarding 
guaranteed payments under section 707(c)) of such partnership.
    (B) A shareholder's interest in an S corporation and share of any 
interest in a passthrough entity or undertaking held through an S 
corporation shall be determined on the basis of such shareholder's stock 
ownership.
    (C) A beneficiary's interest in a trust or estate and share of any 
interest in a passthrough entity or undertaking held through a trust or 
estate shall not be taken into account.
    (iii) Attribution rules--(A) In general. Except as otherwise 
provided in paragraph (j)(3)(iii)(B) of this section, a person's 
ownership percentage in a passthrough entity or in an undertaking shall 
be determined by treating such person as the owner of any interest that 
a person related to such person owns (determined without regard to this 
paragraph (j)(3)(iii)) in such passthrough entity or in such 
undertaking.
    (B) Determination of common-ownership percentage. The common-
ownership percentage of five or fewer persons with respect to two or 
more undertakings shall be determined, in any case in which, after the 
application of paragraph (j)(3)(iii)(A) of this section, two or more 
such persons own the same interest in any such undertaking (the 
``related-party owners'') by treating as the only owner of such interest 
(or portion thereof) the related-party owner whose ownership of such 
interest (or a portion thereof) would result in the highest common-
ownership percentage.
    (C) Related person. A person is related to another person for 
purposes of this paragraph (j)(3)(iii) if the relationship of such 
persons is described in section 267(b) or 707(b)(1).
    (4) Special rule for trade or business activities. In determining 
whether two or more trade or business activities are controlled by the 
same interests for purposes of paragraph (g) of this section, each such 
activity shall be treated as a separate undertaking in applying this 
paragraph (j).
    (5) Examples. The following examples illustrate the application of 
this paragraph (j):

    Example 1. (i) Partnership X is the sole owner of an undertaking 
(undertaking X), and partnership Y is the sole owner of another 
undertaking (undertaking Y). Individuals A, B, C, D, and E are the only 
partners in partnerships X and Y, and the partnership agreements of both 
X and Y provide that no action may be taken or decision made on behalf 
of the partnership without the unanimous consent of the partners. 
Moreover, each partner actually participates in, and agrees to, all 
major decisions that affect the operations of either partnership. The 
ownership percentages (within the meaning of paragraph (j)(3) of this 
section) of A, B, C, D, and E in each partnership (and in the 
undertaking owned by the partnership) are as follows:

------------------------------------------------------------------------
                                                 Partnership/Undertaking
                    Partner                    -------------------------
                                                X (percent)  Y (percent)
------------------------------------------------------------------------
A.............................................           15            5
B.............................................           10           60
C.............................................           10           20
D.............................................           77           12
E.............................................            8           20
                                               -------------------------
                                                        120          117
------------------------------------------------------------------------

    The sum of the ownership percentages exceeds 100 percent for both X 
and Y because, under paragraph (j)(3)(ii)(A) of this section, each 
partner's ownership percentage is determined on the basis of the greater 
of the partner's percentage interest in the capital of the partnership 
or the partner's largest distributive share of any item of income or 
gain of the partnership.

[[Page 532]]

    (ii) Paragraph (j)(2)(ii) of this section provides that a person's 
common-ownership percentage with respect to any two or more undertakings 
is the person's smallest ownership percentage in any such undertaking. 
Thus, the common-ownership percentages of A, B, C, D, and E with respect 
to undertakings X and Y are as follows:

------------------------------------------------------------------------
                                                       Common-ownership
                      Partner                             percentage
------------------------------------------------------------------------
A..................................................                    5
B..................................................                   10
C..................................................                   10
D..................................................                   12
E..................................................                    8
                                                    --------------------
                                                                      45
------------------------------------------------------------------------

    (iii) Paragraph (j)(2)(i) of this section provides that undertakings 
are rebuttably presumed to be controlled by the same interests if the 
undertakings are part of the same common-ownership group. In general, 
undertakings are part of a common-ownership group only if the sum of the 
common-ownership percentages of any five or fewer persons with respect 
to such undertakings exceeds 50 percent. In this case, the sum of the 
partners' common-ownership percentages with respect to undertakings X 
and Y is only 45 percent. Thus, undertakings X and Y are not part of the 
same common-ownership group.
    (iv) If the presumption in paragraph (j)(2)(i) of this section does 
not apply, all the facts and circumstances are taken into account in 
determining whether undertakings are controlled by the same interests 
(see paragraph (j)(1) of this section). In this case, all actions and 
decisions in both undertakings require the unanimous consent of the same 
persons and each of those persons actually participates in, and agrees 
to, all major decisions. Accordingly, undertakings X and Y are 
controlled by the same interests (i.e., A, B, C, D, and E).
    Example 2. (i) Partnerships W, X, Y, and Z are each the sole owner 
of an undertaking (undertakings W, X, Y, and Z). Individuals A, B, and C 
are partners in each of the four partnerships, and the remaining 
interests in each partnership are owned by a number of unrelated 
individuals, none of whom owns more than a one-percent interest in any 
of the partnerships. The ownership percentages (within the meaning of 
paragraph (j)(3) of this section) of A, B, and C in each partnership 
(and in the undertaking owned by the partnership) are as follows:

------------------------------------------------------------------------
                                                        Partner
           Partnership/Undertaking            --------------------------
                                                 A      B         C
------------------------------------------------------------------------
W............................................    23%    21%          40%
X............................................    19%    30%          22%
Y............................................    25%    25%          20%
Z............................................     8%     4%           2%
------------------------------------------------------------------------

    (ii) Paragraph (j)(2)(ii) of this section provides that a person's 
common-ownership percentage with respect to any two or more undertakings 
is the person's smallest ownership percentage in any such undertaking. 
Thus, the common-ownership percentages of A, B, and C in undertakings W, 
X, Y, and Z are as follows:

------------------------------------------------------------------------
                                                       Common-ownership
                      Partner                             percentage
------------------------------------------------------------------------
A..................................................                    8
B..................................................                    4
C..................................................                    2
                                                    --------------------
                                                                      14
------------------------------------------------------------------------

    (iii) The sum of the common-ownership percentages of A, B, and C 
with respect to undertakings W, X, Y, and Z is 14 percent, and no other 
person owns more than a one-percent interest in any of the undertakings. 
Thus, the sum of the common-ownership percentages of any five or fewer 
persons with respect to all four undertakings cannot exceed 50 percent. 
Accordingly, undertakings W, X, Y, and Z are not part of the same 
common-ownership group (see paragraph (j)(2)(ii) of this section) and 
are not rebuttably presumed to be controlled by the same interests (see 
paragraph (j)(2)(i) of this section).
    (iv) The common-ownership percentages of A, B, and C in undertakings 
W, X, and Y are as follows:

------------------------------------------------------------------------
                                                       Common ownership
                      Partner                             percentage
------------------------------------------------------------------------
A..................................................                   19
B..................................................                   21
C..................................................                   20
                                                    --------------------
                                                                      60
------------------------------------------------------------------------

    (v) The sum of the common-ownership percentages of A, B, and C, 
taking into account only undertakings W, X, and Y, is 60 percent. 
Because the sum of the common-ownership percentages exceeds 50 percent, 
undertakings W, X, and Y are part of the same common-ownership group 
(see paragraph (j)(2)(ii) of this section and are rebuttably presumed to 
be controlled by the same interests (see paragraph (j)(2)(i) of this 
section).
    Example 3. (i) Corporation X, an S corporation, is the sole owner of 
an undertaking (undertaking X), and corporation Y, another S 
corporation, is the sole owner of another undertaking (undertaking Y). 
Individuals A, B, and C are shareholders in corporations X and Y. Both A 
and B are related (within the meaning of paragraph (j)(3)(iii)(C) of 
this section) to C, but not to each other. A, B, and C are not related 
to any other person that owns an interest in either corporation X or 
corporation Y. The ownership percentages

[[Page 533]]

(determined without regard to the attribution rules of paragraph 
(j)(3)(iii) of this section) of A, B, and C in each corporation (and in 
the undertaking owned by the corporation) are as follows:

                         Corporation/Undertaking
------------------------------------------------------------------------
                  Shareholder                   X (percent)  Y (percent)
------------------------------------------------------------------------
A.............................................           20  ...........
B.............................................  ...........           20
C.............................................            5            5
------------------------------------------------------------------------

    (ii) In general, a person's ownership percentage is determined by 
treating the person as the owner of interests that are actually owned by 
related persons (see paragraph (j)(3)(iii)(A) of this section). If A, B, 
and C are treated as owning interests that are actually owned by related 
persons, their ownership percentages are as follows:

                         Corporation/Undertaking
------------------------------------------------------------------------
                  Shareholder                   X (percent)  Y (percent)
------------------------------------------------------------------------
A.............................................           25            5
B.............................................            5           25
C.............................................           25           25
------------------------------------------------------------------------

    (iii) Paragraph (j)(3)(iii)(B) of this section provides that, in 
determining the sum of the common-ownership percentages of any five or 
fewer persons with respect to any undertakings, each interest in such 
undertakings is counted only once. If two or more persons are treated as 
owners of the same interest under paragraph (j)(3)(iii)(A) of this 
section, the person whose ownership would result in the highest sum is 
treated as the only owner of the interest. In this case, C's common-
ownership percentage with respect to undertakings X and Y, determined by 
treating C as the owner of the interests actually owned by A and B, is 
25 percent. If, however, A and B are treated as the owners of the 
interests actually owned by C, each has a common-ownership percentage of 
only five percent. Thus, in determining the sum of common-ownership 
percentages with respect to undertakings X and Y, C is treated as the 
owner of the interests actually owned by A and B because this treatment 
results in the highest sum of common-ownership percentages with respect 
to such undertakings.
    Example 4. (i) The ownership percentages of individuals A, B, and C 
in undertakings X, Y, and Z are as follows:

                               Undertaking
------------------------------------------------------------------------
            Individual                  X            Y            Z
------------------------------------------------------------------------
A................................          30%          30%          30%
B................................          30%          30%          30%
C................................  ...........          30%          30%
------------------------------------------------------------------------


No other person owns an interest in more than one of the undertakings.
    (ii) Paragraph (j)(2)(ii) of this section provides that a person's 
common ownership percentage with respect to any two or more undertakings 
is the person's smallest ownership percentage in any such undertaking. 
Thus, A's common-ownership percentage with respect to undertakings X, Y, 
and Z is 30 percent, and the common-ownership percentages of B and C 
(and all other persons owning interests in such undertakings) with 
respect to such undertakings is zero. Accordingly, the sum of the common 
ownership percentages with respect to undertakings X, Y, and Z is only 
30 percent, and undertakings X, Y, and Z are not treated as part of the 
same common-ownership group under paragraph (j)(2)(ii) of this section.
    (iii) B's common-ownership percentage with respect to undertakings X 
and Y is 30 percent, and the sum of A's and B's common-ownership 
percentages with respect to such undertakings is 60 percent. Thus, 
undertakings X and Y are treated as part of the same common-ownership 
group under paragraph (j)(2)(ii) of this section. Similarly, C's common-
ownership percentage with respect to undertakings Y and Z is 30 percent, 
and the sum of A's and C's common-ownership percentages with respect to 
such undertakings is 60 percent. Thus, undertakings Y and Z are also 
treated as part of the same common-ownership group under paragraph 
(j)(2)(ii) of this section.
    (iv) Paragraph (j)(2)(iii) of this section requires the aggregation 
of common-ownership groups that include the same undertaking. In this 
case, undertaking Y is treated as part of the common-ownership group XY 
and as part of the common-ownership group YZ. Accordingly, undertakings 
X, Y, and Z are treated as part of a single common-ownership group and 
are rebuttably presumed to be controlled by the same interests (see 
paragraph (j)(2)(i) of this section) even though B does not own an 
interest in undertaking Z and C does not own an interest in undertaking 
X. The fact that B and C are not common owners with respect to 
undertakings X and Z is taken into account, however, in determining 
whether this presumption is rebutted.

    (k) Identification of rental real estate activities--(1) 
Applicability--(i) In general. Except as otherwise provided in paragraph 
(k)(6) of this section, this paragraph (k) applies to a taxpayer's 
interests in rental real estate undertakings (within the meaning of 
paragraph (k)(1)(ii) of this section).
    (ii) Rental real estate undertaking. For purposes of this paragraph 
(k), a rental

[[Page 534]]

real estate undertaking is a rental undertaking (within the meaning of 
paragraph (d) of this section) in which at least 85 percent of the 
unadjusted basis (within the meaning of Sec.  1.469-2T(f)(3)) of the 
property made available for use by customers is real property. For this 
purpose the term ``real property'' means any tangible property other 
than tangible personal property (within the meaning of Sec.  1.48-1(c)).
    (2) Identification of activities--(i) Multiple undertakings treated 
as a single activity or multiple activities by taxpayer. Except as 
otherwise provided in this paragraph (k), a taxpayer may treat two or 
more rental real estate undertakings (determined after the application 
of paragraph (k)(2) (ii) and (iii) of this section) as a single activity 
or may treat such undertakings as separate activities.
    (ii) Multiple undertakings treated as a single activity by 
passthrough entity. A taxpayer must treat two or more rental real estate 
undertakings as a single rental real estate undertaking for a taxable 
year if any passthrough entity through which the taxpayer holds such 
undertakings treats such undertakings as a single activity on the 
applicable return of the passthrough entity for the taxable year of the 
taxpayer.
    (iii) Single undertaking treated as multiple undertakings. 
Notwithstanding that a taxpayer's interest in leased property would, but 
for the application of this paragraph (k)(2)(iii), be treated as used in 
a single rental real estate undertaking, the taxpayer may, except as 
otherwise provided in paragraph (k)(3) of this section, treat a portion 
of the leased property (including a ratable portion of any common areas 
or facilities) as a rental real estate undertaking that is separate from 
the undertaking or undertakings in which the remaining portion of the 
property is treated as used. This paragraph (k)(2)(iii) shall apply for 
a taxable year if and only if--
    (A) Such portion of the leased property can be separately conveyed 
under applicable State and local law (taking into account the 
limitations, if any, imposed by any special rules or procedures, such as 
condominium conversion laws, restricting the separate conveyance of 
parts of the same structure); and
    (B) The taxpayer holds such leased property directly or through one 
or more passthrough entities, each of which treats such portion of the 
leased property as a separate activity on the applicable return of the 
passthrough entity for the taxable year of the taxpayer.
    (3) Treatment in succeeding taxable years. All rental real estate 
undertakings or portions of such undertakings that are treated, under 
this paragraph (k), as part of the same activity for a taxable year 
ending after August 9, 1989 must be treated as part of the same activity 
in each succeeding taxable year.
    (4) Applicable return of passthrough entity. For purposes of this 
paragraph (k), the applicable return of a passthrough entity for a 
taxable year of a taxpayer is the return reporting the passthrough 
entity's income, gain, loss, deductions, and credits taken into account 
by the taxpayer for such taxable year.
    (5) Evidence of treatment required. For purposes of this paragraph 
(k), a person (including a passthrough entity) does not treat a rental 
real estate undertaking as multiple undertakings for a taxable year or, 
except as otherwise provided in paragraph (k) (2)(ii) or (3) of this 
section, treat multiple rental real estate undertakings as a single 
undertaking for a taxable year unless such treatment is reflected on a 
schedule attached to the person's return for the taxable year.
    (6) Coordination rule for rental of nondepreciable property. This 
paragraph (k) shall not apply to a rental real estate undertaking if 
less than 30 percent of the unadjusted basis (within the meaning of 
Sec.  1.469-2T(f)(3)) of property used or held for use by customers in 
such undertaking during the taxable year is subject to the allowance for 
depreciation under section 167.
    (7) Coordination rule for rental of dwelling unit. For any taxable 
year in which section 280A(c)(5) applies to a taxpayer's use of a 
dwelling unit--
    (i) Paragraph (k) (2) and (3) of this section shall not apply to the 
taxpayer's interest in such dwelling unit; and

[[Page 535]]

    (ii) The taxpayer's interest in such dwelling unit shall be treated 
as a separate activity of the taxpayer.
    (8) Examples. The following examples illustrate the application of 
this paragraph (k). In each example, the taxpayer is an individual whose 
taxable year is the calendar year.

    Example 1. (i) In 1989, the taxpayer directly owns five condominium 
units (units A, B, C, D, and E) in three different buildings. Units A, 
B, and C are in one of the buildings and constitute a single rental real 
estate undertaking (within the meaning of paragraph (k)(1)(ii) of this 
section). Units D and E are in the other two buildings, and each of 
these units constitutes a separate rental real estate undertaking. Each 
of the units can be separately conveyed under applicable State and local 
law.
    (ii) Paragraph (k)(2)(iii) of this section permits a taxpayer to 
treat a portion of the property included in a rental real estate 
undertaking as a separate rental real estate undertaking if the property 
can be separately conveyed under applicable State and local law and the 
taxpayer owns the property directly. Thus, the taxpayer can treat units 
A, B, and C as three separate undertakings. Alternatively, the taxpayer 
could treat two of those units (e.g., units A and C) as an undertaking 
and the remaining unit as a separate undertaking, or could treat units 
A, B, and C as a single undertaking.
    (iii) Paragraph (k)(2)(i) of this section permits a taxpayer to 
treat two or more rental real estate undertakings as a single activity, 
or to treat such undertakings as separate activities. Thus, the 
taxpayer, by combining undertakings, can treat all five units as a 
single activity. Alternatively, the taxpayer could treat each 
undertaking as a separate activity, or could combine some, but not all, 
undertakings. Thus, for example, the taxpayer could treat units A, B, C, 
and D as an activity and unit E as a separate activity.
    (iv) For purposes of paragraph (k)(2)(i) of this section, a 
taxpayer's rental real estate undertakings are determined after the 
application of paragraph (k)(2)(iii) of this section. Thus, the 
taxpayer, by treating units as separate undertakings under paragraph 
(k)(2)(iii) of this section and combining them with other units under 
paragraph (k)(2)(i) of this section, can treat any combination of units 
as a single activity. For example, the taxpayer could treat units A and 
B as a separate rental real estate undertaking, and then treat units A, 
B, and D as a single activity. In that case, the taxpayer could treat 
units C and E either as a single activity or as two separate activities.
    Example 2. (i) The facts are the same as in Example 1. In addition, 
the taxpayer treats all five units as a single activity for 1989 and 
sells unit E in 1990. (See paragraph (k)(5) of this section for a rule 
providing that the units are treated as a single activity only if such 
treatment is reflected on a schedule attached to the taxpayer's return.)
    (ii) Under paragraph (k)(3) of this section, rental real estate 
undertakings that are treated as part of the same activity for a taxable 
year must be treated as part of the same activity in each succeeding 
year. In this case, all five units were treated as part of the same 
activity for 1989 and must therefore be treated as part of the same 
activity for 1990. Accordingly, the taxpayer's sale of unit E in 1990 
cannot be treated as a disposition of the taxpayer's entire interest in 
an activity for purposes of section 469(g) and the rules to be contained 
in Sec.  1.469-6T (relating to the treatment of losses upon certain 
dispositions of passive and former passive activities).
    Example 3. (i) The facts are the same as in Example 1, except that 
the taxpayer is a partner in a partnership that is the direct owner of 
the five condominium units. In its return for its taxable year ending on 
November 30, 1989, the partnership treats the five units as a single 
activity. (See paragraph (k)(5) of this section for a rule providing 
that the units are treated as a single activity only if such treatment 
is reflected on a schedule attached to the partnership's return.) The 
partnership sells unit E on November 1, 1990.
    (ii) Paragraph (k)(2)(ii) of this section provides that a taxpayer 
who holds rental real estate undertakings through a passthrough entity 
must treat those undertakings as a single rental real estate undertaking 
if they are treated as a single activity on the applicable return of the 
passthrough entity. Under paragraph (k)(4) of this section, the 
applicable return of the partnership for the taxpayer's 1989 taxable 
year is the partnership's return for its taxable year ending on November 
30, 1989. Accordingly, the taxpayer must treat the five condominium 
units as a single rental real estate undertaking (and thus as part of 
the same activity) for 1989 because they are treated as a single 
activity on the partnership's return for its taxable year ending in 
1989.
    (iii) Under paragraph (k)(3) of this section, the taxpayer must 
continue treating the condominium units as part of the same activity for 
taxable years after 1989. Accordingly, as in Example 2, the five 
condominium units are treated as part of the same activity for 1990, and 
the sale of unit E in 1990 cannot be treated as a disposition of the 
taxpayer's interest in an activity for purposes of section 469(g) and 
the rules to be contained in Sec.  1.469-6T.
    Example 4. (i) The taxpayer owns a shopping center and a vacant lot 
that are separate rental real estate undertakings (within the meaning of 
paragraph (k)(1)(ii) of this

[[Page 536]]

section). The taxpayer rents space in the shopping center to various 
tenants and rents the vacant lot to a parking lot operator. Most of the 
unadjusted basis of the property used in the shopping-center undertaking 
(taking into account the land on which the shopping center is built) is 
subject to the allowance for depreciation, but no depreciable property 
is used in the parking-lot undertaking.
    (ii) This paragraph (k) provides rules for identifying rental real 
estate activities (including the rule in paragraph (k)(2)(i) of this 
section that permits a taxpayer to treat two or more rental real estate 
undertakings as a single activity). Paragraph (k)(6) of this section 
provides, however, that these rules do not apply to a rental real estate 
undertaking if less than 30 percent of the unadjusted basis of the 
property used in the undertaking is subject to the allowance for 
depreciation. Thus, the taxpayer may not combine the parking-lot 
undertaking, which includes no depreciable property, with the shopping-
center undertaking or any other rental real estate undertaking under 
paragraph (k)(2)(i) of this section. Accordingly, the parking lot 
undertaking is treated as a separate activity under paragraph (b)(1) of 
this section.
    Example 5. (i) The facts are the same as in Example 4, except that 
the shopping center and the vacant lot are at the same location (within 
the meaning of paragraph (c)(2)(iii) of this section) and are part of 
the same rental real estate undertaking (within the meaning of paragraph 
(k)(1)(ii) of this section). Taking into account the property used in 
the shopping center operations (including the land on which the shopping 
center is built) and the vacant lot, 50 percent of the unadjusted basis 
of the property used in the undertaking is subject to the allowance for 
depreciation.
    (ii) In this case, the vacant lot is used in a rental real estate 
undertaking in which depreciable property is also used. Moreover, the 
exception in paragraph (k)(6) of this section does not apply to the 
undertaking consisting of the shopping center and the parking lot 
because at least 30 percent of unadjusted basis of the property used in 
the undertaking is subject to the allowance for depreciation. 
Accordingly, the taxpayer may combine the undertaking with other rental 
real estate undertakings and treat the combined undertakings as a single 
activity under paragraph (k)(2)(i) of this section.

    (l) [Reserved]
    (m) Consolidated groups--(1) In general. The activities of a 
consolidated group (within the meaning of Sec.  1.469-1T(h)(2)(ii)) and 
of each member of such group shall be determined under this section as 
if the consolidated group were one taxpayer.
    (2) Examples. The following examples illustrate the application of 
this paragraph (m). In each example, the facts, analysis, and 
conclusions relate to a single taxable year.

    Example 1. (i) Corporations M, N, and O are the members of a 
consolidated group (within the meaning of Sec.  1.469-1T(h)(2)(ii)). 
Under Sec.  1.469-1T(h)(4)(i)(A) and (ii), the consolidated group and 
its members are treated as closely held corporations (within the meaning 
of Sec.  1.469-1T(g)(2)(ii)). Each member of the consolidated group owns 
a two-percent interest in partnership X and a two-percent interest in 
partnership Y, and owns interests in a number of trade or business 
undertakings (within the meaning of paragraph (f)(1)(ii) of this 
section) through the partnerships. Each of these undertakings is 
directly owned by partnership X or Y, and all the undertakings of 
partnerships X and Y are controlled by the same interests (within the 
meaning of paragraph (j) of this section) and are similar (within the 
meaning of paragraph (f)(4) of this section). The employees of the 
consolidated group and the shareholders of its common parent do not 
participate in the undertakings that the member corporations own through 
the partnerships.
    (ii) Paragraph (f)(2)(i) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns interests in the undertakings through the same 
passthrough entity. In this case, the member corporations own interests 
in similar, commonly-controlled undertakings through both partnerships, 
and such interests are treated under this paragraph (m) as interests 
owned by one taxpayer (the consolidated group). Accordingly, the member 
corporations' interests in the undertakings owned through partnership X 
are treated as part of the same activity of the consolidated group, and 
their interests in the undertakings owned through partnership Y are 
treated similarly.
    Example 2. (i) The facts are the same as in Example 1, except that 
each member of the consolidated group owns a five-percent interest in 
partnership X and a five-percent interest in partnership Y.
    (ii) Paragraph (f)(2)(ii) of this section provides that trade or 
business undertakings that are similar and controlled by the same 
interests are treated as part of the same activity of the taxpayer if 
the taxpayer owns a direct or substantial indirect interest in each such 
undertaking. In this case, the member corporations own, in the 
aggregate, a 15-percent interest in partnership X and a 15-percent 
interest in partnership Y, and

[[Page 537]]

such interests are treated under this paragraph (m) as interests owned 
by one taxpayer (the consolidated group). Thus, the consolidated group 
owns a substantial indirect interest in the similar, commonly-controlled 
undertakings owned by partnerships X and Y (see paragraph (f)(3)(i) of 
this section). Accordingly, the member corporations' interests in the 
undertakings owned through partnerships X and Y are treated as part of 
the same activity of the consolidated group.

    (n) Publicly traded partnerships. The rules of this section shall 
apply to a taxpayer's interest in business and rental operations held 
through a publicly traded partnership (within the meaning of section 
469(k)(2)) as if the taxpayer had no interest in any other business and 
rental operations. The following example illustrates the application of 
this paragraph (n):

    Example. (i) The taxpayer, an individual, owns a 20-percent interest 
in partnership X and a 15-percent interest in partnership Y. Partnership 
X directly owns a hotel (``hotel 1'') and a commercial office building 
(``building 1''). Partnership Y directly owns two hotels (``hotels 2 and 
3'') and two commercial office buildings (``buildings 2 and 3''). Each 
of the three hotels is a separate trade or business undertaking (within 
the meaning of paragraph (f)(1)(ii) of this section), and each of the 
three office buildings is a separate rental real estate undertaking 
(within the meaning of paragraph (k)(1)(ii) of this section). The three 
hotel undertakings are similar (within the meaning of paragraph (f)(4) 
of this section) and are controlled by the same interests (within the 
meaning of paragraph (j) of this section). Partnership X is not a 
publicly traded partnership (within the meaning of section 469(k)(2)). 
Partnership Y, however, is a publicly traded partnership and is not 
treated as a corporation under section 7704.
    (ii) This paragraph (n) provides that the rules of this section 
apply to a taxpayer's interest in business and rental operations held 
through a publicly traded partnership as if the taxpayer had no interest 
in any other business and rental operations. Thus, undertakings owned 
through partnership Y may be treated as part of the same activity under 
the rules of this section, but an undertaking owned through partnership 
Y and an undertaking that is not owned through partnership Y may not be 
treated as part of the same activity.
    (iii) Paragraph (f)(2)(i) of this section provides that a taxpayer's 
interests in two or more trade or business undertakings that are similar 
and controlled by the same interests are treated as part of the same 
activity if the taxpayer owns interests in each undertaking through the 
same passthrough entity. Partnership Y's hotel undertakings (i.e., 
hotels 2 and 3) are similar and are controlled by the same interests. In 
addition, the taxpayer owns interests in both undertakings through the 
same partnership. Accordingly, the taxpayer's interests in partnership 
Y's hotel undertakings are treated as part of the same activity.
    (iv) The hotel undertaking owned through partnership X (i.e., hotel 
1) and the hotel undertakings owned through partnership Y are similar 
and controlled by the same interests, and the taxpayer owns a 
substantial indirect interest in each of the undertakings (see paragraph 
(f)(3)(i) of this section). Thus, the three undertakings would 
ordinarily be treated as part of the same activity under paragraph 
(f)(2)(ii) of this section. Under this paragraph (n), however, 
undertakings that are owned through a publicly traded partnership cannot 
be treated as part of the same activity as any undertaking not owned 
through that partnership. Accordingly, the hotel undertaking that the 
taxpayer owns through partnership X and the hotel undertakings that the 
taxpayer owns through partnership Y are treated as two separate 
activities.
    (v) Paragraph (k)(2)(i) of this section provides that, with certain 
exceptions, a taxpayer may treat two or more rental real estate 
undertakings as a single activity or as separate activities. Thus, the 
taxpayer's interests in the rental real estate undertakings owned 
through partnership Y (i.e., buildings 2 and 3) may be treated as a 
single activity or as separate activities. Under this paragraph (n), 
however, undertakings that are owned through a publicly traded 
partnership cannot be treated as part of the same activity as any 
undertaking not owned through that partnership. Accordingly, the 
taxpayer's interest in the rental real estate undertaking owned through 
partnership X (building 1) cannot be treated as part of an activity that 
includes any rental real estate undertaking owned through partnership Y.

    (o) Elective treatment of undertakings as separate activities--(1) 
Applicability. This paragraph applies to a taxpayer's interest in any 
undertaking (other than a rental real estate undertaking (within the 
meaning of paragraph (k)(1)(ii) of this section)) that would otherwise 
be treated under this section as part of an activity that includes the 
taxpayer's interest in any other undertaking.
    (2) Undertakings treated as separate activities. Except as otherwise 
provided in this paragraph (o), a person (including

[[Page 538]]

a passthrough entity) shall treat an undertaking to which this paragraph 
(o) applies as an activity separate from the remainder of the activity 
in which such undertaking would otherwise be included for a taxable year 
if and only if, for such taxable year or any preceding taxable year, 
such person made an election with respect to such undertaking under this 
paragraph (o).
    (3) Multiple undertakings treated as a single activity by 
passthrough entity. A person (including a passthrough entity) must treat 
interests in two or more undertakings as part of the same activity for a 
taxable year if any passthrough entity through which the person holds 
such undertakings treats such undertakings as part of the same activity 
on the applicable return of the passthrough entity for the taxable year 
of such person.
    (4) Multiple undertakings treated as a single activity for a 
preceding taxable year. If a person (including a passthrough entity) 
treats undertakings as part of the same activity on such person's return 
for a taxable year ending after August 9, 1989, such person may not 
treat such undertakings as part of different activities under this 
paragraph (o) for any subsequent taxable year.
    (5) Applicable return of passthrough entity. For purposes of this 
paragraph (o), the applicable return of a passthrough entity for a 
taxable year of a taxpayer is the return reporting the passthrough 
entity's income, gain, loss, deductions, and credits taken into account 
by the taxpayer for such taxable year.
    (6) Participation. The following rules apply to multiple activities 
(the ``separate activities'') that would be treated as a single activity 
(the ``original activity'') if the taxpayer's activities were determined 
without regard to this paragraph (o):
    (i) The taxpayer shall be treated as materially participating 
(within the meaning of Sec.  1.469-5T) for the taxable year in the 
separate activities if and only if the taxpayer would, but for the 
application of this paragraph (o), be treated as materially 
participating for the taxable year in the original activity.
    (ii) The taxpayer shall be treated as significantly participating 
(within the meaning of Sec.  1.469-5T(c)(2)) for the taxable year in the 
separate activities if and only if the taxpayer would, but for the 
application of this paragraph (o), be treated as significantly 
participating for the taxable year in the original activity.
    (7) Election--(i) In general. A person makes an election with 
respect to an undertaking under this paragraph (o) by attaching the 
written statement described in paragraph (o)(7)(ii) of this section to 
such person's return for the taxable year for which the election is made 
(see paragraph (o)(2) of this section).
    (ii) Written statement. The written statement required by paragraph 
(o)(7)(i) of this section must--
    (A) State the name, address, and taxpayer identification number of 
the person making the election;
    (B) Contain a declaration that an election is being made under Sec.  
1.469-4T(o);
    (C) Identify the undertaking with respect to which such election is 
being made; and
    (D) Identify the remainder of the activity in which such undertaking 
would otherwise be included.
    (8) Examples. The following examples illustrate the application of 
this paragraph (o):

    Example 1. (i) During 1989, the taxpayer, an individual whose 
taxable year is the calendar year, acquires and is the direct owner of 
ten grocery stores. The operations of each grocery store are treated 
under paragraph (c)(1) of this section as a single undertaking that is 
separate from other undertakings (a ``grocery-store undertaking''), and 
the taxpayer's interests in the grocery-store undertakings would be 
treated as part of the same activity of the taxpayer under paragraph 
(f)(2) of this section.
    (ii) Paragraph (o)(2) of this section provides that, with certain 
exceptions, undertakings that would be treated as part of the same 
activity under other rules in this section may, at the election of the 
taxpayer, be treated as separate activities. Thus, the taxpayer may 
elect to treat each grocery-store undertaking as a separate activity for 
1989. Alternatively, the taxpayer may combine grocery-store undertakings 
in any manner and treat each combination of undertakings (and each 
uncombined undertaking) as a separate activity for 1989. In either case, 
the election must be made by attaching the written statement described 
in paragraph

[[Page 539]]

(o)(7)(ii) of this section to the taxpayer's 1989 return.
    Example 2. (i) The facts are the same as in Example 1. In addition, 
the taxpayer, in 1989, elects to treat each grocery-store undertaking as 
a separate activity and participates for 15 hours in each of the 
grocery-store undertakings.
    (ii) The taxpayer's interest in each grocery-store undertaking is 
treated, under paragraph (o)(2) of this section, as a separate activity 
of the taxpayer for 1989 (a ``grocery-store activity''). In 1989, 
however, the taxpayer participates for more than 100 hours in the 
activity in which the undertakings would be included (but for the 
election to treat the grocery-store undertakings as separate activities) 
and would be treated under Sec.  1.469-5T(c)(2) as significantly 
participating in such activity. Accordingly, the taxpayer is treated 
under paragraph (o)(6)(ii) of this section as significantly 
participating in each of the grocery-store activities for 1989.
    Example 3. (i) The facts are the same as in Example 1. In addition, 
the taxpayer, in 1989, elects to treat each grocery-store undertaking as 
a separate activity. The taxpayer does not participate in any of the 
grocery-store undertakings in 1989 or 1990, and sells one of the grocery 
stores in 1990.
    (ii) As in Example 2, the taxpayer's interests in each grocery-store 
undertaking is treated, under paragraph (o)(2) of this section, as a 
separate activity of the taxpayer for 1989. Because the taxpayer elected 
to treat the undertakings as separate activities for a preceding taxable 
year (1989), each grocery-store undertaking is also treated, under 
paragraph (o)(2) of this section, as a separate activity of the taxpayer 
for 1990. In addition, each of the taxpayer's grocery-store activities 
is a passive activity for 1989 and 1990 because the taxpayer does not 
participate in any of the grocery store undertakings for 1989 and 1990. 
Accordingly, the taxpayer's sale of the grocery store will generally be 
treated as a disposition of the taxpayer's entire interest in a passive 
activity for purposes of section 469(g) and the rules to be contained in 
Sec.  1.469-6T (relating to the treatment of losses upon certain 
dispositions of passive and former passive activities).
    Example 4. (i) The facts are the same as in Example 3, except that 
the taxpayer elects to treat the grocery-store undertakings as two 
separate activities. One of the activities includes three grocery-store 
undertakings, and the store sold in 1990 is part of this activity. The 
other activity includes the seven remaining grocery-store undertakings.
    (ii) Paragraph (o)(4) of this section provides that a person who 
treats undertakings as part of the same activity for a taxable year 
ending after August 9, 1989, may not elect to treat those undertakings 
as separate activities for a subsequent taxable year. The grocery store 
sold in 1990 was treated for 1989 as part of an activity that includes 
two other grocery stores. Thus, those three stores must be treated as 
part of the same activity for 1990. Accordingly, the taxpayer's sale of 
the grocery store cannot be treated as a disposition of the taxpayer's 
entire interest in a passive activity for purposes of section 469(g) and 
the rules to be contained in Sec.  1.469-6T.
    Example 5. (i) The facts are the same as in Example 1, except that 
the taxpayer is a partner in a partnership that acquires and is the 
direct owner of the ten grocery stores. The taxable year of the 
partnership ends on November 30, and the partnership acquires the 
grocery stores in its taxable year ending on November 30, 1989. In its 
return for that taxable year, the partnership treats the grocery-store 
undertakings as a single activity.
    (ii) Paragraph (o)(3) of this section provides that a person who 
holds undertakings through a passthrough entity may not elect to treat 
those undertakings as separate activities if they are treated as part of 
the same activity on the applicable return of the passthrough entity. 
Under paragraph (o)(5) of this section, the applicable return of the 
partnership for the taxpayer's 1989 taxable year is the partnership's 
return for its taxable year ending on November 30, 1989. Accordingly, 
the taxpayer must treat the grocery-store undertakings as a single 
activity for 1989 because those undertakings are treated as a single 
activity on the partnership's return for its taxable year ending in 
1989.
    (iii) Under paragraph (o)(4) of this section, the taxpayer must 
continue treating the grocery-store undertakings as part of the same 
activity for taxable years after 1989. This rule applies even if the 
partnership subsequently distributes its interest in the grocery stores 
to the taxpayer, and the taxpayer becomes the direct owner of the 
grocery-store undertakings.

    (p) Special rule for taxable years ending before August 10, 1989--
(1) In general. For purposes of applying section 469 and the regulations 
thereunder for a taxable year ending before August 10, 1989, a 
taxpayer's business and rental operations may be organized into 
activities under the rules or paragraphs (b) through (n) of this section 
or under any other reasonable method. For example, for such taxable 
years a taxpayer may treat each of the taxpayer's undertakings as a 
separate activity, or a taxpayer may treat undertakings that involve the 
provision of similar goods or services as a single activity.
    (2) Unreasonable methods. A method of organizing business and rental 
operations into activities is not reasonable if such method--

[[Page 540]]

    (i) Treats rental operations (within the meaning of paragraph (d)(3) 
of this section) that are not ancillary to a trade or business activity 
(within the meaning of Sec.  1.469-1T(e)(2)) as part of a trade or 
business activity;
    (ii) Treats operations that are not rental operations and are not 
ancillary to a rental activity (within the meaning of Sec.  1.469-
1T(e)(3)) as part of a rental activity;
    (iii) Includes in a passive activity of a taxpayer any oil or gas 
well that would be treated, under paragraph (e)(1) of this section, as a 
separate undertaking in determining the taxpayer's activities;
    (iv) Includes in a passive activity of a taxpayer any interest in a 
dwelling unit that would be treated, under paragraph (K)(7) of this 
section, as a separate activity of the taxpayer; or
    (v) Is inconsistent with the taxpayer's method of organizing 
business and rental operations into activities for the taxpayer's first 
taxable year beginning after December 31, 1986.
    (3) Allocation of dissallowed deductions in succeeding taxable year. 
If any of the taxpayer's passive activity deductions or the taxpayer's 
credits from passive activities are disallowed under Sec.  1.469-1T for 
the last taxable year of the taxpayer ending before August 10, 1989, 
such disallowed deductions or credits shall be allocated among the 
taxpayer's activities for the first taxable year of the taxpayer ending 
after August 9, 1989, using any reasonable method. See Sec.  1.469-
1T(f)(4).

[T.D. 8253, 54 FR 20542, May 12, 1989]



Sec.  1.469-5  Material participation.

    (a)-(e) [Reserved]
    (f) Participation--(1) In general. Except as otherwise provided in 
this paragraph (f), any work done by an individual (without regard to 
the capacity in which the individual does the work) in connection with 
an activity in which the individual owns an interest at the time the 
work is done shall be treated for purposes of this section as 
participation of the individual in the activity.
    (f)(2)-(h)(2) [Reserved]
    (h)(3) Coordination with rules governing the treatment of 
passthrough entities. If a taxpayer takes into account for a taxable 
year of the taxpayer any item of gross income or deduction from a 
partnership or S corporation that is characterized as an item of gross 
income or deduction from an activity in which the taxpayer materially 
participated under Sec.  1.469-2T(e)(1), the taxpayer is treated as 
materially participating in the activity for the taxable year for 
purposes of applying Sec.  1.469-5T(a)(5) and (6) to any succeeding 
taxable year of the taxpayer.
    (i) [Reserved]
    (j) Material participation for preceding taxable years--(1) In 
general. For purposes of Sec.  1.469-5T(a)(5) and (6), a taxpayer has 
materially participated in an activity for a preceding taxable year if 
the activity includes significant section 469 activities that are 
substantially the same as significant section 469 activities that were 
included in an activity in which the taxpayer materially participated 
(determined without regard to Sec.  1.469-5T(a)(5)) for the preceding 
taxable year.
    (2) Material participation for taxable years beginning before 
January 1, 1987. In any case in which it is necessary to determine 
whether an individual materially participated in any activity for a 
taxable year beginning before January 1, 1987 (other than a taxable year 
of a partnership, S corporation, estate, or trust ending after December 
31, 1986), the determination shall be made without regard to paragraphs 
(a)(2) through (7) of this section.
    (k) Examples. Example 1--Example 4 [Reserved]

    Example 5. In 1993, D, an individual, acquires stock in an S 
corporation engaged in a trade or business activity (within the meaning 
of Sec.  1.469-1(e)(2)). For every taxable year from 1993 through 1997, 
D is treated as materially participating (without regard to Sec.  1.469-
5T(a)(5)) in the activity. D retires from the activity at the beginning 
of 1998, and would not be treated as materially participating in the 
activity for 1998 and subsequent taxable years if material participation 
of those years were determined without regard to Sec.  1.469-5T(a)(5). 
Under Sec.  1.469-5T(a)(5) of this section, however, D is treated as 
materially participating in the activity for taxable years 1998 through 
2003 because D materially participated in the activity (determined 
without regard to Sec.  1.469-5T(a)(5) for five taxable years during the 
ten taxable years that immediately precede each of those years. D is not 
treated under Sec.  1.469-5T(a)(5) as materially participating in the

[[Page 541]]

activity for taxable years beginning after 2003 because for those years 
D has not materially participated in the activity (determined without 
regard to Sec.  1.469-5T(a)(5) for five of the last ten immediately 
preceding taxable years.

[T.D. 8417, 57 FR 20758, May 15, 1992]



Sec.  1.469-5T  Material participation (temporary).

    (a) In general. Except as provided in paragraphs (e) and (h)(2) of 
this section, an individual shall be treated, for purposes of section 
469 and the regulations thereunder, as materially participating in an 
activity for the taxable year if and only if--
    (1) The individual participates in the activity for more than 500 
hours during such year;
    (2) The individual's participation in the activity for the taxable 
year constitutes substantially all of the participation in such activity 
of all individuals (including individuals who are not owners of 
interests in the activity) for such year;
    (3) The individual participates in the activity for more than 100 
hours during the taxable year, and such individual's participation in 
the activity for the taxable year is not less than the participation in 
the activity of any other individual (including individuals who are not 
owners of interests in the activity) for such year;
    (4) The activity is a significant participation activity (within the 
meaning of paragraph (c) of this section) for the taxable year, and the 
individual's aggregate participation in all significant participation 
activities during such year exceeds 500 hours;
    (5) The individual materially participated in the activity 
(determined without regard to this paragraph (a)(5)) for any five 
taxable years (whether or not consecutive) during the ten taxable years 
that immediately precede the taxable year;
    (6) The activity is a personal service activity (within the meaning 
of paragraph (d) of this section), and the individual materially 
participated in the activity for any three taxable years (whether or not 
consecutive) preceding the taxable year; or
    (7) Based on all of the facts and circumstances (taking into account 
the rules in paragraph (b) of this section), the individual participates 
in the activity on a regular, continuous, and substantial basis during 
such year.
    (b) Facts and circumstances--(1) In general. [Reserved]
    (2) Certain participation insufficient to constitute material 
participation under this paragraph (b)--(i) Participation satisfying 
standards not contained in section 469. Except as provided in section 
469(h)(3) and paragraph (h)(2) of this section (relating to certain 
retired individuals and surviving spouses in the case of farming 
activities), the fact that an individual satisfies the requirements of 
any participation standard (whether or not referred to as ``material 
participation'') under any provision (including sections 1402 and 2032A 
and the regulations thereunder) other than section 469 and the 
regulations thereunder shall not be taken into account in determining 
whether such individual materially participates in any activity for any 
taxable year for purposes of section 469 and the regulations thereunder.
    (ii) Certain management activities. An individual's services 
performed in the management of an activity shall not be taken into 
account in determining whether such individual is treated as materially 
participating in such activity for the taxable year under paragraph 
(a)(7) of this section unless, for such taxable year--
    (A) No person (other than such individual) who performs services in 
connection with the management of the activity receives compensation 
described in section 911(d)(2)(A) in consideration for such services; 
and
    (B) No individual performs services in connection with the 
management of the activity that exceed (by hours) the amount of such 
services performed by such individual.
    (iii) Participation less than 100 hours. If an individual 
participates in an activity for 100 hours or less during the taxable 
year, such individual shall not be treated as materially participating 
in such activity for the taxable year under paragraph (a)(7) of this 
section.
    (c) Significant participation activity--(1) In general. For purposes 
of paragraph (a)(4) of this section, an activity is a significant 
participation activity

[[Page 542]]

of an individual if and only if such activity--
    (i) Is a trade or business activity (within the meaning of Sec.  
1.469-1T(e)(2)) in which the individual significantly participates for 
the taxable year; and
    (ii) Would be an activity in which the individual does not 
materially participate for the taxable year if material participation 
for such year were determined without regard to paragraph (a)(4) of this 
section.
    (2) Significant participation. An individual is treated as 
significantly participating in an activity for a taxable year if and 
only if the individual participates in the activity for more than 100 
hours during such year.
    (d) Personal service activity. An activity constitutes a personal 
service activity for purposes of paragraph (a)(6) of this section if 
such activity involves the performance of personal services in--
    (1) The fields of health, law, engineering, architecture, 
accounting, actuarial science, performing arts, or consulting; or
    (2) Any other trade or business in which capital is not a material 
income-producing factor.
    (e) Treatment of limited partners--(1) General rule. Except as 
otherwise provided in this paragraph (e), an individual shall not be 
treated as materially participating in any activity of a limited 
partnership for purposes of applying section 469 and the regulations 
thereunder to--
    (i) The individual's share of any income, gain, loss, deduction, or 
credit from such activity that is attributable to a limited partnership 
interest in the partnership; and
    (ii) Any gain or loss from such activity recognized upon a sale or 
exchange of such an interest.
    (2) Exceptions. Paragraph (e)(1) of this section shall not apply to 
an individual's share of income, gain, loss, deduction, and credit for a 
taxable year from any activity in which the individual would be treated 
as materially participating for the taxable year under paragraph (a)(1), 
(5), or (6) of this section if the individual were not a limited partner 
for such taxable year.
    (3) Limited partnership interest--(i) In general. Except as provided 
in paragraph (e)(3)(ii) of this section, for purposes of section 
469(h)(2) and this paragraph (e), a partnership interest shall be 
treated as a limited partnership interest if--
    (A) Such interest is designated a limited partnership interest in 
the limited partnership agreement or the certificate of limited 
partnership, without regard to whether the liability of the holder of 
such interest for obligations of the partnership is limited under the 
applicable State law; or
    (B) The liability of the holder of such interest for obligations of 
the partnership is limited, under the law of the State in which the 
partnership is organized, to a determinable fixed amount (for example, 
the sum of the holder's capital contributions to the partnership and 
contractural obligations to make additional capital contributions to the 
partnership).
    (ii) Limited partner holding general partner interest. A partnership 
interest of an individual shall not be treated as a limited partnership 
interest for the individual's taxable year if the individual is a 
general partner in the partnership at all times during the partnership's 
taxable year ending with or within the individual's taxable year (or the 
portion of the partnership's taxable year during which the individual 
(directly or indirectly) owns such limited partnership interest).
    (f) Participation--(1) [Reserved]. See Sec.  1.469-5(f)(1) for rules 
relating to this paragraph.
    (2) Exceptions--(i) Certain work not customarily done by owners. 
Work done in connection with an activity shall not be treated as 
participation in the activity for purposes of this section if--
    (A) Such work is not of a type that is customarily done by an owner 
of such an activity; and
    (B) One of the principal purposes for the performance of such work 
is to avoid the disallowance, under section 469 and the regulations 
thereunder, of any loss or credit from such activity.
    (ii) Participation as an investor--(A) In general. Work done by an 
individual in the individual's capacity as an investor in an activity 
shall not be treated as participation in the activity for purposes of 
this section unless the individual is directly involved in the day-

[[Page 543]]

to-day management or operations of the activity.
    (B) Work done in individual's capacity as an investor. For purposes 
of this paragraph (f)(2)(ii), work done by an individual in the 
individual's capacity as an investor in an activity includes--
    (1) Studying and reviewing financial statements or reports on 
operations of the activity;
    (2) Preparing or compiling summaries or analyses of the finances or 
operations of the activity for the individual's own use; and
    (3) Monitoring the finances or operations of the activity in a non-
managerial capacity.
    (3) Participation of spouse. In the case of any person who is a 
married individual (within the meaning of section 7703) for the taxable 
year, any participation by such person's spouse in the activity during 
the taxable year (without regard to whether the spouse owns an interest 
in the activity and without regard to whether the spouses file a joint 
return for the taxable year) shall be treated, for purposes of applying 
section 469 and the regulations thereunder to such person, as 
participation by such person in the activity during the taxable year.
    (4) Methods of proof. The extent of an individual's participation in 
an activity may be established by any reasonable means. Contemporaneous 
daily time reports, logs, or similar documents are not required if the 
extent of such participation may be established by other reasonable 
means. Reasonable means for purposes of this paragraph may include but 
are not limited to the identification of services performed over a 
period of time and the approximate number of hours spent performing such 
services during such period, based on appointment books, calendars, or 
narrative summaries.
    (g) Material participation of trusts and estates. [Reserved]
    (h) Miscellaneous rules--(1) Participation of corporations. For 
rules relating to the participation in an activity of a personal service 
corporation (within the meaning of Sec.  1.468-1T(g)(2)(i)) or a closely 
held corporation (within the meaning of Sec.  1.469-1T(g)(2)(ii)), see 
Sec.  1.469-1T(g)(3).
    (2) Treatment of certain retired farmers and surviving spouses of 
retired or disabled farmers. An individual shall be treated as 
materially participating for a taxable year in any trade or business 
activity of farming if paragraph (4) or (5) of section 2032A(b) would 
cause the requirements of section 2032A(b)(1)(C)(ii) to be met with 
respect to real property used in such activity had the individual died 
during such taxable year.
    (3) Coordination with rules governing the treatment of passthrough 
entities. [Reserved]. See Sec.  1.469-5(h)(3) for rules relating to this 
paragraph.
    (i) [Reserved]
    (j) Material participation for preceding taxable years. [Reserved]. 
See Sec.  1.469-5(j) for rules relating to this paragraph.
    (k) Examples. The following examples illustrate the application of 
this section:
    Example 1. A, a calendar year individual, owns all of the stock of 
X, a C corporation. X is the general partner, and A is the limited 
partner, in P, a calendar year partnership. P has a single activity, a 
restaurant, which is a trade or business activity (within the meaning of 
Sec.  1.469-1T(e)(2)). During the taxable year, A works for an average 
of 30 hours per week in connection with P's restaurant activity. Under 
paragraphs (a)(1) and (e)(2) of this section, A is treated as materially 
participating in the activity for the taxable year because A 
participates in the restaurant activity during such year for more than 
500 hours. In addition, under Sec.  1.469-1T(g)(3)(i), A's participation 
will cause X to be treated as materially participating in the restaurant 
activity.
    Example 2. The facts are the same as in Example 1, except that the 
partnership agreement provides that P's restaurant activity is to be 
managed by X, and A's work in the activity is performed pursuant to an 
employment contract between A and X. Under paragraph (f)(1) of this 
section, work done by A in connection with the activity in any capacity 
is treated as participation in the activity by A. Accordingly, the 
conclusion is the same as in Example 1. The conclusion would be the same 
if A owned no stock in X at any time, although in that case A's 
participation would not be taken into account in determining whether X 
materially participates in the restaurant activity.
    Example 3. B, an individual, is employed fulltime as a carpenter. B 
also owns an interest in a partnership which is engaged in a van 
conversion activity, which is a trade or business activity (within the 
meaning of Sec.  1.469-1T(e)(2)). B and C, the other partner, are the 
only participants in the activity for

[[Page 544]]

the taxable year. The activity is conducted entirely on Saturdays. Each 
Saturday throughout the taxable year, B and C work for eight hours in 
the activity. Although B does not participate in the activity for more 
than 500 hours during the taxable year, under paragraph (a)(3) of this 
section, B is treated for such year as materially participating in the 
activity because B participates in the activity for more than 100 hours 
during the taxable year, and B's participation in the activity for such 
year is not less than the participation of any other person in the 
activity for such year.
    Example 4. C, an individual, is employed full-time as an accountant. 
C also owns interests in a restaurant and a shoe store. The restaurant 
and shoe store are trade or business activities (within the meaning of 
Sec.  1.469-1T(e)(2)) that are treated as separate activities under the 
rules to be contained in Sec.  1.469-4T. Each activity has several full-
time employees. During the taxable year, C works in the restaurant 
activity for 400 hours and in the shoe store activity for 150 hours. 
Under paragraph (c) of this section, both the restaurant and shoe store 
activities are significant participation activities of C for the taxable 
year. Accordingly, since C's aggregate participation in the restaurant 
and shoe store activities during the taxable year exceeds 500 hours, C 
is treated under paragraph (a)(4) of this section as materially 
participating in both activities.
    Example 5. [Reserved]. See Sec.  1.469-5(k) Example 5 for this 
example.
    Example 6. The facts are the same as in Example 5, except that D 
does not acquire any stock in the S corporation until 1994. Under 
paragraph (f)(1) of this section, D is not treated as participating in 
the activity for any taxable year prior to 1994 because D does not own 
as interest in the activity for any such taxable year. Accordingly, D 
materially participates in the activity for only one taxable year prior 
to 1995, and D is not treated under paragraph (a)(5) of this section as 
materially participating in the activity for 1995 or subsequent taxable 
years.
    Example 7. (i) E, a married individual filing a separate return for 
the taxable year, is employed full-time as an attorney. E also owns an 
interest in a professional football team that is a trade or business 
activity (within the meaning of Sec.  1.469-1T(e)(2)). E does no work in 
connection with this activity. E anticipates that, for the taxable year, 
E's deductions from the activity will exceed E's gross income from the 
activity and that, if E does not materially participate in the activity 
for the taxable year, part or all of F's passive activity loss for the 
taxable year will be disallowed under Sec.  1.469-1T(a)(1)(i). 
Accordingly, E pays E's spouse to work as an office receptionist in 
connection with the activity for an average of 15 hours per week during 
the taxable year.
    (ii) Under paragraph (f)(3) of this section any participation in the 
activity by E's spouse is treated as participation in the activity by E. 
However, under paragraph (f)(2)(i) of this section, the work done by E's 
spouse is not treated as participation in the activity because work as 
an office receptionist is not work of a type customarily done by an 
owner of a football team, and one of E's principal purposes for paying 
E's spouse to do this work is to avoid the disallowance under Sec.  
1.469-1T(a)(1)(i) of E's passive activity loss. Accordingly, E is not 
treated as participating in the activity for the taxable year.
    Example 8. (i) F, an individual, owns an interest in a partnership 
that feeds and sells cattle. The general partner of the partnership 
periodically mails F a letter setting forth certain proposed actions and 
decisions with respect to the cattle-feeding operation. Such actions and 
decisions include, for example, what kind of feed to purchase, how much 
to purchase, and when to purchase it, how often to feed cattle, and when 
to sell cattle. The letters explain the proposed actions and decisions, 
emphasize that taking or not taking a particular action or decision is 
solely within the discretion of F and other partners, and ask F to 
indicate a decision with respect to each proposed action by answering 
certain questions. The general partner receives a fee that constitutes 
earned income (within the meaning of section 911 (d)(2)(A)) for managing 
the cattle-feeding operation. F is not treated as materially 
participating in the cattle-feeding operation under paragraph (a) (1) 
through (6) of this section.
    (ii) F's only participation in the cattle-feeding operation is to 
make certain managerial decisions. Under paragraph (b)(2)(ii) of this 
section, such management services are not taken into account in 
determining whether the taxpayer is treated as materially participating 
in the activity for a taxable year under paragraph (a)(7) of this 
section, if any other person performs services in connection with the 
management of the activity and receives compensation described in 
section 911(d)(2)(A) for such services. Therefore, F is not treated as 
materially participating for the taxable year in the cattle-feeding 
operation.

[T.D. 8175, 53 FR 5725, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988, as 
amended by T.D. 8253, 54 FR 20565, May 12, 1989; T.D. 8417, 57 FR 20759, 
May 15, 1992; 61 FR 14247, Apr. 1, 1996]

[[Page 545]]



Sec.  1.469-6  Treatment of losses upon certain dispositions. [Reserved]



Sec.  1.469-7  Treatment of self-charged items of interest income 
and deduction.

    (a) In general--(1) Applicability and effect of rules. This section 
sets forth rules that apply, for purposes of section 469 and the 
regulations thereunder, in the case of a lending transaction (including 
guaranteed payments for the use of capital under section 707(c)) between 
a taxpayer and a passthrough entity in which the taxpayer owns a direct 
or indirect interest, or between certain passthrough entities. The rules 
apply only to items of interest income and interest expense that are 
recognized in the same taxable year. The rules--
    (i) Treat certain interest income resulting from these lending 
transactions as passive activity gross income;
    (ii) Treat certain deductions for interest expense that is properly 
allocable to the interest income as passive activity deductions; and
    (iii) Allocate the passive activity gross income and passive 
activity deductions resulting from this treatment among the taxpayer's 
activities.
    (2) Priority of rules in this section. The character of amounts 
treated under the rules of this section as passive activity gross income 
and passive activity deductions and the activities to which these 
amounts are allocated are determined under the rules of this section and 
not under the rules of Sec. Sec.  1.163-8T, 1.469-2(c) and (d), and 
1.469-2T(c) and (d).
    (b) Definitions. The following definitions set forth the meaning of 
certain terms for purposes of this section:
    (1) Passthrough entity. The term passthrough entity means a 
partnership or an S corporation.
    (2) Taxpayer's share. A taxpayer's share of an item of income or 
deduction of a passthrough entity is the amount treated as an item of 
income or deduction of the taxpayer for the taxable year under section 
702 (relating to the treatment of distributive shares of partnership 
items as items of partners) or section 1366 (relating to the treatment 
of pro rata shares of S corporation items as items of shareholders).
    (3) Taxpayer's indirect interest. The taxpayer has an indirect 
interest in an entity if the interest is held through one or more 
passthrough entities.
    (4) Entity taxable year. In applying this section for a taxable year 
of a taxpayer, the term entity taxable year means the taxable year of 
the passthrough entity for which the entity reports items that are taken 
into account under section 702 or section 1366 for the taxpayer's 
taxable year.
    (5) Deductions for a taxable year. The term deductions for a taxable 
year means deductions that would be allowable for the taxable year if 
the taxpayer's taxable income for all taxable years were determined 
without regard to sections 163(d), 170(b), 469, 613A(d), and 1211.
    (c) Taxpayer loans to passthrough entity--(1) Applicability. Except 
as provided in paragraph (g) of this section, this paragraph (c) applies 
with respect to a taxpayer's interest in a passthrough entity (borrowing 
entity) for a taxable year if--
    (i) The borrowing entity has deductions for the entity taxable year 
for interest charged to the borrowing entity by persons that own direct 
or indirect interests in the borrowing entity at any time during the 
entity taxable year (the borrowing entity's self-charged interest 
deductions);
    (ii) The taxpayer owns a direct or an indirect interest in the 
borrowing entity at any time during the entity taxable year and has 
gross income for the taxable year from interest charged to the borrowing 
entity by the taxpayer or a passthrough entity through which the 
taxpayer holds an interest in the borrowing entity (the taxpayer's 
income from interest charged to the borrowing entity); and
    (iii) The taxpayer's share of the borrowing entity's self-charged 
interest deductions includes passive activity deductions.
    (2) General rule. If any of the borrowing entity's self-charged 
interest deductions are allocable to an activity for a taxable year in 
which this paragraph (c) applies, the passive activity gross income and 
passive activity deductions from that activity are determined under the 
following rules--
    (i) The applicable percentage of each item of the taxpayer's income 
for the

[[Page 546]]

taxable year from interest charged to the borrowing entity is treated as 
passive activity gross income from the activity; and
    (ii) The applicable percentage of each deduction for the taxable 
year for interest expense that is properly allocable (within the meaning 
of paragraph (f) of this section) to the taxpayer's income from the 
interest charged to the borrowing entity is treated as a passive 
activity deduction from the activity.
    (3) Applicable percentage. In applying this paragraph (c) with 
respect to a taxpayer's interest in a borrowing entity, the applicable 
percentage is separately determined for each of the taxpayer's 
activities. The percentage applicable to an activity for a taxable year 
is obtained by dividing--
    (i) The taxpayer's share for the taxable year of the borrowing 
entity's self-charged interest deductions that are treated as passive 
activity deductions from the activity by
    (ii) The greater of--
    (A) The taxpayer's share for the taxable year of the borrowing 
entity's aggregate self-charged interest deductions for all activities 
(regardless of whether these deductions are treated as passive activity 
deductions); or
    (B) The taxpayer's aggregate income for the taxable year from 
interest charged to the borrowing entity for all activities of the 
borrowing entity.
    (d) Passthrough entity loans to taxpayer--(1) Applicability. Except 
as provided in paragraph (g) of this section, this paragraph (d) applies 
with respect to a taxpayer's interest in a passthrough entity (lending 
entity) for a taxable year if--
    (i) The lending entity has gross income for the entity taxable year 
from interest charged by the lending entity to persons that own direct 
or indirect interests in the lending entity at any time during the 
entity taxable year (the lending entity's self-charged interest income);
    (ii) The taxpayer owns a direct or an indirect interest in the 
lending entity at any time during the entity taxable year and has 
deductions for the taxable year for interest charged by the lending 
entity to the taxpayer or a passthrough entity through which the 
taxpayer holds an interest in the lending entity (the taxpayer's 
deductions for interest charged by the lending entity); and
    (iii) The taxpayer's deductions for interest charged by the lending 
entity include passive activity deductions.
    (2) General rule. If any of the taxpayer's deductions for interest 
charged by the lending entity are allocable to an activity for a taxable 
year in which this paragraph (d) applies, the passive activity gross 
income and passive activity deductions from that activity are determined 
under the following rules--
    (i) The applicable percentage of the taxpayer's share for the 
taxable year of each item of the lending entity's self-charged interest 
income is treated as passive activity gross income from the activity.
    (ii) The applicable percentage of the taxpayer's share for the 
taxable year of each deduction for interest expense that is properly 
allocable (within the meaning of paragraph (f) of this section) to the 
lending entity's self-charged interest income is treated as a passive 
activity deduction from the activity.
    (3) Applicable percentage. In applying this paragraph (d) with 
respect to a taxpayer's interest in a lending entity, the applicable 
percentage is separately determined for each of the taxpayer's 
activities. The percentage applicable to an activity for a taxable year 
is obtained by dividing--
    (i) The taxpayer's deductions for the taxable year for interest 
charged by the lending entity, to the extent treated as passive activity 
deductions from the activity; by
    (ii) The greater of--
    (A) The taxpayer's aggregate deductions for all activities for the 
taxable year for interest charged by the lending entity (regardless of 
whether these deductions are treated as passive activity deductions); or
    (B) The taxpayer's aggregate share for the taxable year of the 
lending entity's self-charged interest income for all activities of the 
lending entity.
    (e) Identically-owned passthrough entities--(1) Applicability. 
Except as provided in paragraph (g) of this section, this paragraph (e) 
applies with respect

[[Page 547]]

to lending transactions between passthrough entities if each owner of 
the borrowing entity has the same proportionate ownership interest in 
the lending entity.
    (2) General rule. To the extent an owner shares in interest income 
from a loan between passthrough entities described in paragraph (e)(1) 
of this section, the owner is treated as having made the loan to the 
borrowing passthrough entity and paragraph (c) of this section applies 
to determine the applicable percentage of portfolio income of properly 
allocable interest expense that is recharacterized as passive.
    (3) Example. The following example illustrates the application of 
this paragraph (e):

    Example. (i) A and B, both calendar year taxpayers, each own a 50-
percent interest in the capital and profits of partnerships RS and XY, 
both calendar year partnerships. Under the partnership agreements of RS 
and XY, A and B are each entitled to a 50-percent distributive share of 
each partnership's income, gain, loss, deduction, or credit. RS makes a 
$20,000 loan to XY and XY pays RS $2,000 of interest for the taxable 
year. A's distributive share of interest income attributable to this 
loan is $1,000 (50 percent x $2,000). XY uses all of the proceeds 
received from RS is a passive activity. A's distributive share of 
interest expense attributable to the loan is $1,000 (50 percent x 
$2,000).
    (ii) This paragraph (e) applies in determining A's passive activity 
gross income because RS and XY are identically-owned passthrough 
entities as described in paragraph (e)(1) of this section. Under 
paragraph (e)(2) of this section, the RS-to-XY loan is treated as if A 
made the loan to XY. Therefore, A must apply paragraph (c) of this 
section to determine the applicable percentage of portfolio income that 
is recharacterized as passive income.
    (iii) Paragraph (c) of this section applies in determining A's 
passive activity gross income because: XY has deductions for interest 
charged to XY by RS for the taxable year (XY's self-charged interest 
deductions); A owns an interest in XY during XY's taxable year and has 
gross income for the taxable year from interest charged to XY by RS; and 
A's share of XY's self-charged interest deductions includes passive 
activity deductions. See paragraph (c)(1) of this section.
    (iv) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's interest income is recharacterized as passive activity 
gross income from the activity. Paragraph (c)(3) of this section 
provides that the applicable percentage is obtained by dividing A's 
share for the taxable year of XY's self-charged interest deductions that 
are treated as passive activity deductions from the activity ($1,000) by 
the greater of A's share for the taxable year of XY's self-charged 
interest deductions ($1,000), or A's income for the year from interest 
charged to XY ($1,000). Thus, A's applicable percentage is 100 percent 
($1,000/$1,000), and $1,000 (100 percent x $1,000) of A's income from 
interest charged to XY is treated as passive activity gross income from 
the passive activity.

    (f) Identification of properly allocable deductions. For purposes of 
this section, interest expense is properly allocable to an item of 
interest income if the interest expense is allocated under Sec.  1.163-
8T to an expenditure that--
    (1) Is properly chargeable to capital account with respect to the 
investment producing the item of interest income; or
    (2) May reasonably be taken into account as a cost of producing the 
item of interest income.
    (g) Election to avoid application of the rules of this section--(1) 
In general. Paragraphs (c), (d) and (e) of this section shall not apply 
with respect to any taxpayer's interest in a passthrough entity for a 
taxable year if the passthrough entity has made, under this paragraph 
(g), an election that applies to the entity's taxable year.
    (2) Form of election. A passthrough entity makes an election under 
this paragraph (g) by attaching to its return (or amended return) a 
written statement that includes the name, address, and taxpayer 
identification number of the passthrough entity and a declaration that 
an election is being made under this paragraph (g).
    (3) Period for which election applies. An election under this 
paragraph (g) made with a return (or amended return) for a taxable year 
applies to that taxable year and all subsequent taxable years that end 
before the date on which the election is revoked.
    (4) Revocation. An election under this paragraph (g) may be revoked 
only with the consent of the Commissioner.
    (h) Examples. The following examples illustrate the principles of 
this section. The examples assume for purposes of simplifying the 
presentation, that the lending transactions described do not result in 
foregone interest (within the meaning of section 7872(e)(2)), original

[[Page 548]]

issue discount (within the meaning of section 1273), or total unstated 
interest (within the meaning of section 483(b)).

    Example 1. (i) A and B, two calendar year individuals, each own 50-
percent interests in the capital, profits and losses of AB, a calendar 
year partnership. AB is engaged in a single rental activity within the 
meaning of Sec.  1.469-1T(e)(3). AB borrows $50,000 from A and uses the 
loan proceeds in the rental activity. AB pays $5,000 of interest to A 
for the taxable year. A and B each incur $2,500 of interest expense as 
their distributive share of AB's interest expense.
    (ii) AB has self-charged interest deductions for the taxable year 
(i.e., the deductions for interest charged to AB by A); A owns a direct 
interest in AB during AB's taxable year and has income for A's taxable 
year from interest charged to AB; and A's share of AB's self-charged 
interest deductions includes passive activity deductions. Accordingly, 
paragraph (c) of this section applies in determining A's passive 
activity gross income. See paragraph (c)(1) of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's interest income is recharacterized as passive activity 
gross income from AB's rental activity. Paragraph (c)(3) of this section 
provides that the applicable percentage is obtained by dividing A's 
share for the taxable year of AB's self-charged interest deductions that 
are treated as passive activity deductions from the activity ($2,500) by 
the greater of A's share for the taxable year of AB's self-charged 
interest deductions ($2,500), or A's income for the taxable year from 
interest charged to AB ($5,000). Thus, A's applicable percentage is 50 
percent ($2,500/$5,000), and $2,500 (50 percent x $5,000) of A's income 
from interest charged to AB is treated as passive activity gross income 
from the passive activity A conducts through AB.
    (iv) Because B does not have any gross income for the year from 
interest charged to AB, this section does not apply to B. See paragraph 
(c)(1)(ii) of this section.
    Example 2. (i) C and D, two calendar year taxpayers, each own 50-
percent interests in the capital and profits of CD, a calendar year 
partnership. CD is engaged in a single rental activity, within the 
meaning of Sec.  1.469-1T(e)(3). C obtains a $10,000 loan from a third-
party lender, and pays the lender $900 in interest for the taxable year. 
C lends the $10,000 to CD, and receives $1,000 of interest income from 
CD for the taxable year. D lends $20,000 to CD and receives $2,000 of 
interest income from CD for the taxable year. CD uses all of the 
proceeds in the rental activity. C and D are each allocated $1,500 (50 
percent x $3,000) of interest expense as their distributive share of 
CD's interest expense for the taxable year.
    (ii) CD has self-charged interest deductions for the taxable year 
(i.e., deductions for interest charged to CD by C and D); C and D each 
own direct interests in CD during CD's taxable year and have gross 
income for the taxable year from interest charged to CD; and both C's 
and D's shares of CD's self-charged interest deductions include passive 
activity deductions. Accordingly, paragraph (c) of this section applies 
in determining C's and D's passive activity gross income. See paragraph 
(c)(1) of this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of each partner's interest income is recharacterized as 
passive activity gross income from CD's rental activity. Paragraph 
(c)(3) of this section provides that C's applicable percentage is 
obtained by dividing C's share for the taxable year of CD's self-charged 
interest deductions that are treated as passive activity deductions from 
the activity ($1,500) by the greater of C's share for the taxable year 
of CD's self-charged interest deductions ($1,500), or C's income for the 
taxable year from interest charged to CD ($1,000). Thus, C's applicable 
percentage is 100 percent ($1,500/$1,500), and all of C's income from 
interest charged to CD ($1,000) is treated as passive activity gross 
income from the passive activity C conducts through CD. Similarly, D's 
applicable percentage is obtained by dividing D's share for the taxable 
year of CD's self-charged interest deductions that are treated as 
passive activity deductions from the activity ($1,500) by the greater of 
D's share for the taxable year of CD's self-charged interest deductions 
($1,500), or D's income for the taxable year from interest charged to CD 
($2,000). Thus, D's applicable percentage is 75 percent ($1,500/$2,000), 
and $1,500 (75 percent x $2,000) of D's income from interest charged to 
CD is treated as passive activity gross income from the rental activity.
    (iv) The $900 of interest expense that C pays to the third-party 
lender is allocated under Sec.  1.163-8T(c)(1) to an expenditure that is 
properly chargeable to capital account with respect to the loan to CD. 
Thus, the expense is properly allocable to the interest income C 
receives from CD (see paragraph (f) of this section). Under paragraph 
(c)(2)(ii) of this section, the applicable percentage of C's deductions 
for the taxable year for interest expense that is properly allocable to 
C's income from interest charged to CD is recharacterized as a passive 
activity deduction from CD's rental activity. Accordingly, all of C's 
$900 interest deduction is treated as a passive activity deduction from 
the rental activity.
    Example 3. (i) E and F, calendar year taxpayers, each own 50 percent 
of the stock of X, a calendar year S corporation. E borrows $30,000 from 
X, and pays X $3,000 of interest for the taxable year. E uses $15,000 of 
the

[[Page 549]]

loan proceeds to make a personal expenditure (as defined in Sec.  1.163-
8T(b)(5)), and uses $15,000 of loan proceeds to purchase a trade or 
business activity in which E does not materially participate (within the 
meaning of Sec.  1.469-5T) for the taxable year. E and F each receive 
$1,500 as their pro rata share of X's interest income from the loan for 
the taxable year.
    (ii) X has gross income for X's taxable year from interest charged 
to E (X's self-charged interest income); E owns a direct interest in X 
during X's taxable year and has deductions for the taxable year for 
interest charged by X; and E's deductions for interest charged by X 
include passive activity deductions. Accordingly, paragraph (d) of this 
section applies in determining E's passive activity gross income. See 
paragraph (d)(1) of this section.
    (iii) Under the rules in paragraph (d)(2)(i) of this section, the 
applicable percentage of E's share of X's self-charged interest income 
is recharacterized as passive activity gross income from the activity. 
Paragraph (d)(3) of this section provides that the applicable percentage 
is obtained by dividing E's deductions for the taxable year for interest 
charged by X, to the extent treated as passive activity deductions from 
the activity ($1,500), by the greater of E's deductions for the taxable 
year for interest charged by X, regardless of whether those deductions 
are treated as passive activity deductions ($3,000), or E's share for 
the taxable year of X's self-charged interest income ($1,500). Thus, E's 
applicable percentage is 50 percent ($1,500/$3,000), and $750 (50 
percent x $1,500) of E's share of X's self-charged interest income is 
treated as passive activity gross income.
    (iv) Because F does not have any deductions for the taxable year for 
interest charged by X, this section does not apply to F. See paragraph 
(d)(1)(ii) of this section.
    Example 4. (i) This Example 4 illustrates the application of this 
section to a partner that has a different taxable year from the 
partnership. The facts are the same as in Example 1 except as follows: 
Partnership AB has properly adopted a fiscal year ending June 30 for 
federal tax purposes; AB borrows the $50,000 from A on October 1, 1990; 
and under the terms of the loan, AB must pay A $5,000 in interest 
annually, in quarterly installments, for a term of 2 years.
    (ii) For A's taxable years from 1990 through 1993 and AB's 
corresponding entity taxable years (as defined in paragraph (b)(4) of 
this section) A's interest income and AB's interest deductions from the 
loan are as follows:

------------------------------------------------------------------------
                                                    A's          AB's
                                                  interest     interest
                                                   income     deductions
------------------------------------------------------------------------
1990..........................................       $1,250            0
1991..........................................        5,000       $3,750
1992..........................................        3,750        5,000
1993..........................................            0        1,250
------------------------------------------------------------------------

    (iii) For A's taxable year ending December 31, 1990, the 
corresponding entity taxable year is AB's taxable year ending June 30, 
1990. Because AB does not have any deductions for the entity taxable 
year for interest charged to AB by A, paragraph (c) of this section does 
not apply in determining A's passive activity gross income for 1990 (see 
paragraph (c)(1)(i) of this section). Accordingly, A reports $1,250 of 
portfolio income on A's 1990 income tax return.
    (iv) For A's taxable year ending December 31, 1991, the 
corresponding entity taxable year ends on June 30, 1991. AB has $3,750 
of deductions for the entity taxable year for interest charged to AB by 
A (AB's self-charged interest deductions); A owns a direct interest in 
AB during the entity taxable year and has $5,000 of interest income for 
A's taxable year from interest charged to AB; and A's share of AB's 
self-charged interest deductions includes passive activity deductions. 
Accordingly, paragraph (c) of this section applies in determining A's 
passive activity gross income.
    (v) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of A's 1991 interest income is recharacterized as passive 
activity gross income from the activity. Paragraph (c)(3) of this 
section provides that the applicable percentage is obtained by dividing 
A's share for A's 1991 taxable year of AB's self-charged interest 
deductions that are treated as passive activity deductions from the 
activity (50 percent x $3,750 = $1,875) by the greater of A's share for 
A's taxable year of AB's self-charged interest deductions ($1,875), or 
A's income for A's taxable year from interest charged to AB ($5,000). 
Thus, A's applicable percentage is 37.5 percent ($1,875/$5,000), and 
$1,875 (37.5 percent x $5,000) of A's income from interest charged to AB 
is treated as passive activity gross income from the passive activity A 
conducts through AB.
    (vi) For A's taxable year ending December 31, 1992, the 
corresponding entity taxable year ends on June 30, 1992. AB has $5,000 
of deductions for the entity taxable year for interest charged to AB by 
A (AB's self-charged interest deductions); A owns a direct interest in 
AB during the entity taxable year and has $3,750 of gross income for A's 
taxable year from interest charged to AB; and A's share of AB's self-
charged interest deductions includes passive activity deductions. 
Accordingly, paragraph (c) of this section applies in determining A's 
passive activity gross income.
    (vii) The applicable percentage for 1992 is obtained by dividing A's 
share for A's 1992

[[Page 550]]

taxable year of AB's self-charged interest deductions that are treated 
as passive activity deductions from the activity ($2,500) by the greater 
of A's share for A's taxable year of AB's self-charged interest 
deductions ($2,500), or A's income for A's taxable year from interest 
charged to AB ($3,750). Thus, A's applicable percentage is 66\2/3\ 
percent ($2,500/$3,750), and $2,500 (66\2/3\ percent x $3,750) of A's 
income from interest charged to AB is treated as passive activity gross 
income from the passive activity A conducts through AB.
    (viii) Paragraph (c) of this section does not apply in determining 
A's passive activity gross income for the taxable year ending December 
31, 1993, because A has no gross income for the taxable year from 
interest charged to AB (see paragraph (c)(1)(ii) of this section). A's 
share of AB's self-charged interest deductions for the entity taxable 
year ending June 30, 1993 ($625) is taken into account as a passive 
activity deduction on A's 1993 income tax return.
    (ix) Because B does not have any gross income from interest charged 
to AB for any of the taxable years, this section does not apply to B. 
See paragraph (c)(1)(ii) of this section.
    Example 5. (i) This Example 5 illustrates the application of the 
rules of this section in the case of a taxpayer who has an indirect 
interest in a partnership. G, a calendar year taxpayer, is an 80-percent 
partner in partnership UTP. UTP owns a 25-percent interest in the 
capital and profits of partnership LTP. UTP and LTP are both calendar 
year partnerships. The partners of LTP conduct a single passive activity 
through LTP. UTP obtains a $10,000 loan from a bank, and pays the bank 
$1,000 of interest per year. G's distributive share of the interest paid 
to the bank is $800 (80 percent x $1,000). UTP uses the $10,000 debt 
proceeds and another $10,000 of cash to make a loan to LTP, and LTP pays 
UTP $2,000 of interest for the taxable year. G's distributive share of 
interest income attributable to the UTP-to-LTP loan is $1,600 (80 
percent x $2,000). LTP uses all of the proceeds received from UTP in the 
passive activity. UTP's distributive share of interest expense 
attributable to the UTP-to-LTP loan is $500 (25 percent x $2,000). G's 
distributive share of interest expense attributable to the UTP-to-LTP 
loan is $400 (80 percent x $500).
    (ii) LTP has deductions for interest charged to LTP by UTP for the 
taxable year (LTP's self-charged interest deductions); G owns an 
indirect interest in LTP during LTP's taxable year and has gross income 
for the taxable year from interest charged to LTP by a passthrough 
entity (UTP) through which G owns an interest in LTP; and G's share of 
LTP's self-charged interest deductions includes passive activity 
deductions. Accordingly, paragraph (c) of this section applies in 
determining G's passive activity gross income. See paragraph (c)(1) of 
this section.
    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of G's interest income is recharacterized as passive activity 
gross income from the activity. Paragraph (c)(3) of this section 
provides that the applicable percentage is obtained by dividing G's 
share for the taxable year of LTP's self-charged interest deductions 
that are treated as passive activity deductions from the activity ($400) 
by the greater of G's share for the taxable year of LTP's self-charged 
interest deductions ($400), or G's income for the year from interest 
charged to LTP ($1,600). Thus, G's applicable percentage is 25 percent 
($400/$1,600), and $400 (25 percent x $1,600) of G's income from 
interest charged to LTP is treated as passive activity gross income from 
the passive activity that G conducts through UTP and LTP.
    (iv) G's $800 distributive share of the interest expense that UTP 
pays to the third-party lender is allocated under Sec.  1.163-8T(c)(1) 
to an expenditure that is properly chargeable to capital account with 
respect to the loan to LTP. Thus, the expense is a deduction properly 
allocable to the interest income that G receives as a result of the UTP-
to-LTP loan (see paragraph (f) of this section). Under paragraph 
(c)(2)(ii) of this section, the applicable percentage of G's deductions 
for the taxable year for interest expense that is properly allocable to 
G's income from interest charged by UTP to LTP is recharacterized as a 
passive activity deduction from LTP's passive activity. Accordingly, 
$200 (25 percent x $800) of G's interest deduction is treated as a 
passive activity deduction from LTP's activity.
    Example 6. (i) This Example 6 illustrates the application of the 
rules of this section in the case of a taxpayer who conducts two passive 
activities through a passthrough entity. J, a calendar year taxpayer, is 
the 100-percent shareholder of Y, a calendar year S corporation. J 
conducts two passive activities through Y: a rental activity and a trade 
or business activity in which J does not materially participate. Y 
borrows $80,000 from J, and uses $60,000 of the loan proceeds in the 
rental activity and $20,000 of the loan proceeds in the passive trade or 
business activity. Y pays $8,000 of interest to J for the taxable year, 
and J incurs $8,000 of interest expense as J's distributive share of Y's 
interest expense.
    (ii) Y has self-charged interest deductions for the taxable year 
(i.e., the deductions for interest charged to Y by J); J owns a direct 
interest in Y during Y's taxable year and has gross income for J's 
taxable year from interest charged to Y; and J's share of Y's self-
charged interest deductions includes passive activity deductions. 
Accordingly, paragraph (c) of this section applies in determining J's 
passive activity gross income. See paragraph (c)(1) of this section.

[[Page 551]]

    (iii) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of J's interest income is recharacterized as passive activity 
gross income attributable to the rental activity. Paragraph (c)(3) of 
this section provides that the applicable percentage is obtained by 
dividing J's share for the taxable year of Y's self-charged interest 
deductions that are treated as passive activity deductions from the 
rental activity ($6,000) by the greater of J's share for the taxable 
year of Y's self-charged interest deductions ($8,000), or J's income for 
the taxable year from interest charged to Y ($8,000). Thus, J's 
applicable percentage is 75 percent ($6,000/$8,000), and $6,000 (75 
percent x $8,000) of J's income from interest charged to Y is treated as 
passive activity gross income from the rental activity J conducts 
through Y.
    (iv) Under paragraph (c)(2)(i) of this section, the applicable 
percentage of J's interest income is recharacterized as passive activity 
gross income attributable to the passive trade or business activity. 
Paragraph (c)(3) of this section provides that the applicable percentage 
is obtained by dividing J's share for the taxable year of Y's self-
charged interest deductions that are treated as passive activity 
deductions from the passive trade or business activity ($2,000) by the 
greater of J's share for the taxable year of Y's self-charged interest 
deductions ($8,000), or J's income for the taxable year from interest 
charged to Y ($8,000). Thus, J's applicable percentage is 25 percent 
($2,000/$8,000), and $2,000 of J's income from interest charged to Y is 
treated as passive activity gross income from the passive trade or 
business activity J conducts through Y.

[T.D. 9013, 67 FR 54089, Aug. 21, 2002]



Sec.  1.469-8  Application of section 469 to trust, estates, 
and their beneficiaries. [Reserved]



Sec.  1.469-9  Rules for certain rental real estate activities.

    (a) Scope and purpose. This section provides guidance to taxpayers 
engaged in certain real property trades or businesses on applying 
section 469(c)(7) to their rental real estate activities.
    (b) Definitions. The following definitions apply for purposes of 
this section:
    (1) Trade or business. A trade or business is any trade or business 
determined by treating the types of activities in Sec.  1.469-4(b)(1) as 
if they involved the conduct of a trade or business, and any interest in 
rental real estate, including any interest in rental real estate that 
gives rise to deductions under section 212.
    (2) Real property trade or business. The following terms have the 
following meanings in determining whether a trade or business is a real 
property trade or business for purposes of section 469(c)(7)(C) and this 
section.
    (i) Real property--(A) In general. The term real property includes 
land, buildings, and other inherently permanent structures that are 
permanently affixed to land. Any interest in real property, including 
fee ownership, co-ownership, a leasehold, an option, or a similar 
interest is real property under this section. Tenant improvements to 
land, buildings, or other structures that are inherently permanent or 
otherwise classified as real property under this section are real 
property for purposes of section 469(c)(7)(C). However, property 
manufactured or produced for sale that is not real property in the hands 
of the manufacturer or producer, but that may be incorporated into real 
property through installation or any similar process or technique by any 
person after the manufacture or production of such property (for 
example, bricks, nails, paint, and windowpanes), is not treated as real 
property in the hands of any person (including any person involved in 
the manufacture, production, sale, incorporation or installation of such 
property) prior to the completed incorporation or installation of such 
property into the real property for purposes of section 469(c)(7)(C) and 
this section.
    (B) Land. The term land includes water and air space superjacent to 
land and natural products and deposits that are unsevered from the land. 
Natural products and deposits, such as plants, crops, trees, water, 
ores, and minerals, cease to be real property when they are harvested, 
severed, extracted, or removed from the land. Accordingly, any trade or 
business that involves the cultivation and harvesting of plants, crops, 
or certain types of trees in a farming operation as defined in section 
464(e), or severing, extracting, or removing natural products or 
deposits from land is not a real property trade or business for purposes 
of section 469(c)(7)(C) and this section. The storage or maintenance of 
severed or extracted natural products or deposits, such as plants, 
crops, trees, water,

[[Page 552]]

ores, and minerals, in or upon real property does not cause the stored 
property to be recharacterized as real property, and any trade or 
business relating to or involving such storage or maintenance of severed 
or extracted natural products or deposits is not a real property trade 
or business, even though such storage or maintenance otherwise may occur 
upon or within real property.
    (C) Inherently permanent structure. The term inherently permanent 
structure means any permanently affixed building or other permanently 
affixed structure. If the affixation is reasonably expected to last 
indefinitely, based on all the facts and circumstances, the affixation 
is considered permanent. However, an asset that serves an active 
function, such as an item of machinery or equipment (for example, HVAC 
system, elevator or escalator), is not a building or other inherently 
permanent structure, and therefore is not real property for purposes of 
section 469(c)(7)(C) and this section, even if such item of machinery or 
equipment is permanently affixed to or becomes incorporated within a 
building or other inherently permanent structure. Accordingly, a trade 
or business that involves the manufacture, installation, operation, 
maintenance, or repair of any asset that serves an active function will 
not be a real property trade or business, or a unit or component of 
another real property trade or business, for purposes of section 
469(c)(7)(C) and this section.
    (D) Building--(1) In general. A building encloses a space within its 
walls and is generally covered by a roof or other external upper 
covering that protects the walls and inner space from the elements.
    (2) Types of buildings. Buildings include the following assets if 
permanently affixed to land: Houses; townhouses; apartments; 
condominiums; hotels; motels; stadiums; arenas; shopping malls; factory 
and office buildings; warehouses; barns; enclosed garages; enclosed 
transportation stations and terminals; and stores.
    (E) Other inherently permanent structures--(1) In general. Other 
inherently permanent structures include the following assets if 
permanently affixed to land: Parking facilities; bridges; tunnels; 
roadbeds; railroad tracks; pipelines; storage structures such as silos 
and oil and gas storage tanks; and stationary wharves and docks.
    (2) Facts and circumstances determination. The determination of 
whether an asset is an inherently permanent structure is based on all 
the facts and circumstances. In particular, the following factors must 
be taken into account:
    (i) The manner in which the asset is affixed to land and whether 
such manner of affixation allows the asset to be easily removed from the 
land;
    (ii) Whether the asset is designed to be removed or to remain in 
place indefinitely on the land;
    (iii) The damage that removal of the asset would cause to the asset 
itself or to the land to which it is affixed;
    (iv) Any circumstances that suggest the expected period of 
affixation is not indefinite (for example, a lease that requires or 
permits removal of the asset from the land upon the expiration of the 
lease); and
    (v) The time and expense required to move the asset from the land.
    (ii) Other definitions
    (A) Real property development. The term real property development 
means the maintenance and improvement of raw land to make the land 
suitable for subdivision, further development, or construction of 
residential or commercial buildings, or to establish, cultivate, 
maintain or improve timberlands (that is, land covered by timber-
producing forest). Improvement of land may include any clearing (such as 
through the mechanical separation and removal of boulders, rocks, brush, 
brushwood, and underbrush from the land); excavation and gradation work; 
diversion or redirection of creeks, streams, rivers, or other sources or 
bodies of water; and the installation of roads (including highways, 
streets, roads, public sidewalks, and bridges), utility lines, sewer and 
drainage systems, and any other infrastructure that may be necessary for 
subdivision, further development, or construction of residential or 
commercial buildings, or for the establishment, cultivation, maintenance 
or improvement of timberlands.

[[Page 553]]

    (B) Real property redevelopment. The term real property 
redevelopment means the demolition, deconstruction, separation, and 
removal of existing buildings, landscaping, and infrastructure on a 
parcel of land to return the land to a raw condition or otherwise 
prepare the land for new development or construction, or for the 
establishment and cultivation of new timberlands.
    (C) through (G) [Reserved]
    (H) Real property operation. The term real property operation means 
handling, by a direct or indirect owner of the real property, the day-
to-day operations of a trade or business, under paragraph (b)(1) of this 
section, relating to the maintenance and occupancy of the real property 
that affect the availability and functionality of that real property 
used, or held out for use, by customers where payments received from 
customers are principally for the customers' use of the real property. 
The principal purpose of such business operations must be the provision 
of the use of the real property, or physical space accorded by or within 
the real property, to one or more customers, and not the provision of 
other significant or extraordinary personal services, under Sec.  1.469-
1T(e)(3)(iv) and (v), to customers in conjunction with the customers' 
incidental use of the real property or physical space. If the real 
property or physical space is provided to a customer to be used to carry 
on the customer's trade or business, the principal purpose of the 
business operations must be to provide the customer with exclusive use 
of the real property or physical space in furtherance of the customer's 
trade or business, and not to provide other significant or extraordinary 
personal services to the customer in addition to or in conjunction with 
the use of the real property or physical space, regardless of whether 
the customer pays for the services separately. However, for purposes of 
and with respect to the preceding sentence, other incidental personal 
services may be provided to the customer in conjunction with the use of 
real property or physical space, as long as such services are 
insubstantial in relation to the customer's use of the real property or 
physical space.
    (I) Real property management. The term real property management 
means handling, by a professional manager, the day-to-day operations of 
a trade or business, under paragraph (b)(1) of this section, relating to 
the maintenance and occupancy of real property that affect the 
availability and functionality of that property used, or held out for 
use, by customers where payments received from customers are principally 
for the customers' use of the real property. The principal purpose of 
such business operations must be the provision of the use of the real 
property, or physical space accorded by or within the real property, to 
one or more customers, and not the provision of other significant or 
extraordinary personal services, under Sec.  1.469-1T(e)(3)(iv) and (v), 
to customers in conjunction with the customers' incidental use of the 
real property or physical space. If the real property or physical space 
is provided to a customer to be used to carry on the customer's trade or 
business, the principal purpose of the business operations must be to 
provide the customer with exclusive use of the real property or physical 
space in furtherance of the customer's trade or business, and not to 
provide other significant or extraordinary personal services to the 
customer in addition to or in conjunction with the use of the real 
property or physical space, regardless of whether the customer pays for 
the services separately. However, for purposes of and with respect to 
the preceding sentence, other incidental personal services may be 
provided to the customer in conjunction with the use of real property or 
physical space, as long as such services are insubstantial in relation 
to the customer's use of the real property or physical space. A 
professional manager is a person responsible, on a full-time basis, for 
the overall management and oversight of the real property or properties 
and who is not a direct or indirect owner of the real property or 
properties.
    (iii) Examples. The following examples illustrate the operation of 
this paragraph (b)(2):
    (A) Example 1. A owns farmland and uses the land in A's farming 
business to grow and harvest crops of various kinds. As part of this 
farming business,

[[Page 554]]

A utilizes a greenhouse that is an inherently permanent structure to 
grow certain crops during the winter months. Under the rules of this 
section, any trade or business that involves the cultivation and 
harvesting of plants, crops, or trees is not a real property trade or 
business for purposes of section 469(c)(7)(C) and this section, even 
though the cultivation and harvesting of crops occurs upon or within 
real property. Accordingly, under these facts, A is not engaged in a 
real property trade or business for purposes of section 469(c)(7)(C) and 
this section.
    (B) Example 2. B is a retired farmer and owns farmland that B rents 
exclusively to C to operate a farm. The arrangement between B and C is a 
trade or business (under paragraph (b)(1) of this section) where 
payments by C are principally for C's use of B's real property. B also 
provides certain farm equipment for C's use. However, C is solely 
responsible for the maintenance and repair of the farm equipment along 
with any costs associated with operating the equipment. B also 
occasionally provides oral advice to C regarding various aspects of the 
farm operation, based on B's prior experience as a farmer. Other than 
the provision of this occasional advice, B does not provide any 
significant or extraordinary personal services to C in connection with 
the rental of the farmland to C. Under these facts, B is engaged in a 
real property trade or business (which does not include the use or 
deemed rental of any farm equipment) for purposes of section 
469(c)(7)(C) and this section, and B's oral advice is an incidental 
personal service that B provides in conjunction with C's use of the real 
property. Nevertheless, under these facts, C is not engaged in a real 
property trade or business for purposes of section 469(c)(7)(C) and this 
section because C is engaged in the business of farming.
    (C) Example 3. D owns a building in which D operates a restaurant 
and bar. Even though D provides customers with use of the physical space 
inside the building, D is not engaged in a trade or business where 
payments by customers are principally for the use of real property or 
physical space. Instead, the payments by D's customers are principally 
for the receipt of significant or extraordinary personal services (under 
Sec.  1.469-1T(e)(3)(iv) and (v)), mainly food and beverage preparation 
and presentation services, and the use of the physical space by 
customers is incidental to the receipt of these personal services. Under 
the rules of this section, any trade or business that involves the 
provision of significant or extraordinary personal services to customers 
in conjunction with the customers' incidental use of real property or 
physical space is not a real property trade or business, even though the 
business operations occur upon or within real property. Accordingly, 
under these facts, D is not engaged in a real property trade or business 
for purposes of section 469(c)(7)(C) and this section.
    (D) Example 4. E owns a majority interest in an S corporation, X, 
that is engaged in the trade or business of manufacturing industrial 
cooling systems for installation in commercial buildings and for other 
uses. E also owns a majority interest in an S corporation, Y, that 
purchases the industrial cooling systems from X and that installs, 
maintains, and repairs those systems in both existing commercial 
buildings and commercial buildings under construction. Under the rules 
of this section, any trade or business that involves the manufacture, 
installation, operation, maintenance, or repair of any machinery or 
equipment that serves an active function will not be a real property 
trade or business (or a unit or component of another real property trade 
or business) for purposes of section 469(c)(7)(C) and this section, even 
though the machinery or equipment will be permanently affixed to real 
property once it is installed. In this case, the industrial cooling 
systems are machinery or equipment that serves an active function. 
Accordingly, under these facts, E, X and Y will not be treated as 
engaged in one or more real property trades or businesses for purposes 
of section 469(c)(7)(C) and this section.
    (E) Example 5. (1) F owns an interest in P, a limited partnership. P 
owns and operates a luxury hotel. In addition to providing rooms and 
suites for use by customers, the hotel offers many additional amenities 
such as in-room food

[[Page 555]]

and beverage service, maid and linen service, parking valet service, 
concierge service, front desk and bellhop service, dry cleaning and 
laundry service, and in-room barber and hairdresser service. P 
contracted with M to provide maid and janitorial services to P's hotel. 
M is an S corporation principally engaged in the trade or business of 
providing maid and janitorial services to various types of businesses, 
including hotels. G is a professional manager employed by M who handles 
the day-to-day business operations relating to M's provision of maid and 
janitorial services to M's various customers, including P.
    (2) Even though the personal services that P provides to the 
customers of its hotel are significant personal services under Sec.  
1.469-1T(e)(3)(iv), the principal purpose of P's hotel business 
operations is the provision of use of the hotel's rooms and suites to 
customers, and not the provision of the significant personal services to 
P's customers in conjunction with the customers' incidental use of those 
rooms or suites. The provision of these significant personal services by 
P to P's customers is incidental to the customers' use of the hotel's 
real property. Accordingly, under these facts, F is treated as owning an 
interest in a real property trade or business conducted by or through P 
and P is treated as engaged in a real property trade or business for 
purposes of section 469(c)(7)(C) and this section.
    (3) With respect to the maid and janitorial services provided by M, 
M's operations affect the availability and functionality of real 
property used, or held out for use, by customers in a trade or business 
where payments by customers are principally for the use of real property 
(in this case, P's hotel). However, M does not operate or manage real 
property. Instead, M is engaged in a trade or business of providing maid 
and janitorial services to customers, such as P, that are engaged in 
real property trades or businesses. Thus, M's business operations are 
merely ancillary to real property trades or businesses. Therefore, M is 
not engaged in real property operations or management as defined in this 
section. Accordingly, under these facts, M is not engaged in a real 
property trade or business under section 469(c)(7)(C) and this section.
    (4) With respect to the day-to-day business operations that G 
handles as a professional manager of M, the business operations that G 
manages is not the provision of use of P's hotel rooms and suites to 
customers. G does not operate or manage real property. Instead, G 
manages the provision of maid and janitorial services to customers, 
including P's hotel. Therefore, G is not engaged in real property 
management as defined in this section. Accordingly, under these facts, G 
is not engaged in a real property trade or business under section 
469(c)(7)(C) and this section.
    (3) Rental real estate. Rental real estate is any real property used 
by customers or held for use by customers in a rental activity within 
the meaning of Sec.  1.469-1T(e)(3). However, any rental real estate 
that the taxpayer grouped with a trade or business activity under Sec.  
1.469-4(d)(1)(i)(A) or (C) is not an interest in rental real estate for 
purposes of this section.
    (4) Personal services. Personal services means any work performed by 
an individual in connection with a trade or business. However, personal 
services do not include any work performed by an individual in the 
individual's capacity as an investor as described in Sec.  1.469-
5T(f)(2)(ii).
    (5) Material participation. Material participation has the same 
meaning as under Sec.  1.469-5T. Paragraph (f) of this section contains 
rules applicable to limited partnership interests in rental real estate 
that a qualifying taxpayer elects to aggregate with other interests in 
rental real estate of that taxpayer.
    (6) Qualifying taxpayer. A qualifying taxpayer is a taxpayer that 
owns at least one interest in rental real estate and meets the 
requirements of paragraph (c) of this section.
    (c) Requirements for qualifying taxpayers--(1) In general. A 
qualifying taxpayer must meet the requirements of section 469(c)(7)(B).
    (2) Closely held C corporations. A closely held C corporation meets 
the requirements of paragraph (c)(1) of this section by satisfying the 
requirements of section 469(c)(7)(D)(i). For purposes of section 
469(c)(7)(D)(i), gross receipts

[[Page 556]]

do not include items of portfolio income within the meaning of Sec.  
1.469-2T(c)(3).
    (3) Requirement of material participation in the real property 
trades or businesses. A taxpayer must materially participate in a real 
property trade or business in order for the personal services provided 
by the taxpayer in that real property trade or business to count towards 
meeting the requirements of paragraph (c)(1) of this section.
    (4) Treatment of spouses. Spouses filing a joint return are 
qualifying taxpayers only if one spouse separately satisfies both 
requirements of section 469(c)(7)(B). In determining the real property 
trades or businesses in which a married taxpayer materially participates 
(but not for any other purpose under this paragraph (c)), work performed 
by the taxpayer's spouse in a trade or business is treated as work 
performed by the taxpayer under Sec.  1.469-5T(f)(3), regardless of 
whether the spouses file a joint return for the year.
    (5) Employees in real property trades or businesses. For purposes of 
paragraph (c)(1) of this section, personal services performed during a 
taxable year as an employee generally will be treated as performed in a 
trade or business but will not be treated as performed in a real 
property trade or business, unless the taxpayer is a five-percent owner 
(within the meaning of section 416(i)(1)(B)) in the employer. If an 
employee is not a five-percent owner in the employer at all times during 
the taxable year, only the personal services performed by the employee 
during the period the employee is a five-percent owner in the employer 
will be treated as performed in a real property trade or business.
    (d) General rule for determining real property trades or 
businesses--(1) Facts and circumstances. The determination of a 
taxpayer's real property trades or businesses for purposes of paragraph 
(c) of this section is based on all of the relevant facts and 
circumstances. A taxpayer may use any reasonable method of applying the 
facts and circumstances in determining the real property trades or 
businesses in which the taxpayer provides personal services. Depending 
on the facts and circumstances, a real property trade or business 
consists either of one or more than one trade or business specifically 
described in section 469(c)(7)(C). A taxpayer's grouping of activities 
under Sec.  1.469-4 does not control the determination of the taxpayer's 
real property trades or businesses under this paragraph (d).
    (2) Consistency requirement. Once a taxpayer determines the real 
property trades or businesses in which personal services are provided 
for purposes of paragraph (c) of this section, the taxpayer may not 
redetermine those real property trades or businesses in subsequent 
taxable years unless the original determination was clearly 
inappropriate or there has been a material change in the facts and 
circumstances that makes the original determination clearly 
inappropriate.
    (e) Treatment of rental real estate activities of a qualifying 
taxpayer--(1) In general. Section 469(c)(2) does not apply to any rental 
real estate activity of a taxpayer for a taxable year in which the 
taxpayer is a qualifying taxpayer under paragraph (c) of this section. 
Instead, a rental real estate activity of a qualifying taxpayer is a 
passive activity under section 469 for the taxable year unless the 
taxpayer materially participates in the activity. Each interest in 
rental real estate of a qualifying taxpayer will be treated as a 
separate rental real estate activity, unless the taxpayer makes an 
election under paragraph (g) of this section to treat all interests in 
rental real estate as a single rental real estate activity. Each 
separate rental real estate activity, or the single combined rental real 
estate activity if the taxpayer makes an election under paragraph (g), 
will be an activity of the taxpayer for all purposes of section 469, 
including the former passive activity rules under section 469(f) and the 
disposition rules under section 469(g). However, section 469 will 
continue to be applied separately with respect to each publicly traded 
partnership, as required under section 469(k), notwithstanding the rules 
of this section.
    (2) Treatment as a former passive activity. For any taxable year in 
which a

[[Page 557]]

qualifying taxpayer materially participates in a rental real estate 
activity, that rental real estate activity will be treated as a former 
passive activity under section 469(f) if disallowed deductions or 
credits are allocated to the activity under Sec.  1.469-1(f)(4).
    (3) Grouping rental real estate activities with other activities--
(i) In general. For purposes of this section, a qualifying taxpayer may 
not group a rental real estate activity with any other activity of the 
taxpayer. For example, if a qualifying taxpayer develops real property, 
constructs buildings, and owns an interest in rental real estate, the 
taxpayer's interest in rental real estate may not be grouped with the 
taxpayer's development activity or construction activity. Thus, only the 
participation of the taxpayer with respect to the rental real estate may 
be used to determine if the taxpayer materially participates in the 
rental real estate activity under Sec.  1.469-5T.
    (ii) Special rule for certain management activities. A qualifying 
taxpayer may participate in a rental real estate activity through 
participation, within the meaning of Sec. Sec.  1.469-5(f) and 5T(f), in 
an activity involving the management of rental real estate (even if this 
management activity is conducted through a separate entity). In 
determining whether the taxpayer materially participates in the rental 
real estate activity, however, work the taxpayer performs in the 
management activity is taken into account only to the extent it is 
performed in managing the taxpayer's own rental real estate interests.
    (4) Example. The following example illustrates the application of 
this paragraph (e).

    Example. (i) Taxpayer B owns interests in three rental buildings, U, 
V and W. In 1995, B has $30,000 of disallowed passive losses allocable 
to Building U and $10,000 of disallowed passive losses allocable to 
Building V under Sec.  1.469-1(f)(4). In 1996, B has $5,000 of net 
income from Building U, $5,000 of net losses from Building V, and 
$10,000 of net income from Building W. Also in 1996, B is a qualifying 
taxpayer within the meaning of paragraph (c) of this section. Each 
building is treated as a separate activity of B under paragraph (e)(1) 
of this section, unless B makes the election under paragraph (g) to 
treat the three buildings as a single rental real estate activity. If 
the buildings are treated as separate activities, material participation 
is determined separately with respect to each building. If B makes the 
election under paragraph (g) to treat the buildings as a single 
activity, all participation relating to the buildings is aggregated in 
determining whether B materially participates in the combined activity.
    (ii) Effective beginning in 1996, B makes the election under 
paragraph (g) to treat the three buildings as a single rental real 
estate activity. B works full-time managing the three buildings and thus 
materially participates in the combined activity in 1996 (even if B 
conducts this management function through a separate entity, including a 
closely held C corporation). Accordingly, the combined activity is not a 
passive activity of B in 1996. Moreover, as a result of the election 
under paragraph (g), disallowed passive losses of $40,000 ($30,000 + 
$10,000) are allocated to the combined activity. B's net income from the 
activity for 1996 is $10,000 ($5,000-$5,000 + $10,000). This net income 
is nonpassive income for purposes of section 469. However, under section 
469(f), the net income from a former passive activity may be offset with 
the disallowed passive losses from the same activity. Because Buildings 
U, V and W are treated as one activity for all purposes of section 469 
due to the election under paragraph (g), and this activity is a former 
passive activity under section 469(f), B may offset the $10,000 of net 
income from the buildings with an equal amount of disallowed passive 
losses allocable to the buildings, regardless of which buildings 
produced the income or losses. As a result, B has $30,000 ($40,000-
$10,000) of disallowed passive losses remaining from the buildings after 
1996.

    (f) Limited partnership interests in rental real estate activities--
(1) In general. If a taxpayer elects under paragraph (g) of this section 
to treat all interests in rental real estate as a single rental real 
estate activity, and at least one interest in rental real estate is held 
by the taxpayer as a limited partnership interest (within the meaning of 
Sec.  1.469-5T(e)(3)), the combined rental real estate activity will be 
treated as a limited partnership interest of the taxpayer for purposes 
of determining material participation. Accordingly, the taxpayer will 
not be treated under this section as materially participating in the 
combined rental real estate activity unless the taxpayer materially 
participates in the activity under the tests listed in Sec.  1.469-
5T(e)(2) (dealing with the tests for determining the material 
participation of a limited partner).

[[Page 558]]

    (2) De minimis exception. If a qualifying taxpayer elects under 
paragraph (g) of this section to treat all interests in rental real 
estate as a single rental real estate activity, and the taxpayer's share 
of gross rental income from all of the taxpayer's limited partnership 
interests in rental real estate is less than ten percent of the 
taxpayer's share of gross rental income from all of the taxpayer's 
interests in rental real estate for the taxable year, paragraph (f)(1) 
of this section does not apply. Thus the taxpayer may determine material 
participation under any of the tests listed in Sec.  1.469-5T(a) that 
apply to rental real estate activities.
    (g) Election to treat all interests in rental real estate as a 
single rental real estate activity--(1) In general. A qualifying 
taxpayer may make an election to treat all of the taxpayer's interests 
in rental real estate as a single rental real estate activity. This 
election is binding for the taxable year in which it is made and for all 
future years in which the taxpayer is a qualifying taxpayer under 
paragraph (c) of this section, even if there are intervening years in 
which the taxpayer is not a qualifying taxpayer. The election may be 
made in any year in which the taxpayer is a qualifying taxpayer, and the 
failure to make the election in one year does not preclude the taxpayer 
from making the election in a subsequent year. In years in which the 
taxpayer is not a qualifying taxpayer, the election will not have effect 
and the taxpayer's activities will be those determined under Sec.  
1.469-4. If there is a material change in the taxpayer's facts and 
circumstances, the taxpayer may revoke the election using the procedure 
described in paragraph (g)(3) of this section.
    (2) Certain changes not material. The fact that an election is less 
advantageous to the taxpayer in a particular taxable year is not, of 
itself, a material change in the taxpayer's facts and circumstances. 
Similarly, a break in the taxpayer's status as a qualifying taxpayer is 
not, of itself, a material change in the taxpayer's facts and 
circumstances.
    (3) Filing a statement to make or revoke the election. A qualifying 
taxpayer makes the election to treat all interests in rental real estate 
as a single rental real estate activity by filing a statement with the 
taxpayer's original income tax return for the taxable year. This 
statement must contain a declaration that the taxpayer is a qualifying 
taxpayer for the taxable year and is making the election pursuant to 
section 469(c)(7)(A). The taxpayer may make this election for any 
taxable year in which section 469(c)(7) is applicable. A taxpayer may 
revoke the election only in the taxable year in which a material change 
in the taxpayer's facts and circumstances occurs or in a subsequent year 
in which the facts and circumstances remain materially changed from 
those in the taxable year for which the election was made. To revoke the 
election, the taxpayer must file a statement with the taxpayer's 
original income tax return for the year of revocation. This statement 
must contain a declaration that the taxpayer is revoking the election 
under section 469(c)(7)(A) and an explanation of the nature of the 
material change.
    (h) Interests in rental real estate held by certain passthrough 
entities--(1) General rule. Except as provided in paragraph (h)(2) of 
this section, a qualifying taxpayer's interest in rental real estate 
held by a partnership or an S corporation (passthrough entity) is 
treated as a single interest in rental real estate if the passthrough 
entity grouped its rental real estate as one rental activity under Sec.  
1.469-4(d)(5). If the passthrough entity grouped its rental real estate 
into separate rental activities under Sec.  1.469-4(d)(5), each rental 
real estate activity of the passthrough entity will be treated as a 
separate interest in rental real estate of the qualifying taxpayer. 
However, the qualifying taxpayer may elect under paragraph (g) of this 
section to treat all interests in rental real estate, including the 
rental real estate interests held through passthrough entities, as a 
single rental real estate activity.
    (2) Special rule if a qualifying taxpayer holds a fifty-percent or 
greater interest in a passthrough entity. If a qualifying taxpayer owns, 
directly or indirectly, a fifty-percent or greater interest in the 
capital, profits, or losses of a passthrough entity for a taxable year, 
each interest in rental real estate held by

[[Page 559]]

the passthrough entity will be treated as a separate interest in rental 
real estate of the qualifying taxpayer, regardless of the passthrough 
entity's grouping of activities under Sec.  1.469-4(d)(5). However, the 
qualifying taxpayer may elect under paragraph (g) of this section to 
treat all interests in rental real estate, including the rental real 
estate interests held through passthrough entities, as a single rental 
real estate activity.
    (3) Special rule for interests held in tiered passthrough entities. 
If a passthrough entity owns a fifty-percent or greater interest in the 
capital, profits, or losses of another passthrough entity for a taxable 
year, each interest in rental real estate held by the lower-tier entity 
will be treated as a separate interest in rental real estate of the 
upper-tier entity, regardless of the lower-tier entity's grouping of 
activities under Sec.  1.469-4(d)(5).
    (i) [Reserved]
    (j) $25,000 offset for rental real estate activities of qualifying 
taxpayers--(1) In general. A qualifying taxpayer's passive losses and 
credits from rental real estate activities (including prior-year 
disallowed passive activity losses and credits from rental real estate 
activities in which the taxpayer materially participates) are allowed to 
the extent permitted under section 469(i). The amount of losses or 
credits allowable under section 469(i) is determined after the rules of 
this section are applied. However, losses allowable by reason of this 
section are not taken into account in determining adjusted gross income 
for purposes of section 469(i)(3).
    (2) Example. The following example illustrates the application of 
this paragraph (j).

    Example. (i) Taxpayer A owns building X and building Y, both 
interests in rental real estate. In 1995, A is a qualifying taxpayer 
within the meaning of paragraph (c) of this section. A does not elect to 
treat X and Y as one activity under section 469(c)(7)(A) and paragraph 
(g) of this section. As a result, X and Y are treated as separate 
activities pursuant to section 469(c)(7)(A)(ii). A materially 
participates in X which has $100,000 of passive losses disallowed from 
prior years and produces $20,000 of losses in 1995. A does not 
materially participate in Y which produces $40,000 of income in 1995. A 
also has $50,000 of income from other nonpassive sources in 1995. A 
otherwise meets the requirements of section 469(i).
    (ii) Because X is not a passive activity in 1995, the $20,000 of 
losses produced by X in 1995 are nonpassive losses that may be used by A 
to offset part of the $50,000 of nonpassive income. Accordingly, A is 
left with $30,000 ($50,000-$20,000) of nonpassive income. In addition, A 
may use the prior year disallowed passive losses of X to offset any 
income from X and passive income from other sources. Therefore, A may 
offset the $40,000 of passive income from Y with $40,000 of passive 
losses from X.
    (iii) Because A has $60,000 ($100,000-$40,000) of passive losses 
remaining from X and meets all of the requirements of section 469(i), A 
may offset up to $25,000 of nonpassive income with passive losses from X 
pursuant to section 469(i). As a result, A has $5,000 ($30,000-$25,000) 
of nonpassive income remaining and disallowed passive losses from X of 
$35,000 ($60,000-$25,000) in 1995.

[T.D. 8645, 60 FR 66499, Dec. 22, 1995, as amended by T.D. 9905, 85 FR 
56840, Sept. 14, 2020; T.D. 9943, 86 FR 5540, Jan. 19, 2021]



Sec.  1.469-10  Application of section 469 to publicly traded partnerships.

    (a) [Reserved]
    (b) Publicly traded partnership--(1) In general. For purposes of 
section 469(k), a partnership is a publicly traded partnership only if 
the partnership is a publicly traded partnership as defined in Sec.  
1.7704-1.
    (2) Effective date. This section applies for taxable years of a 
partnership beginning on or after December 17, 1998.

[T.D. 8799, 63 FR 69553, Dec. 17, 1998]



Sec.  1.469-11  Applicability date and transition rules.

    (a) Generally applicable effective dates. Except as otherwise 
provided in this section--
    (1) The rules contained in Sec. Sec.  1.469-1, 1.469-1T, 1.469-2, 
1.469-2T, 1.469-3, 1.469-3T, 1.469-4, but not Sec.  1.469-4(d)(6), 
1.469-5 and 1.469-5T, apply for taxable years ending after May 10, 1992. 
The rules contained in Sec.  1.469-4(d)(6) apply for taxable years 
beginning on or after March 22, 2021. However, taxpayers and their 
related parties, within the meaning of sections 267(b) (determined 
without regard to section 267(c)(3)) and 707(b)(1), may choose to apply 
the rules in Sec.  1.469-4(d)(6) to a taxable year beginning after 
December 31, 2017, and before

[[Page 560]]

March 22, 2021, provided that those taxpayers and their related parties 
consistently apply all of the rules in the section 163(j) regulations as 
contained in T.D. 9905 (Sec. Sec.  1.163(j)-0 through 1.163(j)-11, 
effective November 13, 2020) as modified by T.D. 9943 (effective January 
13, 2021), and, if applicable, Sec. Sec.  1.263A-9, 1.263A-15, 
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.383-0, 1.383-1, 
1.469-9, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 
1.1502-21, 1.1502-79, 1.1502-91 through 1.1502-99 (to the extent they 
effectuate the rules of Sec. Sec.  1.382-2, 1.382-5, 1.382-6, and 1.383-
1), and 1.1504-4 contained in T.D. 9905 as modified by T.D. 9943, to 
that taxable year and each subsequent taxable year.
    (2) The rules contained in 26 CFR 1.469-1T, 1.469-2T, 1.469-3T, 
1.469-4T, 1.469-5T, 1.469-11T (b) and (c) (as contained in the CFR 
edition revised as of April 1, 1992) apply for taxable years beginning 
after December 31, 1986, and ending on or before May 10, 1992;
    (3) The rules contained in Sec.  1.469-9, other than paragraph 
(b)(2), apply for taxable years beginning on or after January 1, 1995, 
and to elections made under Sec.  1.469-9(g) with returns filed on or 
after January 1, 1995;
    (4) The rules contained in Sec.  1.469-9(b)(2), other than 
paragraphs (b)(2)(ii)(A) and (B), apply to taxable years beginning on or 
after November 13, 2020. Section 1.469-9(b)(2)(ii)(A) and (B) applies to 
taxable years beginning on or after March 22, 2021. However, taxpayers 
and their related parties, within the meaning of sections 267(b) 
(determined without regard to section 267(c)(3)) and 707(b)(1), may 
choose to apply the rules in Sec.  1.469-9(b)(2), other than paragraphs 
(b)(2)(ii)(A) and (B), to a taxable year beginning after December 31, 
2017, and on or before November 13, 2020 and may choose to apply the 
rules in Sec.  1.469-9(b)(2)(ii)(A) and (B) to taxable years beginning 
after December 31, 2017, and before March 22, 2021, provided that those 
taxpayers and their related parties consistently apply all of the rules 
in the section 163(j) regulations contained in T.D. 9905 (Sec. Sec.  
1.163(j)-0 through 1.163(j)-11, effective November 13, 2020) as modified 
by T.D. 9943 (effective January 13, 2021), and, if applicable, 
Sec. Sec.  1.263A-9, 1.263A-15, 1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-
5, 1.382-6, 1.383-0, 1.383-1, 1.469-9, 1.704-1, 1.882-5, 1.1362-3, 
1.1368-1, 1.1377-1, 1.1502-13, 1.1502-21, 1.1502-79, 1.1502-91 through 
1.1502-99 (to the extent they effectuate the rules of Sec. Sec.  1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, contained in T.D. 9905 
as modified by T.D. 9943, to that taxable year and each subsequent 
taxable year.
    (5) The rules contained in Sec.  1.469-7 apply for taxable years 
ending after December 31, 1986; and
    (6) This section applies for taxable years beginning after December 
31, 1986.
    (b) Additional effective dates--(1) Application of 1992 amendments 
for taxable years beginning before October 4, 1994. Except as provided 
in paragraph (b)(2) of this section, for taxable years that end after 
May 10, 1992, and begin before October 4, 1994, a taxpayer may determine 
tax liability in accordance with Project PS-1-89 published at 1992-1 
C.B. 1219 (see Sec.  601.601(d)(2)(ii)(b) of this chapter).
    (2) Additional transition rule for 1992 amendments. If a taxpayer's 
first taxable year ending after May 10, 1992, begins on or before that 
date, the taxpayer may treat the taxable year, for purposes of paragraph 
(a) of this section, as a taxable year ending on or before May 10, 1992.
    (3) Fresh starts under consistency rules--(i) Regrouping when tax 
liability is first determined under Project PS-1-89. For the first 
taxable year in which a taxpayer determines its tax liability under 
Project PS-1-89, the taxpayer may regroup its activities without regard 
to the manner in which the activities were grouped in the preceding 
taxable year and must regroup its activities if the grouping in the 
preceding taxable year is inconsistent with the rules of Project PS-1-
89.
    (ii) Regrouping when tax liability is first determined under Sec.  
1.469-4. For the first taxable year in which a taxpayer determines its 
tax liability under Sec.  1.469-4, rather than under the rules of 
Project PS-1-89, the taxpayer may regroup its activities without regard 
to the manner in which the activities were grouped in the preceding 
taxable year and must regroup its activities if the grouping in the 
preceding taxable

[[Page 561]]

year is inconsistent with the rules of Sec.  1.469-4.
    (iii) Regrouping when taxpayer is first subject to section 
469(c)(7). For the first taxable year beginning after December 31, 1993, 
a taxpayer may regroup its activities to the extent necessary or 
appropriate to avail itself of the provisions of section 469(c)(7) and 
without regard to the manner in which the activities were grouped in the 
preceding taxable year.
    (iv) Regrouping for taxpayers subject to section 1411--(A) In 
general. If an individual, estate, or trust meets the Eligibility 
Criteria, as defined in paragraph (b)(3)(iv)(B) of this section, such 
individual, estate, or trust, in the first taxable year beginning after 
December 31, 2013, in which section 1411 would apply to such taxpayer, 
may regroup its activities without regard to the manner in which the 
activities were grouped in the preceding taxable year. For this purpose, 
the determination of whether a taxpayer meets the Eligibility Criteria 
is made without regard to the effect of regrouping. The regrouping must 
be made in the manner prescribed by forms, instructions, or in other 
guidance on an original return for the taxable year for which the 
regrouping is done. A taxpayer that is an individual, estate, or trust 
may regroup its activities for any taxable year that begins during 2013, 
if the individual, estate, or trust meets the Eligibility Criteria for 
such year. A taxpayer may regroup activities only once pursuant to this 
paragraph (b)(3)(iv), and a regrouping made pursuant to this paragraph 
(b)(3)(iv) will apply to the taxable year for which the regrouping is 
done and all subsequent years.
    (B) Eligibility criteria. The term Eligibility Criteria means that 
an individual, estate, or trust has net investment income (as defined in 
Sec.  1.1411-4) and such individual's (as defined in Sec.  1.1411-2(a)) 
modified adjusted gross income (as defined in Sec.  1.1411-2(c)) exceeds 
the applicable threshold in Sec.  1.1411-2(d) or such estate's or 
trust's (as defined in Sec.  1.1411-3(a)(1)(i)) adjusted gross income 
exceeds the amount described in Sec.  1.1411-3(a)(1)(ii)(B)(2).
    (C) Consequences of amended returns and examination adjustments--(1) 
Taxpayers first subject to section 1411. An individual, estate, or trust 
also may regroup activities, in the manner described in paragraph 
(b)(3)(iv)(A) of this section, on an amended return only if the changes 
reported on such amended return cause the taxpayer to meet the 
Eligibility Criteria for the first time beginning in the taxable year 
for which the amended return is applicable and that the taxable year is 
not closed by the period of limitations on assessments under section 
6501. If the amended return is for a tax year that precedes a tax year 
for which a taxpayer had regrouped its activities pursuant to paragraph 
(b)(3)(iv)(A) of this section, the regrouping on such amended return 
must be consistent with the taxpayer's subsequent year's regrouping. If 
a regrouping on an amended return is inconsistent with a subsequent 
year's grouping, the subsequent year's grouping is invalid under Sec.  
1.469-4(e)(1) unless a material change in facts and circumstances 
occurred in the subsequent year such that the subsequent year's grouping 
constitutes a permissible regrouping under Sec.  1.469-4(e)(2). Similar 
rules also apply for any taxable year that begins during 2013.
    (2) Taxpayers ceasing to be subject to section 1411. In the event a 
taxpayer regroups activities pursuant to paragraphs (b)(3)(iv)(A) or (C) 
of this section and it is subsequently determined that such taxpayer 
does not meet the Eligibility Criteria for the year of such regrouping, 
such regrouping will have no effect for that year and all future years. 
Appropriate adjustments should be made to reflect the voiding of the 
ineffective regrouping. However, notwithstanding the previous sentence, 
if an individual, estate, or trust meets the Eligibility Criteria in a 
subsequent year, such taxpayer is deemed to treat such regrouping as 
being made in such subsequent year unless the taxpayer either regroups 
in a different manner (so long as such alternative regrouping is 
permissible under Sec.  1.469-4) or properly reflects the ineffective 
regrouping in the previous year. The subsequent year's regrouping may be 
made on an original or on an amended return for that year. This 
paragraph (b)(3)(iv)(C)(2) shall not apply if a taxpayer does not meet 
the Eligibility Criteria for the year of such regrouping as

[[Page 562]]

a result of the carryback of a net operating loss pursuant to section 
172. Similar rules also apply for any taxable year that begins during 
2013.
    (3) Examples. The following examples illustrate the principles of 
paragraph (b)(3)(iv)(C) of this section. In each example, unless 
otherwise indicated, the taxpayer uses a calendar taxable year, the 
taxpayer is a United States citizen, and Year 1 is a taxable year in 
which section 1411 is in effect:

    Example 1. In Year 1, X, a single individual, reports modified 
adjusted gross income (as defined in Sec.  1.1411-2(c)) of $198,000 
(including $12,000 of net investment income (as defined in Sec.  1.1411-
4)); thus is not subject to 1411. After X filed his original return, X 
receives a corrected Form 1099-DIV, which increases his modified 
adjusted gross income (as defined in Sec.  1.1411-2(c)) and his net 
investment income by $2,500. X files an amended return for Year 1 in 
Year 2 reporting modified adjusted gross income of $200,500 and net 
investment income of $14,500. Pursuant to paragraph (b)(3)(iv)(C)(1) of 
this section, X may regroup his passive activities on an amended return, 
because X now has MAGI above the applicable threshold amount and net 
investment income.
    Example 2. Same facts as Example 1, except that the $2,500 increase 
to modified adjusted gross income and net investment income was a result 
of an examination of X's Year 1 return. Pursuant to paragraph 
(b)(3)(iv)(C)(1) of this section, X may regroup his passive activities 
on an amended return.
    Example 3. In Year 1, Y, a single individual reported modified 
adjusted gross income (as defined in Sec.  1.1411-2(c)) of $205,000 and 
net investment income (as defined in Sec.  1.1411-4) of $500. Pursuant 
to paragraph (b)(3)(iv)(A) of this section, Y regrouped his four passive 
activities, A, B, C, and D, into a single activity group. Prior to the 
Year 1 regrouping, Y had grouped A and B into one group, and treated 
each of C and D as separate activities. Y did not meet the Eligibly 
Criteria in any year prior to Year 1 or Year 2. In Year 3, Y's employer 
issued Y a corrected Year 1 Form W-2, which reduced Y's taxable wages by 
$6,000. As a result, Y no longer meets the Eligibility Criteria in Year 
1 because Y's modified adjusted gross income is now $199,000. Therefore, 
Y's Year 1 regrouping is no longer effective and the prior groupings are 
in effect (that is, Activity A and B are one group and Activity C and 
Activity D separately). Appropriate adjustments should be made to 
reflect the ineffective regrouping. However, if Y had a material change 
in facts and circumstances such that Y could regroup in Year 1 or a 
subsequent year, as applicable, by reason of Sec.  1.469-4(e)(2), then 
the regrouping will be deemed to occur. Y could designate a different 
regrouping for the year of the material change in facts and 
circumstances.
    Example 4. Same facts as Example 3, except that Y met the Eligibly 
Criteria in Year 2. In this case, Y's Year 1 regrouping is no longer 
effective and Y must report his income consistent with the pre-Year 1 
groupings. In Year 2, Y has three options. First, without any action by 
Y, Y's activities are regrouped as originally reported in Year 1. In 
this case, the regrouping from the Year 1 return is deemed to occur on 
the Year 2 return. This option is the default option. Second, pursuant 
to paragraph (b)(3)(iv)(C)(2) of this section, Y may file an amended 
return to report his income consistent with groupings in effect prior to 
Year 1. Third, Y may file an original or an amended return to regroup in 
a manner different from groupings in effect prior to Year 1 and 
different from the Year 1 groupings (for example, Y could choose to 
group Activity C and D into a single activity, thus causing Y to have 
two groups; Group A-B and Group C-D).

    (D) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013. However, taxpayers may apply 
this section to taxable years beginning after December 31, 2012.
    (4) Certain investment credit property. (i) The rules contained in 
Sec.  1.469-3(f) apply with respect to property placed in service after 
December 31, 1990 (other than property described in section 11813 (c)(2) 
of the Omnibus Reconciliation Act of 1990 (P.L. 101-508)).
    (ii) The rules contained in 26 CFR 1.469-3T(f) (as contained in the 
CFR edition revised as of April 1, 1992) apply with respect to property 
placed in service on or before December 31, 1990, and property described 
in section 11813(c)(2) of the Omnibus Reconcilation Act of 1990.
    (c) Special rules--(1) Application of certain income 
recharacterization rules and self-charged rules--(i) Certain 
recharacterization rules inapplicable in 1987. No amount of gross income 
shall be treated under Sec.  1.469-2T(f)(3) through (7) as income that 
is not from a passive activity for any taxable year of the taxpayer 
beginning before January 1, 1988.
    (ii) Property rented to a nonpassive activity. In applying Sec.  
1.469-2(f)(6) or Sec.  1.469-2T(f)(6) to a taxpayer's rental of an item 
of property, the taxpayer's net rental activity income (within the 
meaning of Sec.  1.469-2(f)(9)(iv) or Sec.  1.469-

[[Page 563]]

2T(f)(9)(iv)) from the property for any taxable year beginning after 
December 31, 1987, does not include the portion of the income (if any) 
that is attributable to the rental of that item of property pursuant to 
a written binding contract entered into before February 19, 1988.
    (iii) Self-charged rules. For taxable years beginning before June 4, 
1991--
    (1) A taxpayer is not required to apply the rules in Sec.  1.469-7 
in computing the taxpayer's passive activity loss and passive activity 
credit; and
    (2) A taxpayer that owns an interest in a passthrough entity may use 
any reasonable method of offsetting items of interest income and 
interest expense from lending transactions between the passthrough 
entity and its owners or between identically-owned passthrough entities 
(as defined in Sec.  1.469-7(e)) to compute the taxpayer's passive 
activity loss and passive activity credit. Items from nonlending 
transactions cannot be offset under the self-charged rules.
    (2) Qualified low-income housing projects. For a transitional rule 
concerning the application of section 469 to losses from qualified low-
income housing projects, see section 502 of the Tax Reform Act of 1986.
    (3) Effect of events occurring in years prior to 1987. The treatment 
for a taxable year beginning after December 31, 1986, of any item of 
income, gain, loss, deduction, or credit as an item of passive activity 
gross income, passive activity deduction, or credit from a passive 
activity, is determined as if section 469 and the regulations thereunder 
had been in effect for taxable years beginning before January 1, 1987, 
but without regard to any passive activity loss or passive activity 
credit that would have been disallowed for any taxable year beginning 
before January 1, 1987, if section 469 and the regulations thereunder 
had been in effect for that year. For example, in determining whether a 
taxpayer materially participates in an activity under Sec.  1.469-
5T(a)(5) (relating to taxpayers who have materially participated in an 
activity for five of the ten immediately preceding taxable years) for 
any taxable year beginning after December 31, 1986, the taxpayer's 
participation in the activity for all prior taxable years (including 
taxable years beginning before 1987) is taken into account. See Sec.  
1.469-5(j) (relating to the determination of material participation for 
taxable years beginning before January 1, 1987).
    (d) Examples. The following examples illustrate the application of 
paragraph (c) of this section:

    Example 1. A, a calendar year individual, is a partner in a 
partnership with a taxable year ending on January 31. During its taxable 
year ending January 31, 1987, the partnership was engaged in a single 
activity involving the conduct of a trade or business. In applying 
section 469 and the regulations thereunder to A for calendar year 1987, 
A's distributive share of partnership items for the partnership's 
taxable year ending January 31, 1987, is taken into account. Therefore, 
under Sec.  1.469-2T(e)(1) and paragraph (c)(3) of this section, A's 
participation in the activity throughout the partnership's taxable year 
beginning February 1, 1986, and ending January 31, 1987, is taken into 
account for purposes of determining the character under section 469 of 
the items of gross income, deduction, and credit allocated to A for the 
partnership's taxable year ending January 31, 1987.
    Example 2. B, a calendar year individual, is a beneficiary of a 
trust described in section 651 that has a taxable year ending January 
31. The trust conducts a rental activity (within the meaning of Sec.  
1.469-1T(e)(3)). Because the trust's taxable year ending January 31, 
1987, began before January 1, 1987, section 469 and the regulations 
thereunder do not applying to the trust for that year. Section 469 and 
the regulations thereunder do apply, however, to B for B's calendar year 
1987. Therefore, income of the trust from the rental activity for the 
trust's taxable year ending January 31, 1987, that is included in B's 
gross income for 1987 is taken into account in apply section 469 to B 
for 1987.

[T.D. 8417, 57 FR 20759, May 15, 1992, as amended by T.D. 8417, 59 FR 
45623, Sept. 2, 1994; T.D. 8565, 59 FR 50489, Oct. 4, 1994; T.D. 8645, 
60 FR 66501, Dec. 22, 1995; T.D. 9013, 67 FR 54093, Aug. 21, 2002; T.D. 
9644, 78 FR 72421, Dec. 2, 2013; 79 FR 18159, Apr. 1, 2014; T.D. 9905, 
85 FR 56842, Sept. 14, 2020; T.D. 9943, 86 FR 5540, Jan. 19, 2021]

                               inventories



Sec.  1.471-1  Need for inventories.

    (a) In general. Except as provided in paragraph (b) of this section, 
in order to reflect taxable income correctly, inventories at the 
beginning and end of each taxable year are necessary in

[[Page 564]]

every case in which the production, purchase, or sale of merchandise is 
an income-producing factor. The inventory should include all finished or 
partly finished goods and, in the case of raw materials and supplies, 
only those which have been acquired for sale or which will physically 
become a part of merchandise intended for sale, in which class fall 
containers, such as kegs, bottles, and cases, whether returnable or not, 
if title thereto will pass to the purchaser of the product to be sold 
therein. Merchandise should be included in the inventory only if title 
thereto is vested in the taxpayer. Accordingly, the seller should 
include in his inventory goods under contract for sale but not yet 
segregated and applied to the contract and goods out upon consignment, 
but should exclude from inventory goods sold (including containers), 
title to which has passed to the purchaser. A purchaser should include 
in inventory merchandise purchased (including containers), title to 
which has passed to him, although such merchandise is in transit or for 
other reasons has not been reduced to physical possession, but should 
not include goods ordered for future delivery, transfer of title to 
which has not yet been effected. (But see Sec.  1.472-1.)
    (b) Exemption for certain small business taxpayers--(1) In general. 
Paragraph (a) of this section shall not apply to a taxpayer, other than 
a tax shelter prohibited from using the cash receipts and disbursements 
method of accounting (cash method) under section 448(a)(3), in any 
taxable year if the taxpayer meets the gross receipts test described in 
paragraph (b)(2) of this section, and uses as a method of accounting for 
its inventory a method that is described in paragraph (b)(3) of this 
section.
    (2) Gross receipts test--(i) In general. A taxpayer, other than a 
tax shelter prohibited from using the cash method under section 
448(a)(3), meets the gross receipts test of this paragraph (b)(2) if it 
meets the gross receipts test of section 448(c) and Sec.  1.448-2(c). 
This gross receipts test applies even if the taxpayer is not otherwise 
subject to section 448(a).
    (ii) Application of the gross receipts test--(A) In general. In the 
case of any taxpayer that is not a corporation or partnership, and 
except as otherwise provided in paragraphs (b)(2)(ii)(B) and (C) of this 
section, the gross receipts test of section 448(c) and the accompanying 
regulations are applied in the same manner as each trade or business of 
the taxpayer were a corporation or partnership.
    (B) Gross receipts of individuals, etc. Except when the aggregation 
rules of section 448(c)(2) apply, the gross receipts of a taxpayer other 
than a corporation or partnership are the amount derived from all trades 
or businesses of such taxpayer. Amounts not related to a trade or 
businesses are excluded from the gross receipts of the taxpayer. For 
example, an individual taxpayer's gross receipts do not include 
inherently personal amounts, such as: personal injury awards or 
settlements with respect to an injury of the individual taxpayer, 
disability benefits, Social Security benefits received by the taxpayer 
during the taxable year, and wages received as an employee that are 
reported on Form W-2.
    (C) Partners and S corporation shareholders--(1) In general. Except 
when the aggregation rules of section 448(c)(2) apply, each partner in a 
partnership includes a share of the partnership's gross receipts in 
proportion to such partner's distributive share (as determined under 
section 704) of items of gross income that were taken into account by 
the partnership under section 703. Similarly, a shareholder includes the 
pro rata share of S corporation gross receipts taken into account by the 
S corporation under section 1363(b).
    (2) [Reserved]
    (D) Examples. The operation of this paragraph (b)(2) is illustrated 
by the following examples:
    (1) Example 1. Taxpayer A, a calendar year S corporation, is a 
reseller and maintains inventories. In 2017, 2018, and 2019, A's gross 
receipts were $10 million, $11 million, and $13 million respectively. A 
is not prohibited from using the cash method under section 448(a)(3). 
For 2020, A meets the gross receipts test of paragraph (b)(2) of this 
section.
    (2) Example 2. Taxpayer B operates two separate and distinct trades 
or businesses that are reported on Schedule C, Profit or Loss from 
Business, of B's

[[Page 565]]

Federal income tax return. For 2020, one trade or business has annual 
average gross receipts of $5 million, and the other trade or business 
has average annual gross receipts of $35 million. Under paragraph 
(b)(2)(ii)(B) of this section, for 2020, neither of B's trades or 
businesses meets the gross receipts test of paragraph (b)(2) of this 
section ($5 million + $35 million = $40 million, which is greater than 
the inflation-adjusted gross receipts test amount for 2020, which is $26 
million).
    (3) Example 3. Taxpayer C is an individual who operates three 
separate and distinct trades or business that are reported on Schedule C 
of C's Federal income tax return. For 2020, Business X is a retail store 
with average annual gross receipts of $15 million, Business Y is a dance 
studio with average annual gross receipts of $6 million, and Business Z 
is a car repair shop with average annual gross receipts of $12 million. 
Under paragraph (b)(2)(ii)(B) of this section, C's gross receipts are 
the combined amount derived from all three of C's trades or businesses. 
Therefore, for 2020, X, Y and Z do not meet the gross receipts test of 
paragraph (b)(2)(i) of this section ($15 million + $6 million + $12 
million = $33 million, which is greater than the inflation-adjusted 
gross receipts test amount for 2020, which is $26 million).
    (3) Methods of accounting under the small business taxpayer 
exemption. A taxpayer eligible to use, and that chooses to use, the 
exemption described in paragraph (b) of this section may account for its 
inventory by either:
    (i) Using a method that treats its inventory as non-incidental 
materials and supplies (section 471(c) NIMS inventory method), as 
described in paragraph (b)(4) of this section; or
    (ii) Using the method for each item that is reflected in the 
taxpayer's applicable financial statement (AFS) (AFS section 471(c) 
inventory method); or, if the taxpayer does not have an AFS for the 
taxable year, the books and records of the taxpayer prepared in 
accordance with the taxpayer's accounting procedures, as defined in 
paragraph (b)(6)(ii) of this section (non-AFS section 471(c) inventory 
method).
    (4) Inventory treated as non-incidental materials and supplies--(i) 
In general. The costs of inventory treated as non-incidental materials 
and supplies are recovered through cost of goods sold only in the 
taxable year in which the inventory is used or consumed in the 
taxpayer's business, or in the taxable year in which the taxpayer pays 
for or incurs the cost of the inventory, whichever is later. Inventory 
treated as non-incidental materials and supplies is used or consumed in 
the taxpayer's business in the taxable year in which the taxpayer 
provides the inventory to its customer. The costs of inventory are 
treated as non-incidental materials and supplies under this paragraph 
(b)(4) are not eligible for the de minimis safe harbor election under 
Sec.  1.263(a)-1(f)(2).
    (ii) Identification and valuation of inventory treated as non-
incidental materials and supplies. A taxpayer may determine the amount 
of the costs of its inventory treated as non-incidental materials and 
supplies that are recoverable through costs of goods sold by using 
either a specific identification method, a first-in, first-out (FIFO) 
method, or an average cost method, provided that method is used 
consistently. See Sec.  1.471-2(d). A taxpayer that uses the section 
471(c) NIMS inventory method may not use any other method described in 
the regulations under section 471, or the last-in, first-out (LIFO) 
method described in section 472 and the accompanying regulations, to 
either identify inventory treated as non-incidental materials and 
supplies, or to value that inventory treated as non-incidental materials 
and supplies. The inventory costs includible in the section 471(c) NIMS 
inventory method are the direct material costs of the property produced 
or the costs of property acquired for resale. However, an inventory cost 
does not include a cost for which a deduction would be disallowed, or 
that is not otherwise recoverable but for paragraph (b)(4) of this 
section, in whole or in part, under a provision of the Internal Revenue 
Code.
    (iii) Allocation methods. A taxpayer treating its inventory as non-
incidental materials and supplies under this paragraph (b)(4) may 
allocate the costs of such inventory by using specific identification or 
any other reasonable method.

[[Page 566]]

    (iv) Example. Taxpayer D is a baker that reports its baking trade or 
business on Schedule C, Profit or Loss From Business, of the Form 1040, 
Individual Tax Return, and D's baking business has average annual gross 
receipts for the 3-taxable years prior to 2019 of less than $100,000. D 
meets the gross receipts test of section 448(c) and is not prohibited 
from using the cash method under section 448(a)(3) in 2019. Therefore, D 
qualifies as a small business taxpayer under paragraph (b)(2) of this 
section. D uses the overall cash method, and the section 471(c) NIMS 
inventory method. D purchases $50 of peanut butter in November 2019. In 
December 2019, D uses all of the peanut butter to bake cookies available 
for immediate sale. D sells those peanut butter cookies to customers in 
January 2020. The peanut butter cookies are used or consumed under 
paragraph (b)(4)(i) of this section in January 2020 when the cookies are 
sold to customers, and D may recover the cost of the peanut butter in 
2020.
    (5) AFS section 471(c) inventory method--(i) In general. A taxpayer 
that meets the gross receipts test described in paragraph (b)(2) of this 
section and that has an AFS for such taxable year may use the AFS 
section 471(c) inventory method described in this paragraph to account 
for its inventory costs for the taxable year. For purposes of the AFS 
section 471(c) inventory method, an inventory cost is a cost of 
production or resale that a taxpayer capitalizes to inventory property 
produced or property acquired for resale in its AFS. For purposes of the 
AFS section 471(c) inventory method, costs that are generally required 
to be capitalized to inventory under section 471(a) but that the 
taxpayer does not capitalize to inventory on its AFS are not required to 
be capitalized to inventory. However, an inventory cost does not include 
a cost that is neither deductible nor otherwise recoverable but for 
paragraph (b)(5) of this section, in whole or in part, under a provision 
of the Internal Revenue Code (for example, section 162(c), (e), (f), 
(g), or 274). In lieu of the inventory method described in section 
471(a), a taxpayer using the AFS section 471(c) inventory method 
recovers its inventory costs in accordance with the inventory method 
used in its AFS.
    (ii) Definition of Applicable Financial Statement (AFS). The term 
applicable financial statement (AFS) is defined in section 451(b)(3) and 
the accompanying regulations. See Sec.  1.451-3(a)(5). The rules 
relating to additional AFS issues provided in Sec.  1.451-3(h) apply to 
the AFS section 471(c) inventory method. In the case of a taxpayer with 
a financial accounting year that differs from the taxpayer's taxable 
year, the taxpayer must consistently use the same method of accounting 
described in Sec.  1.451-3(h)(4)(i)(A) through (C) that is used for 
section 451(b) purposes to also determine its inventory for the taxable 
year under this paragraph (b)(5)(ii). A taxpayer has an AFS for the 
taxable year if all of the taxpayer's taxable year is covered by an AFS.
    (iii) Timing of inventory costs. Notwithstanding the timing rules 
used in the taxpayer's AFS, the amount of any inventoriable cost may not 
be capitalized or otherwise taken into account for Federal income tax 
purposes any earlier than the taxable year during which the amount is 
paid or incurred under the taxpayer's overall method of accounting, as 
described in Sec.  1.446-1(c)(1). For example, in the case of an accrual 
method taxpayer, inventoriable costs must satisfy the all events test, 
including economic performance, of section 461. See Sec.  1.446-
1(c)(1)(ii) and section 461 and the accompanying regulations.
    (iv) Example. H is a calendar year C corporation that is engaged in 
the trade or business of selling office supplies and providing copier 
repair services. H meets the gross receipts test of section 448(c) and 
is not prohibited from using the cash method under section 448(a)(3) for 
2019 or 2020. For Federal income tax purposes, H chooses to account for 
purchases and sales of inventory using an accrual method of accounting 
and for all other items using the cash method. For AFS purposes, H uses 
an overall accrual method of accounting. H uses the AFS section 471(c) 
inventory method of accounting. In H's 2019 AFS, H incurred $2 million 
in purchases of office supplies held for resale and recovered the $2 
million as cost of goods sold. On January 5, 2020, H makes

[[Page 567]]

payment on $1.5 million of these office supplies. For purposes of the 
AFS section 471(c) inventory method of accounting, H can recover the $2 
million of office supplies in 2019 because the amount has been included 
in cost of goods sold in its AFS inventory method and section 461 has 
been satisfied.
    (6) Non-AFS section 471(c) inventory method--(i) In general. A 
taxpayer that meets the gross receipts test described in paragraph 
(b)(2) of this section for a taxable year and that does not have an AFS, 
as defined in paragraph (b)(5)(ii) of this section, for such taxable 
year may use the non-AFS section 471(c) inventory method to account for 
its inventories for the taxable year in accordance with this paragraph 
(b)(6). The non-AFS section 471(c) inventory method is the method of 
accounting used for inventory in the taxpayer's books and records that 
properly reflect its business activities for non-tax purposes and are 
prepared in accordance with the taxpayer's accounting procedures. For 
purposes of the non-AFS section 471(c) inventory method, an inventory 
cost is a cost of production or resale that the taxpayer capitalizes to 
inventory property produced or property acquired for resale in its books 
and records, except as provided in paragraph (b)(6)(ii) of this section. 
Costs that are generally required to be capitalized to inventory under 
section 471(a), but that the taxpayer does not capitalize in its books 
and records are not required to be capitalized to inventory. However, an 
inventory cost does not include a cost that is neither deductible nor 
otherwise recoverable but for paragraph (b)(5) of this section, in whole 
or in part, under a provision of the Internal Revenue Code (for example, 
section 162(c), (e), (f), (g), or 274). In lieu of the inventory method 
described in section 471(a), a taxpayer using the non-AFS section 471(c) 
inventory method recovers its applicable costs through its book 
inventory method of accounting. A taxpayer that has an AFS for such 
taxable year may not use the non-AFS section 471(c) inventory method.
    (ii) Timing and amounts of costs. Notwithstanding the timing of 
costs reflected in the taxpayer's books and records, a taxpayer may not 
recover any costs that have not been paid or incurred under the 
taxpayer's overall method of accounting, as described in Sec.  1.446-
1(c)(1). For example, in the case of an accrual method taxpayer or a 
taxpayer using an accrual method for purchases and sales, inventory 
costs must satisfy the all events test, including economic performance, 
under section 461(h). See Sec.  1.446-1(c)(1)(ii), and section 461 and 
the accompanying regulations.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (b)(6) of this section.
    (A) Example 1. Taxpayer E is a C corporation that is engaged in the 
retail trade or business of selling beer, wine, and liquor. In 2019, E 
has average annual gross receipts for the prior 3-taxable-years of $15 
million and is not otherwise prohibited from using the cash method under 
section 448(a)(3). E does not have an AFS for the 2019 taxable year. E 
is eligible to use the non-AFS section 471(c) inventory method of 
accounting. E uses the overall cash method, and the non-AFS section 
471(c) inventory method of accounting for Federal income tax purposes. 
In E's electronic bookkeeping software, E treats all costs paid during 
the taxable year as presently deductible. As part of its regular 
business practice, E's employees take a physical count of inventory on 
E's selling floor and its warehouse on December 31, 2019, and E uses 
this physical count as part of its books and records for purposes of 
capitalizing and allocating costs to inventory. E also makes 
representations to its creditor of the cost of inventory on hand for 
specific categories of product it sells. E may not expense all of its 
costs paid during the 2019 taxable year because its books and records do 
not accurately reflect the inventory records used for non-tax purposes 
in its regular business activity. Instead, E must use the physical 
inventory count taken at the end of 2019 to determine how its 
capitalized costs are allocated and recovered.
    (B) Example 2. Same facts as Example (1) in paragraph (b)(6)(iii)(A) 
of this section but E does not use the physical count to capitalize and 
allocate costs to inventory and does not make any representations about 
inventory on hand to any creditors. Although E pays

[[Page 568]]

or incurs costs that are generally required to be capitalized to 
inventory under section 471(a), because such costs are not capitalized 
to inventory in E's books and records, they are not required to be 
capitalized to inventory under paragraph (b)(6)(i) of this section.
    (C) Example 3. Same facts as Example (1) in paragraph (b)(6)(iii)(A) 
of this section but E does not use the physical count to capitalize and 
allocate costs to inventory in its electronic bookkeeping software and 
does not make any representations about inventory on hand to any 
external parties. E does use the physical count to value inventory on 
hand for internal reports to its shareholders. The internal reports to 
its shareholders are part of E's books and records and must be taken 
into account for E's non-AFS section 471(c) inventory method. E recovers 
its inventory costs consistent with its non-AFS section 471(c) inventory 
method.
    (D) Example 4. Taxpayer F is a C corporation that is engaged in the 
manufacture of baseball bats. In 2019, F has average annual gross 
receipts for the prior 3-taxable-years of less than $25 million and is 
not otherwise prohibited from using the cash method under section 
448(a)(3). F does not have an AFS for the 2019 taxable year. For Federal 
income tax purposes, F uses the overall cash method of accounting, and 
the non-AFS section 471(c) inventory method of accounting. For its books 
and records, F uses an overall accrual method and maintains inventories. 
In December 2019, F's financial statements show $500,000 of direct and 
indirect material costs. F pays its supplier in January 2020. Under 
paragraph (b)(6)(ii) of this section, F recovers its direct and indirect 
material costs in 2020.
    (E) Example 5. Taxpayer G is a baker that reports its baking trade 
or business on Schedule C, Profit or Loss From Business, of the Form 
1040, Individual Tax Return. In 2020, G's baking business has average 
annual gross receipts for the prior 3-taxable years of less than 
$100,000 and is not otherwise prohibited from using the cash method 
under section 448(a)(3). G does not have an AFS for the 2020 taxable 
year. For Federal income tax purposes, G uses the overall cash method of 
accounting and the non-AFS section 471(c) inventory method. In G's books 
and records for 2020 that properly reflects its business activities for 
non-tax purposes, G capitalizes the cost of its cookie ingredients to 
inventory but immediately expenses the cost of labor for G's employee 
who bakes the cookies. Under paragraphs (b)(6)(i) and (ii) of this 
section, G treats as an inventory cost the cost of its cookie 
ingredients and recovers such costs in accordance with the accounting 
procedures used to prepare its books and records, or, if later, when 
paid. Additionally, although the cost of direct labor is generally 
required to be capitalized to inventory under section 471(a), because 
such cost is not capitalized to inventory in G's books and records, it 
is not required to be capitalized to inventory under paragraph (b)(6)(i) 
of this section. Further, because such direct labor cost is generally 
deductible under section 162, and not otherwise required to be 
capitalized under section 263(a), G may deduct the cost of labor in the 
year G pays that expense.
    (F) Example 6. Taxpayer H is a partnership engaged in the resale of 
beer, wine, and liquor. In 2020, H has average annual gross receipts for 
the prior 3-taxable-years of less than $25 million and is not otherwise 
prohibited from using the cash method under section 448(a)(3). H does 
not have an AFS for the 2020 taxable year. For Federal income tax 
purposes, H uses the overall cash method of accounting, and the non-AFS 
section 471(c) inventory method of accounting. For its books and 
records, H uses the overall cash method. As part of its regular business 
practice, H's employees take regular physical counts of the inventory on 
the shop floor and in the storeroom, however H's method of accounting 
for inventory for its books and records does not allocate costs between 
ending inventory and cost of goods sold, and instead expenses the cost 
of the inventory in the year it was paid for. Prior to December 2020, H 
acquires and pays for $500,000 of beer, wine, and liquor. In addition, 
on December 1, 2020, H acquires $50,000 in beer and wine, and

[[Page 569]]

pays for this beer and wine on December 20, 2020. H may recover as 
deductions in 2020 the $550,000 of inventory costs.
    (G) Example 7. Taxpayer J is a partnership engaged in the resale of 
beer, wine, and liquor. In 2020, J has average annual gross receipts for 
the prior 3-taxable-years of less than $25 million and is not otherwise 
prohibited from using the cash method under section 448(a)(3). J does 
not have an AFS for the 2020 taxable year. For Federal income tax 
purposes, J uses the overall cash method of accounting, and the non-AFS 
section 471(c) inventory method of accounting. For its books and 
records, J uses the overall cash method. J maintains a point-of-sale 
computer system that tracks acquisition costs and inventory levels of 
the beer, wine, and liquor. The ledger is periodically reconciled with 
physical counts performed by J's employees. J must use the physical 
inventory count and ledger to determine its ending inventory. J includes 
in cost of goods sold for 2020 those inventory costs that are not 
properly allocated to ending inventory.
    (7) Effect of section 471(c) on other provisions. Nothing in section 
471(c) shall have any effect on the application of any other provision 
of law that would otherwise apply, and no inference shall be drawn from 
section 471(c) with respect to the application of any such provision. 
For example, an accrual method taxpayer that includes inventory costs in 
its AFS is required to satisfy section 461 before such cost can be 
included in cost of goods sold for the taxable year. Similarly, nothing 
in section 471(c) affects the requirement under section 446(e) that a 
taxpayer secure the consent of the Commissioner before changing its 
method of accounting. If an item of income or expense is not treated 
consistently from year to year, that treatment may not clearly reflect 
income, notwithstanding the application of this section. Finally, 
nothing in section 471(c) permits the deduction or recovery of any cost 
that a taxpayer is otherwise precluded from deducting or recovering 
under any other provision in the Code or Regulations.
    (8) Method of accounting--(i) In general. A change in the method of 
treating inventory under this paragraph (b) is a change in method of 
accounting under sections 446 and 481 and the accompanying regulations. 
A taxpayer changing its method of accounting under paragraph (b) of this 
section may do so only with the consent of the Commissioner as required 
under section 446(e) and Sec.  1.446-1. For example, a taxpayer using 
the AFS section 471(c) inventory method or non-AFS section 471(c) 
inventory method that wants to change its method of accounting for 
inventory in its AFS, or its books and records, respectively, is 
required to secure the consent of the Commissioner before using this new 
method for Federal income tax purposes. However, a change from having an 
AFS to not having an AFS, or vice versa, without a change in the 
underlying method for inventory for financial reporting purposes that 
affects Federal income tax is not a change in method of accounting for 
such inventory under section 446(e). In the case of any taxpayer 
required by this section to change its method of accounting for any 
taxable year, the change shall be treated as a change initiated by the 
taxpayer. For rules relating to the clear reflection of income and the 
pattern of consistent treatment of an item, see section 446 and Sec.  
1.446-1. The amount of the net section 481(a) adjustment and the 
adjustment period necessary to implement a change in method of 
accounting required under this section are determined under Sec.  1.446-
1(e) and the applicable administrative procedures to obtain the 
Commissioner's consent to change a method of accounting as published in 
the Internal Revenue Bulletin (see Revenue Procedure 2015-13 (2015-5 IRB 
419) (or successor) (see also Sec.  601.601(d)(2) of this chapter).
    (ii) Automatic consent for certain method changes. Certain changes 
in method of accounting made under paragraph (b) of this section may be 
made under the procedures to obtain the automatic consent of the 
Commissioner to change a method of accounting. See Revenue Procedure 
2015-13 (2015-5 IRB 419) (or successor) (see Sec.  601.601(d)(2) of this 
chapter)). In certain situations, special terms and conditions may 
apply.

[[Page 570]]

    (c) Applicability dates. This section applies for taxable years 
beginning on or after January 5, 2021. However, for a taxable year 
beginning after December 31, 2017, and before January 5, 2021, a 
taxpayer may apply this section provided that the taxpayer follows all 
the applicable rules contained in this section for such taxable year and 
all subsequent taxable years.

[T.D. 6500, 25 FR 11724, Nov. 26, 1960, as amended by T.D. 9942, 86 FR 
275, Jan. 5, 2021]



Sec.  1.471-2  Valuation of inventories.

    (a) Section 471 provides two tests to which each inventory must 
conform:
    (1) It must conform as nearly as may be to the best accounting 
practice in the trade or business, and
    (2) It must clearly reflect the income.
    (b) It follows, therefore, that inventory rules cannot be uniform 
but must give effect to trade customs which come within the scope of the 
best accounting practice in the particular trade or business. In order 
to clearly reflect income, the inventory practice of a taxpayer should 
be consistent from year to year, and greater weight is to be given to 
consistency than to any particular method of inventorying or basis of 
valuation so long as the method or basis used is in accord with 
Sec. Sec.  1.471-1 through 1.471-11.
    (c) The bases of valuation most commonly used by business concerns 
and which meet the requirements of section 471 are (1) cost and (2) cost 
or market, whichever is lower. (For inventories by dealers in 
securities, see Sec.  1.471-5.) Any goods in an inventory which are 
unsalable at normal prices or unusable in the normal way because of 
damage, imperfections, shop wear, changes of style, odd or broken lots, 
or other similar causes, including second-hand goods taken in exchange, 
should be valued at bona fide selling prices less direct cost of 
disposition, whether subparagraph (1) or (2) of this paragraph is used, 
or if such goods consist of raw materials or partly finished goods held 
for use or consumption, they shall be valued upon a reasonable basis, 
taking into consideration the usability and the condition of the goods, 
but in no case shall such value be less than the scrap value. Bona fide 
selling price means actual offering of goods during a period ending not 
later than 30 days after inventory date. The burden of proof will rest 
upon the taxpayer to show that such exceptional goods as are valued upon 
such selling basis come within the classifications indicated above, and 
he shall maintain such records of the disposition of the goods as will 
enable a verification of the inventory to be made.
    (d) In respect of normal goods, whichever method is adopted must be 
applied with reasonable consistency to the entire inventory of the 
taxpayer's trade or business except as to those goods inventoried under 
the last-in, first-out method authorized by section 472 or to animals 
inventoried under the elective unit, livestock-price-method authorized 
by Sec.  1.471-6. See paragraph (d) of Sec.  1.446-1 for rules 
permitting the use of different methods of accounting if the taxpayer 
has more than one trade or business. Where the taxpayer is engaged in 
more than one trade or business the Commissioner may require that the 
method of valuing inventories with respect to goods in one trade or 
business also be used with respect to similar goods in other trades or 
businesses if, in the opinion of the Commissioner, the use of such 
method with respect to such other goods is essential to a clear 
reflection of income. Taxpayers were given an option to adopt the basis 
of either (1) cost or (2) cost or market, whichever is lower, for their 
1920 inventories. The basis properly adopted for that year or any 
subsequent year is controlling, and a change can now be made only after 
permission is secured from the Commissioner. Application for permission 
to change the basis of valuing inventories shall be made in writing and 
filed with the Commissioner as provided in paragraph (e) of Sec.  1.446-
1. Goods taken in the inventory which have been so intermingled that 
they cannot be identified with specific invoices will be deemed to be 
the goods most recently purchased or produced, and the cost thereof will 
be the actual cost of the goods purchased or produced during the period 
in which the quantity of goods in the inventory has been acquired. But 
see section 472 as to last-in, first-out inventories. Where the taxpayer 
maintains book inventories in accordance with a

[[Page 571]]

sound accounting system in which the respective inventory accounts are 
charged with the actual cost of the goods purchased or produced and 
credited with the value of goods used, transferred, or sold, calculated 
upon the basis of the actual cost of the goods acquired during the 
taxable year (including the inventory at the beginning of the year), the 
net value as shown by such inventory accounts will be deemed to be the 
cost of the goods on hand. The balances shown by such book inventories 
should be verified by physical inventories at reasonable intervals and 
adjusted to conform therewith.
    (e) Inventories should be recorded in a legible manner, properly 
computed and summarized, and should be preserved as a part of the 
accounting records of the taxpayer. The inventories of taxpayers on 
whatever basis taken will be subject to investigation by the district 
director, and the taxpayer must satisfy the district director of the 
correctness of the prices adopted.
    (f) The following methods, among others, are sometimes used in 
taking or valuing inventories, but are not in accord with the 
regulations in this part:
    (1) Deducting from the inventory a reserve for price changes, or an 
estimated depreciation in the value thereof.
    (2) Taking work in process, or other parts of the inventory, at a 
nominal price or at less than its proper value.
    (3) Omitting portions of the stock on hand.
    (4) Using a constant price or nominal value for so-called normal 
quantity of materials or goods in stock.
    (5) Including stock in transit, shipped either to or from the 
taxpayer, the title to which is not vested in the taxpayer.
    (6) Segregating indirect production costs into fixed and variable 
production cost classifications (as defined in Sec.  1.471-11(b)(3)(ii)) 
and allocating only the variable costs to the cost of goods produced 
while treating fixed costs as period costs which are currently 
deductible. This method is commonly referred to as the ``direct cost'' 
method.
    (7) Treating all or substantially all indirect production costs 
(whether classified as fixed or variable) as period costs which are 
currently deductible. This method is generally referred to as the 
``prime cost'' method.

[T.D. 6500, 25 FR 11724, Nov. 26, 1960, as amended by T.D. 7285, 38 FR 
26185, Sept. 19, 1973]



Sec.  1.471-3  Inventories at cost.

    Cost means:
    (a) In the case of merchandise on hand at the beginning of the 
taxable year, the inventory price of such goods.
    (b) In the case of merchandise purchased since the beginning of the 
taxable year, the invoice price less trade or other discounts, except 
strictly cash discounts approximating a fair interest rate, which may be 
deducted or not at the option of the taxpayer, provided a consistent 
course is followed. To this net invoice price should be added 
transportation or other necessary charges incurred in acquiring 
possession of the goods. But see Sec.  1.263A-1(d)(2)(iv)(C) for special 
rules for certain direct material costs that in certain cases are 
permitted to be capitalized as additional section 263A costs by 
taxpayers using a simplified method under Sec.  1.263A-2(b) or (c) or 
Sec.  1.263A-3(d). For taxpayers acquiring merchandise for resale that 
are subject to the provisions of section 263A, see Sec. Sec.  1.263A-1 
and 1.263A-3 for additional amounts that must be included in inventory 
costs.
    (c) In the case of merchandise produced by the taxpayer since the 
beginning of the taxable year, (1) the cost of raw materials and 
supplies entering into or consumed in connection with the product, (2) 
expenditures for direct labor, and (3) indirect production costs 
incident to and necessary for the production of the particular article, 
including in such indirect production costs an appropriate portion of 
management expenses, but not including any cost of selling or return on 
capital, whether by way of interest or profit. See Sec. Sec.  1.263A-1 
and 1.263A-2 for more specific rules regarding the treatment of 
production costs.
    (d) In any industry in which the usual rules for computation of cost 
of production are inapplicable, costs may be approximated upon such 
basis as may be reasonable and in conformity with established trade 
practice in the

[[Page 572]]

particular industry. Among such cases are:
    (1) Farmers and raisers of livestock (see Sec.  1.471-6);
    (2) Miners and manufacturers who by a single process or uniform 
series of processes derive a product of two or more kinds, sizes, or 
grades, the unit cost of which is substantially alike (see Sec.  1.471-
7); and
    (3) Retail merchants who use what is known as the ``retail method'' 
in ascertaining approximate cost (see Sec.  1.471-8).
    (e) Sales-based vendor allowances--(1) Treatment of sales-based 
vendor chargebacks--(i) In general. A sales-based vendor chargeback is 
an allowance, discount, or price rebate that a taxpayer becomes 
unconditionally entitled to by selling a vendor's merchandise to 
specific customers identified by the vendor at a price determined by the 
vendor. A sales-based vendor chargeback decreases cost of goods sold and 
does not reduce the cost of goods on hand at the end of the taxable 
year.
    (ii) Example. The following example illustrates the provisions of 
this paragraph (e)(1).

    Example. (i) W is a wholesaler of pharmaceuticals. W purchases Drug 
X from the manufacturer, M, for $10x per unit. M has agreements with 
specific customers that allow those customers to acquire Drug X from M's 
wholesalers for $6x per unit. Under an agreement between W and M, W is 
required to sell Drug X to specific customers at the prices M has 
negotiated with such customers ($6x per unit) and, in exchange, M agrees 
to provide a price rebate to W equal to the difference between W's cost 
for Drug X and the price W is required to charge specific customers 
under the agreement (a difference of $4x per unit). W sells Drug X to 
specific customer Y for $6x. Under the agreement between W and M, the 
price rebate can be paid to W, credited against M's invoice to W for W's 
purchase of Drug X, or it can be credited to W's future purchases of 
drugs from M.
    (ii) Under the terms of the agreement, W is unconditionally entitled 
to the price rebate of Drug X when it sells Drug X to specific customer 
Y, a specifically identified customer of M. The price rebate received by 
W for the sale of Drug X to Y is a sales-based vendor chargeback. 
Therefore, the amount of the sales-based vendor charge back, $4x per 
unit for Drug X, whether paid to W, credited against M's invoice to W 
for W's purchase of Drug X or credited against a future purchase, 
decreases cost of goods sold and does not reduce the cost of Drug X on 
hand at the end of the taxable year.

    (2) Treatment of other sales-based vendor allowances. [Reserved]
    (f) Notwithstanding the other rules of this section, cost shall not 
include an amount which is of a type for which a deduction would be 
disallowed under section 162 (c), (f), or (g) and the regulations 
thereunder in the case of a business expense.
    (g) Effective/applicability date. Paragraph (f) of this section 
applies to taxable years ending on or after January 13, 2014.

[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 7285, 38 FR 
26185, Sept. 19, 1973; T.D. 7345, 40 FR 7439, Feb. 20, 1975; T.D. 8131, 
52 FR 10084, Mar. 30, 1987; T.D. 8482, 58 FR 42233, Aug. 9, 1993; T.D. 
9652, 79 FR 2098, Jan. 13, 2014; T.D. 9843, 83 FR 58498, Nov. 20, 2018]



Sec.  1.471-4  Inventories at cost or market, whichever is lower.

    (a) In general--(1) Market definition. Under ordinary circumstances 
and for normal goods in an inventory, market means the aggregate of the 
current bid prices prevailing at the date of the inventory of the basic 
elements of cost reflected in inventories of goods purchased and on 
hand, goods in process of manufacture, and finished manufactured goods 
on hand. The basic elements of cost include direct materials, direct 
labor, and indirect costs required to be included in inventories by the 
taxpayer (e.g., under section 263A and its underlying regulations for 
taxpayers subject to that section). For taxpayers to which section 263A 
applies, for example, the basic elements of cost must reflect all direct 
costs and all indirect costs properly allocable to goods on hand at the 
inventory date at the current bid price of those costs, including but 
not limited to the cost of purchasing, handling, and storage activities 
conducted by the taxpayer, both prior to and subsequent to acquisition 
or production of the goods. The determination of the current bid price 
of the basic elements of costs reflected in goods on hand at the 
inventory date must be based on the usual volume of particular cost 
elements purchased (or incurred) by the taxpayer.

[[Page 573]]

    (2) Fixed price contracts. Paragraph (a)(1) of this section does not 
apply to any goods on hand or in process of manufacture for delivery 
upon firm sales contracts (i.e., those not legally subject to 
cancellation by either party) at fixed prices entered into before the 
date of the inventory, under which the taxpayer is protected against 
actual loss. Any such goods must be inventoried at cost.
    (3) Examples. The valuation principles in paragraph (a)(1) of this 
section are illustrated by the following examples:

    Example 1. (i) Taxpayer A manufactures tractors. A values its 
inventory using cost or market, whichever is lower, under paragraph 
(a)(1) of this section. At the end of 1994, the cost of one of A's 
tractors on hand is determined as follows:

Direct materials..............................................    $3,000
Direct labor..................................................     4,000
Indirect costs under section 263A.............................     3,000
                                                               ---------
      Total section 263A costs (cost).........................   $10,000
 

    (ii) A determines that the aggregate of the current bid prices of 
the materials, labor, and overhead required to reproduce the tractor at 
the end of 1994 are as follows:

Direct materials..............................................    $3,100
Direct labor..................................................     4,100
Indirect costs under section 263A.............................     3,100
                                                               ---------
      Total section 263A costs (market).......................   $10,300
 

    (iii) In determining the lower of cost or market value of the 
tractor, A compares the cost of the tractor, $10,000, with the market 
value of the tractor, $10,300, in accordance with paragraph (c) of this 
section. Thus, under this section, A values the tractor at $10,000.
    Example 2. (i) Taxpayer B purchases and resells several lines of 
shoes and is subject to section 263A. B values its inventory using cost 
or market, whichever is lower, under paragraph (a)(1) of this section. 
At the end of 1994, the cost of one pair of shoes on hand is determined 
as follows:

Acquisition cost..............................................      $200
Indirect costs under section 263A.............................        10
                                                               ---------
      Total section 263A costs (cost).........................      $210
 

    (ii) B determines the aggregate current bid prices prevailing at the 
end of 1994 for the elements of cost (both direct costs and indirect 
costs incurred prior and subsequent to acquisition of the shoes) based 
on the volume of the elements usually purchased (or incurred) by B as 
follows:

Acquisition cost..............................................      $178
Indirect costs under section 263A.............................        12
                                                               ---------
      Total Sec.   263A costs (market)........................      $190
 

    (iii) In determining the lower of cost or market value of the shoes, 
B compares the cost of the pair of shoes, $210, with the market value of 
the shoes, $190, in accordance with paragraph (c) of this section. Thus, 
under this section, B values the shoes at $190.

    (b) Inactive markets. Where no open market exists or where 
quotations are nominal, due to inactive market conditions, the taxpayer 
must use such evidence of a fair market price at the date or dates 
nearest the inventory as may be available, such as specific purchases or 
sales by the taxpayer or others in reasonable volume and made in good 
faith, or compensation paid for cancellation of contracts for purchase 
commitments. Where the taxpayer in the regular course of business has 
offered for sale such merchandise at prices lower than the current price 
as above defined, the inventory may be valued at such prices less direct 
cost of disposition, and the correctness of such prices will be 
determined by reference to the actual sales of the taxpayer for a 
reasonable period before and after the date of the inventory. Prices 
which vary materially from the actual prices so ascertained will not be 
accepted as reflecting the market.
    (c) Comparison of cost and market. Where the inventory is valued 
upon the basis of cost or market, whichever is lower, the market value 
of each article on hand at the inventory date shall be compared with the 
cost of the article, and the lower of such values shall be taken as the 
inventory value of the article.
    (d) Effective date. This section applies to inventory valuations for 
taxable years beginning after December 31, 1993. For taxable years 
beginning before January 1, 1994, taxpayers must take reasonable 
positions on their federal income tax returns with respect to the 
application of section 263A, and must have otherwise complied with Sec.  
1.471-4 (as contained in the 26 CFR part 1 edition revised April 1, 
1993). For purposes of this paragraph (d), a reasonable position as to 
the application of section 263A is a position consistent with the 
temporary regulations, revenue rulings, revenue procedures, notices, and 
announcements concerning section 263A applicable in taxable years

[[Page 574]]

beginning before January 1, 1994. (See Sec.  601.601(d)(2)(ii)(b) of 
this chapter.)

[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 8482, 58 FR 
42233, Aug. 9, 1993]



Sec.  1.471-5  Inventories by dealers in securities.

    A dealer in securities who in his books of account regularly 
inventories unsold securities on hand either--
    (a) At cost,
    (b) At cost or market, whichever is lower, or
    (c) At market value,

may make his return upon the basis upon which his accounts are kept, 
provided that a description of the method employed is included in or 
attached to the return, that all the securities are inventoried by the 
same method, and that such method is adhered to in subsequent years, 
unless another method is authorized by the Commissioner pursuant to a 
written application therefor filed as provided in paragraph (e) of Sec.  
1.446-1. A dealer in securities in whose books of account separate 
computations of the gain or loss from the sale of the various lots of 
securities sold are made on the basis of the cost of each lot shall be 
regarded, for the purposes of this section, as regularly inventorying 
his securities at cost. For the purposes of this section, a dealer in 
securities is a merchant of securities, whether an individual, 
partnership, or corporation, with an established place of business, 
regularly engaged in the purchase of securities and their resale to 
customers; that is, one who as a merchant buys securities and sells them 
to customers with a view to the gains and profits that may be derived 
therefrom. If such business is simply a branch of the activities carried 
on by such person, the securities inventoried as provided in this 
section may include only those held for purposes of resale and not for 
investment. Taxpayers who buy and sell or hold securities for investment 
or speculation, irrespective of whether such buying or selling 
constitutes the carrying on of a trade or business, and officers of 
corporations and members of partnerships who in their individual 
capacities buy and sell securities, are not dealers in securities within 
the meaning of this section. See Sec. Sec.  1.263A-1 and 1.263A-3 for 
rules regarding the treatment of costs with respect to property acquired 
for resale.

[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 8131, 52 FR 
10084, Mar. 30, 1987; T.D. 8482, 58 FR 42234, Aug. 9, 1993]



Sec.  1.471-6  Inventories of livestock raisers and other farmers.

    (a) A farmer may make his return upon an inventory method instead of 
the cash receipts and disbursements method. It is optional with the 
taxpayer which of these methods of accounting is used but, having 
elected one method, the option so exercised will be binding upon the 
taxpayer for the year for which the option is exercised and for 
subsequent years unless another method is authorized by the Commissioner 
as provided in paragraph (e) of Sec.  1.446-1.
    (b) In any change of accounting method from the cash receipts and 
disbursements method to an inventory method, adjustments shall be made 
as provided in section 481 (relating to adjustments required by change 
in method of accounting) and the regulations thereunder.
    (c) Because of the difficulty of ascertaining actual cost of 
livestock and other farm products, farmers who render their returns upon 
an inventory method may value their inventories according to the ``farm-
price method'', and farmers raising livestock may value their 
inventories of animals according to either the ``farm-price method'' or 
the ``unit-livestock-price method''. In addition, these inventory 
methods may be used to account for the costs of property produced in a 
farming business that are required to be capitalized under section 263A 
regardless of whether the property being produced is otherwise treated 
as inventory by the taxpayer, and regardless of whether the taxpayer is 
otherwise using the cash or an accrual method of accounting.
    (d) The ``farm-price method'' provides for the valuation of 
inventories at market price less direct cost of disposition. If this 
method of valuation is used, it generally must be applied to all 
property produced by the taxpayer in the trade or business of farming, 
except as to livestock accounted for, at

[[Page 575]]

the taxpayer's election, under the unit livestock method of accounting. 
However, see Sec.  1.263A-4(c)(3) for an exception to this rule. If the 
use of the ``farm-price method'' of valuing inventories for any taxable 
year involves a change in method of valuing inventories from that 
employed in prior years, permission for such change shall first be 
secured from the Commissioner as provided in paragraph (e) of Sec.  
1.446-1.
    (e) The ``unit-livestock-price method'' provides for the valuation 
of the different classes of animals in the inventory at a standard unit 
price for each animal within a class. A livestock raiser electing this 
method of valuing his animals must adopt a reasonable classification of 
the animals in his inventory with respect to the age and kind included 
so that the unit prices assigned to the several classes will reasonably 
account for the normal costs incurred in producing the animals within 
such classes. Thus, if a cattle raiser determines that it costs 
approximately $15 to produce a calf, and $7.50 each year to raise the 
calf to maturity, his classifications and unit prices would be as 
follows: Calves, $15; yearlings, $22.50; 2-year olds, $30; mature 
animals, $37.50. The classification selected by the livestock raiser, 
and the unit prices assigned to the several classes, are subject to 
approval by the district director upon examination of the taxpayer's 
return.
    (f) A taxpayer that elects to use the ``unit-livestock-price 
method'' must apply it to all livestock raised, whether for sale or for 
draft, breeding, or dairy purposes. The inventoriable costs of animals 
raised for draft, breeding, or dairy purposes can, at the election of 
the livestock raiser, be included in inventory or treated as property 
used in a trade or business subject to depreciation after maturity. See 
Sec.  1.263A-4 for rules regarding the computation of inventoriable 
costs for purposes of the unit-livestock-price method. Once established, 
the methods of accounting used by the taxpayer to determine unit prices 
and to classify animals must be consistently applied in all subsequent 
taxable years. A taxpayer that uses the unit-livestock-price method must 
annually reevaluate its unit prices and adjust the prices either upward 
to reflect increases, or downward to reflect decreases, in the costs of 
raising livestock. The consent of the Commissioner is not required to 
make such upward or downward adjustments. No other changes in the 
classification of animals or unit prices may be made without the consent 
of the Commissioner. See Sec.  1.446-1(e) for procedures for obtaining 
the consent of the Commissioner. The provisions of this paragraph (f) 
apply to taxable years ending after October 28, 2002.
    (g) A livestock raiser who uses the ``unit-livestock-price method'' 
must include in his inventory at cost any livestock purchased, except 
that animals purchased for draft, breeding, or dairy purposes can, at 
the election of the livestock raiser, be included in inventory or be 
treated as property used in a trade or business subject to depreciation 
after maturity. If the animals purchased are not mature at the time of 
purchase, the cost should be increased at the end of each taxable year 
in accordance with the established unit prices, except that no increase 
is to be made in the taxable year of purchase if the animal is acquired 
during the last six months of that year. If the records maintained 
permit identification of a purchased animal, the cost of such animal 
will be eliminated from the closing inventory in the event of its sale 
or loss. Otherwise, the first-in, first-out method of valuing 
inventories must be applied.
    (h) If a taxpayer using the ``farm-price method'' desires to adopt 
the ``unit-livestock-price method'' in valuing his inventories of 
livestock, permission for the change shall first be secured from the 
Commissioner as provided in paragraph (e) of Sec.  1.446-1. However, a 
taxpayer who has filed returns on the basis of inventories at cost, or 
cost or market whichever is lower, may adopt the ``unit-livestock-price 
method'' for valuing his inventories of livestock without formal 
application for permission, but the classifications and unit prices 
selected are subject to approval by the district director upon 
examination of the taxpayer's return. A livestock raiser who has adopted 
a constant unit-price method of valuing livestock inventories and filed 
returns

[[Page 576]]

on that basis will be considered as having elected the ``unit-livestock-
price method''.
    (i) If returns have been made in which the taxable income has been 
computed upon incomplete inventories, the abnormality should be 
corrected by submitting with the return for the current taxable year a 
statement for the preceding taxable year. In this statement such 
adjustments shall be made as are necessary to bring the closing 
inventory for the preceding taxable year into agreement with the opening 
complete inventory for the current taxable year. If necessary clearly to 
reflect income, similar adjustments may be made as at the beginning of 
the preceding year or years, and the tax, if any be due, shall be 
assessed and paid at the rate of tax in effect for such year or years.

[T.D. 6500, 25 FR 11726, Nov. 26, 1960, as amended by T.D. 8131, 52 FR 
10084, Mar. 30, 1987; T.D. 8729, 62 FR 44551, Aug. 22, 1997; T.D. 8897, 
65 FR 50650, Aug. 21, 2000; T.D. 9019, 67 FR 65698, Oct. 28, 2002]



Sec.  1.471-7  Inventories of miners and manufacturers.

    A taxpayer engaged in mining or manufacturing who by a single 
process or uniform series of processes derives a product of two or more 
kinds, sizes, or grades, the unit cost of which is substantially alike, 
and who in conformity to a recognized trade practice allocates an amount 
of cost to each kind, size, or grade of product, which in the aggregate 
will absorb the total cost of production, may, with the consent of the 
Commissioner, use such allocated cost as a basis for pricing 
inventories, provided such allocation bears a reasonable relation to the 
respective selling values of the different kinds, sizes, or grades of 
product. See section 472 as to last-in, first-out inventories.

[T.D. 6500, 25 FR 11726, Nov. 26, 1960]



Sec.  1.471-8  Inventories of retail merchants.

    (a) In general. A taxpayer that is a retail merchant may use the 
retail inventory method of accounting described in this section. The 
retail inventory method uses a formula to convert the retail selling 
price of ending inventory to an approximation of cost (retail cost 
method) or an approximation of lower of cost or market (retail LCM 
method). A taxpayer may use the retail inventory method instead of 
valuing inventory at cost under Sec.  1.471-3 or lower of cost or market 
under Sec.  1.471-4.
    (b) Computation--(1) In general. A taxpayer computes the value of 
ending inventory under the retail inventory method by multiplying a cost 
complement by the retail selling prices of the goods on hand at the end 
of the taxable year.
    (2) Cost complement--(i) In general. The cost complement is a ratio 
computed as follows:
    (A) The numerator is the value of beginning inventory plus the cost 
(as determined under Sec.  1.471-3, except as otherwise provided in this 
section) of goods purchased during the taxable year.
    (B) The denominator is the retail selling prices of beginning 
inventory plus the retail selling prices of goods purchased during the 
year (that is, the bona fide retail selling prices of the items at the 
time acquired), adjusted for all permanent markups and markdowns, 
including markup and markdown cancellations and corrections. The 
denominator is not adjusted for temporary markups or markdowns.
    (ii) Vendor allowances required to reduce only cost of goods sold. A 
taxpayer may not reduce the numerator of the cost complement by the 
amount of an allowance, discount, or price rebate that is required under 
Sec.  1.471-3(e) to reduce only cost of goods sold.
    (3) Additional rules for cost complement for retail LCM method--(i) 
In general--(A) Margin protection payments. A taxpayer using the retail 
LCM method may not reduce the numerator of the cost complement by the 
amount of an allowance, discount, or price rebate that is related to or 
intended to compensate for a permanent reduction in the taxpayer's 
retail selling price of inventory (a margin protection payment).
    (B) Markdowns. A taxpayer using the retail LCM method does not 
adjust the denominator of the cost complement for markdowns (and 
markdown cancellations or corrections). Markups must be reduced by the 
markdowns made to cancel or correct them.

[[Page 577]]

    (ii) Alternative methods for computing cost complement--(A) In 
general. In lieu of the method described in paragraph (b)(3)(i) of this 
section, a taxpayer using the retail LCM method may compute the cost 
complement using one of the alternative methods described in this 
paragraph (b)(3)(ii). A taxpayer using an alternative method under this 
paragraph (b)(3)(ii) must use that method for all cost complements.
    (B) Adjust numerator and denominator. A taxpayer using the retail 
LCM method may reduce the numerator of the cost complement by the amount 
of all margin protection payments if the taxpayer also reduces the 
denominator of the cost complement by the amount of the permanent 
reduction in retail selling price to which the margin protection 
payments relate (related markdowns).
    (C) Deemed adjustment to denominator. A taxpayer using the retail 
LCM method that is able to determine the amount of all margin protection 
payments but cannot determine the amount of the related markdowns may 
reduce the numerator of the cost complement by the amount of all margin 
protection payments if the taxpayer also reduces the denominator by the 
amount that, in conjunction with the reduction of the numerator for the 
margin protection payments, maintains what would have been the cost 
complement percentage before taking into account the margin protection 
payment and the related markdown. A taxpayer that can determine the 
amount of a related markdown but not the associated margin protection 
payments may not use this method to compute an adjustment to the 
numerator.
    (iii) Statistical sampling. A taxpayer using the retail LCM method 
may use statistical sampling in accordance with Rev. Proc. 2011-42 or 
any successor (see Sec.  601.601(d) of this chapter), in conjunction 
with any method of computing the cost complement described in this 
paragraph (b)(3), to determine the amount of margin protection payments 
and related markdowns. A taxpayer using statistical sampling must use it 
for all margin protection payments and related markdowns associated with 
the inventory items valued by a particular cost complement, but is not 
required to use it for every cost complement.
    (4) Ending inventory retail selling prices. A taxpayer must include 
all permanent markups and markdowns but may not include temporary 
markups or markdowns in determining the retail selling prices of goods 
on hand at the end of the taxable year. A taxpayer may not include a 
markdown that is not an actual reduction of retail selling price.
    (c) Special rules for LIFO taxpayers. A taxpayer using the last-in, 
first-out (LIFO) inventory method with the retail inventory method uses 
the retail cost method. See Sec.  1.472-1(k) for additional adjustments 
for a taxpayer using the LIFO inventory method with the retail cost 
method.
    (d) Scope of retail inventory method. A taxpayer may use the retail 
inventory method to value ending inventory for a department, a class of 
goods, or a stock-keeping unit. A taxpayer maintaining more than one 
department or dealing in classes of goods with different percentages of 
gross profit must compute cost complements separately for each 
department or class of goods.
    (e) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (i) R, a retail merchant who uses the retail LCM method 
and uses a calendar taxable year, has no beginning inventory in 2012. R 
purchases 40 tables during 2012 for $60 each for a total of $2,400. R 
offers the tables for sale at $100 each for an aggregate retail selling 
price of $4,000. R does not sell any tables at a price of $100, so R 
permanently marks down the retail selling price of its tables to $90 
each. As a result of the $10 markdown, R's supplier provides R a $6 per 
table margin protection payment. R sells 25 tables during 2012 and has 
15 tables in ending inventory at the end of 2012.
    (ii) Under paragraph (b)(2)(i)(A) of this section, the numerator of 
the cost complement is the aggregate cost of the tables, $2,400. Under 
paragraph (b)(3)(i)(A) of this section, R may not reduce the numerator 
of the cost complement by the amount of the margin protection payment. 
Under paragraph (b)(2)(i)(B) of this section, the denominator of the 
cost complement is the aggregate of the bona fide retail selling prices 
of all the tables at the time acquired, $4,000. Under paragraph 
(b)(3)(i)(B) of this section, R does not adjust the denominator of the 
cost complement for the markdown. Therefore, R's cost complement is 
$2,400/$4,000, or 60%.

[[Page 578]]

    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdown in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending table 
inventory is $1,350 (15 * $90). Approximating LCM under the retail 
method, the value of R's ending table inventory is $810 (60% * $1,350).
    Example 2. (i) The facts are the same as in Example 1, except that R 
permanently reduces the retail selling price of all 40 tables to $50 per 
unit and the 15 tables on hand at the end of the year are marked for 
sale at that price. The additional $40 markdown is unrelated to a margin 
protection payment or other allowance.
    (ii) Under paragraph (b)(3)(i)(B) of this section, R does not adjust 
the denominator of the cost complement for the markdown. Therefore, R's 
cost complement is $2,400/$4,000, or 60%.
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdowns in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending inventory is 
$750 (15 * $50). Approximating LCM under the retail method, the value of 
R's ending inventory is $450 (60% * $750).
    Example 3. (i) The facts are the same as in Example 1, except that R 
computes the cost complement using the alternative method under 
paragraph (b)(3)(ii)(B) of this section.
    (ii) R reduces the numerator of the cost complement by the margin 
protection payments of $240 ($6 * 40) and reduces the denominator of the 
cost complement by the related markdowns of $400 ($10 * 40). Therefore, 
R's cost complement is $2,160/$3,600, or 60%.
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdown in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending table 
inventory is $1,350 (15 * $90). Approximating LCM under the retail 
method, the value of R's ending table inventory is $810 (60% * $1,350).
    Example 4. (i) The facts are the same as in Example 1, except that R 
cannot determine the amount of its related markdowns and computes the 
cost complement using the alternative method under paragraph 
(b)(3)(ii)(C) of this section.
    (ii) R reduces the numerator of the cost complement by the margin 
protection payments of $240 ($6 * 40). R reduces the denominator of the 
cost complement by the amount that, in conjunction with the reduction in 
the numerator, maintains the cost complement percentage before taking 
into account the margin protection payments and the related markdowns. 
R's original cost complement was 60% ($2,400/$4,000). The numerator of 
R's new cost complement is $2,160 ($2,400-$240). Therefore, R reduces 
the denominator by $400, which maintains the cost complement of 60% 
($2,160/$3,600).
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdowns in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending table 
inventory is $1,350 (15 * $90). Approximating LCM under the retail 
method, the value of R's ending table inventory is $810 (60% * $1,350).
    Example 5. (i) The facts are the same as in Example 1, except that R 
uses the LIFO inventory method. R must value inventories at cost and, 
under paragraph (c) of this section, uses the retail cost method.
    (ii) Under paragraph (b)(2)(i)(A) of this section, R reduces the 
numerator of the cost complement by the amount of the margin protection 
payment. Under paragraph (b)(2)(i)(B) of this section, R includes the 
permanent markdown in the denominator of the cost complement. Therefore, 
R's cost complement is $2,160/$3,600, or 60%.
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdown in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending inventory is 
$1,350 (15 * $90). Approximating cost under the retail method, the value 
of R's ending inventory is $810 (60% * $1,350).

    (f) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2014. For taxable years beginning 
before January 1, 2015, see Sec.  1.471-8 as contained in 26 CFR part 1, 
revised April 1, 2014.

[T.D. 9688, 79 FR 48036, Aug. 15, 2014]



Sec.  1.471-9  Inventories of acquiring corporations.

    For additional rules in the case of certain corporate acquisitions 
specified in section 381(a), see section 381(c)(5) and the regulations 
thereunder.

[T.D. 6500, 25 FR 11727, Nov. 26, 1960]



Sec.  1.471-10  Applicability of long-term contract methods.

    See Sec.  1.460-2 for rules providing for the application of the 
long-term contract methods to certain manufacturing contracts.

[T.D. 8067, 51 FR 393, Jan. 6, 1986, as amended by T.D. 8929, 66 FR 
2240, Jan. 11, 2001]



Sec.  1.471-11  Inventories of manufacturers.

    (a) Use of full absorption method of inventory costing. In order to 
conform as nearly as may be possible to the best accounting practices 
and to clearly reflect income (as required by section 471

[[Page 579]]

of the Code), both direct and indirect production costs must be taken 
into account in the computation of inventoriable costs in accordance 
with the ``full absorption'' method of inventory costing. Under the full 
absorption method of inventory costing production costs must be 
allocated to goods produced during the taxable year, whether sold during 
the taxable year or in inventory at the close of the taxable year 
determined in accordance with the taxpayer's method of identifying goods 
in inventory. Thus, the taxpayer must include as inventoriable costs all 
direct production costs and, to the extent provided by paragraphs (c) 
and (d) of this section, all indirect production costs. For purposes of 
this section, the term ``financial reports'' means financial reports 
(including consolidated financial statements) to shareholders, partners, 
beneficiaries or other proprietors and for credit purposes. See also 
Sec.  1.263A-1T with respect to the treatment of production costs 
incurred in taxable years beginning after December 31, 1986, and before 
January 1, 1994. See also Sec. Sec.  1.263A-1 and 1.263A-2 with respect 
to the treatment of production costs incurred in taxable years beginning 
after December 31, 1993.
    (b) Production costs--(1) In general. Costs are considered to be 
production costs to the extent that they are incident to and necessary 
for production or manufacturing operations or processes. Production 
costs include direct production costs and fixed and variable indirect 
production costs.
    (2) Direct production costs. (i) Costs classified as ``direct 
production costs'' are generally those costs which are incident to and 
necessary for production or manufacturing operations or processes and 
are components of the cost of either direct material or direct labor. 
Direct material costs include the cost of those materials which become 
an integral part of the specific product and those materials which are 
consumed in the ordinary course of manufacturing and can be identified 
or associated with particular units or groups of units of that product. 
See Sec.  1.471-3 for the elements of direct material costs. Direct 
labor costs include the cost of labor which can be identified or 
associated with particular units or groups of units of a specific 
product. The elements of direct labor costs include such items as basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d)), shift differential, payroll taxes and payments to a 
supplemental unemployment benefit plan paid or incurred on behalf of 
employees engaged in direct labor. For the treatment of rework labor, 
scrap, spoilage costs, and any other costs not specifically described as 
direct production costs see Sec.  1.471-11(c)(2).
    (ii) Under the full absorption method, a taxpayer must take into 
account all items of direct production cost in his inventoriable costs. 
Nevertheless, a taxpayer will not be treated as using an incorrect 
method of inventory costing if he treats any direct production costs as 
indirect production costs, provided such costs are allocated to the 
taxpayer's ending inventory to the extent provided by paragraph (d) of 
this section. Thus, for example, a taxpayer may treat direct labor costs 
as part of indirect production costs (for example, by use of the 
conversion cost method), provided all such costs are allocated to ending 
inventory to the extent provided by paragraph (d) of this section.
    (3) Indirect production costs--(i) In general. The term ``indirect 
production costs'' includes all costs which are incident to and 
necessary for production or manufacturing operations or processes other 
than direct production costs (as defined in subparagraph (2) of this 
paragraph). Indirect production costs may be classified as to kind or 
type in accordance with acceptable accounting principles so as to enable 
convenient identification with various production or manufacturing 
activities or functions and to facilitate reasonable groupings of such 
costs for purposes of determining unit product costs.
    (ii) Fixed and variable classifications. For purposes of this 
section, fixed indirect production costs are generally those costs which 
do not vary significantly with changes in the amount of goods produced 
at any given level of production capacity. These fixed costs may 
include, among other costs, rent and property taxes on buildings and 
machinery incident to and necessary

[[Page 580]]

for manufacturing operations or processes. On the other hand, variable 
indirect production costs are generally those costs which do vary 
significantly with changes in the amount of goods produced at any given 
level of production capacity. These variable costs may include, among 
other costs, indirect materials, factory janitorial supplies, and 
utilities. Where a particular cost contains both fixed and variable 
elements, these elements should be segregated into fixed and variable 
classifications to the extent necessary under the taxpayer's method of 
allocation, such as for the application of the practical capacity 
concept (as described in paragraph (d) (4) of this section).
    (c) Certain indirect and production costs--(1) General rule. Except 
as provided in paragraph (c)(3) of this section and in paragraph 
(d)(6)(v) of Sec.  1.451-3, in order to determine whether indirect 
production costs referred to in paragraph (b) of this section must be 
included in a taxpayer's computation of the amount of inventoriable 
costs, three categories of costs have been provided in subparagraph (2) 
of this paragraph. Costs described in subparagraph (2)(i) of this 
paragraph must be included in the taxpayer's computation of the amount 
of inventoriable costs, regardless of their treatment by the taxpayer in 
his financial reports. Costs described in subparagraph (2)(ii) of this 
paragraph need not enter into the taxpayer's computation of the amount 
of inventoriable costs, regardless of their treatment by the taxpayer in 
his financial reports. Costs described in subparagraph (2)(iii) of this 
paragraph must be included in or excluded from the taxpayer's 
computation of the amount inventoriable costs in accordance with the 
treatment of such costs by the taxpayer in his financial reports and 
generally accepted accounting principles. For the treatment of indirect 
production costs described in subparagraph (2) of this paragraph in the 
case of a taxpayer who is not using comparable methods of accounting for 
such costs for tax and financial reporting see paragraph (c)(3) of this 
section. For contracts entered into after December 31, 1982, 
notwithstanding this section, taxpayers who use an inventory method of 
accounting for extended period long-term contracts (as defined in 
paragraph (b)(3) of Sec.  1.451-3) for tax purposes may be required to 
use the cost allocation rules provided in paragraph (d)(6) of Sec.  
1.451-3 rather than the cost allocation rules provided in this section. 
See paragraph (d)(6)(v) of Sec.  1.451-3. After a taxpayer has 
determined which costs must be treated as indirect production costs 
includible in the computation of the amount of inventoriable costs, such 
costs must be allocated to a taxpayer's ending inventory in a manner 
prescribed by paragraph (d) of this section.
    (2) Includibility of certain indirect production costs--(i) Indirect 
production costs included in inventoriable costs. Indirect production 
costs which must enter into the computation of the amount of 
inventoriable costs (regardless of their treatment by a taxpayer in his 
financial reports) include:
    (a) Repair expenses,
    (b) Maintenance,
    (c) Utilities, such as heat, power and light,
    (d) Rent,
    (e) Indirect labor and production supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d), shift differential, payroll taxes and contributions to a 
supplemental unemployment benefit plan,
    (f) Indirect materials and supplies,
    (g) Tools and equipment not capitalized, and
    (h) Costs of quality control and inspection,


to the extent, and only to the extent, such costs are incident to and 
necessary for production or manufacturing operations or processes.
    (ii) Costs not included in inventoriable costs. Costs which are not 
required to be included for tax purposes in the computation of the 
amount of inventoriable costs (regardless of their treatment by a 
taxpayer in his financial reports) include:
    (a) Marketing expenses,
    (b) Advertising expenses,
    (c) Selling expenses,
    (d) Other distribution expenses,
    (e) Interest,

[[Page 581]]

    (f) Research and experimental expenses including engineering and 
product development expenses,
    (g) Losses under section 165 and the regulations thereunder,
    (h) Percentage depletion in excess of cost depletion,
    (i) Depreciation and amortization reported for Federal income tax 
purposes in excess of depreciation reported by the taxpayer in his 
financial reports,
    (j) Income taxes attributable to income received on the sale of 
inventory,
    (k) Pension contributions to the extent that they represent past 
services cost,
    (l) General and administrative expenses incident to and necessary 
for the taxpayer's activities as a whole rather than to production or 
manufacturing operations or processes, and
    (m) Salaries paid to officers attributable to the performance of 
services which are incident to and necessary for the taxpayer's 
activities taken as a whole rather than to production or manufacturing 
operations or processes.


Notwithstanding the preceding sentence, if a taxpayer consistently 
includes in his computation of the amount of inventoriable costs any of 
the costs described in the preceding sentence, a change in such method 
of inclusion shall be considered a change in method of accounting within 
the meaning of sections 446, 481, and paragraph (e)(4) of this section.
    (iii) Indirect production costs includible in inventoriable costs 
depending upon treatment in taxpayer's financial reports. In the case of 
costs listed in this subdivision, the inclusion or exclusion of such 
costs from the amount of inventoriable costs for purposes of a 
taxpayer's financial reports shall determine whether such costs must be 
included in or excluded from the computation of inventoriable costs for 
tax purposes, but only if such treatment is not inconsistent with 
generally accepted accounting principles. In the case of costs which are 
not included in subdivision (i) or (ii) of this subparagraph, nor listed 
in this subdivision, whether such costs must be included in or excluded 
from the computation of inventoriable costs for tax purposes depends 
upon the extent to which such costs are similar to costs included in 
subdivision (i) or (ii), and if such costs are dissimilar to costs in 
subdivision (i) or (ii), such costs shall be treated as included in or 
excludable from the amount of inventoriable costs in accordance with 
this subdivision. The costs listed in this subdivision are:
    (a) Taxes. Taxes otherwise allowable as a deduction under section 
164 (other than State and local and foreign income taxes) attributable 
to assets incident to and necessary for production or manufacturing 
operations or processes. Thus, for example, the cost of State and local 
property taxes imposed on a factory or other production facility and any 
State and local taxes imposed on inventory must be included in or 
excluded from the computation of the amount of inventoriable costs for 
tax purposes depending upon their treatment by a taxpayer in his 
financial reports.
    (b) Depreciation and depletion. Depreciation reported in financial 
reports and cost depletion on assets incident to and necessary for 
production or manufacturing operations or processes. In computing cost 
depletion under this section, the adjusted basis of such assets shall be 
reduced by cost depletion and not by percentage depletion taken thereon.
    (c) Employee benefits. Pension and profit-sharing contributions 
representing current service costs otherwise allowable as a deduction 
under section 404, and other employee benefits incurred on behalf of 
labor incident to and necessary for production or manufacturing 
operations or processes. These other benefits include workmen's 
compensation expenses, payments under a wage continuation plan described 
in section 105(d), amounts of a type which would be includible in the 
gross income of employees under non-qualified pension, profit-sharing 
and stock bonus plans, premiums on life and health insurance and 
miscellaneous benefits provided for employees such as safety, medical 
treatment, cafeteria, recreational facilities, membership dues, etc., 
which are otherwise allowable as deductions under chapter 1 of the Code.

[[Page 582]]

    (d) Costs attributable to strikes, rework labor, scrap and spoilage. 
Costs attributable to rework labor, scrap and spoilage which are 
incident to and necessary for production or manufacturing operations or 
processes and costs attributable to strikes incident to production or 
manufacturing operation or processes.
    (e) Factory administrative expenses. Administrative costs of 
production (but not including any cost of selling or any return on 
capital) incident to and necessary for production or manufacturing 
operations or processes.
    (f) Officers' salaries. Salaries paid to officers attributable to 
services performed incident to and necessary for production or 
manufacturing operations or processes.
    (g) Insurance costs. Insurance costs incident to and necessary for 
production or manufacturing operations or processes such as insurance on 
production machinery and equipment. A change in the taxpayer's treatment 
in his financial reports of costs described in this subdivision which 
results in a change in treatment of such costs for tax purposes shall 
constitute a change in method of accounting within the meaning of 
sections 446 and 481 to which paragraph (e) applies.
    (3) Exception. Except as provided in paragraph (d)(6) of Sec.  
1.451-3, in the case of a taxpayer whose method of accounting for 
production costs in his financial reports is not comparable to his 
method of accounting for such costs for tax purposes (such as a taxpayer 
using the prime cost method for purposes of financial reports), the 
following rules apply:
    (i) Indirect production costs included in inventoriable costs. 
Indirect production costs which must enter into the computation of the 
amount of inventoriable costs (to the extent, and only to the extent, 
such costs are incident to and necessary for production or manufacturing 
operations or processes) include:
    (a) Repair expenses,
    (b) Maintenance,
    (c) Utilities, such as heat, power and light,
    (d) Rent,
    (e) Indirect labor and production supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d)), shift differential, payroll taxes and contributions to a 
supplemental unemployment benefit plan,
    (f) Indirect materials and supplies,
    (g) Tools and equipment not capitalized,
    (h) Costs of quality control and inspection,
    (i) Taxes otherwise allowable as a deduction under section 164 
(other than State and local and foreign income taxes),
    (j) Depreciation and amortization reported for financial purposes 
and cost depletion,
    (k) Administrative costs of production (but not including any cost 
of selling or any return on capital) incident to and necessary for 
production or manufacturing operations or processes,
    (l) Salaries paid to officers attributable to services performed 
incident to and necessary for production or manufacturing operations or 
processes, and
    (m) Insurance costs incident to and necessary for production or 
manufacturing operations or processes such as insurance on production 
machinery and equipment.
    (ii) Costs not included in inventoriable costs. Costs which are not 
required to be included in the computation of the amount of 
inventoriable costs include:
    (a) Marketing expenses,
    (b) Advertising expenses,
    (c) Selling expenses,
    (d) Other distribution expenses,
    (e) Interest,
    (f) Research and experimental expenses including engineering and 
product development expenses,
    (g) Losses under section 165 and the regulations thereunder,
    (h) Percentage depletion in excess of cost depletion,
    (i) Depreciation reported for Federal income tax purposes in excess 
of depreciation reported by the taxpayer in his financial reports,
    (j) Income taxes attributable to income received on the sale of 
inventory,
    (k) Pension and profit-sharing contributions representing either 
past service costs or representing current

[[Page 583]]

service costs otherwise allowable as a deduction under section 404, and 
other employee benefits incurred on behalf of labor. These other 
benefits include workmen's compensation expenses, payments under a wage 
continuation plan described in section 105(d), amounts of a type which 
would be includible in the gross income of employees under nonqualified 
pension, profit-sharing and stock bonus plans, premiums on life and 
health insurance and miscellaneous benefits provided for employees such 
as safety, medical treatment, cafeteria, recreational facilities, 
membership dues, etc., which are otherwise allowable as deductions under 
chapter 1 of the Code,
    (l) Cost attributable to strikes, rework labor, scrap and spoilage,
    (m) General and administrative expenses incident to and necessary 
for the taxpayer's activities as a whole rather than to production or 
manufacturing operations or processes, and
    (n) Salaries paid to officers attributable to the performance of 
services which are incident to and necessary for the taxpayer's 
activities as a whole rather than to production or manufacturing 
operations or processes.
    (d) Allocation methods--(1) In general. Indirect production costs 
required to be included in the computation of the amount of 
inventoriable costs pursuant to paragraphs (b) and (c) of this paragraph 
must be allocated to goods in a taxpayer's ending inventory (determined 
in accordance with the taxpayer's method of identification) by the use 
of a method of allocation which fairly apportions such costs among the 
various items produced. Acceptable methods for allocating indirect 
production costs to the cost of goods in the ending inventory include 
the manufacturing burden rate method and the standard cost method. In 
addition, the practical capacity concept can be used in conjunction with 
either the manufacturing burden rate or standard cost method.
    (2) Manufacturing burden rate method--(i) In general. Manufacturing 
burden rates may be developed in accordance with acceptable accounting 
principles and applied in a reasonable manner. In developing a 
manufacturing burden rate, the factors described in paragraph (d)(2)(ii) 
of this section may be taken into account. Furthermore, if the taxpayer 
chooses, he may allocate different indirect production costs on the 
basis of different manufacturing burden rates. Thus, for example, the 
taxpayer may use one burden rate for allocating rent and another burden 
rate for allocating utilities. The method used by the taxpayer in 
allocating such costs in his financial reports shall be given great 
weight in determining whether the taxpayer's method employed for tax 
purposes fairly allocates indirect production costs to the ending 
inventory. Any change in a manufacturing burden rate which is merely a 
periodic adjustment to reflect current operating conditions, such as 
increases in automation or changes in operation, does not constitute a 
change in method of accounting under section 446. However, a change in 
the concept upon which such rates are developed does constitute a change 
in method of accounting requiring the consent of the Commissioner. The 
taxpayer shall maintain adequate records and working papers to support 
all manufacturing burden rate calculations.
    (ii) Development of manufacturing burden rate. The following 
factors, among others, may be taken into account in developing 
manufacturing burden rates:
    (a) The selection of an appropriate level of activity and period of 
time upon which to base the calculation of rates which will reflect 
operating conditions for purposes of the unit costs being determined;
    (b) The selection of an appropriate statistical base such as direct 
labor hours, direct labor dollars, or machine hours, or a combination 
thereof, upon which to apply the overhead rate to determine production 
costs; and
    (c) The appropriate budgeting, classification and analysis of 
expenses (for example, the analysis of fixed and variable costs).
    (iii) Operation of the manufacturing burden rate method. (a) The 
purpose of the manufacturing burden rate method used in conjunction with 
the full absorption method of inventory costing is to allocate an 
appropriate amount of indirect production costs to a taxpayer's goods in 
ending inventory by

[[Page 584]]

the use of predetermined rates intended to approximate the actual amount 
of indirect production costs incurred. Accordingly, the proper use of 
the manufacturing burden rate method under this section requires that 
any net negative or net positive difference between the total 
predetermined amount of indirect production costs allocated to the goods 
in ending inventory and the total amount of indirect production costs 
actually incurred and required to be allocated to such goods (i.e., the 
under or over-applied burden) must be treated as an adjustment to the 
taxpayer's ending inventory in the taxable year in which such difference 
arises. However, if such adjustment is not significant in amount in 
relation to the taxpayer's total actual indirect production costs for 
the year then such adjustment need not be allocated to the taxpayer's 
goods in ending inventory unless such allocation is made in the 
taxpayer's financial reports. The taxpayer must treat both positive and 
negative adjustments consistently.
    (b) Notwithstanding subdivision (a), the practical capacity concept 
may be used to determine the total amount of fixed indirect production 
costs which must be allocated to goods in ending inventory. See 
subparagraph (4) of this paragraph.
    (3) Standard cost method--(i) In general. A taxpayer may use the so-
called ``standard cost'' method of allocating inventoriable costs to the 
goods in ending inventory, provided he treats variances in accordance 
with the procedures prescribed in paragraph (d)(3)(ii) of this section. 
The method used by the taxpayer in allocating such costs in his 
financial reports shall be given great weight in determining whether the 
taxpayer's method employed for tax purposes fairly allocates indirect 
production costs to the ending inventory. For purposes of this 
subparagraph, a ``net positive overhead variance'' shall mean the excess 
of total standard (or estimated) indirect production costs over total 
actual indirect production costs and a ``net negative overhead 
variance'' shall mean the excess of total actual indirect production 
costs over total standard (or estimated) indirect production costs.
    (ii) Treatment of variances. (a) The proper use of the standard cost 
method pursuant to this subparagraph requires that a taxpayer must 
reallocate to the goods in ending inventory a pro rata portion of any 
net negative or net positive overhead variances and any net negative or 
net positive direct production cost variances. The taxpayer must 
apportion such variances among his various items in ending inventory. 
However, if such variances are not significant in amount in relation to 
the taxpayer's total actual indirect production costs for the year then 
such variances need not be allocated to the taxpayer's goods in ending 
inventory unless such allocation is made in the taxpayer's financial 
reports. The taxpayer must treat both positive and negative variances 
consistently.
    (b) Notwithstanding subdivision (a), the practical capacity concept 
may be used to determine the total amount of fixed indirect production 
costs which must be allocated to goods in ending inventory. See 
subparagraph (4) of this paragraph.
    (4) Practical capacity concept--(i) In general. Under the practical 
capacity concept, the percentage of practical capacity represented by 
actual production (not greater than 100 percent), as calculated under 
subdivision (ii) of this subparagraph, is used to determine the total 
amount of fixed indirect production costs which must be included in the 
taxpayer's computation of the amount of inventoriable costs. The portion 
of such costs to be included in the taxpayer's computation of the amount 
of inventoriable costs is then combined with variable indirect 
production costs and both are allocated to the goods in ending inventory 
in accordance with this paragraph. See the example in subdivision 
(ii)(d) of this subparagraph. The difference (if any) between the amount 
of all fixed indirect production costs and the fixed indirect production 
costs which are included in the computation of the amount of 
inventoriable costs under the practical capacity concept is allowable as 
a deduction for the taxable year in which such difference occurs.
    (ii) Calculation of practical capacity--(a) In general. Practical 
capacity and theoretical capacity (as described in (c)

[[Page 585]]

of this subdivision) may be computed in terms of tons, pounds, yards, 
labor hours, machine hours, or any other unit of production appropriate 
to the cost accounting system used by a particular taxpayer. The 
determination of practical capacity and theoretical capacity should be 
modified from time to time to reflect a change in underlying facts and 
conditions such as increased output due to automation or other changes 
in plant operation. Such a change does not constitute a change in method 
of accounting under sections 446 and 481.
    (b) Based upon taxpayer's experience. In selecting an appropriate 
level of production activity upon which to base the calculation of 
practical capacity, the taxpayer shall establish the production 
operating conditions expected during the period for which the costs are 
being determined, assuming that the utilization of production facilities 
during operations will be approximately at capacity. This level of 
production activity is frequently described as practical capacity for 
the period and is ordinarily based upon the historical experience of the 
taxpayer. For example, a taxpayer operating on a 5-day, 8-hour basis may 
have a ``normal'' production of 100,000 units a year based upon three 
years of experience.
    (c) Based upon theoretical capacity. Practical capacity may also be 
established by the use of ``theoretical'' capacity, adjusted for 
allowances for estimated inability to achieve maximum production, such 
as machine breakdown, idle time, and other normal work stoppages. 
Theoretical capacity is the level of production the manufacturer could 
reach if all machines and departments were operated continously at peak 
efficiency.
    (d) Example. The provisions of (c) of this subdivision may be 
illustrated by the following example:

    Corporation X operates a stamping plant with a theoretical capacity 
of 50 units per hour. The plant actually operates 1960 hours per year 
based on an 8-hour day, 5 day week basis and 15 shutdown days for 
vacations and holidays. A reasonable allowance for down time (the time 
allowed for ordinary and necessary repairs and maintenance) is 5 percent 
of practical capacity before reduction for down time. Assuming no loss 
of production during starting up, closing down, or employee work breaks, 
under these facts and circumstances X may properly make a practical 
capacity computation as follows:

Practical capacity without allowance for down time based on       98,000
 theoretical capacity per hour is (1960 x 50)..................
Reduction for down time (98,000 x 5 percent)...................    4,900
Practical capacity.............................................   93,100
 


The 93,100 unit level of activity (i.e., practical capacity) would, 
therefore, constitute an appropriate base for calculating the amount of 
fixed indirect production costs to be included in the computation of the 
amount of inventoriable costs for the period under review. On this basis 
if only 76,000 units were produced for the period, the effect would be 
that approximately 81.6 percent (76,000, the actual number of units 
produced, divided by 93,100, the maximum number of units producible at 
practical capacity) of the fixed indirect production costs would be 
included in the computation of the amount of inventoriable costs during 
the year. The portion of the fixed indirect production costs not so 
included in the computation of the amount of inventoriable costs would 
be deductible in the year in which paid or incurred. Assume further that 
7,600 units were on hand at the end of the taxable year and the 7,600 
units were in the same proportion to the total units produced. Thus, 10 
percent (7,600 units in inventory at the end of the taxable year, 
divided by 76,000, the actual number of units produced) of the fixed 
indirect production costs included in the computation of the amount of 
inventoriable costs (the above-mentioned 81.6 percent) and 10 percent of 
the variable indirect production costs would be included in the cost of 
the goods in the ending inventory, in accordance with a method of 
allocation provided by this paragraph.

    (e) Transition to full absorption method of inventory costing--(1) 
In general--(i) Mandatory requirement. A taxpayer not using the full 
absorption method of inventory costing, as prescribed by paragraph (a) 
of this section, must change to that method. Any change to the full 
absorption method must be made by the taxpayer with respect to all 
trades or businesses of the taxpayer to which this section applies. A 
taxpayer not using the full absorption method of inventory costing, as 
prescribed by paragraph (a) of this section, who makes the special 
election provided in subdivision (ii) of this subparagraph during the 
transition period described in subdivision (ii) of this subparagraph 
need not change to the full absorption method of inventory costing for 
taxable years prior to the year for which

[[Page 586]]

such election is made. In determining whether the taxpayer is changing 
to a more or less inclusive method of inventory costing, all positive 
and negative adjustments for all items and all trades or businesses of 
the taxpayer shall be aggregated. If the net adjustment is positive, 
paragraph (e)(3) shall apply, and if the net adjustment is negative, 
paragraph (e)(4) shall apply to the change. The rules otherwise 
prescribed in sections 446 and 481 and the regulations thereunder shall 
apply to any taxpayer who fails to make the special election in 
subdivision (ii) of this subparagraph. The transition rules of this 
paragraph are available only to those taxpayers who change their method 
of inventory costing.
    (ii) Special election during two-year-transition period. If a 
taxpayer elects to change to the full absorption method of inventory 
costing during the transition period provided herein, he may elect on 
Form 3115 to change to such full absorption method of inventory costing 
and, in so doing, employ the transition procedures and adopt any of the 
transition methods prescribed in subparagraph (3) of this paragraph. 
Such election shall be made during the first 180 days of any taxable 
year beginning on or after September 19, 1973 and before September 19, 
1975 (i.e., the ``transition period'') and the change in inventory 
costing method shall be made for the taxable year in which the election 
is made. Notwithstanding the preceding sentence if the taxpayer's prior 
returns have been examined by the Service prior to Sept. 19, 1973, and 
there is a pending issue involving the taxpayer's method of inventory 
costing, the taxpayer may request the application of this regulation by 
agreeing and filing a letter to that effect with the district director, 
within 90 days after September 19, 1973 to change to the full absorption 
method for the first taxable year of the taxpayer beginning after Sept. 
19, 1973 and subsequently filing Form 3115 within the first 180 days of 
such taxable year of change.
    (iii) Change initiated by the Commissioner. A taxpayer who properly 
makes an election under subdivision (ii) of this subparagraph shall be 
considered to have made a change in method of accounting not initiated 
by the taxpayer, notwithstanding the provisions of Sec.  1.481-1(c)(5). 
Thus, any of the taxpayer's ``pre-1954 inventory balances'' with respect 
to such inventory shall not be taken into account as an adjustment under 
section 481. For purposes of this paragraph, a ``pre-1954 inventory 
balance'' is the net amount of the adjustments which would have been 
required if the taxpayer had made such change in his method of 
accounting with respect to his inventory in his first taxable year which 
began after December 31, 1953, and ended after August 16, 1954. See 
section 481(a)(2) and Sec.  1.481-3.
    (2) Procedural rules for change. If a taxpayer makes an election 
pursuant to subparagraph (1)(ii) of this paragraph, the Commissioner's 
consent will be evidenced by a letter of consent to the taxpayer, 
setting forth the values of inventory, as provided by the taxpayer, 
determined under the full absorption method of inventory costing, except 
to the extent that no determination of such values is necessary under 
subparagraph (3)(ii)(B) of this paragraph (the cut off method), the 
amount of the adjustments (if any) required to be taken into account by 
section 481, and the treatment to be accorded to any such adjustments. 
Such full absorption values shall be subject to verification on 
examination by the district director. The taxpayer shall preserve at his 
principal place of business all records, data, and other evidence 
relating to the full absorption values of inventory.
    (3) Transition methods. In the case of a taxpayer who properly makes 
an election under subparagraph (1)(ii) of this paragraph during the 
transition period--
    (i) 10-year adjustment period. Such taxpayer may elect to take any 
adjustment required by section 481 with respect to any inventory being 
revalued under the full absorption method into account ratably over a 
period designated by the taxpayer at the time of such election, not to 
exceed the lesser of 10 taxable years commencing with the year of 
transition or the number of years the taxpayer has been on the inventory 
method from which he is changing. If the taxpayer dies or ceases to 
exist in a transaction other than one

[[Page 587]]

to which section 381(a) of the Code applies or if the taxpayer's 
inventory (determined under the full absorption method) on the last day 
of any taxable year is reduced (by other than a strike or involuntary 
conversion) by more than an amount equal to 33\1/3\ percent of the 
taxpayer's inventory (determined under the full absorption method) as of 
the beginning of the year of change, the entire amount of the section 
481 adjustment not previously taken into account in computing income 
shall be taken into account in computing income for the taxable year in 
which such taxpayer so ceases to exist or such taxpayer's inventory is 
so reduced.
    (ii) Additional rules for LIFO taxpayers. A taxpayer who uses the 
LIFO method of inventory identification may either--
    (a) Employ the special transition rules described in subdivision (i) 
of this subparagraph. Accordingly, all LIFO layers must be revalued 
under the full absorption method and the section 481 adjustment must be 
computed for all items in all layers in inventory, but no pre-1954 
inventory balances shall be taken into account as adjustments under 
section 481; or
    (b)(1) Employ a cut-off method whereby the full absorption method is 
only applied in costing layers of inventory acquired during all taxable 
years beginning with the year for which an election is made under 
subparagraph (e)(1)(ii).
    (2) In the case of a taxpayer using dollar value LIFO, employ a cut-
off method whereby the taxpayer must use, for the year of change, the 
full absorption method in computing the base year cost and current cost 
of a dollar value inventory pool for the beginning of such year. The 
taxpayer shall not be required to recompute his LIFO inventories based 
on the full absorption method for a taxable year beginning prior to the 
year of change to the full absorption method. The base cost and layers 
of increment previously computed shall be retained and treated as if 
such base cost and layers of increment had been computed under the 
method authorized by this section. The taxpayer shall use the year of 
change as the base year in applying the double extension method or other 
method approved by the Commissioner, instead of the earliest year for 
which he adopted the LIFO method for any items in the pool.
    (4) Transition to full absorption method of inventory costing from a 
method more inclusive of indirect production costs--(i) Taxpayer has not 
previously changed to his present method pursuant to subparagraphs (1), 
(2), and (3) of this paragraph. If a taxpayer wishes to change to the 
full absorption method of inventory costing (as prescribed by paragraph 
(a) of this section) from a method of inventory costing which is more 
inclusive of indirect production costs and he has not previously changed 
to his present method by use of the special transition rules provided by 
subparagraphs (1), (2) and (3) of this paragraph, he may elect on Form 
3115 to change to the full absorption method of inventory costing and, 
in so doing, take into account any resulting section 481 adjustment 
generally over 10 taxable years commencing with the year of transition. 
The Commissioner's consent to such election will be evidenced by a 
letter of consent to the taxpayer setting forth the values of inventory, 
as provided by the taxpayer determined under the full absorption method 
of inventory costing, except to the extent that no determination of such 
values is necessary under subparagraph (3)(ii)(b) of this paragraph, the 
amount of the adjustments (if any) required to be taken into account by 
section 481, and the treatment to be accorded such adjustments, subject 
to terms and conditions specified by the Commissioner to prevent 
distortions of income. Such election must be made within the transition 
period described in subparagraph (1)(ii) of this paragraph. A change 
pursuant to this subparagraph shall be a change initiated by the 
taxpayer as provided by Sec.  1.481-1(c)(5). Thus, any of the taxpayers 
``pre-1954 inventory balances'' will be taken into account as an 
adjustment under section 481.
    (ii) Taxpayer has previously changed to his present method pursuant 
to subparagraph (1), (2), and (3) of this paragraph or would satisfy all 
the requirements of subdivision (i) of this subparagraph but fails to 
elect within the transition period. If a taxpayer wishes to change to 
the full

[[Page 588]]

absorption method of inventory costing (as prescribed by paragraph (a) 
of this section) from a method of inventory costing which is more 
inclusive of indirect production costs and he has previously changed to 
his present method pursuant to subparagraphs (1), (2), and (3) of this 
paragraph or he would satisfy the requirements of subdivision (i) of 
this subparagraph but he fails to elect within the transition period, he 
must secure the consent of the Commissioner prior to making such change.

[T.D. 7285, 38 FR 26185, Sept. 19, 1973, as amended by T.D. 8067, 51 FR 
393, Jan. 6, 1986; T.D. 8131, 52 FR 10084, Mar. 30, 1987; T.D. 8482, 58 
FR 42234, Aug. 9, 1993]



Sec.  1.472-1  Last-in, first-out inventories.

    (a) Any taxpayer permitted or required to take inventories pursuant 
to the provisions of section 471, and pursuant to the provisions of 
Sec. Sec.  1.471-1 to 1.471-9, inclusive, may elect with respect to 
those goods specified in his application and properly subject to 
inventory to compute his opening and closing inventories in accordance 
with the method provided by section 472, this section, and Sec.  1.472-
2. Under this last-in, first-out (LIFO) inventory method, the taxpayer 
is permitted to treat those goods remaining on hand at the close of the 
taxable year as being:
    (1) Those included in the opening inventory of the taxable year, in 
the order of acquisition and to the extent thereof, and
    (2) Those acquired during the taxable year.


The LIFO inventory method is not dependent upon the character of the 
business in which the taxpayer is engaged, or upon the identity or want 
of identity through commingling of any of the goods on hand, and may be 
adopted by the taxpayer as of the close of any taxable year.
    (b) If the LIFO inventory method is used by a taxpayer who regularly 
and consistently, in a manner similar to hedging on a futures market, 
matches purchases with sales, then firm purchases and sales contracts 
(i.e., those not legally subject to cancellation by either party) 
entered into at fixed prices on or before the date of the inventory may 
be included in purchases or sales, as the case may be, for the purpose 
of determining the cost of goods sold and the resulting profit or loss, 
provided that this practice is regularly and consistently adhered to by 
the taxpayer and provided that, in the opinion of the Commissioner, 
income is clearly reflected thereby.
    (c) A manufacturer or processor who has adopted the LIFO inventory 
method as to a class of goods may elect to have such method apply to the 
raw materials only (including those included in goods in process and in 
finished goods) expressed in terms of appropriate units. If such method 
is adopted, the adjustments are confined to costs of the raw material in 
the inventory and the cost of the raw material in goods in process and 
in finished goods produced by such manufacturer or processor and 
reflected in the inventory. The provisions of this paragraph may be 
illustrated by the following examples:

    Example 1. Assume that the opening inventory had 10 units of raw 
material, 10 units of goods in process, and 10 units of finished goods, 
and that the raw material cost was 6 cents a unit, the processing cost 2 
cents a unit, and overhead cost 1 cent a unit. For the purposes of this 
example, it is assumed that the entire amount of goods in process was 50 
percent processed.

                            Opening Inventory
------------------------------------------------------------------------
                                                        Goods
                                                Raw       in    Finished
                                             material  process    goods
------------------------------------------------------------------------
Raw material                                    $0.60    $0.60     $0.60
Processing cost                              ........      .10       .20
Overhead                                     ........      .05       .10
------------------------------------------------------------------------


In the closing inventory there are 20 units of raw material, 6 units of 
goods in process, and 8 units of finished goods and the costs were: Raw 
material 10 cents, processing cost 4 cents, and overhead 1 cent.

                            Closing Inventory
                 [Based on cost and prior to adjustment]
------------------------------------------------------------------------
                                                        Goods
                                                Raw       in    Finished
                                             material  process    goods
------------------------------------------------------------------------
Raw material                                    $2.00    $0.60     $0.80
Processing costs                             ........      .12       .32
Overhead                                     ........      .03       .08
                                            ----------------------------
   Total                                         2.00      .75      1.20
------------------------------------------------------------------------

There were 30 units of raw material in the opening inventory and 34 
units in the closing inventory. The adjustment to the closing inventory 
would be as follows:

[[Page 589]]


                      Closing Inventory as Adjusted
------------------------------------------------------------------------
                                                        Goods
                                                Raw       in    Finished
                                             material  process    goods
------------------------------------------------------------------------
Raw material:
  20 at 6 cents                                 $1.20  .......  ........
  6 at 6 cents                               ........    $0.36  ........
  4 at 6 cents                               ........  .......     $0.24
  4 at 10 cents \1\                          ........  .......       .40
Processing costs                             ........      .12       .32
Overhead                                     ........      .03       .08
                                            ----------------------------
      Total                                      1.20      .51     1.04
------------------------------------------------------------------------
\1\ This excess is subject to determination of price under section
  472(b)(1) and Sec.   1.472-2. If the excess falls in goods in process,
  the same adjustment is applicable.

The only adjustment to the closing inventory is the cost of the raw 
material; the processing costs and overhead cost are not changed.
    Example 2. Assume that the opening inventory had 5 units of raw 
material, 10 units of goods in process, and 20 units of finished goods, 
with the same prices as in Example 1, and that the closing inventory had 
20 units of raw material, 20 units of goods in process, and 10 units of 
finished goods, with raw material costs as in the closing inventory in 
Example 1. The adjusted closing inventory would be as follows in so far 
as the raw material is concerned:

Raw material, 20 at 6 cents....................................    $1.20
Goods in process:
  15 at 6 cents................................................      .90
  5 at 10 cents \1\............................................      .50
Finished goods:
  None at 6 cents..............................................     0.00
  10 at 10 cents \1\...........................................     1.00
 
\1\ This excess is subject to determination of price under section
  472(b)(1) and Sec.   1.472-2.

The 20 units of raw material in the raw state plus 15 units of raw 
material in goods in process make up the 35 units of raw material that 
were contained in the opening inventory.

    (d) For the purposes of this section, raw material in the opening 
inventory must be compared with similar raw material in the closing 
inventory. There may be several types of raw materials, depending upon 
the character, quality, or price, and each type of raw material in the 
opening inventory must be compared with a similar type in the closing 
inventory.
    (e) In the cotton textile industry there may be different raw 
materials depending upon marked differences in length of staple, in 
color or grade of the cotton. But where different staple lengths or 
grades of cotton are being used at different times in the same mill to 
produce the same class of goods, such differences would not necessarily 
require the classification into different raw materials.
    (f) As to the pork packing industry a live hog is considered as 
being composed of various raw materials, different cuts of a hog varying 
markedly in price and use. Generally a hog is processed into 
approximately 10 primal cuts and several miscellaneous articles. 
However, due to similarity in price and use, these may be grouped into 
fewer classifications, each group being classed as one raw material.
    (g) When the finished product contains two or more different raw 
materials as in the case of cotton and rayon mixtures, each raw material 
is treated separately and adjustments made accordingly.
    (h) Upon written notice addressed to the Commissioner of Internal 
Revenue, Attention T:R, Washington, D.C. 20224 by the taxpayer, a 
taxpayer who has heretofore adopted the LIFO inventory method in respect 
of any goods may adopt the method authorized in this section and limit 
the election to the raw material including raw materials entering into 
goods in process and in finished goods. If this method is adopted as to 
any specific goods, it must be used exclusively for such goods for any 
prior taxable year (not closed by agreement) to which the prior election 
applies and for all subsequent taxable years, unless permission to 
change is granted by the Commissioner.
    (i) The election may also be limited to that phase in the 
manufacturing process where a product is produced that is recognized 
generally as a salable product as, for example, in the textile industry 
where one phase of the process is the production of yarn. Since yarn is 
generally recognized as a salable product, the election may be limited 
to that portion of the process when yarn is produced. In the case of 
copper and brass processors, the election may be limited to the 
production of bars, plates, sheets, etc., although these may be further 
processed into other products.
    (j) The election may also apply to any one raw material, when two or 
more raw materials enter into the composition of the finished product; 
for example, in the case of cotton and rayon

[[Page 590]]

yarn, the taxpayer may elect to inventory the cotton only. However, a 
taxpayer who has previously made an election to use the LIFO inventory 
method may not later elect to exclude any raw materials that were 
covered by such previous election.
    (k) If a taxpayer using the retail method of pricing inventories, 
authorized by Sec.  1.471-8, elects to use in connection therewith the 
LIFO inventory method authorized by section 472 and this section, the 
apparent cost of the goods on hand at the end of the year, determined 
pursuant to Sec.  1.471-8, shall be adjusted to the extent of price 
changes therein taking place after the close of the preceding taxable 
year. The amount of any apparent inventory increase or decrease to be 
eliminated in this adjustment shall be determined by reference to 
acceptable price indexes established to the satisfaction of the 
Commissioner. Price indexes prepared by the United States Bureau of 
Labor Statistics which are applicable to the goods in question will be 
considered acceptable to the Commissioner. Price indexes which are based 
upon inadequate records, or which are not subject to complete and 
detailed audit within the Internal Revenue Service, will not be 
approved.
    (l) If a taxpayer uses consistently the so-called ``dollar-value'' 
method of pricing inventories, or any other method of computation 
established to the satisfaction of the Commissioner as reasonably 
adaptable to the purpose and intent of section 472 and this section, and 
if such taxpayer elects under section 472 to use the LIFO inventory 
method authorized by such section, the taxpayer's opening and closing 
inventories shall be determined under section 472 by the use of the 
appropriate adaptation. See Sec.  1.472-8 for rules relating to the use 
of the dollar-value method.

[T.D. 6500, 25 FR 11727, Nov. 26, 1960, as amended by T.D. 6539, 26 FR 
518, Jan. 20, 1961]



Sec.  1.472-2  Requirements incident to adoption and use 
of LIFO inventory method.

    Except as otherwise provided in Sec.  1.472-1 with respect to raw 
material computations, with respect to retail inventory computations, 
and with respect to other methods of computation established to the 
satisfaction of the Commissioner as reasonably adapted to the purpose 
and intent of section 472, and in Sec.  1.472-8 with respect to the 
``dollar-value'' method, the adoption and use of the LIFO inventory 
method is subject to the following requirements:
    (a) The taxpayer shall file an application to use such method 
specifying with particularity the goods to which it is to be applied.
    (b) The inventory shall be taken at cost regardless of market value.
    (c) Goods of the specified type included in the opening inventory of 
the taxable year for which the method is first used shall be considered 
as having been acquired at the same time and at a unit cost equal to the 
actual cost of the aggregate divided by the number of units on hand. The 
actual cost of the aggregate shall be determined pursuant to the 
inventory method employed by the taxpayer under the regulations 
applicable to the prior taxable year with the exception that restoration 
shall be made with respect to any writedown to market values resulting 
from the pricing of former inventories.
    (d) Goods of the specified type on hand as of the close of the 
taxable year in excess of what were on hand as of the beginning of the 
taxable year shall be included in the closing inventory, regardless of 
identification with specific invoices and regardless of specific cost 
accounting records, at costs determined pursuant to the provisions of 
subparagraph (1) or (2) of this paragraph, dependent upon the character 
of the transactions in which the taxpayer is engaged:
    (1)(i) In the case of a taxpayer engaged in the purchase and sale of 
merchandise, such as a retail grocer or druggist, or engaged in the 
initial production of merchandise and its sale without processing, such 
as a miner selling his ore output without smelting or refining, such 
costs shall be determined--
    (a) By reference to the actual cost of the goods most recently 
purchased or produced;
    (b) By reference to the actual cost of the goods purchased or 
produced during

[[Page 591]]

the taxable year in the order of acquisition;
    (c) By application of an average unit cost equal to the aggregate 
cost of all of the goods purchased or produced throughout the taxable 
year divided by the total number of units so purchased or produced, the 
goods reflected in such inventory increase being considered for the 
purposes of section 472 as having been acquired all at the same time; or
    (d) Pursuant to any other proper method which, in the opinion of the 
Commissioner, clearly reflects income.
    (ii) Whichever of the several methods of valuing the inventory 
increase is adopted by the taxpayer and approved by the Commissioner 
shall be consistently adhered to in all subsequent taxable years so long 
as the LIFO inventory method is used by the taxpayer.
    (iii) The application of subdivisions (i) and (ii) of this 
subparagraph may be illustrated by the following examples:

    Example 1. Suppose that the taxpayer adopts the LIFO inventory 
method for the taxable year 1957 with an opening inventory of 10 units 
at 10 cents per unit, that it makes 1957 purchases of 10 units as 
follows:

January...................................      1 at    $0.11=     $0.11
April.....................................      2 at      .12=       .24
July......................................      3 at      .13=       .39
October...................................      4 at      .14=       .56
                                           ----------          ---------
   Totals.................................        10  ........      1.30
 


and that it has a 1957 closing inventory of 15 units. This closing 
inventory, depending upon the taxpayer's method of valuing inventory 
increases, will be computed as follows:
    (a) Most recent purchases--

                                                 10 at    $0.10    $1.00
October......................................     4 at      .14      .56
July.........................................     1 at      .13      .13
                                              ---------         --------
  Totals.....................................       15  .......     1.69
 

    (b) In order of acquisitions--

                                                 10 at    $0.10    $1.00
January......................................     1 at      .11      .11
April........................................     2 at      .12      .24
July.........................................     2 at      .13      .26
                                              ---------         --------
   Totals....................................       15  .......     1.61
 

or
    (c) At an annual average--

                                                 10 at    $0.10    $1.00
(130/10).....................................     5 at      .13      .65
                                              ---------         --------
   Totals....................................       15  .......     1.65
 

    Example 2. Suppose that the taxpayer's closing inventory for 1958, 
the year following that involved in Example 1 of this subdivision, 
reflects an inventory decrease for the year, and not an increase; 
suppose that there is, accordingly, a 1958 closing inventory of 13 
units. Inasmuch as the decreased closing inventory will be determined 
wholly by reference to the 15 units reflected in the opening inventory 
for the year, and will be taken ``in the order of acquisition'' pursuant 
to section 472 (b) (1), and inasmuch as the character of the taxpayer's 
opening inventory for 1958 will be dependent upon its method of valuing 
its 5-unit inventory increase for 1957, the closing inventory for 1958 
will be computed as follows:
    (a) In case the increase for 1957 was taken by reference to the most 
recent purchases--

From 1956....................................    10 at    $0.10    $1.00
July 1957....................................     1 at      .13      .13
October 1957.................................     2 at      .14      .28
                                              ---------         --------
    Totals...................................       13  .......     1.41
 


or
    (b) In case the increase for 1957 was taken in the order of 
acquisition--

From 1956....................................    10 at    $0.10    $1.00
January 1957.................................    51 at      .11      .11
April 1957...................................     2 at      .12      .24
                                              ---------         --------
    Totals...................................       13  .......     1.35
 

or
    (c) In case the increase for 1957 was taken on the basis of an 
average--

From 1956....................................    10 at    $0.10    $1.00
From 1957....................................     3 at      .13      .39
                                              ---------         --------
    Totals...................................       13  .......     1.39
 

    (2) In the case of a taxpayer engaged in manufacturing, fabricating, 
processing, or otherwise producing merchandise, such costs shall be 
determined:
    (i) In the case of raw materials purchased or initially produced by 
the taxpayer, in the manner elected by the taxpayer under subparagraph 
(1) of this paragraph to the same extent as if the taxpayer were engaged 
in purchase and sale transactions; and
    (ii) In the case of goods in process, regardless of the stage to 
which the manufacture, fabricating, or processing may have advanced, and 
in the case of finished goods, pursuant to any proper method which, in 
the opinion of the Commissioner, clearly reflects income.
    (e) LIFO conformity requirement--(1) In general. The taxpayer must 
establish to the satisfaction of the Commissioner that the taxpayer, in 
ascertaining the income, profit, or loss for the taxable year for which 
the LIFO inventory method is first used, or for any subsequent taxable 
year, for credit purposes

[[Page 592]]

or for purposes of reports to shareholders, partners, or other 
proprietors, or to beneficiaries, has not used any inventory method 
other than that referred to in Sec.  1.472-1 or at variance with the 
requirement referred to in Sec.  1.472-2(c). See paragraph (e)(2) of 
this section for rules relating to the meaning of the term ``taxable 
year'' as used in this paragraph. The following are not considered at 
variance with the requirement of this paragraph:
    (i) The taxpayer's use of an inventory method other than LIFO for 
purposes of ascertaining information reported as a supplement to or 
explanation of the taxpayer's primary presentation of the taxpayer's 
income, profit, or loss for a taxable year in credit statements or 
financial reports (including preliminary and unaudited financial 
reports). See paragraph (e)(3) of this section for rules relating to the 
reporting of supplemental and explanatory information ascertained by the 
use of an inventory method other than LIFO.
    (ii) The taxpayer's use of an inventory method other than LIFO to 
ascertain the value of the taxpayer's inventory of goods on hand for 
purposes of reporting the value of such inventories as assets. See 
paragraph (e)(4) of this section for rules relating to such disclosures.
    (iii) The taxpayer's use of an inventory method other than LIFO for 
purposes of ascertaining information reported in internal management 
reports. See paragraph (e)(5) of this section for rules relating to such 
reports.
    (iv) The taxpayer's use of an inventory method other than LIFO for 
purposes of issuing reports or credit statements covering a period of 
operations that is less than the whole of a taxable year for which the 
LIFO method is used for Federal income tax purposes. See paragraph 
(e)(6) of this section for rules relating to series of interim reports.
    (v) The taxpayer's use of the lower of LIFO cost or market method to 
value LIFO inventories for purposes of financial reports and credit 
statements. However, except as provided in paragraph (e)(7) of this 
section, a taxpayer may not use market value in lieu of cost to value 
inventories for purposes of financial reports or credit statements.
    (vi) The taxpayer's use of a costing method or accounting method to 
ascertain income, profit, or loss for credit purposes or for purposes of 
financial reports if such costing method or accounting method is neither 
inconsistent with the inventory method referred to in Sec.  1.472-1 nor 
at variance with the requirement referred to in Sec.  1.472-2(c), 
regardless of whether such costing method or accounting method is used 
by the taxpayer for Federal income tax purposes. See paragraph (e)(8) of 
this section for examples of such costing methods and accounting 
methods.
    (vii) For credit purposes or for purposes of financial reports, the 
taxpayer's treatment of inventories, after such inventories have been 
acquired in a transaction to which section 351 applies from a transferor 
that used the LIFO method with respect to such inventories, as if such 
inventories had the same acquisition dates and costs as in the hands of 
the transferor.
    (viii) For credit purposes or for purposes of financial reports 
relating to a taxable year, the taxpayer's determination of income, 
profit, or loss for the taxable year by valuing inventories in 
accordance with the procedures described in section 472(b) (1) and (3), 
notwithstanding that such valuation differs from the valuation of 
inventories for Federal income tax purposes because the taxpayer 
either--
    (A) Adopted such procedures for credit or financial reporting 
purposes beginning with an accounting period other than the taxable year 
for which the LIFO method was first used by the taxpayer for Federal 
income tax purposes, or
    (B) With respect to such inventories treated a business combination 
for credit or financial reporting purposes in a manner different from 
the treatment of the business combination for Federal income tax 
purposes.
    (2) One-year periods other than a taxable year. The rules of this 
paragraph relating to the determination of income, profit, or loss for a 
taxable year and credit statements or financial reports that cover a 
taxable year also apply to the determination of income,

[[Page 593]]

profit, or loss for a one-year period other than a taxable year and 
credit statements or financial reports that cover a one-year period 
other than a taxable year, but only if the one-year period both begins 
and ends in a taxable year or years for which the taxpayer uses the LIFO 
method for Federal income tax purposes. For example, the requirements of 
paragraph (e)(1) of this section apply to a taxpayer's determination of 
income for purposes of a credit statement that covers a 52-week fiscal 
year beginning and ending in a taxable year for which the taxpayer uses 
the LIFO method for Federal income tax purposes. Similarly, in the case 
of a calendar year taxpayer, the requirements of paragraph (e)(1) of 
this section apply to the taxpayer's determination of income for 
purposes of a credit statement that covers the period October 1, 1981, 
through September 30, 1982, if the taxpayer uses the LIFO method for 
Federal income tax purposes in taxable years 1981 and 1982. However, the 
Commissioner will waive any violation of the requirements of this 
paragraph in the case of a credit statement or financial report that 
covers a one-year period other than a taxable year if the report was 
issued before January 22, 1981.
    (3) Supplemental and explanatory information--(i) Face of the income 
statement. Information reported on the face of a taxpayer's financial 
income statement for a taxable year is not considered a supplement to or 
explanation of the taxpayer's primary presentation of the taxpayer's 
income, profit, or loss for the taxable year in credit statements or 
financial reports. For purposes of paragraph (e)(3) of this section, the 
face of an income statement does not include notes to the income 
statement presented on the same page as the income statement, but only 
if all notes to the financial income statement are presented together.
    (ii) Notes to the income statement. Information reported in notes to 
a taxpayer's financial income statement is considered a supplement to or 
explanation of the taxpayer's primary presentation of income, profit, or 
loss for the period covered by the income statement if all notes to the 
financial income statement are presented together and if they accompany 
the income statement in a single report. If notes to an income statement 
are issued in a report that does not include the income statement, the 
question of whether the information reported therein is supplemental or 
explanatory is determined under the rules in paragraph (e)(3)(iv) of 
this section.
    (iii) Appendices and supplements to the income statement. 
Information reported in an appendix or supplement to a taxpayer's 
financial income statement is considered a supplement to or explanation 
of the taxpayer's primary presentation of income, profit, or loss for 
the period covered by the income statement if the appendix or supplement 
accompanies the income statement in a single report and the information 
reported in the appendix or supplement is clearly identified as a 
supplement to or explanation of the taxpayer's primary presentation of 
income, profit, or loss as reported on the face of the taxpayer's income 
statement. If an appendix or supplement to an income statement is issued 
in a report that does not include the income statement, the question of 
whether the information reported therein is supplemental or explanatory 
is determined under the rules in paragraph (e)(3)(iv) of this section. 
For purposes of paragraph (e)(3)(iii) of this section, an appendix or 
supplement to an income statement includes written statements, 
schedules, and reports that are labelled supplements or appendices to 
the income statement. However, sections of an annual report such as 
those labelled ``President's Letter'', ``Management's Analysis'', 
``Statement of Changes in Financial Position'', ``Summary of Key 
Figures'', and similar sections are reports described in paragraph 
(e)(3)(iv) of this section and are not considered ``supplements or 
appendices to an income statement'' within the meaning of paragraph 
(e)(3)(iii) of this section, regardless of whether such sections are 
also labelled as supplements or appendices. For purposes of paragraph 
(e)(3)(iii) of this section, information is considered to be clearly 
identified as a supplement to or explanation of the taxpayer's primary 
presentation of income, profit, or loss as reported on the

[[Page 594]]

face of the taxpayer's income statement if the information either--
    (A) Is reported in an appendix or supplement that contains a general 
statement identifying all such supplemental or explanatory information;
    (B) Is identified specifically as supplemental or explanatory by a 
statement immediately preceding or following the disclosure of the 
information;
    (C) Is disclosed in the context of making a comparison to 
corresponding information disclosed both on the face of the taxpayer's 
income statement and in the supplement or appendix; or
    (D) Is a disclosure of the effect on an item reported on the face of 
the taxpayer's income statement of having used the LIFO method.

For example, a restatement of cost of goods sold based on an inventory 
method other than LIFO is considered to be clearly identified as 
supplemental or explanatory information if the supplement or appendix 
containing the restatement contains a general statement that all 
information based on such inventory method is reported in the appendix 
or supplement as a supplement to or explanation of the taxpayer's 
primary presentation of income, profit, or loss as reported on the face 
of the taxpayer's income statement.
    (iv) Other reports; in general. The rules of paragraph (e)(3) (iv), 
(v), and (vi) of this section apply to the following types of reports: 
news releases; letters to shareholders, partners, or other proprietors 
or beneficiaries; oral statements at press conferences, shareholders' 
meetings or securities analysts' meetings; sections of an annual report 
such as those labelled ``President's Letter'', ``Management's 
Analysis'', ``Statement of Changes in Financial Position'', ``Summary of 
Key Figures'', and similar sections; and reports other than a taxpayer's 
income statement or accompanying notes, appendices, or supplements. 
Information disclosed in such a report is considered a supplement to or 
explanation of the taxpayer's primary presentation of income, profit, or 
loss for the period covered by an income statement if the supplemental 
or explanatory information is clearly identified as a supplement to or 
explanation of the taxpayer's primary presentation of income, profit, or 
loss as reported on the face of the taxpayer's income statement and the 
specific item of information being explained or supplemented, such as 
the cost of goods sold, net income, or earnings per share ascertained 
using the LIFO method, is also reported in the other report.
    (v) Other reports; disclosure of non-LIFO income. For purposes of 
paragraph (e)(3)(iv) of this section, supplemental or explanatory 
information is considered to have been clearly identified as such if it 
would be considered to have been clearly identified as such under the 
rules of paragraph (e)(3)(iii) of this section, relating to information 
reported in supplements or appendices to an income statement. For 
example, if at a securities analysts' meeting the following question is 
asked, ``What would the reported earnings per share for the year have 
been if the FIFO method had been used to value inventories?'', it would 
be permissible to respond ``Reported earnings per share for the year 
were $6.00. If the company had used the FIFO method to value inventories 
this year and had computed earnings based upon the following 
assumptions, earnings per share would have been $8.20. FIFO earnings are 
based on the following assumptions:
    ``(A) The use of the same effective tax rate as used in computing 
LIFO earnings, and
    ``(B) All other conditions and assumptions remain the same, 
including--
    ``(1) The use of the LIFO method for Federal income tax purposes and
    ``(2) The investment of the tax savings resulting from such use of 
the LIFO method, the income from which is included in both LIFO and FIFO 
``earnings.'' ''
    (vi) Other reports; disclosure of effect on income. For purposes of 
paragraph (e)(3)(iv) of this section, if the only supplement to or 
explanation of a specific item is the effect on the item of having used 
LIFO instead of a method other than LIFO to value inventories, it is not 
necessary to also report the specific item. For example, if at a 
shareholders' meeting the question is

[[Page 595]]

asked, ``What was the effect on reported earnings per share of not 
having used FIFO to value inventories?'', it would be permissible to 
respond ``If earnings would have been computed on the basis of the 
following assumptions, the use of LIFO instead of FIFO to value 
inventories would have decreased reported earnings per share by $2.20. 
FIFO earnings are based on the following assumptions:
    ``(A) The use of the same effective tax rate as used in computing 
LIFO earnings, and
    ``(B) All other conditions and assumptions remain the same, 
including--
    ``(1) The use of the LIFO method for Federal income tax purposes and
    ``(2) The investment of the tax savings resulting from such use of 
the LIFO method, the income from which is included in both LIFO and FIFO 
earnings.''
    (4) Inventory asset value disclosures. Under paragraph (e)(1)(ii) of 
this section, the use of an inventory method other than LIFO to 
ascertain the value of the taxpayer's inventories for purposes of 
reporting the value of the inventories as assets is not considered the 
ascertainment of income, profit, or loss and therefore is not considered 
at variance with the requirement of paragraph (e)(1) of this section. 
Therefore, a taxpayer may disclose the value of inventories on a balance 
sheet using a method other than LIFO to identify the inventories, and 
such a disclosure will not be considered at variance with the 
requirement of paragraph (e)(1) of this section. However, the disclosure 
of income, profit, or loss for a taxable year on a balance sheet issued 
to creditors, shareholders, partners, other proprietors, or 
beneficiaries is considered at variance with the requirement of 
paragraph (e)(1) of this section if such income information is 
ascertained using an inventory method other than LIFO and such income 
information is for a taxable year for which the LIFO method is used for 
Federal income tax purposes. Therefore, a balance sheet that discloses 
the net worth of a taxpayer, determined as if income had been 
ascertained using an inventory method other than LIFO, may be at 
variance with the requirement of paragraph (e)(1) of this section if the 
disclosure of net worth is made in a manner that also discloses income, 
profit, or loss for a taxable year.

However, a disclosure of income, profit, or loss using an inventory 
method other than LIFO is not considered at variance with the 
requirement of paragraph (e)(1) of this section if the disclosure is 
made in the form of either a footnote to the balance sheet or a 
parenthetical disclosure on the face of the balance sheet. In addition, 
an income disclosure is not considered at variance with the requirement 
of paragraph (e)(1) of this section if the disclosure is made on the 
face of a supplemental balance sheet labelled as a supplement to the 
taxpayer's primary presentation of financial position, but only if, 
consistent with the rules of paragraph (e)(3) of this section, such a 
disclosure is clearly identified as a supplement to or explanation of 
the taxpayer's primary presentation of financial income as reported on 
the face of the taxpayer's income statement.
    (5) Internal management reports. [Reserved]
    (6) Series of interim reports. For purposes of paragraph (e)(1)(iv) 
of this section, a series of credit statements or financial reports is 
considered a single statement or report covering a period of operations 
if the statements or reports in the series are prepared using a single 
inventory method and can be combined to disclose the income, profit, or 
loss for the period. However, the Commissioner will waive any violation 
of the requirement of this paragraph in the case of a series of interim 
reports issued before February 6, 1978, that cover a taxable year, or a 
series of interim reports issued before January 22, 1981 that cover a 
one-year period other than a taxable year.
    (7) Market value. The Commissioner will waive any violation of the 
requirement of this paragraph in the case of a taxpayer's use of market 
value in lieu of cost for a credit statement or financial report issued 
before January 22, 1981. However, the special rule of this (7) applies 
only to a taxpayer's use of market value in lieu of cost and does not 
apply to the use of a method of valuation such as market value in lieu 
of cost but not more than FIFO cost.

[[Page 596]]

    (8) Use of different methods. The following are examples of costing 
methods and accounting methods that are neither inconsistent with the 
inventory method referred to in Sec.  1.472-1 nor at variance with the 
requirement of Sec.  1.472-2(c) and which, under paragraph (e)(1)(vi) of 
this section, may be used to ascertain income, profit, or loss for 
credit purposes or for purposes of financial reports regardless of 
whether such method is also used by the taxpayer for Federal income tax 
purposes:
    (i) Any method relating to the determination of which costs are 
includible in the computation of the cost of inventory under the full 
absorption inventory method.
    (ii) Any method of establishing pools for inventory under the 
dollar-value LIFO inventory method.
    (iii) Any method of determining the LIFO value of a dollar-value 
inventory pool, such as the double-extension method, the index method, 
and the link chain method.
    (iv) Any method of determining or selecting a price index to be used 
with the index or link chain method of valuing inventory pools under the 
dollar-value LIFO inventory method.
    (v) Any method permitted under Sec.  1.472-8 for determining the 
current-year cost of closing inventory for purposes of using the dollar-
value LIFO inventory method.
    (vi) Any method permitted under Sec.  1.472-2(d) for determining the 
cost of goods in excess of goods on hand at the beginning of the year 
for purposes of using a LIFO method other than the dollar-value LIFO 
method.
    (vii) Any method relating to the classification of an item as 
inventory or a capital asset.
    (viii) The use of an accounting period other than the period used 
for Federal income tax purposes.
    (ix) The use of cost estimates.
    (x) The use of actual cost of cut timber or the cost determined 
under section 631(a).
    (xi) The use of inventory costs unreduced by any adjustment required 
by the application of section 108 and section 1017, relating to 
discharge of indebtedness.
    (xii) The determination of the time when sales or purchases are 
accrued.
    (xiii) The use of a method to allocate basis in the case of a 
business combination other than the method used for Federal income tax 
purposes.
    (xiv) The treatment of transfers of inventory between affiliated 
corporations in a manner different from that required by Sec.  1.1502-
13.
    (9) Reconciliation of LIFO inventory values. A taxpayer may be 
required to reconcile differences between the value of inventories 
maintained for credit or financial reporting purposes and for Federal 
income tax purposes in order to show that the taxpayer has satisfied the 
requirements of this paragraph.
    (f) Goods of the specified type on hand as of the close of the 
taxable year preceding the taxable year for which this inventory method 
is first used shall be included in the taxpayer's closing inventory for 
such preceding taxable year at cost determined in the manner prescribed 
in paragraph (c) of this section.
    (g) The LIFO inventory method, once adopted by the taxpayer with the 
approval of the Commissioner, shall be adhered to in all subsequent 
taxable years unless--
    (1) A change to a different method is approved by the Commissioner; 
or
    (2) The Commissioner determines that the taxpayer, in ascertaining 
income, profit, or loss for the whole of any taxable year subsequent to 
his adoption of the LIFO inventory method, for credit purposes or for 
the purpose of reports to shareholders, partners, or other proprietors, 
or to beneficiaries, has used any inventory method at variance with that 
referred to in Sec.  1.472-1 and requires of the taxpayer a change to a 
different method for such subsequent taxable year or any taxable year 
thereafter.
    (h) The records and accounts employed by the taxpayer in keeping his 
books shall be maintained in conformity with the inventory method 
referred to in Sec.  1.472-1; and such supplemental and detailed 
inventory records shall be maintained as will enable the district 
director readily to verify the taxpayer's inventory computations as well 
as his compliance with the requirements of section 472 and Sec. Sec.  
1.472-1 through 1.472-7.

[[Page 597]]

    (i) Where the taxpayer is engaged in more than one trade or 
business, the Commissioner may require that if the LIFO method of 
valuing inventories is used with respect to goods in one trade or 
business the same method shall also be used with respect to similar 
goods in the other trades or businesses if, in the opinion of the 
Commissioner, the use of such method with respect to such other goods is 
essential to a clear reflection of income.

[T.D. 6500, 25 FR 11728, Nov. 26, 1960, as amended by T.D. 6539, 26 FR 
518, Jan. 20, 1961; T.D. 7756, 46 FR 6920, Jan. 22, 1981; T.D. 7756, 46 
FR 15685, Mar. 9, 1981]



Sec.  1.472-3  Time and manner of making election.

    (a) The LIFO inventory method may be adopted and used only if the 
taxpayer files with his income tax return for the taxable year as of the 
close of which the method is first to be used a statement of his 
election to use such inventory method. The statement shall be made on 
Form 970 pursuant to the instructions printed with respect thereto and 
to the requirements of this section, or in such other manner as may be 
acceptable to the Commissioner. Such statement shall be accompanied by 
an analysis of all inventories of the taxpayer as of the beginning and 
as of the end of the taxable year for which the LIFO inventory method is 
proposed first to be used, and also as of the beginning of the prior 
taxable year. In the case of a manufacturer, this analysis shall show in 
detail the manner in which costs are computed with respect to raw 
materials, goods in process, and finished goods, segregating the 
products (whether in process or finished goods) into natural groups on 
the basis of either (1) similarity in factory processes through which 
they pass, or (2) similarity of raw materials used, or (3) similarity in 
style, shape, or use of finished products. Each group of products shall 
be clearly described.
    (b) The taxpayer shall submit for the consideration of the 
Commissioner in connection with the taxpayer's adoption or use of the 
LIFO inventory method such other detailed information with respect to 
his business or accounting system as may be at any time requested by the 
Commissioner.
    (c) As a condition to the taxpayer's use of the LIFO inventory 
method, the Commissioner may require that the method be used with 
respect to goods other than those specified in the taxpayer's statement 
of election if, in the opinion of the Commissioner, the use of such 
method with respect to such other goods is essential to a clear 
reflection of income.
    (d) Whether or not the taxpayer's application for the adoption and 
use of the LIFO inventory method should be approved, and whether or not 
such method, once adopted, may be continued, and the propriety of all 
computations incidental to the use of such method, will be determined by 
the Commissioner in connection with the examination of the taxpayer's 
income tax returns.

[T.D. 6500, 25 FR 11729, Nov. 26, 1960, as amended by T.D. 7295, 38 FR 
34203, Dec. 12, 1973]



Sec.  1.472-4  Adjustments to be made by taxpayer.

    A taxpayer may not change to the LIFO method of taking inventories 
unless, at the time he files his application for the adoption of such 
method, he agrees to such adjustments incident to the change to or from 
such method, or incident to the use of such method, in the inventories 
of prior taxable years or otherwise, as the district director upon the 
examination of the taxpayer's returns may deem necessary in order that 
the true income of the taxpayer will be clearly reflected for the years 
involved.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]



Sec.  1.472-5  Revocation of election.

    An election made to adopt and use the LIFO inventory method is 
irrevocable, and the method once adopted shall be used in all subsequent 
taxable years, unless the use of another method is required by the 
Commissioner, or authorized by him pursuant to a written application 
therefor filed as provided in paragraph (e) of Sec.  1.446-1.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]

[[Page 598]]



Sec.  1.472-6  Change from LIFO inventory method.

    If the taxpayer is granted permission by the Commissioner to 
discontinue the use of LIFO method of taking inventories, and thereafter 
to use some other method, or if the taxpayer is required by the 
Commissioner to discontinue the use of the LIFO method by reason of the 
taxpayer's failure to conform to the requirements detailed in Sec.  
1.472-2, the inventory of the specified goods for the first taxable year 
affected by the change and for each taxable year thereafter shall be 
taken--
    (a) In conformity with the method used by the taxpayer under section 
471 in inventorying goods not included in his LIFO inventory 
computations; or
    (b) If the LIFO inventory method was used by the taxpayer with 
respect to all of his goods subject to inventory, then in conformity 
with the inventory method used by the taxpayer prior to his adoption of 
the LIFO inventory method; or
    (c) If the taxpayer had not used inventories prior to his adoption 
of the LIFO inventory method and had no goods currently subject to 
inventory by a method other than the LIFO inventory method, then in 
conformity with such inventory method as may be selected by the taxpayer 
and approved by the Commissioner as resulting in a clear reflection of 
income; or
    (d) In any event, in conformity with any inventory method to which 
the taxpayer may change pursuant to application approved by the 
Commissioner.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]



Sec.  1.472-7  Inventories of acquiring corporations.

    For additional rules in the case of certain corporate acquisitions 
specified in section 381(a), see section 381(c)(5) and the regulations 
thereunder.

[T.D. 6500, 25 FR 11730, Nov. 26, 1960]



Sec.  1.472-8  Dollar-value method of pricing LIFO inventories.

    (a) Election to use dollar-value method. Any taxpayer may elect to 
determine the cost of his LIFO inventories under the so-called ``dollar-
value'' LIFO method, provided such method is used consistently and 
clearly reflects the income of the taxpayer in accordance with the rules 
of this section. The dollar-value method of valuing LIFO inventories is 
a method of determining cost by using ``base-year'' cost expressed in 
terms of total dollars rather than the quantity and price of specific 
goods as the unit of measurement. Under such method the goods contained 
in the inventory are grouped into a pool or pools as described in 
paragraphs (b) and (c) of this section. The term ``base-year cost'' is 
the aggregate of the cost (determined as of the beginning of the taxable 
year for which the LIFO method is first adopted, i.e., the base date) of 
all items in a pool. The taxable year for which the LIFO method is first 
adopted with respect to any item in the pool is the ``base year'' for 
that pool, except as provided in paragraph (g)(3) of this section. 
Liquidations and increments of items contained in the pool shall be 
reflected only in terms of a net liquidation or increment for the pool 
as a whole. Fluctuations may occur in quantities of various items within 
the pool, new items which properly fall within the pool may be added, 
and old items may disappear from the pool, all without necessarily 
effecting a change in the dollar value of the pool as a whole. An 
increment in the LIFO inventory occurs when the end of the year 
inventory for any pool expressed in terms of base-year cost is in excess 
of the beginning of the year inventory for that pool expressed in terms 
of base-year cost. In determining the inventory value for a pool, the 
increment, if any, is adjusted for changing unit costs or values by 
reference to a percentage, relative to base-year-cost, determined for 
the pool as a whole. See paragraph (e) of this section. See also 
paragraph (f) of this section for rules relating to the change to the 
dollar-value LIFO method from another LIFO method.
    (b) Principles for establishing pools of manufacturers and 
processors--(1) Natural business unit pools. A pool shall consist of all 
items entering into the entire inventory investment for a natural 
business unit of a business enterprise, unless the taxpayer elects to 
use the multiple pooling method provided

[[Page 599]]

in subparagraph (3) of this paragraph. Thus, if a business enterprise is 
composed of only one natural business unit, one pool shall be used for 
all of its inventories, including raw materials, goods in process, and 
finished goods. If, however, a business enterprise is actually composed 
of more than one natural business unit, more than one pool is required. 
Where similar types of goods are inventoried in two or more natural 
business units of the taxpayer, the Commissioner may apportion or 
allocate such goods among the various natural business units, if he 
determines that such apportionment or allocation is necessary in order 
to clearly reflect the income of such taxpayer. Where a manufacturer or 
processor is also engaged in the wholesaling or retailing of goods 
purchased from others, any pooling of the LIFO inventory of such 
purchased goods for the wholesaling or retailing operations shall be 
determined in accordance with the rules of paragraph (c) of this 
section.
    (2) Definition of natural business unit. (i) Whether an enterprise 
is composed of more than one natural business unit is a matter of fact 
to be determined from all the circumstances. The natural business 
divisions adopted by the taxpayer for internal management purposes, the 
existence of separate and distinct production facilities and processes, 
and the maintenance of separate profit and loss records with respect to 
separate operations are important considerations in determining what is 
a business unit, unless such divisions, facilities, or accounting 
records are set up merely because of differences in geographical 
location. In the case of a manufacturer or processor, a natural business 
unit ordinarily consists of the entire productive activity of the 
enterprise within one product line or within two or more related product 
lines including (to the extent engaged in by the enterprise) the 
obtaining of materials, the processing of materials, and the selling of 
manufactured or processed goods. Thus, in the case of a manufacturer or 
processor, the maintenance and operation of a raw material warehouse 
does not generally constitute, of itself, a natural business unit. If 
the taxpayer maintains and operates a supplier unit the production of 
which is both sold to others and transferred to a different unit of the 
taxpayer to be used as a component part of another product, the supplier 
unit will ordinarily constitute a separate and distinct natural business 
unit. Ordinarily, a processing plant would not in itself be considered a 
natural business unit if the production of the plant, although saleable 
at this stage, is not sold to others, but is transferred to another 
plant of the enterprise, not operated as a separate division, for 
further processing or incorporation into another product. On the other 
hand, if the production of a manufacturing or processing plant is 
transferred to a separate and distinct division of the taxpayer, which 
constitutes a natural business unit, the supplier unit itself will 
ordinarily be considered a natural business unit. However, the mere fact 
that a portion of the production of a manufacturing or processing plant 
may be sold to others at a certain stage of processing with the 
remainder of the production being further processed or incorporated into 
another product will not of itself be determinative that the activities 
devoted to the production of the portion sold constitute a separate 
business unit. Where a manufacturer or processor is also engaged in the 
wholesaling or retailing of goods purchased from others, the wholesaling 
or retailing operations with respect to such purchased goods shall not 
be considered a part of any manufacturing or processing unit.
    (ii) The rules of this subparagraph may be illustrated by the 
following examples:

    Example 1. A corporation manufactures, in one division, automatic 
clothes washers and driers of both commercial and domestic grade as well 
as electric ranges, mangles, and dishwashers. The corporation 
manufactures, in another division, radios and television sets. The 
manufacturing facilities and processes used in manufacturing the radios 
and television sets are distinct from those used in manufacturing the 
automatic clothes washers, etc. Under these circumstances, the 
enterprise would consist of two business units and two pools would be 
appropriate, one consisting of all of the LIFO inventories entering into 
the manufacture of clothes washers and driers, electric ranges, mangles, 
and dishwashers and the other consisting of

[[Page 600]]

all of the LIFO inventories entering into the production of radio and 
television sets.
    Example 2. A taxpayer produces plastics in one of its plants. 
Substantial amounts of the production are sold as plastics. The 
remainder of the production is shipped to a second plant of the taxpayer 
for the production of plastic toys which are sold to customers. The 
taxpayer operates his plastics plant and toy plant as separate 
divisions. Because of the different product lines and the separate 
divisions the taxpayer has two natural business units.
    Example 3. A taxpayer is engaged in the manufacture of paper. At one 
stage of processing, uncoated paper is produced. Substantial amounts of 
uncoated paper are sold at this stage of processing. The remainder of 
the uncoated paper is transferred to the taxpayer's finishing mill where 
coated paper is produced and sold. This taxpayer has only one natural 
business unit since coated and uncoated paper are within the same 
product line.

    (3) Multiple pools--(i) Principles for establishing multiple pools. 
(a) A taxpayer may elect to establish multiple pools for inventory items 
which are not within a natural business unit as to which the taxpayer 
has adopted the natural business unit method of pooling as provided in 
subparagraph (1) of this paragraph. Each such pool shall ordinarily 
consist of a group of inventory items which are substantially similar. 
In determining whether such similarity exists, consideration shall be 
given to all the facts and circumstances. The formulation of detailed 
rules for selection of pools applicable to all taxpayers is not 
feasible. Important considerations to be taken into account include, for 
example, whether there is substantial similarity in the types of raw 
materials used or in the processing operations applied; whether the raw 
materials used are readily interchangeable; whether there is similarity 
in the use of the products; whether the groupings are consistently 
followed for purposes of internal accounting and management; and whether 
the groupings follow customary business practice in the taxpayer's 
industry. The selection of pools in each case must also take into 
consideration such factors as the nature of the inventory items subject 
to the dollar-value LIFO method and the significance of such items to 
the taxpayer's business operations. Where similar types of goods are 
inventoried in natural business units and multiple pools of the 
taxpayer, the Commissioner may apportion or allocate such goods among 
the natural business units and the multiple pools, if he determines that 
such apportionment or allocation is necessary in order to clearly 
reflect the income of the taxpayer.
    (b) Raw materials which are substantially similar shall be pooled 
together in accordance with the principles of this subparagraph. 
However, inventories of raw or unprocessed materials of an unlike nature 
may not be placed into one pool, even though such materials become part 
of otherwise identical finished products.
    (c) Finished goods and goods-in-process in the inventory shall be 
placed into pools classified by major classes or types of goods. The 
same class or type of finished goods and goods-in-process shall 
ordinarily be included in the same pool. Where the material content of a 
class of finished goods and goods-in-process included in a pool has been 
changed, for example, to conform with current trends in an industry, a 
separate pool of finished goods and goods-in-process will not ordinarily 
be required unless the change in material content results in a 
substantial change in the finished goods.
    (d) The requirement that pools be established by major types of 
materials or major classes of goods is not to be construed so as to 
preclude the establishment of a miscellaneous pool. Since a taxpayer may 
elect the dollar-value LIFO method with respect to all or any designated 
goods in his inventory, there may be a number of such inventory items 
covered in the election. A miscellaneous pool shall consist only of 
items which are relatively insignificant in dollar value by comparison 
with other inventory items in the particular trade or business and which 
are not properly includible as part of another pool.
    (ii) Raw materials content pools. The dollar-value method of pricing 
LIFO inventories may be used in conjunction with the raw materials 
content method authorized in Sec.  1.472-1. Raw materials (including the 
raw material content of finished goods and goods-in-process) which are 
substantially similar shall

[[Page 601]]

be pooled together in accordance with the principles of subdivision (i) 
of this subparagraph. However, inventories of materials of an unlike 
nature may not be placed into one pool, even though such materials 
become part of otherwise identical finished products.
    (4) IPIC method pools. A manufacturer or processor that elects to 
use the inventory price index computation method described in paragraph 
(e)(3) of this section (IPIC method) for a trade or business may elect 
to establish dollar-value pools for those items accounted for using the 
IPIC method based on the 2-digit commodity codes (i.e., major commodity 
groups) in Table 6 (Producer price indexes and percent changes for 
commodity groupings and individual items, not seasonally adjusted) of 
the ``PPI Detailed Report'' published monthly by the United States 
Bureau of Labor Statistics (available from New Orders, Superintendent of 
Documents, PO Box 371954, Pittsburgh, PA 15250-7954). A taxpayer 
electing to establish dollar-value pools under this paragraph (b)(4) may 
combine IPIC pools that comprise less than 5 percent of the total 
current-year cost of all dollar-value pools to form a single 
miscellaneous IPIC pool. A taxpayer electing to establish dollar-value 
pools under this paragraph (b)(4) may combine a miscellaneous IPIC pool 
that comprises less than 5 percent of the total current-year cost of all 
dollar-value pools with the largest IPIC pool. Each of these 5 percent 
rules is a method of accounting. A taxpayer may not change to, or cease 
using, either 5 percent rule without obtaining the Commissioner's prior 
consent. Whether a specific IPIC pool or the miscellaneous IPIC pool 
satisfies the applicable 5 percent rule must be determined in the year 
of adoption or year of change (whichever is applicable) and redetermined 
every third taxable year. Any change in pooling required or permitted as 
a result of a 5 percent rule is a change in method of accounting. A 
taxpayer must secure the consent of the Commissioner pursuant to Sec.  
1.446-1(e) before combining or separating pools and must combine or 
separate its IPIC pools in accordance with paragraph (g)(2) of this 
section.
    (c) Principles for establishing pools for wholesalers, retailers, 
etc--(1) In general. Items of inventory in the hands of wholesalers, 
retailers, jobbers, and distributors shall be placed into pools by major 
lines, types, or classes of goods. In determining such groupings, 
customary business classifications of the particular trade in which the 
taxpayer is engaged is an important consideration. An example of such 
customary business classification is the department in the department 
store. In such case, practices are relatively uniform throughout the 
trade, and departmental grouping is peculiarly adapted to the customs 
and needs of the business. However, in appropriate cases, the principles 
set forth in paragraphs (b) (1) and (2) of this section, relating to 
pooling by natural business units, may be used, with permission of the 
Commissioner, by wholesalers, retailers, jobbers, or distributors. Where 
a wholesaler or retailer is also engaged in the manufacturing or 
processing of goods, the pooling of the LIFO inventory for the 
manufacturing or processing operations shall be determined in accordance 
with the rules of paragraph (b) of this section.
    (2) IPIC method pools. A retailer that elects to use the inventory 
price index computation method described in paragraph (e)(3) of this 
section (IPIC method) for a trade or business may elect to establish 
dollar-value pools for those items accounted for using the IPIC method 
based on either the general expenditure categories (i.e., major groups) 
in Table 3 (Consumer Price Index for all Urban Consumers (CPI-U): U.S. 
city average, detailed expenditure categories) of the ``CPI Detailed 
Report'' or the 2-digit commodity codes (i.e., major commodity groups) 
in Table 6 (Producer price indexes and percent changes for commodity 
groupings and individual items, not seasonally adjusted) of the ``PPI 
Detailed Report.'' A wholesaler, jobber, or distributor that elects to 
use the IPIC method for a trade or business may elect to establish 
dollar-value pools for any group of goods accounted for using the IPIC 
method and included within one of the 2-digit commodity codes (i.e., 
major commodity groups) in Table 6 (Producer price indexes and

[[Page 602]]

percent changes for commodity groupings and individual items, not 
seasonally adjusted) of the ``PPI Detailed Report.'' The ``CPI Detailed 
Report'' and the ``PPI Detailed Report'' are published monthly by the 
United States Bureau of Labor Statistics (BLS) (available from New 
Orders, Superintendent of Documents, P.O. Box 371954, Pittsburgh, PA 
15250-7954). A taxpayer electing to establish dollar-value pools under 
this paragraph (c)(2) may combine IPIC pools that comprise less than 5 
percent of the total current-year cost of all dollar-value pools to form 
a single miscellaneous IPIC pool. A taxpayer electing to establish pools 
under this paragraph (c)(2) may combine a miscellaneous IPIC pool that 
comprises less than 5 percent of the total current-year cost of all 
dollar-value pools with the largest IPIC pool. Each of these 5 percent 
rules is a method of accounting. Thus, a taxpayer may not change to, or 
cease using, either 5 percent rule without obtaining the Commissioner's 
prior consent. Whether a specific IPIC pool or the miscellaneous IPIC 
pool satisfies the applicable 5 percent rule must be determined in the 
year of adoption or year of change (whichever is applicable) and 
redetermined every third taxable year. Any change in pooling required or 
permitted under a 5 percent rule is a change in method of accounting. A 
taxpayer must secure the consent of the Commissioner pursuant to section 
1.446-1(e) before combining or separating pools and must combine or 
separate its IPIC pools in accordance with paragraph (g)(2) of this 
section.
    (d) Determination of appropriateness of pools. Whether the number 
and the composition of the pools used by the taxpayer is appropriate, as 
well as the propriety of all computations incidental to the use of such 
pools, will be determined in connection with the examination of the 
taxpayer's income tax returns. Adequate records must be maintained to 
support the base-year unit cost as well as the current-year unit cost 
for all items priced on the dollar-value LIFO inventory method, 
regardless of the method authorized by paragraph (e) of this section 
which is used in computing the LIFO value of the dollar-value pool. The 
pool or pools selected must be used for the year of adoption and for all 
subsequent taxable years unless a change is required by the Commissioner 
in order to clearly reflect income, or unless permission to change is 
granted by the Commissioner as provided in paragraph (e) of Sec.  1.446-
1. However, see paragraph (h) of this section for authorization to 
change the method of pooling in certain specified cases.
    (e) Methods of computation of the LIFO value of a dollar-value 
pool--(1) Methods authorized. A taxpayer may ordinarily use only the so-
called ``double-extension'' method for computing the base-year and 
current-year cost of a dollar-value inventory pool. Where the use of the 
double-extension method is impractical, because of technological 
changes, the extensive variety of items, or extreme fluctuations in the 
variety of the items, in a dollar-value pool, the taxpayer may use an 
index method for computing all or part of the LIFO value of the pool. An 
index may be computed by double-extending a representative portion of 
the inventory in a pool or by the use of other sound and consistent 
statistical methods. The index used must be appropriate to the inventory 
pool to which it is to be applied. The appropriateness of the method of 
computing the index and the accuracy, reliability, and suitability of 
the use of such index must be demonstrated to the satisfaction of the 
district director in connection with the examination of the taxpayer's 
income tax returns. The use of any so-called ``link-chain'' method will 
be approved for taxable years beginning after December 31, 1960, only in 
those cases where the taxpayer can demonstrate to the satisfaction of 
the district director that the use of either an index method or the 
double-extension method would be impractical or unsuitable in view of 
the nature of the pool. A taxpayer using either an index or link-chain 
method shall attach to his income tax return for the first taxable year 
beginning after December 31, 1960, for which the index or link-chain 
method is used, a statement describing the particular link-chain method 
or the method used in computing the index. The statement shall be in 
sufficient detail to facilitate the determination as to whether the

[[Page 603]]

method used meets the standards set forth in this subparagraph. In 
addition, a copy of the statement shall be filed with the Commissioner 
of Internal Revenue, Attention: T:R, Washington, D.C. 20224. The 
taxpayer shall submit such other information as may be requested with 
respect to such index or link-chain method. Adequate records must be 
maintained by the taxpayer to support the appropriateness, accuracy, and 
reliability of an index or link-chain method. A taxpayer may request the 
Commissioner to approve the appropriateness of an index or link-chain 
method for the first taxable year beginning after December 31, 1960, for 
which it is used. Such request must be submitted within 90 days after 
the beginning of the first taxable year beginning after December 31, 
1960, in which the taxpayer desires to use the index or link-chain 
method, or on or before May 1, 1961, whichever is later. A taxpayer 
entitled to use the retail method of pricing LIFO inventories authorized 
by paragraph (k) of Sec.  1.472-1 may use retail price indexes prepared 
by the United States Bureau of Labor Statistics. Any method of computing 
the LIFO value of a dollar-value pool must be used for the year of 
adoption and all subsequent taxable years, unless the taxpayer obtains 
the consent of the Commissioner in accordance with paragraph (e) of 
Sec.  1.446-1 to use a different method.
    (2) Double-extension method. (i) Under the double-extension method 
the quantity of each item in the inventory pool at the close of the 
taxable year is extended at both base-year unit cost and current-year 
unit cost. The respective extensions at the two costs are then each 
totaled. The first total gives the amount of the current inventory in 
terms of base-year cost and the second total gives the amount of such 
inventory in terms of current-year cost.
    (ii) The total current-year cost of items making up a pool may be 
determined--
    (a) By reference to the actual cost of the goods most recently 
purchased or produced;
    (b) By reference to the actual cost of the goods purchased or 
produced during the taxable year in the order of acquisition;
    (c) By application of an average unit cost equal to the aggregate 
cost of all of the goods purchased or produced throughout the taxable 
year divided by the total number of units so purchased or produced; or
    (d) Pursuant to any other proper method which, in the opinion of the 
Commissioner, clearly reflects income.
    (iii) Under the double-extension method a base-year unit cost must 
be ascertained for each item entering a pool for the first time 
subsequent to the beginning of the base year. In such a case, the base-
year unit cost of the entering item shall be the current-year cost of 
that item unless the taxpayer is able to reconstruct or otherwise 
establish a different cost. If the entering item is a product or raw 
material not in existence on the base date, its cost may be 
reconstructed, that is, the taxpayer using reasonable means may 
determine what the cost of the item would have been had it been in 
existence in the base year. If the item was in existence on the base 
date but not stocked by the taxpayer, he may establish, by using 
available data or records, what the cost of the item would have been to 
the taxpayer had he stocked the item. If the base-year unit cost of the 
entering item is either reconstructed or otherwise established to the 
satisfaction of the Commissioner, such cost may be used as the base-year 
unit cost in applying the double-extension method. If the taxpayer does 
not reconstruct or establish to the satisfaction of the Commissioner a 
base-year unit cost, but does reconstruct or establish to the 
satisfaction of the Commissioner the cost of the item at some year 
subsequent to the base year, he may use the earliest cost which he does 
reconstruct or establish as the base-year unit cost.
    (iv) To determine whether there is an increment or liquidation in a 
pool for a particular taxable year, the end of the year inventory of the 
pool expressed in terms of base-year cost is compared with the beginning 
of the year inventory of the pool expressed in terms of base-year cost. 
When the end of the year inventory of the pool is in excess of the 
beginning of the year inventory of the pool an increment occurs in the

[[Page 604]]

pool for that year. If there is an increment for the taxable year, the 
ratio of the total current-year cost of the pool to the total base-year 
cost of the pool must be computed. This ratio when multiplied by the 
amount of the increment measured in terms of base-year cost gives the 
LIFO value of such increment. The LIFO value of each such increment is 
hereinafter referred to in this section as the ``layer of increment'' 
and must be separately accounted for and a record thereof maintained as 
a separate layer of the pool, and may not be combined with a layer of 
increment occurring in a different year. On the other hand, when the end 
of the year inventory of the pool is less than the beginning of the year 
inventory of the pool, a liquidation occurs in the pool for that year. 
Such liquidation is to be reflected by reducing the most recent layer of 
increment by the excess of the beginning of the year inventory over the 
end of the year inventory of the pool. However, if the amount of the 
liquidation exceeds the amount of the most recent layer of increment, 
the preceding layers of increment in reverse chronological order are to 
be successively reduced by the amount of such excess until all the 
excess is absorbed. The base-year inventory is to be reduced by 
liquidation only to the extent that the aggregate of all liquidation 
exceeds the aggregate of all layers of increment.
    (v) The following examples illustrate inventories under the double-
extension the computation of the LIFO value of method.

    Example 1. (a) A taxpayer elects, beginning with the calendar year 
1961, to compute his inventories by use of the LIFO inventory method 
under section 472 and further elects to use the dollar-value method in 
pricing such inventories as provided in paragraph (a) of this section. 
He creates Pool No. 1 for items A, B, and C. The composition of the 
inventory for Pool No. 1 at the base date, January 1, 1961, is as 
follows:

------------------------------------------------------------------------
                                                          Unit    Total
                     Items                        Units   cost     cost
------------------------------------------------------------------------
A..............................................   1,000      $5   $5,000
B..............................................   2,000       4    8,000
C..............................................     500       2    1,000
                                                                --------
  Total base-year cost at Jan. 1, 1961.........  ......  ......   14,000
------------------------------------------------------------------------

    (b) The closing inventory of Pool No. 1 at December 31, 1961, 
contains 3,000 units of A, 1,000 units of B, and 500 units of C. The 
taxpayer computes the current-year cost of the items making up the pool 
by reference to the actual cost of goods most recently purchased. The 
most recent purchases of items A, B, and C are as follows:

------------------------------------------------------------------------
                                                       Quantity    Unit
              Item                   Purchase date    purchased    cost
------------------------------------------------------------------------
A...............................  Dec. 15, 1961.....      3,500    $6.00
B...............................  Dec. 10, 1961.....      2,000     5.00
C...............................  Nov. 1, 1961......        500     2.50
------------------------------------------------------------------------

    (c) The inventory of Pool No. 1 at December 31, 1961, shown at base-
year and current-year cost is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               Dec. 31, 1961,    Dec. 31, 1961,
                                                                                inventory at      inventory at
                                                                                Jan. 1, 1961,     current-year
                               Item                                 Quantity   base-year cost         cost
                                                                             -----------------------------------
                                                                               Unit              Unit
                                                                               cost    Amount    cost    Amount
----------------------------------------------------------------------------------------------------------------
A.................................................................    3,000    $5.00   $15,000   $6.00   $18,000
B.................................................................    1,000     4.00     4,000    5.00     5,000
C.................................................................      500     2.00     1,000    2.50     1,250
                                                                                     ----------        ---------
  Total...........................................................  ........  ......    20,000  ......    24,250
----------------------------------------------------------------------------------------------------------------

    (d) If the amount of the December 31, 1961, inventory at base-year 
cost were equal to, or less than, the base-year cost of $14,000 at 
January 1, 1961, such amount would be the closing LIFO inventory at 
December 31, 1961. However, since the base-year cost of the closing LIFO 
inventory at December 31, 1961, amounts to $20,000, and is in excess of 
the $14,000 base-year cost of the opening inventory for that year, there 
is a $6,000 increment in Pool No. 1 during the year. This increment must 
be valued at current-year cost, i.e., the ratio of 24,250/20,000, or 
121.25 percent. The LIFO value of the inventory at December 31, 1961, is 
$21,275, computed as follows:

                               Pool No. 1
------------------------------------------------------------------------
                                                     Ratio of
                                          Dec. 31,    total
                                           1961,     current-   Dec. 31,
                                         inventory  year cost    1961,
                                          at Jan.    to total  inventory
                                          1, 1961,  base-year   at LIFO
                                         base-year     cost      value
                                            cost    (percent)
------------------------------------------------------------------------
Jan. 1, 1961, base cost................     14,000     100.00    $14,000
Dec. 31, 1961, increment...............      6,000     121.25      7,275
                                        -----------           ----------
    Total..............................     20,000  .........     21,275
------------------------------------------------------------------------


[[Page 605]]

    Example 2. (a) Assume the taxpayer in Example 1 during the year 1962 
completely disposes of item C and purchases item D. Assume further that 
item D is properly includible in Pool No. 1 under the provisions of this 
section. The closing inventory on December 31, 1962, consists of 
quantities at current-year unit cost, as follows:

------------------------------------------------------------------------
                                                               Current-
                                                               year unit
                       Items                          Units    cost Dec.
                                                               31, 1962
------------------------------------------------------------------------
A..................................................    2,000       $6.50
B..................................................    1,500        6.00
D..................................................    1,000        5.00
------------------------------------------------------------------------

    (b) The taxpayer establishes that the cost of item D, had he 
acquired it on January 1, 1961, would have been $2.00 per unit. Such 
cost shall be used as the base-year unit cost for item D, and the LIFO 
computations at December 31, 1962, are made as follows:

----------------------------------------------------------------------------------------------------------------
                                                                               Dec. 31, 1962,    Dec. 31, 1962,
                                                                                inventory at      inventory at
                                                                                Jan. 1, 1961,     current-year
                               Item                                 Quantity   base-year cost         cost
                                                                             -----------------------------------
                                                                               Unit              Unit
                                                                               cost    Amount    cost    Amount
----------------------------------------------------------------------------------------------------------------
A.................................................................    2,000    $5.00   $10,000   $6.50   $13,000
B.................................................................    1,500     4.00     6,000    6.00     9,000
D.................................................................    1,000     2.00     2,000    5.00     5,000
                                                                                     ----------        ---------
   Total..........................................................  ........  ......    18,000  ......    27,000
----------------------------------------------------------------------------------------------------------------

    (c) Since the closing inventory at base-year cost, $18,000, is less 
than the 1962 opening inventory at base-year cost, $20,000, a 
liquidation of $2,000 has occurred during 1962. This liquidation is to 
be reflected by reducing the most recent layer of increment. The LIFO 
value of the inventory at December 31, 1962, is $18,850, and is 
summarized as follows:

                               Pool No. 1
------------------------------------------------------------------------
                                                     Ratio of
                                          Dec. 31,    total
                                           1962,     current-   Dec. 31,
                                         inventory  year cost    1962,
                                          at Jan.    to total  inventory
                                          1, 1961,  base-year   at LIFO
                                         base-year     cost      value
                                            cost    (percent)
------------------------------------------------------------------------
Jan. 1, 1961, base cost................     14,000     100.00    $14,000
Dec. 31, 1961, increment...............      4,000     121.25      4,850
                                        -----------           ----------
   Total...............................     18,000  .........     18,850
------------------------------------------------------------------------

    (3) Inventory price index computation (IPIC) method--(i) In general. 
The inventory price index computation method provided by this paragraph 
(e)(3) (IPIC method) is an elective method of determining the LIFO value 
of a dollar-value pool using consumer or producer price indexes 
published by the United States Bureau of Labor Statistics (BLS). A 
taxpayer using the IPIC method must compute a separate inventory price 
index (IPI) for each dollar-value pool. This IPI is used to convert the 
total current-year cost of the items in a dollar-value pool to base-year 
cost in order to determine whether there is an increment or liquidation 
in terms of base-year cost and, if there is an increment, to determine 
the LIFO inventory value of the current year's layer of increment 
(layer). Using one IPI to compute the base-year cost of a dollar-value 
pool for the current taxable year and using a different IPI to compute 
the LIFO inventory value of the current taxable year's layer is not 
permitted under the IPIC method. The IPIC method will be accepted by the 
Commissioner as an appropriate method of computing an index, and the use 
of that index to compute the LIFO value of a dollar-value pool will be 
accepted as accurate, reliable, and suitable. The appropriateness of a 
taxpayer's computation of an IPI, which includes all the steps described 
in paragraph (e)(3)(iii) of this section, will be determined in 
connection with an examination of the taxpayer's federal income tax 
return. A taxpayer using the IPIC method may elect to establish dollar-
value pools according to the special rules in paragraphs (b)(4) and 
(c)(2) of this section or the general rules in paragraphs (b) and (c) of 
this section. Taxpayers eligible to use the IPIC method are described in 
paragraph (e)(3)(ii) of this section. The manner in which an IPI is 
computed is described in paragraph (e)(3)(iii) of this section. Rules 
relating to the adoption of, or change to, the IPIC method are in 
paragraph (e)(3)(iv) of this section.
    (ii) Eligibility. Any taxpayer electing to use the dollar-value LIFO 
method may elect to use the IPIC method. Except as provided in this 
paragraph (e)(3)(ii) or in other published guidance, a taxpayer that 
elects to use the IPIC method for a specific trade or business must use 
that method to account for all items of dollar-value LIFO inventory. A 
taxpayer that uses the retail price indexes computed by the BLS and 
published in ``Department Store Inventory Price Indexes'' (available 
from the

[[Page 606]]

BLS by calling (202) 606-6325 and entering document code 2415) may elect 
to use the IPIC method for items that do not fall within any of the 
major groups listed in ``Department Store Inventory Price Indexes.''
    (iii) Computation of an inventory price index--(A) In general. The 
computation of an IPI for a dollar-value pool requires the following 
four steps, which are described in more detail in this paragraph 
(e)(3)(iii): First, selection of a BLS table and an appropriate month; 
second, assignment of items in a dollar-value pool to BLS categories 
(selected BLS categories); third, computation of category inflation 
indexes for selected BLS categories; and fourth, computation of the IPI. 
A taxpayer may compute the IPI for each dollar-value pool using either 
the double-extension method (double-extension IPIC method) or the link-
chain method (link-chain IPIC method), without regard to whether the use 
of a double-extension method is impractical or unsuitable. The use of 
either the double-extension IPIC method or the link-chain IPIC method is 
a method of accounting, and the adopted method must be applied 
consistently to all dollar-value pools within a trade or business 
accounted for under the IPIC method. A taxpayer that wants to change 
from the double-extension IPIC method to the link-chain IPIC method, or 
vice versa, must secure the consent of the Commissioner under Sec.  
1.446-1(e). This change must be made with a new base year as described 
in paragraph (e)(3)(iv)(B)(1).
    (B) Selection of BLS table and appropriate month--(1) In general. 
Under the IPIC method, an IPI is computed using the consumer or producer 
price indexes for certain categories (BLS price indexes and BLS 
categories, respectively) listed in the selected BLS table of the ``CPI 
Detailed Report'' or the ``PPI Detailed Report'' for the appropriate 
month.
    (2) BLS table selection. Manufacturers, processors, wholesalers, 
jobbers, and distributors must select BLS price indexes from Table 6 
(Producer price indexes and percent changes for commodity groupings and 
individual items, not seasonally adjusted) of the ``PPI Detailed 
Report'', unless the taxpayer can demonstrate that selecting BLS price 
indexes from another table of the ``PPI Detailed Report'' is more 
appropriate. Retailers may select BLS price indexes from either Table 3 
(Consumer Price Index for all Urban Consumers (CPI-U): U.S. city 
average, detailed expenditure categories) of the ``CPI Detailed Report'' 
or from Table 6 (or another more appropriate table) of the ``PPI 
Detailed Report.'' The selection of a BLS table is a method of 
accounting and must be used for the taxable year of adoption and all 
subsequent years, unless the taxpayer obtains the Commissioner's consent 
under Sec.  1.446-1(e) to change its table selection. A taxpayer that 
changes its BLS table must establish a new base year in the year of 
change as described in paragraph (e)(3)(iv)(B) of this section.
    (3) Appropriate month. In the case of a retailer using the retail 
method, the appropriate month is the last month of the retailer's 
taxable year. In the case of all other taxpayers, the appropriate month 
is the month most consistent with the method used to determine the 
current-year cost of the dollar-value pool under paragraph (e)(2)(ii) of 
this section and the taxpayer's history of inventory production or 
purchases during the taxable year. A taxpayer not using the retail 
method may annually select an appropriate month for each dollar-value 
pool or make an election on Form 970, ``Application to Use LIFO 
Inventory Method,'' to use a representative appropriate month 
(representative month). An election to use a representative month is a 
method of accounting and the month elected must be used for the taxable 
year of the election and all subsequent taxable years, unless the 
taxpayer obtains the Commissioner's consent under Sec.  1.446-1(e) to 
change or revoke its election.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (e)(3)(iii)(B)(3):

    Example 1. Determining an appropriate month. A wholesaler of 
seasonal goods timely files a Form 970, ``Application to Use LIFO 
Inventory Method,'' for the taxable year ending December 31, 2001. The 
taxpayer indicates elections to use the dollar-value LIFO method, to 
determine the current-year cost using the earliest acquisitions method 
in accordance with paragraph (e)(2)(ii)(b) of this section, and to use 
the IPIC method under

[[Page 607]]

paragraph (e)(3) of this section. Although the taxpayer purchases 
inventory items regularly throughout the year, the items purchased vary 
according to the seasons. The seasonal items on hand at December 31, 
2001, are purchased between October and December. Thus, based on the 
taxpayer's use of the earliest acquisitions method of determining 
current-year cost and its experience with inventory purchases, the 
appropriate month for the items represented in the ending inventory at 
December 31, 2001, is October.
    Example 2. Electing a representative month. A retailer not using the 
retail method timely files a Form 970, ``Application to Use LIFO 
Inventory Method,'' for the taxable year ending December 31, 2001. The 
taxpayer indicates elections to use the dollar-value LIFO method, the 
most recent purchases method of determining current-year cost under 
paragraph (e)(2)(ii)(a) of this section, the IPIC method under paragraph 
(e)(3) of this section, and December as its representative month under 
paragraph (e)(3)(iii)(B)(3) of this section. The items in the taxpayer's 
ending inventory are purchased fairly uniformly throughout the year, 
with the first purchases normally occurring in January and the last 
purchases normally occurring in December. The taxpayer's election to use 
December as its representative month is permissible because the taxpayer 
elected to use the most recent purchases method and the taxpayer's last 
purchases of the taxable year normally occur during December, the last 
month of the taxpayer's taxable year.
    Example 3. Changing representative month. The facts are the same as 
in Example 2, except the taxpayer files a Form 3115, ``Application for 
Change in Accounting Method,'' requesting permission to change to the 
earliest acquisitions method of determining current-year cost in 
accordance with paragraph (e)(2)(ii)(b) of this section and to change 
its representative month from December to January beginning with the 
taxable year ending December 31, 2003. If the Commissioner consents to 
the taxpayer's request to change to the earliest acquisitions method, 
December will no longer be a permissible representative month for this 
taxpayer because of the absence of a nexus between the earliest 
acquisitions method, the month of December (the last month of the 
taxpayer's taxable year), and the taxpayer's experience with inventory 
purchases during the year. Thus, the Commissioner will permit the 
taxpayer to change its representative month to January, the first month 
of the taxpayer's taxable year.
    Example 4. Changing representative month. The facts are the same as 
in Example 2. In 2002, the taxpayer changes its annual accounting period 
to a taxable year ending June 30, which requires the taxpayer to file a 
return for the short taxable year beginning January 1, 2002, and ending 
June 30, 2002. As a result, December is no longer a permissible 
representative month because of the absence of a nexus between the most 
recent purchases method, the month of December, and the taxpayer's 
experience with inventory purchases during the year. The taxpayer should 
file a Form 3115 requesting permission to change its representative 
month from December to June beginning with the short taxable year ending 
June 30, 2002. Because the taxpayer's last purchases of the taxable year 
now will occur in June, the Commissioner will consent to the taxpayer's 
request to change its representative month to June.
    Example 5. Changing representative month. The facts are the same as 
in Example 2, except that the taxpayer elects to use January as its 
representative month. The taxpayer timely files a Form 3115 requesting 
permission to change its representative month from January to December 
beginning with the taxable year ending December 31, 2003. January is not 
a permissible representative month because of the absence of a nexus 
between the most recent purchases method, the taxpayer's history of 
inventory purchases, and the month of January, the first month in the 
taxpayer's taxable year. Because December is a permissible 
representative month, the Commissioner will permit the taxpayer to 
change its representative month to December.

    (C) Assignment of inventory items to BLS categories--(1) In general. 
Except as provided in paragraph (e)(3)(iii)(C)(2) of this section, a 
taxpayer must assign each item in a dollar-value pool to the most-
detailed BLS category of the selected BLS table that contains that item. 
For example, in Table 6 of the ``PPI Detailed Report'' for a given 
month, the commodity codes for the various BLS categories run from 2 to 
8 digits, with the least-detailed BLS categories having a 2-digit code 
and the most-detailed BLS categories usually (but not always) having an 
8-digit code. For purposes of assigning items to the most-detailed BLS 
category, manufacturers and processors must assign each raw material 
item to the most-detailed PPI category that includes that raw material 
and must assign each finished good item to the most-detailed PPI 
category that includes that finished good. In addition, manufacturers 
and processors must assign each work-in-process (WIP) item to the most-
detailed PPI category that includes the finished good into which the 
item will be manufactured or processed. For this purpose, finished good 
means a salable

[[Page 608]]

item that the taxpayer regularly sells. For example, a gasoline-engine 
manufacturer that also manufactures the pistons used in those engines 
and regularly sells some of the pistons (e.g., to retailers of 
replacement parts) must assign both finished pistons that have not been 
affixed to an engine block and piston WIP items to the most-detailed PPI 
category that includes pistons. Finished pistons that have been affixed 
to an engine block must be assigned to the most-detailed PPI category 
that includes gasoline engines. In contrast, if sales of these pistons 
occur infrequently, the taxpayer must assign both finished pistons and 
piston WIP items to the most-detailed PPI category that includes 
gasoline engines.
    (2) 10 percent method. Instead of assigning each item in a dollar-
value pool to the most-detailed BLS categories, as described in 
paragraph (e)(3)(iii)(C)(1) of this section, a taxpayer may elect to use 
the 10 percent method described in this paragraph (e)(3)(iii)(C)(2). 
Under the 10 percent method, items are assigned to BLS categories using 
a three-step procedure. First, when the current-year cost of a specific 
item is 10 percent or more of the total current-year cost of the dollar-
value pool, the taxpayer must assign that item to the most-detailed BLS 
category that includes that item (10 percent BLS category). Any other 
item that is includible in that 10 percent BLS category (other than an 
item that qualifies for its own 10 percent BLS category under the 
preceding sentence) must be assigned to that 10 percent BLS category. 
Second, if one or more items have not been assigned to BLS categories in 
the first step, the taxpayer must investigate successively less-detailed 
BLS categories and assign the unassigned item(s) to the first BLS 
category that contains unassigned items whose current-year cost, in the 
aggregate, is 10 percent or more of the total current-year cost of the 
dollar-value pool (also, 10 percent BLS categories). This step must be 
repeated until all the items in the dollar-value pool have been included 
in an appropriate 10 percent BLS category, the current-year cost of the 
unassigned items, in the aggregate, is less than 10 percent of the total 
current-year cost of the dollar-value pool, or the taxpayer determines 
that a single BLS category is not appropriate for the aggregate of the 
unassigned items. Third, if items in a dollar-value pool have not been 
assigned to a 10 percent BLS category because the current-year cost of 
those items, in the aggregate, is less than 10 percent of the total 
current-year cost of the dollar-value pool, the taxpayer must assign 
those items to the most-detailed BLS category that includes all those 
items (also, a 10 percent category). On the other hand, if items in a 
dollar-value pool have not been assigned to a 10 percent BLS category 
because the taxpayer determines that a single BLS category is not 
appropriate for the aggregate of those items, the taxpayer must assign 
each of those items to a single miscellaneous BLS category created by 
the taxpayer (also, a 10 percent category). In no event may a taxpayer 
assign items in a dollar-value pool to a BLS category that is less 
detailed than either the major groups of consumer goods described in 
Table 3 of the monthly ``CPI Detailed Report'' or the major commodity 
groups of producer goods described in Table 6 of the monthly ``PPI 
Detailed Report.'' Principles similar to those described in paragraph 
(e)(3)(iii)(C)(1) apply for purposes of assigning raw material, work-in-
process, and finished good items to the most-detailed BLS category under 
the 10 percent method.
    (3) Change in method of accounting. The 10 percent method of 
assigning items in a dollar-value pool to BLS categories is a method of 
accounting. In addition, a taxpayer's selection of a BLS category for a 
specific item is a method of accounting. However, the assignment of 
items to different BLS categories solely as a result of the application 
of the 10 percent method is a change in underlying facts and not a 
change in method of accounting. Likewise, the selection of a new BLS 
category for a specific item as a result of a revision to a BLS table is 
a change in underlying facts and not a change in method of accounting. A 
taxpayer that wants to change its method of selecting BLS categories 
(i.e., to or from the 10-percent method) or of selecting a BLS category 
for a specific item must

[[Page 609]]

secure the Commissioner's consent in accordance with Sec.  1.446-1(e). A 
taxpayer that voluntarily changes its method of selecting BLS categories 
or of selecting a BLS category for a specific item must establish a new 
base year in the year of change as described in paragraph (e)(3)(iv)(B) 
of this section.
    (D) Computation of a category inflation index--(1) In general. As 
described in more detail in this paragraph (e)(3)(iii)(D), a category 
inflation index reflects the inflation that occurs in the BLS price 
indexes for a selected BLS category (or, if applicable, 10 percent BLS 
category) during the relevant measurement period.
    (2) BLS price indexes. The BLS price indexes are the cumulative 
indexes published in the selected BLS table for the appropriate month. A 
taxpayer may elect to use either preliminary or final BLS price indexes 
for the appropriate month, provided that the selected BLS price indexes 
are used consistently. However, a taxpayer that elects to use final BLS 
price indexes for the appropriate month must use preliminary BLS price 
indexes for any taxable year for which the taxpayer files its original 
federal income tax return before the BLS publishes final BLS price 
indexes for the appropriate month. If a BLS price index for a most-
detailed or 10 percent BLS category is not otherwise available for the 
appropriate or representative month (but not because the BLS categories 
in the BLS table have been revised), the taxpayer must use the BLS price 
index for the next most-detailed BLS category that includes the specific 
item(s) in the most-detailed or 10 percent BLS category. If a BLS price 
index is not otherwise available for the appropriate or representative 
month because the BLS categories in the BLS table have been revised, the 
rules of paragraph (e)(3)(iii)(D)(4) of this section apply.
    (3) Category inflation index--(i) In general. Except as provided in 
paragraph (e)(3)(iii)(D)(4) of this section (concerning compound 
category inflation indexes) or (e)(3)(iii)(D)(5) of this section 
(concerning category inflation indexes for certain 10 percent BLS 
categories), a category inflation index for a selected BLS category (or, 
if applicable, 10 percent BLS category) is computed under the rules of 
this paragraph (e)(3)(iii)(D)(3).
    (ii) Double-extension IPIC method. In the case of a taxpayer using 
the double-extension IPIC method, the category inflation index for a BLS 
category is the quotient of the BLS price index for the appropriate or 
representative month of the current year divided by the BLS price index 
for the appropriate month of the taxable year preceding the base year 
(base month). However, if the taxpayer did not have an opening inventory 
in the year that its election to use the dollar-value LIFO method and 
double-extension IPIC method became effective, the category inflation 
index for a BLS category is the quotient of the BLS price index for the 
appropriate or representative month of the current year divided by the 
BLS price index for the month immediately preceding the month of the 
taxpayer's first inventory production or purchase.
    (iii) Link-chain IPIC method. In the case of a taxpayer using the 
link-chain IPIC method, the category inflation index for a BLS category 
is the quotient of the BLS price index for the appropriate or 
representative month of the current year divided by the BLS price index 
for the appropriate month used for the immediately preceding taxable 
year. However, if the taxpayer did not have an opening inventory in the 
year that its election to use the dollar-value LIFO method and link-
chain IPIC method became effective, the category inflation index for a 
BLS category for the year of election is the quotient of the BLS price 
index for the appropriate or representative month of the current year 
divided by the BLS price index for the month immediately preceding the 
month of the taxpayer's first inventory production or purchase.
    (iv) Special rules concerning representative months. A taxpayer 
electing to use a representative month under paragraph (e)(3)(iii)(B)(3) 
of this section must use an appropriate month, rather than the 
representative month, to determine category inflation indexes in the 
circumstances described in this paragraph (e)(3)(iii)(D)(3)(iv) and in 
other similar circumstances. For example, in the case of a short taxable 
year, the category inflation index

[[Page 610]]

should reflect the inflation that occurs from the base month (in the 
case of the double-extension IPIC method), or the appropriate or 
representative month used for the preceding taxable year (in the case of 
the link-chain IPIC method), and the appropriate month for the short 
taxable year. Similarly, if a taxpayer using the link-chain IPIC method 
is granted consent to change both its method of determining the current-
year cost of a dollar-value pool and its representative month, the 
category inflation index for the year of change should reflect the 
inflation that occurs between the old representative month used for the 
preceding taxable year and the new representative month used for the 
year of change.
    (4) Compound category inflation index for revised BLS categories or 
price indexes--(i) In general. Periodically, the BLS revises a BLS table 
to add one or more new BLS categories, eliminate one or more previously 
reported BLS categories, or reset the base-year BLS price index of one 
or more BLS categories. If the BLS has revised the applicable BLS table 
for a taxable year, a taxpayer must compute the category inflation index 
for each BLS category for which the taxpayer cannot compute a category 
inflation index in accordance with paragraph (e)(3)(iii)(D)(3) of this 
section (affected BLS category) using a reasonable method, provided the 
method is used consistently for all affected BLS categories within a 
particular taxable year. For example, if the BLS revised the CPI by 
adding new BLS categories as of January 2001 and eliminating some 
previously reported BLS categories as of December 2000, January 2002 
would be the first month for which it would be possible to compute a 
category inflation index for a 12-month period using the BLS price 
indexes for any affected category. The compound category inflation index 
described in paragraph (e)(3)(iii)(D)(4)(ii) of this section is a 
reasonable method of computing the category inflation index for an 
affected BLS category.
    (ii) Computation of compound category inflation index. When the 
applicable BLS table is revised as described in paragraph 
(e)(3)(iii)(D)(4)(i) of this section, a taxpayer may use the procedure 
described in this paragraph (e)(3)(iii)(D)(4)(ii) to compute a compound 
category inflation index for each affected BLS category represented in 
the taxpayer's ending inventory. For this purpose, a compound category 
inflation index is the product of the category inflation index for the 
``first portion'' multiplied by the corresponding category inflation 
index for the ``second portion.'' The category inflation index for the 
first portion must reflect the inflation that occurs between the end of 
the base month (in the case of the double-extension IPIC method), or the 
preceding year's appropriate or representative month (in the case of the 
link-chain IPIC method), and the end of the last month covered by the 
unrevised BLS table based on the old BLS category. The corresponding 
category inflation index for the second portion must reflect the 
inflation that occurs between the beginning of the first month covered 
by the revised BLS table based on the new BLS category and the end of 
the current year's appropriate or representative month. First, using the 
revised BLS table for the current-year's appropriate or representative 
month, the taxpayer assigns items in the dollar-value pool using its 
method of assigning items to BLS categories as described in paragraph 
(e)(3)(iii)(C) of this section. Second, for each affected BLS category 
represented in the ending inventory, the taxpayer computes the category 
inflation index for the second portion using this formula: [A/B], where 
A equals the BLS price index for the current year's appropriate or 
representative month and B equals the BLS price index for the last month 
covered by the unrevised BLS table (as published for the first month of 
the revised BLS table). Third, using the unrevised BLS table for the 
base month (in the case of the double extension IPIC method) or the 
preceding year's appropriate or representative month (in the case of the 
link-chain IPIC method), the taxpayer assigns each of the items in the 
dollar-value pool using its method of assigning items to BLS categories. 
Fourth, for each affected BLS category represented in the ending 
inventory, the taxpayer computes the category inflation index for the 
first portion using this formula: [C/D], where C equals the

[[Page 611]]

BLS price index for the last month covered by the unrevised BLS table 
(as published for the last month of the unrevised BLS table) and D 
equals the BLS price index for the base month (in the case of the 
double-extension IPIC method) or the preceding year's appropriate or 
representative month (in the case of the link-chain IPIC method). Fifth, 
for each affected BLS category represented in the ending inventory, the 
taxpayer computes the compound category inflation index using this 
formula: [X*Y], where X equals the category inflation index for the 
second portion, and Y equals the corresponding category inflation index 
for the first portion. For the purpose of computing the compound 
category inflation index for each affected BLS category, the 
corresponding category inflation index for the first portion is the 
category inflation index for the unrevised BLS category that includes 
the specific inventory item(s) included in the revised BLS category. If 
items included in a single revised BLS category had been included in 
separate BLS categories before the revision of the BLS table, the 
corresponding category inflation index for the first portion is the 
weighted harmonic mean of the category inflation indexes for these 
unrevised BLS categories. See paragraph (e)(3)(iii)(E)(1) of this 
section for a formula of the weighted harmonic mean. When computing this 
weighted-average category inflation index, a taxpayer must use the 
current-year costs (or in the case of a retailer using the retail 
method, the retail selling prices) in ending inventory as the weights.
    (iii) New base year. A taxpayer may establish a new base year in the 
year following the taxable year for which the taxpayer computed a 
compound category inflation index under this paragraph (e)(3)(iii)(D)(4) 
for one or more affected BLS categories in a dollar-value pool. See 
paragraph (e)(3)(iv)(B) of this section for the procedures and 
computations incident to establishing a new base year.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (e)(3)(iii)(D)(4):

    Example 1. BLS categories eliminated. (i) A retailer, whose taxable 
year ends January 31, elected to account for its inventories using the 
dollar-value LIFO method and double-extension IPIC method (based on the 
CPI), beginning with the taxable year ending January 31, 1997. The 
taxpayer does not use the retail method, but elected to use January as 
its representative month. On January 31, 1999, the taxpayer's only 
dollar-value pool contains only two items--lemons and peaches. The total 
current-year cost of these items is as follows: lemons, $40, and 
peaches, $30.
    (ii) The CPI was revised in October of 1998 to eliminate the 
``Citrus fruits'' subcategory of ``Other fresh fruits.'' In addition, 
the base-year BLS price index for ``Other fresh fruits'' was reset to 
100.00 as of October 1, 1998. In relevant part, the January 1999 CPI 
permits the assignment of both lemons and peaches to ``Other fresh 
fruits.'' The January 1999 BLS price indexes for ``Citrus fruits'' and 
``Other fresh fruits'' are 96.6 and 105.6, respectively. In relevant 
part, the September 1998 CPI permits the assignment of lemons to 
``Citrus fruits'' and peaches to ``Other fresh fruits.'' The September 
1998 BLS price indexes for ``Citrus fruits'' and ``Other fresh fruits'' 
are 194.9 and 294.9, respectively, and the January 1997 BLS price 
indexes for ``Citrus fruits'' and ``Other fresh fruits'' are 190.2 and 
290.2, respectively.
    (iii) Because the BLS eliminated the category, ``Citrus fruits,'' as 
of October 1998, it did not publish a BLS price index for that category 
in the January 1999 CPI. Thus, the taxpayer cannot compute a category 
inflation index for ``Citrus fruits'' under the normal procedures, but 
may compute a compound category inflation index for that affected BLS 
category using the procedures described in paragraph 
(e)(3)(iii)(D)(4)(ii) of this section.
    (iv) The taxpayer computes a compound category inflation index for 
the two BLS categories that formerly included lemons and peaches. The 
taxpayer first assigns lemons and peaches to ``Other fresh fruits,'' the 
most-detailed index in the January 1999 CPI, and then computes the 
category inflation index for the second portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                                       Jan. 1999 index/Sept.
              Item                          1999 category                  1998 index (as           Category
                                                                      published in Oct. 1998)   inflation index
----------------------------------------------------------------------------------------------------------------
Lemons and Peaches.............  Other fresh fruits.................              105.6/100.0             1.0560
----------------------------------------------------------------------------------------------------------------


[[Page 612]]

    (v) The taxpayer assigns the lemons and peaches to the most-detailed 
BLS categories in the January 1998 CPI as follows: lemons to ``Citrus 
fruits'' and peaches to ``Other fresh fruits.'' Then, the taxpayer 
computes the category inflation index for the first portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                                       Sept. 1998 index (as
             Item                          1998 category                published in Sept.    Category inflation
                                                                         1998)/Jan. 1997             index
----------------------------------------------------------------------------------------------------------------
Lemons........................  Citrus fruits......................              194.9/190.2             1.0247
Peaches.......................  Other fresh Fruits.................              294.9/290.2             1.0162
----------------------------------------------------------------------------------------------------------------

    (vi) Because lemons and peaches, which are included together in the 
revised ``Other fresh fruits'' category, had been included in separate 
BLS categories before the BLS table was revised, the taxpayer must 
compute a single corresponding category inflation index for the affected 
BLS categories for the first portion. This corresponding category 
inflation index is the weighted harmonic mean of the separate 
corresponding category inflation indexes for the first portion using the 
cost of the items in ending inventory as the weights. The taxpayer 
computes the corresponding category inflation index for ``Other fresh 
fruits'' for the first portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                            (I) Weight (cost    (II) Category    (III) Quotient:
                           Item                                 of item)       inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Lemons....................................................            $40.00            1.0247            $39.04
Peaches...................................................             30.00            1.0162             29.52
                                                           -----------------------------------------------------
    Total.................................................             70.00  ................             68.56
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                 (V) Sum of (weight/     (VI) Weighted harmonic
                     (IV) Sum of weights                         category inflation        mean of other fresh
                                                                       index)               fruits: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$70.00......................................................                   $68.56                    1.0210
----------------------------------------------------------------------------------------------------------------

    (vii) Finally, the taxpayer computes the compound category inflation 
index for Other fresh fruits as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III) Compound
                                                            (I) Category      (II) Category         category
                          Item                            inflation index    inflation index    inflation index:
                                                          (second portion)   (first portion)        (I)*(II)
----------------------------------------------------------------------------------------------------------------
Other fresh fruits.....................................            1.0560             1.0210             1.0782
----------------------------------------------------------------------------------------------------------------

    (viii) The taxpayer may establish a new base year for the taxable 
year ending January 31, 2000.
    Example 2. BLS categories separated. (i) The facts are the same as 
in Example 1, except prior to October 1998, both lemons and peaches were 
assigned to ``Other fresh fruits'' and in the October 1998 CPI, the BLS 
created a new category, ``Citrus fruits,'' for citrus fruits, such as 
lemons. Moreover, the BLS reset the base-year BLS price index for 
``Other fresh fruits'' to 100.0 as of October 1, 1998. As a result of 
these changes, the taxpayer may no longer assign lemons to ``Other fresh 
fruits.''
    (ii) Because ``Citrus fruits'' is new as of October 1998, the BLS 
did not publish a BLS price index for this BLS category in the January 
1999 CPI. Thus, because the taxpayer cannot compute a category inflation 
index for ``Citrus fruits'' under the normal procedures, the taxpayer 
may compute a compound category inflation index for the affected BLS 
category using the procedures described in paragraph 
(e)(3)(iii)(D)(4)(ii) of this section.
    (iii) Based on the January 1999 CPI, the taxpayer assigns lemons to 
``Citrus fruits'' and peaches to ``Other fresh fruits.'' Then, the 
taxpayer computes a compound category inflation index for each of the 
two BLS categories. The computation of the category inflation index for 
the second portion is as follows:

[[Page 613]]



----------------------------------------------------------------------------------------------------------------
                                                                       Jan. 1999 index/Sept.
              Item                          1999 category                  1998 index (as           Category
                                                                      published in Oct. 1998)   inflation index
----------------------------------------------------------------------------------------------------------------
Lemons.........................  Citrus fruits......................                 96.6/100             0.9660
Peaches........................  Other fresh fruits.................                105.6/100             1.0560
----------------------------------------------------------------------------------------------------------------

    (iv) Then, the taxpayer computes the category inflation index for 
the first portion as follows:

----------------------------------------------------------------------------------------------------------------
                                                                      Sept. 1998 index (as
             Item                          1998 category            published in Sept. 1998)/ Category inflation
                                                                            Jan. 1997                index
----------------------------------------------------------------------------------------------------------------
Lemons & Peaches..............  Other fresh fruits................              294.9/290.2              1.0162
----------------------------------------------------------------------------------------------------------------

    (v) Finally, the taxpayer computes the compound category inflation 
index for ``Citrus fruits'' and ``Other fresh fruits'':

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III) Compound
                                                              (I) Category      (II) Category       category
                           Item                              inflation index   inflation index  inflation index:
                                                            (second portion)   (first portion)      (I)*(II)
----------------------------------------------------------------------------------------------------------------
Citrus fruits.............................................            0.9660            1.0162            0.9816
Other fresh fruits........................................            1.0560            1.0162            1.0731
----------------------------------------------------------------------------------------------------------------

    (vi) The taxpayer may establish a new base year for the taxable year 
ending January 31, 2000.

    (5) 10 percent method. (i) Applicability. A taxpayer that elects to 
use the 10 percent method described in paragraph (e)(3)(iii)(C)(2) of 
this section must compute a category inflation index for a less-detailed 
10 percent BLS category as provided in this paragraph (e)(3)(iii)(D)(5). 
A less-detailed 10 percent category is a BLS category that--
    (A) subsumes two or more BLS categories;
    (B) Does not have a single assigned item whose current-year cost is 
10 percent or more of the current-year cost of all the items in the 
dollar-value pool;
    (C) Has at least one item in at least one of the subsumed BLS 
categories; and
    (D) Has at least one subsumed BLS category that either does not have 
any assigned items or is a separate 10 percent BLS category.
    (ii) Determination of category inflation index. If the rules of this 
paragraph (e)(3)(iii)(D)(5) apply, the category inflation index for the 
less-detailed 10 percent BLS category is equal to the weighted 
arithmetic mean of the category inflation index (or, compound category 
inflation index, if applicable) for each of the subsumed BLS categories 
that have been assigned at least one item from the taxpayer's dollar-
value pool (excluding any item that is properly assigned to a separate 
10 percent BLS category). [Weighted Arithmetic Mean = Sum of (Weight x 
Category Inflation Index)]/Sum of Weights]. The appropriate weight for 
each of the most-detailed BLS categories referenced in the preceding 
sentence is the corresponding BLS weight. Currently, in January of each 
year, the BLS publishes the BLS weights determined for December of the 
preceding year. In the case of a taxpayer using the double-extension 
IPIC method, the BLS weights for December of the taxable year preceding 
the base year are to be used for all taxable years. In the case of a 
taxpayer using the link-chain IPIC method, the BLS weights for December 
of a given calendar year are to be used for taxable years that end 
during the 12-month period that begins on July 1 of the following 
calendar year. However, if the BLS weights are not published for all of 
the most-detailed BLS categories referenced above, the

[[Page 614]]

taxpayer may use the current-year cost (or in the case of a retailer 
using the retail method, the retail selling prices) of all items 
assigned to a specific most-detailed BLS category as the appropriate 
weight for that category, but must compute a weighted harmonic mean. See 
paragraph (e)(3)(iii)(E)(1) of this section for a formula of the 
weighted harmonic mean.
    (E) Computation of Inventory Price Index (IPI)--(1) Double-extension 
IPIC method. Under the double-extension IPIC method, the IPI for a 
dollar-value pool is the weighted harmonic mean of the category 
inflation indexes (or, if applicable, compound category inflation 
indexes) determined under paragraph (e)(3)(iii)(D) of this section for 
each selected BLS category (or, if applicable 10 percent BLS category) 
represented in the taxpayer's dollar-value pool at the end of the 
taxable year. The formula for computing the weighted harmonic mean of 
the category inflation indexes is: [Sum of Weights/Sum of (Weight/
Category Inflation Index)]. The weights to be used when computing this 
weighted harmonic mean are the current-year costs (or, in the case of a 
retailer using the retail method, the retail selling prices) in each 
selected BLS category represented in the dollar-value pool at the end of 
the taxable year.
    (2) Link-chain IPIC method. Under the link-chain IPIC method, the 
IPI for a dollar-value pool is the product of the weighted harmonic mean 
of the category inflation indexes (or, if applicable, the compound 
category inflation indexes) determined under paragraph (e)(3)(iii)(D) of 
this section for each selected BLS category (or, if applicable, 10 
percent BLS category) represented in the taxpayer's dollar-value pool at 
the end of the taxable year multiplied by the IPI for the immediately 
preceding taxable year. The formula for computing the weighted harmonic 
mean of the category inflation indexes is: [Sum of Weights/Sum of 
(Weight/Category Inflation Index)]. The weights to be used when 
computing this weighted harmonic mean are the current-year costs (or, in 
the case of a retailer using the retail method, the retail selling 
prices) in each selected BLS category represented in the dollar-value 
pool at the end of the taxable year.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (e)(3)(iii)(E):

    Example 1. Double-extension method. (i) Introduction. R is a retail 
furniture merchant that does not use the retail method. For the taxable 
year ending December 31, 2000, R used the first-in, first-out method of 
identifying inventory and valued its inventory at cost. The total cost 
of R's inventory on December 31, 2000, was $850,000. R elected to use 
the dollar-value LIFO and double-extension IPIC methods for its taxable 
year ending December 31, 2001. R does not elect to use the 10 percent 
method described in paragraph (e)(3)(iii)(C)(2) of this section. R 
determines the current-year cost of the items using the actual cost of 
the most recently purchased goods. R elected to pool its inventory based 
on the major groups in Table 6 of the monthly ``PPI Detailed Report'' in 
accordance with the special IPIC pooling rules of paragraph (b)(4) of 
this section. All items in R's inventory fall within the 2-digit 
commodity code in Table 6 of the monthly ``PPI Detailed Report'' for 
``furniture and household durables.'' Therefore, R will maintain a 
single dollar-value pool.
    (ii) Select a BLS table and appropriate month for 2001. R determines 
that the appropriate month for 2001 is October. R also determines that 
the appropriate month for 2000 would have been December if R had used 
the IPIC method for that year.
    (iii) Assign inventory items to BLS categories for 2001. For 2001, R 
assigns all items in the dollar-value pool to the most-detailed BLS 
categories listed in Table 6 of the October 2001 ``PPI Detailed Report'' 
that contain those items. The BLS categories and the current-year cost 
of the items assigned to them are summarized as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                  Current-year
                 Commodity code                                     Category                          cost
----------------------------------------------------------------------------------------------------------------
12120101........................................  Living Room Table...........................       $111,924.00
12120211........................................  Dining Room Table...........................        159,578.00
12120216........................................  Dining Room Chairs..........................         98,639.00
12130101........................................  Upholstered Sofas...........................        332,488.00
12130111........................................  Upholstered Chairs..........................        218,751.00
                                                                                               -----------------
    Total.......................................  ............................................        921,380.00
----------------------------------------------------------------------------------------------------------------


[[Page 615]]

    (iv) Compute category inflation indexes for 2001. Because R elected 
to use the double-extension IPIC method and did not elect the 10 percent 
method, the category inflation indexes are computed in accordance with 
paragraph (e)(3)(iii)(D)(3)(ii) of this section (BLS price indexes for 
October 2001 divided by BLS price indexes for December 2000). R computes 
the category inflation indexes for 2001 as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III) Category
                         Category                             (I) Oct. 2001    (II) Dec. 2000   inflation index:
                                                                  index             index           (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Table.........................................             172.4             169.2          1.018913
Dining Room Table.........................................             171.9             168.1          1.022606
Dining Room Chairs........................................             172.8             169.7          1.018268
Upholstered Sofas.........................................             142.2             140.9          1.009226
Upholstered Chairs........................................             134.1             132.5          1.012075
----------------------------------------------------------------------------------------------------------------

    (v) Compute IPI for 2001. R must compute the IPI for 2001, which is 
the weighted harmonic mean of the category inflation indexes for 2001. 
The formula for the weighted harmonic mean provided in paragraph 
(e)(3)(iii)(E)(1) of this section is [Sum of Weights/Sum of (Weight/
Category Inflation Index)]. The IPI for 2001 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                (II) Category    (III) Quotient:
                         Category                              (I) Weight      inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Table.........................................       $111,924.00          1.018913       $109,846.47
Dining Room Table.........................................        159,578.00          1.022606        156,050.33
Dining Room Chairs........................................         98,639.00          1.018268         96,869.39
Upholstered Sofas.........................................        332,488.00          1.009226        329,448.51
Upholstered Chairs........................................        218,751.00          1.012075        216,141.10
                                                           -----------------------------------------------------
    Total.................................................       $921,380.00  ................       $908,355.80
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                     (V) Sum of (weight/
                        (IV) Sum of weights                           category inflation    (VI) Inventory price
                                                                            index)            index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$921,380.00.......................................................           $908,355.80             1.01433821
----------------------------------------------------------------------------------------------------------------

    (vi) Determine the LIFO value of the dollar-value pool for 2001. For 
2001, R determines the total base-year cost of its ending inventory by 
dividing the total current-year cost of the items in the dollar-value 
pool by the IPI for 2001. The total base-year cost of R's ending 
inventory is $908,355.80 ($921,380/1.01433821). Comparing the base-year 
cost of the ending inventory to the base-year cost of the beginning 
inventory, R determines that the base-year cost of the 2001 increment is 
$58,355.80 ($908,355.80 - $850,000.00). R multiplies the base-year cost 
of the 2001 increment by the IPI for 2001 and determines that the LIFO 
value of the 2001 layer is $59,192.52 ($58,355.80 * 1.01433821). Thus, 
the LIFO value of R's total inventory at the end of 2001 is $909,192.52 
($850,000.00 (opening inventory) + $59,192.52 (2001 layer)).
    (vii) Select a BLS table and appropriate month for 2002. For 2002, R 
must compute a new IPI under the double-extension IPIC method to 
determine the LIFO value of its dollar-value pool. R determines that the 
appropriate month for 2002 is November.
    (viii) Assign inventory items to BLS categories for 2002. For 2002, 
R assigns all items in the dollar-value pool to the most-detailed BLS 
categories listed in Table 6 of the November 2002 ``PPI Detailed 
Report'' that contain those items. The BLS categories and the current-
year cost of the items assigned to them are summarized as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                  Current-year
                 Commodity code                                     Category                          cost
----------------------------------------------------------------------------------------------------------------
12120103........................................  Living Room Desks...........................       $125,008.00
12120211........................................  Dining Room Table...........................        136,216.00
12120216........................................  Dining Room Chairs..........................        113,569.00
12130101........................................  Upholstered Sofas...........................        343,900.00
12130111........................................  Upholstered Chairs..........................        233,050.00
                                                                                               -----------------
    Total.......................................  ............................................       $951,743.00
----------------------------------------------------------------------------------------------------------------


[[Page 616]]

    (ix) Compute category inflation indexes for 2002. Because R uses the 
double-extension IPIC method and did not elect the 10 percent method, 
the category inflation indexes are computed in accordance with paragraph 
(e)(3)(iii)(D)(3)(ii) of this section (BLS price indexes for November 
2002 divided by BLS price indexes for December 2000). R computes the 
category inflation indexes for 2002 as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III) Category
                         Category                             (I) Nov. 2002    (II) Dec. 2000    inflation index
                                                                  index             index           (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................             172.6             160.3          1.076731
Dining Room Table.........................................             174.8             168.1          1.039857
Dining Room Chairs........................................             177.0             169.7          1.043017
Upholstered Sofas.........................................             144.9             140.9          1.028389
Upholstered Chairs........................................             136.6             132.5          1.030943
----------------------------------------------------------------------------------------------------------------

    (x) Compute IPI for 2002. R must compute the IPI for 2002, which is 
the weighted harmonic mean [Sum of Weights/Sum of (Weight/Category 
Inflation Index)] of the category inflation indexes for 2002. The IPI 
for 2002 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                (II) Category    (III) Quotient:
                         Category                              (I) Weight      inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................       $125,008.00          1.076731       $116,099.56
Dining Room Table.........................................        136,216.00          1.039857        130,994.93
Dining Room Chairs........................................        113,569.00          1.043017        108,885.09
Upholstered Sofas.........................................        343,900.00          1.028389        334,406.53
Upholstered Chairs........................................        233,050.00          1.030943        226,055.17
                                                           -----------------------------------------------------
    Total.................................................        951,743.00  ................        916,441.28
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                         (V) Category       (VI) Inventory price
                        (IV) Sum of weights                            inflation index        index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$951,743.00.......................................................           $916,441.28             1.03852044
----------------------------------------------------------------------------------------------------------------

    (xi) Determine the LIFO value of the pool for 2002. For 2002, R 
determines the total base-year cost of its ending inventory by dividing 
the total current-year cost of the items in the dollar-value pool by the 
IPI for 2002. The total base-year cost of the ending inventory is 
$916,441.28 ($951,743.00/1.03852044). Comparing the base-year cost of 
the ending inventory to the base-year cost of the beginning inventory, R 
determines that the base-year cost of the 2002 increment is $8,085.48 
($916,441.28-$908,355.80). R multiplies the base-year cost of the 2002 
increment by the IPI for 2002 and determines that the LIFO value of the 
2002 layer is $8,396.94 ($8,085.48 * 1.03852044). Thus, the LIFO value 
of R's total inventory at the end of 2002 is $917,589.46 ($850,000.00 
(opening inventory) + $59,192.52 (2001 layer) + $8,396.94 (2002 layer)).
    Example 2. Link-chain method. (i) Introduction. The facts are the 
same as Example 1, except that R uses the link-chain IPIC method. The 
double-extension IPIC method and the link-chain IPIC method yield the 
same results for the first taxable year in which the dollar-value LIFO 
and IPIC methods are used. Therefore, this example illustrates only how 
R will compute the IPI for, and determine the LIFO value of, its dollar-
value pool for 2002.
    (ii) Select a BLS table and appropriate month for 2002. R determines 
that the appropriate month for 2002 is November.
    (iii) Assign inventory items to BLS categories for 2002. For 2002, R 
assigns all items in the dollar-value pool to the most-detailed BLS 
categories listed in Table 6 of the November 2002 ``PPI Detailed 
Report'' that contain those items. The BLS categories and the current-
year cost of the items assigned to them are summarized as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                  Current-year
                 Commodity code                                     Category                          cost
----------------------------------------------------------------------------------------------------------------
12120103........................................  Living Room Desks...........................       $125,008.00
12120211........................................  Dining Room Table...........................        136,216.00
12120216........................................  Dining Room Chairs..........................        113,569.00
12130101........................................  Upholstered Sofas...........................        343,900.00
12130111........................................  Upholstered Chairs..........................        233,050.00
                                                                                               -----------------

[[Page 617]]

 
    Total.......................................  ............................................        951,743.00
----------------------------------------------------------------------------------------------------------------

    (iv) Compute category inflation indexes for 2002. Because R uses the 
link-chain IPIC method and did not elect the 10 percent method, the 
category inflation indexes are computed in accordance with paragraph 
(e)(3)(iii)(D)(3)(iii) of this section (BLS price indexes for November 
2002 divided by BLS price indexes for October 2001). R computes the 
category inflation indexes for 2002 as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (III) Category
                         Category                             (I) Nov. 2002    (II) Oct. 2001   inflation index:
                                                                  index             index           (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................             172.6             162.0          1.065432
Dining Room Table.........................................             174.8             171.9          1.016870
Dining Room Chairs........................................             177.0             172.8          1.024306
Upholstered Sofas.........................................             144.9             142.2          1.018987
Upholstered Chairs........................................             136.6             134.1          1.018643
----------------------------------------------------------------------------------------------------------------

    (v) Compute IPI for 2002. As provided in paragraph (e)(3)(iii)(E)(2) 
of this section, R must compute the IPI for 2002 by multiplying the 
weighted harmonic mean of the category inflation indexes for 2002 by the 
IPI for 2001. The IPI for 2002 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                (II) Category    (III) Quotient:
                         Category                              (I) Weight      inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks.........................................       $125,008.00          1.065432       $117,330.81
Dining Room Table.........................................        136,216.00          1.016870        133,956.16
Dining Room Chairs........................................        113,569.00          1.024306        110,874.09
Upholstered Sofas.........................................        343,900.00          1.018987        337,492.04
                                                           ------------------                  -----------------
Upholstered Chairs........................................        233,050.00          1.018643        228,784.77
    Total.................................................        951,743.00  ................        928,437.87
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                      (VI) Weighted
                              (V) Sum of (weight/    harmonic mean of     (VII) Inventory      (VIII) Inventory
     (IV) Sum of weights       category inflation   category inflation    price index for      price index for
                                     index)         indexes for 2002:           2001           2002: (VI)*(VII)
                                                         (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$951,743.00.................         $928,437.87           1.02510144           1.01433821           1.03979956
----------------------------------------------------------------------------------------------------------------

    (vi) Determine the LIFO value of the pool for 2002. R determines the 
total base-year cost of its ending inventory by dividing the total 
current-year cost of the items in the dollar-value pool by the IPI for 
2002. The total base-year cost of the ending inventory is $915,313.91 
($951,743.00 / 1.03979956). Comparing the base-year cost of the ending 
inventory to the base-year cost of the beginning inventory, R determines 
that the base-year cost of the 2002 layer is $6,958.11 ($915,313.91-
$908,355.80). R multiplies the base-year cost of the 2002 layer by the 
IPI for 2002 and determines that the LIFO value of the 2002 layer is 
$7,235.04 ($6,958.11 * 1.03979956). Thus, the LIFO value of R's total 
inventory at the end of 2002 is $916,427.56 ($850,000.00 (opening 
inventory) + $59,192.52 (2001 layer) + $7,235.04 (2002 layer)).

    (iv) Adoption or change of method--(A) Adoption or change to IPIC 
method. The use of an inventory price index computed under the IPIC 
method is a method of accounting. A taxpayer permitted to adopt the 
dollar-value LIFO method without first securing the Commissioner's 
consent also may adopt the IPIC method without first securing the 
Commissioner's consent. The IPIC method may be adopted and used, 
however, only if the taxpayer provides the following information on a 
Form 970, ``Application to Use LIFO Inventory Method,'' or in another 
manner as may be acceptable to the Commissioner: A complete list of 
dollar-value pools (including a description of

[[Page 618]]

the items in each dollar-value pool); the BLS table (i.e., CPI or PPI) 
selected for each dollar-value pool; the representative month, if 
applicable, elected for each dollar-value pool; the BLS categories to 
which the items in each dollar-value pool will be assigned; the method 
of assigning items to BLS categories (e.g., the 10 percent method) for 
each dollar-value pool; and the method of computing the IPI (i.e., 
double-extension IPIC method or link-chain IPIC method) for each dollar-
value pool. In the case of a taxpayer permitted to adopt the IPIC method 
without requesting the Commissioner's consent, the Form 970 must be 
attached to the taxpayer's income tax return for the taxable year of 
adoption. In all other cases, a taxpayer may change to the IPIC method 
only after securing the Commissioner's consent as provided in Sec.  
1.446-1(e). In these latter cases, the Form 970 containing the 
information described in this paragraph (e)(3)(iv)(A) must be attached 
to a Form 3115, ``Application for Change in Accounting Method,'' filed 
as required by Sec.  1.446-1(e). A taxpayer that simultaneously changes 
to the dollar-value LIFO and IPIC methods from another LIFO method must 
apply the rules of paragraph (f)(2) of this section before applying the 
rules of paragraph (e)(3)(iv)(B)(1) of this section. To satisfy the 
requirements of Sec.  1.472-2(h), taxpayers must maintain adequate books 
and records, including those concerning the use of the IPIC method and 
necessary computations. Notwithstanding the rules in paragraph (e)(1) of 
this section, a taxpayer that adopts, or changes to, the link-chain IPIC 
method is not required to demonstrate that the use of any other method 
of determining the LIFO value of a dollar-value pool is impractical.
    (B) New base year--(1) Voluntary change--(i) In general. In the case 
of a taxpayer using a non-IPIC method to determine the LIFO value of 
inventory, the layers previously determined under that method, if any, 
and the LIFO values of those layers are retained if the taxpayer 
voluntarily changes to the IPIC method. Instead of using the earliest 
taxable year for which the taxpayer adopted the LIFO method for any 
items in the dollar-value pool, the year of change is used as the new 
base year for the purpose of determining the amount of increments and 
liquidations, if any, for the year of change and subsequent taxable 
years. The base-year cost of the layers in a dollar-value pool at the 
beginning of the year of change must be restated in terms of new base-
year cost using the year of change as the new base year and, if 
applicable, the indexes for the previously determined layers must be 
recomputed accordingly. The recomputed indexes will be used to determine 
the LIFO value of subsequent liquidations. For purposes of computing an 
IPI under paragraph (e)(3)(iii)(E) of this section, the IPI for the 
immediately preceding year is 1.00. The new total base-year cost of the 
items in a dollar-value pool for the purpose of determining future 
increments and liquidations is equal to the total current-year cost of 
the items in the dollar-value pool (determined using the taxpayer's 
method of determining the total current-year cost of the items in the 
dollar-value pool under paragraph (e)(2)(ii) of this section). A 
taxpayer must allocate this new total base-year cost to each layer based 
on the ratio of the old base-year cost of the layer to the old total 
base-year cost of the dollar-value pool.
    (ii) Example. The following example illustrates the rules of this 
paragraph (e)(3)(iv)(B)(1):

    Example. (i) In 1990, X elected to use a dollar-value LIFO method 
(other than the IPIC method) for its single dollar-value pool. X is 
granted permission to change to the link-chain IPIC method, beginning 
with the taxable year ending December 31, 2001. X will continue using a 
single dollar-value pool. X's beginning inventory as of January 1, 2001, 
computed using its former inventory method, is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III) LIFO
                           Layer                              (I) Base-year    (II) Inflation     value: (I) *
                                                                  cost              index             (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $135,000              1.00          $135,000
1991 layer................................................            20,000              1.43            28,600
1994 layer................................................            60,000              1.55            93,000

[[Page 619]]

 
1995 layer................................................            13,000              1.59            20,670
1997 layer................................................             2,000              1.61             3,220
                                                           ------------------                  -----------------
    Total.................................................           230,000  ................           280,490
----------------------------------------------------------------------------------------------------------------

    (ii) Under X's method of determining the current-year cost of items 
in a dollar-value pool, the current-year cost of the beginning inventory 
is $391,000. Thus, X's new base-year cost as of January 1, 2001, is 
$391,000. X allocates this new base-year cost to each layer based on the 
ratio of old base-year cost of the layer to the total old base-year cost 
of the dollar-value pool. To recompute the inflation indexes for each of 
its layers, X divides the LIFO value of each layer by the new base-year 
cost attributable to the layer. The new base-year cost, recomputed 
inflation indexes, and LIFO value of X's layers as of January 1, 2001, 
are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III) LIFO
                           Layer                              (I) Base-year    (II) Inflation     value: (I) *
                                                                  cost              index             (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $229,500          0.588235          $135,000
1991 layer................................................            34,000          0.841176            28,600
1994 layer................................................           102,000          0.911765            93,000
1995 layer................................................            22,100          0.935294            20,670
1997 layer................................................             3,400          0.947059             3,220
                                                           ------------------                  -----------------
    Total.................................................           391,000  ................           280,490
----------------------------------------------------------------------------------------------------------------

    (iii) In 2001, the current-year cost of X's ending inventory is 
$430,139. The weighted harmonic mean of the category inflation indexes 
applicable to X's ending inventory is 1.075347, and in accordance with 
paragraph (e)(3)(iv)(B)(1)(i) of this section, the inflation index for 
the immediately preceding taxable year is 1.00. Thus, X's IPI for 2001 
is 1.075347 (1.00 * 1.075347). The total base-year cost of X's ending 
inventory is $400,000 ($430,139/1.075347). The base-year cost, IPI, and 
LIFO value of X's layers as of December 31, 2001, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III) LIFO
                           Layer                              (I) Base-year    (II) Inventory     value: (I) *
                                                                  cost           price index          (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $229,500          0.588235          $135,000
1991 layer................................................            34,000          0.841176            28,600
1994 layer................................................           102,000          0.911765            93,000
1995 layer................................................            22,100          0.935294            20,670
1997 layer................................................             3,400          0.947059             3,220
2001 layer................................................             9,000          1.075347             9,678
                                                           ------------------                  -----------------
    Total.................................................           400,000  ................           290,168
----------------------------------------------------------------------------------------------------------------

    (iv) In 2002, the current-year cost of X's ending inventory is 
$418,000. The weighted harmonic mean of the category inflation indexes 
applicable to X's ending inventory is 1.02292562, and the IPI for the 
immediately preceding year is 1.075347. Thus, X's IPI for 2001 is 1.10 
(1.075347 * 1.02292562). The total base-year cost of X's ending 
inventory is $380,000 ($418,000/1.10), which results in a liquidation of 
$20,000 ($400,000-$380,000) in terms of base-year cost. This liquidation 
eliminates the 2001 layer ($9,000 base-year cost), the 1997 layer 
($3,400 base-year cost), and part of the 1995 layer ($7,600 base-year 
cost). The base-year cost, indexes, and LIFO value of X's layers as of 
December 31, 2002, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   (III) LIFO
                           Layer                              (I) Base-year    (II) Inventory     value: (I) *
                                                                  cost           price index          (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $229,500          0.588235          $135,000
1991 layer................................................            34,000          0.841176            28,600

[[Page 620]]

 
1994 layer................................................           102,000          0.911765            93,000
1995 layer................................................            14,500          0.935294            13,562
                                                           ------------------                  -----------------
    Total.................................................           380,000  ................           270,162
----------------------------------------------------------------------------------------------------------------

    (2) Involuntary change--(i) In general. If a taxpayer uses a non-
IPIC method to compute the LIFO value of a dollar-value pool, and if the 
Commissioner determines that the taxpayer's method does not clearly 
reflect income, the Commissioner may require the taxpayer to change to 
the IPIC method. If the Commissioner requires a taxpayer to change to 
the IPIC method, and the taxpayer does not provide sufficient 
information from its books and records to compute an adjustment under 
section 481, the Commissioner may implement the change using the 
simplified transition method described in paragraph (e)(3)(iv)(B)(2)(ii) 
of this section.
    (ii) Simplified Transition Method. Under the simplified transition 
method, the Commissioner will recompute the LIFO value of each dollar-
value pool as of the beginning of the year of change using the double-
extension IPIC method or the link-chain IPIC method. The adjustment 
under section 481 is equal to the difference between the recomputed LIFO 
value and the LIFO value of the pool determined under the taxpayer's 
former method. The Commissioner will compute an IPI using the double-
extension IPIC method or link-chain IPIC method for each taxable year in 
which the LIFO method was used by the taxpayer based on the assumptions 
that the ending inventory of the pool in each taxable year was comprised 
of items that fall into the same BLS categories as the items in the 
ending inventory of the year of change and that the relative weights of 
those BLS categories in all prior years were the same as the relative 
weights of those BLS categories in the ending inventory of the year of 
change. The base-year cost of the items in a dollar-value pool at the 
end of a taxable year will be determined by dividing the IPI computed 
for the taxable year into the current-year cost of the items in that 
pool determined in accordance with paragraph (e)(2)(ii) of this section. 
If the comparison of the base-year cost of the beginning and ending 
inventory produces a current-year increment, the base-year cost of that 
increment will be multiplied by the IPI computed for that taxable year 
to determine the LIFO value of that layer.
    (iii) Example. The following example illustrates the rules of this 
paragraph (e)(3)(iv)(B)(2)(ii).

    Example. (i) Z began using a dollar-value LIFO method other than the 
IPIC method in the taxable year ending December 31, 1998, and maintains 
a single dollar-value pool. Z's beginning inventory as of January 1, 
2000, computed using its method of accounting, was as follows:

----------------------------------------------------------------------------------------------------------------
                                                              (I) Base-year    (II) Inflation      (III) LIFO
                           Layer                                  cost              index        value: (I)*(II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $105,000              1.00          $105,000
1998 layer................................................             3,000              1.40             4,200
                                                           ------------------                  -----------------
    Total.................................................           108,000  ................           109,200
----------------------------------------------------------------------------------------------------------------

    (ii) Upon examining Z's federal income tax return for the taxable 
year ending December 31, 2000, the examining agent determines that Z's 
dollar-value LIFO method does not clearly reflect income. The examining 
agent chooses to change Z to the double-extension IPIC method for 2000 
and implements the change using the simplified transition method as 
follows. First, the inventory in Z's dollar-value pool at the end of 
2000 is assigned to the most-detailed categories in the CPI or PPI, 
whichever is appropriate. Assume that 80 percent of the current-year 
cost of Z's inventory as of December 31, 2000, is assigned

[[Page 621]]

to Category 1, 10 percent is assigned to Category 2, and 10 percent is 
assigned to Category 3. Assume further that the current-year cost of the 
inventory in Z's dollar-value pool at the end of 1998 and 1999 was 
$133,000 and $145,000, respectively.
    (iii) The category inflation indexes for 1998 computed under the 
double-extension IPIC method are 1.17 for Category 1, 1.26 for Category 
2, and 1.19 for Category 3. The weights to be used in computing the IPI 
for 1998 are $106,400 ($133,000 * 80 percent) for Category 1, $13,300 
($133,000 * 10 percent) for Category 2, and $13,300 ($133,000 * 10 
percent) for Category 3. The IPI for 1998 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                (II) Category    (III) Quotient:
                         Category                              (I) Weight      inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
1.........................................................          $106,400              1.17            90,940
2.........................................................            13,300              1.26            10,556
3.........................................................            13,300              1.19            11,176
                                                           ------------------                  -----------------
    Total.................................................           133,000  ................           112,672
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                     (V) Sum of (weight/
                        (IV) Sum of weights                           category inflation    (VI) Inventory price
                                                                            index)            index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$133,000..........................................................              $112,672               1.180417
----------------------------------------------------------------------------------------------------------------

    (iv) The base-year cost of the inventory in Z's pool at the end of 
1998 is $112,672 ($133,000/1.180417), and the base-year cost of the 1998 
increment is $7,672 ($112,672-$105,000). The LIFO value of the 1998 
layer is $9,056 ($7,672 x 1.180417).
    (v) The category inflation indexes for 1999 computed under the 
double-extension IPIC method were 1.21 for Category 1, 1.29 for Category 
2 and 1.23 for Category 3. The weights to be used in computing the IPI 
for 1999 are $116,000 ($145,000 x 80 percent) for Category 1, $14,500 
($145,000 x 10 percent) for Category 2, and $14,500 ($145,000 x 10 
percent) for Category 3. The IPI for 1999 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                (II) Category    (III) Quotient:
                         Category                              (I) Weight      inflation index      (I)/(II)
----------------------------------------------------------------------------------------------------------------
1.........................................................          $116,000              1.21           $95,868
2.........................................................            14,500              1.29            11,240
3.........................................................            14,500              1.23            11,789
                                                           ------------------                  -----------------
    Total.................................................           145,000  ................           118,897
----------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------
                                                                     (V) Sum of (weight/
                        (IV) Sum of weights                           category inflation    (VI) Inventory price
                                                                            index)            index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$145,000..........................................................              $118,897               1.219543
----------------------------------------------------------------------------------------------------------------

    (vi) The base-year cost of the inventory in Z's pool at the end of 
1999 is $118,897 ($145,000/1.219543), and the base-year cost of the 1999 
layer is $6,225 ($118,897-$112,672). The LIFO value of the 1999 layer is 
$7,592 ($6,225 x 1.219543).
    (vii) The LIFO value of Z's dollar-value pool at the end of 1999 
computed under the double-extension IPIC method is as follows:

----------------------------------------------------------------------------------------------------------------
                                                              (I) Base-year    (II) Inventory      (III) LIFO
                           Layer                                  cost           price index     value: (I)*(II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................          $105,000          1.000000          $105,000
1998 layer................................................             7,672          1.180417             9,056
1999 layer................................................             6,225          1.219542             7,592
(((((((((((((((((((((((((((((((((((((((((((((((((((((((((((
    Total.................................................           118,897  ................           121,648
----------------------------------------------------------------------------------------------------------------


[[Page 622]]

    (viii) The section 481(a) adjustment is equal to the difference 
between the LIFO value of the inventory at the beginning of 2000 
computed under Z's former method of accounting and recomputed by the 
examining agent under the double-extension IPIC method, or $12,448 
($121,648--$109,200).
    (ix) Finally, the examining agent will recompute Z's taxable income 
for 2000 and succeeding taxable years using the double-extension IPIC 
method.

    (v) Effective date--(A) In general. The rules of this paragraph 
(e)(3) and paragraphs (b)(4) and (c)(2) of this section are applicable 
for taxable years ending on or after December 31, 2001.
    (B) Change in method of accounting. Any change in a taxpayer's 
method of accounting necessary to comply with this paragraph (e)(3) or 
with paragraphs (b)(4) or (c)(2) of this section is a change in method 
of accounting to which the provisions of section 446 and the regulations 
thereunder apply. For the first or second taxable year ending on or 
after December 31, 2001, a taxpayer is granted the consent of the 
Commissioner to change its method of accounting to a method required or 
permitted by this paragraph (e)(3) and paragraphs (b)(4) and (c)(2) of 
this section. A taxpayer that wants to change its method of accounting 
under this paragraph (e)(3)(v) must follow the automatic consent 
procedures in Rev. Proc. 2002-9 (2002-3 I.R.B. xxx) (see Sec.  
601.601(d)(2) of this chapter). However, the scope limitations in 
section 4.02 of Rev. Proc. 2002-9 do not apply, and the five-year 
limitation on the readoption of the LIFO method under section 10.01(2) 
of the appendix is waived. In addition, if the taxpayer's method of 
accounting for its LIFO inventories is an issue under consideration at 
the time the application is filed with the national office, the audit 
protection of section 7 of Rev. Proc. 2002-9 does not apply. If a 
taxpayer changing its method of accounting under this paragraph 
(e)(3)(v)(B) is under examination, before an appeals office, or before a 
federal court with respect to any income tax issue, the taxpayer must 
provide a copy of the application to the examining agent(s), appeals 
officer or counsel for the government, as appropriate, at the same time 
it files the application with the national office. Any change under this 
paragraph (e)(3)(v)(B) must be made using a cut-off method and new base 
year. See paragraph (e)(3)(iv)(B)(1) of this section for an example of 
this computation. Because a change under this paragraph (e)(3)(v)(B) is 
made using a cut-off method, a section 481(a) adjustment is not 
permitted. However, a taxpayer changing its method of accounting under 
this paragraph (e)(3)(v)(B) must comply with the requirements of section 
10.06(3) of the APPENDIX of Rev. Proc. 2002-9 (concerning bargain 
purchases).
    (f) Change to dollar-value method from another method of pricing 
LIFO inventories--(1) Consent required. Except as provided in Sec.  
1.472-3 in the case of a taxpayer electing to use a LIFO inventory 
method for the first time, or in the case of a taxpayer changing to the 
dollar-value method and continuing to use the same pools as were used 
under another LIFO method, a taxpayer using another LIFO method of 
pricing inventories may not change to the dollar-value method of pricing 
such inventories unless he first secures the consent of the Commissioner 
in accordance with paragraph (e) of Sec.  1.446-1.
    (2) Method of converting inventory. Where the taxpayer changes from 
one method of pricing LIFO inventories to the dollar-value method, the 
ending LIFO inventory for the taxable year immediately preceding the 
year of change shall be converted to the dollar-value LIFO method. This 
is done to establish the base-year cost for subsequent calculations. 
Thus, if the taxpayer was previously valuing LIFO inventories on the 
specific goods method, these separate values shall be combined into 
appropriate pools. For this purpose, the base year for the pool shall be 
the earliest taxable year for which the LIFO inventory method had been 
adopted for any item in that pool. No change will be made in the overall 
LIFO value of the opening inventory for the year of change as a result 
of the conversion, and that inventory will merely be restated in the 
manner used under the dollar-value method. All layers of increment for 
such inventory must be retained, except that all layers of increment 
which occurred in the same taxable year must be combined.

[[Page 623]]

The following examples illustrate the provisions of this subparagraph:

    Example 1. (i) Assume that the taxpayer has used another LIFO method 
for finished goods since 1954 and has complied with all the requirements 
prerequisite for a change to the dollar-value method. Items A, B, and C, 
which have previously been inventoried under the specific goods LIFO 
method, may properly be included in a single dollar-value LIFO pool. The 
LIFO inventory value of items A, B, and C at December 31, 1960, is 
$12,200, computed as follows:

------------------------------------------------------------------------
                                                                Dec. 31,
                                             Base                1960,
                  Year                     quantity     Unit   inventory
                                          and yearly    cost    at LIFO
                                          increments             value
------------------------------------------------------------------------
                 Item A
1954 (base year)........................         100       $1       $100
1955....................................         200        2        400
1956....................................         100        4        400
1960....................................         100        6        600
                                         ------------         ----------
   Total................................         500  .......      1,500
 
                 Item B
 
1954 (base year)........................         300        6      1,800
1955....................................         100        8        800
1960....................................          50       10        500
                                         ------------         ----------
   Total................................         450  .......      3,100
 
                 Item C
 
1954 (base year)........................       1,000        4      4,000
1955....................................         200        6      1,200
1956....................................         300        8      2,400
                                         ------------         ----------
  Total.................................       1,500  .......      7,600
                                         ============
  LIFO value of items A, B, and C at      ..........  .......     12,200
   Dec. 31, 1960........................
------------------------------------------------------------------------


There were no increments in the years 1957, 1958, or 1959.
    (ii) The computation of the ratio of the total current-year cost to 
the total base-year cost for the base year and each layer of increment 
in Pool No. 1 is shown as follows:

----------------------------------------------------------------------------------------------------------------
                                                       1954                              Increments
                                                      base-               --------------------------------------
                        Item                           year    Year 1954
                                                       unit                    1955         1956         1960
                                                       cost
----------------------------------------------------------------------------------------------------------------
                         A
 
Base-year cost.....................................    $1.00         $100         $200         $100         $100
LIFO value.........................................  .......          100          400          400          600
                         B
 
Base-year cost.....................................     6.00        1,800          600  ...........          300
LIFO value.........................................  .......        1,800          800  ...........          500
 
                         C
 
Base-year cost.....................................     4.00        4,000          800        1,200  ...........
LIFO value.........................................  .......        4,000        1,200        2,400  ...........
                                                             ---------------------------------------------------
Total--Base-year cost..............................    5,900        1,600        1,300          400
Total--LIFO value..................................    5,900        2,400        2,800        1,100
                                                             ===================================================
Ratio of total current-year cost to total base-year  .......       100.00       150.00       215.38       275.00
 cost (percent)....................................
----------------------------------------------------------------------------------------------------------------

    (iii) On the basis of the foregoing computations, the LIFO inventory 
of Pool No. 1, at December 31, 1960, is restated as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                                      total
                                        Dec. 31,    current-    Dec. 31,
                                          1960,     year cost    1960,
                                        inventory   to total   inventory
                                        at base-    base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
1954 base cost.......................      $5,900      100.00     $5,900
1955 increment.......................       1,600      150.00      2,400
1956 increment.......................       1,300      215.38      2,800
1960 increment.......................         400      275.00      1,100
                                      ------------            ----------
    Total............................       9,200  ..........     12,200
------------------------------------------------------------------------

    Example 2. Assume the same facts as in Example 1 and assume further 
that the base-year cost of Pool No. 1 at December 31, 1961, is $8,350. 
Since the closing inventory for the taxable year 1961 at base-year cost 
is less than the opening inventory for that year at base-year cost, a 
liquidation has occurred during 1961. This liquidation absorbs all of 
the 1960 layer of increment and part of the 1956 layer of increment. The 
December 31, 1961, inventory is $10,131, computed as follows:

[[Page 624]]



------------------------------------------------------------------------
                                                    Ratio of
                                                      total
                                        Dec. 31,    current-    Dec. 31,
                                          1961,     year cost    1961,
                                        inventory   to total   inventory
                                        at base-    base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
1954 base cost.......................      $5,900      100.00     $5,900
1955 increment.......................       1,600      150.00      2,400
1956 increment.......................         850      215.38      1,831
                                      ------------            ----------
    Total............................       8,350  ..........     10,131
------------------------------------------------------------------------

    (g) Transitional rules--(1) Change in method of pooling. Any method 
of pooling authorized by this section and used by the taxpayer in 
computing his LIFO inventories under the dollar-value method shall be 
treated as a method of accounting. Any method of pooling which is 
authorized by this section shall be used for the year of adoption and 
for all subsequent taxable years unless a change is required by the 
Commissioner in order to clearly reflect income, or unless permission to 
change is granted by the Commissioner as provided in paragraph (e) of 
Sec.  1.446-1. Where the taxpayer changes from one method of pooling to 
another method of pooling permitted by this section, the ending LIFO 
inventory for the taxable year preceding the year of change shall be 
restated under the new method of pooling.
    (2) Manner of combining or separating dollar-value pools. (i) A 
taxpayer who has been using the dollar-value LIFO method and who is 
permitted or required to change his method of pooling, shall combine or 
separate the LIFO value of his inventory for the base year and each 
yearly layer of increment in order to conform to the new pool or pools. 
Each yearly layer of increment in the new pool or pools must be 
separately accounted for and a record thereof maintained, and any 
liquidation occurring in the new pool or pools subsequent to the 
formation thereof shall be treated in the same manner as if the new pool 
or pools had existed from the date the taxpayer first adopted the LIFO 
inventory method. The combination or separation of the LIFO value of his 
inventory for the base year and each yearly layer of increment shall be 
made in accordance with the appropriate method set forth in this 
subparagraph, unless the use of a different method is approved by the 
Commissioner.
    (ii) Where the taxpayer is permitted or required to separate a pool 
into more than one pool, the separation shall be made in the following 
manner: First, each item in the former pool shall be placed in an 
appropriate new pool. Every item in each new pool is then extended at 
its base-year unit cost and the extensions are totaled. Each total is 
the amount of inventory for each new pool expressed in terms of base-
year cost. Then a ratio of the total base-year cost of each new pool to 
the base-year cost of the former pool is computed. The resulting ratio 
is applied to the amount of inventory for the base year and each yearly 
layer of increment of the former pool to obtain an allocation to each 
new pool of the base-year inventory of the former pool and subsequent 
layers of increment thereof. The foregoing may be illustrated by the 
following example of a change for the taxable year 1961:

    Example. (a) Assume that items A, B, C, and D are all grouped 
together in one pool prior to December 31, 1960. The LIFO inventory 
value at December 31, 1960, is computed as follows:

------------------------------------------------------------------------
                                                   Pool ABCD
                                      ----------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1956, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
Jan. 1, 1956, base cost..............     $10,000         100    $10,000
Dec. 31, 1956, increment.............       1,000         110      1,100
Dec. 31, 1958, increment.............       5,000         120      6,000
Dec. 31, 1960, increment.............       4,000         125      5,000
                                      ------------            ----------
  Total..............................      20,000  ..........     22,100
------------------------------------------------------------------------

    (b) The extension of the quantity of items A, B, C, and D at 
respective base-year unit costs is as follows:

------------------------------------------------------------------------
                                                         Base-
                                                         year
                    Item                     Quantity    unit     Amount
                                                         cost
------------------------------------------------------------------------
A..........................................    2,000         $2   $4,000
B..........................................    1,000          3    3,000
C..........................................    1,000          5    5,000
D..........................................    4,000          2    8,000
                                                                --------
    Total..................................  ........  ........   20,000
------------------------------------------------------------------------

    (c) Under the provisions of this section the taxpayer separates 
former Pool ABCD into

[[Page 625]]

two pools, Pool AB and Pool CD. The computation of the ratio of total 
base-year cost for each of the new pools to the base-year cost of the 
former pool is as follows:

------------------------------------------------------------------------
                                                 Total
                     Item                      base-year       Ratio
                                                  cost
------------------------------------------------------------------------
Pool AB:
  A..........................................     $4,000  ..............
  B..........................................      3,000  ..............
                                              -----------
                                                   7,000    7,000/20,000
                                              ===========
Pool CD:
  C..........................................      5,000  ..............
  D..........................................      8,000  ..............
                                                  13,000   13,000/20,000
                                              -----------
  Total for pool ABCD........................     20,000  ..............
------------------------------------------------------------------------

    (d) The ratio of the base-year cost of new Pools AB and CD to the 
base-year cost of former Pool ABCD is 7,000/20,000 and 13,000/20,000, 
respectively. The allocation of the January 1, 1956 base cost and 
subsequent yearly layers of increment of former Pool ABCD to new Pools 
AB and CD is as follows:

------------------------------------------------------------------------
                                             Base-year        Pool
                                              cost to  -----------------
                                                 be
                                             allocated     AB       CD
------------------------------------------------------------------------
Jan. 1, 1956, base cost....................    $10,000   $3,500   $6,500
Dec. 31, 1956, increment...................      1,000      350      650
Dec. 31, 1958, increment...................      5,000    1,750    3,250
  Dec. 31, 1960, increment.................      4,000    1,400    2,600
                                            ----------------------------
      Total................................     20,000    7,000   13,000
------------------------------------------------------------------------

    (e) The LIFO value of new Pools AB and CD at December 31, 1960, as 
allocated, is as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1956, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
               Pool AB
Jan. 1, 1956, base cost..............      $3,500         100     $3,500
Dec. 31, 1956, increment.............         350         110        385
Dec. 31, 1958, increment.............       1,750          20      2,100
Dec. 31, 1960, increment.............       1,400         125      1,750
                                      ------------            ----------
      Total..........................       7,000  ..........      7,735
                                      =============
               Pool CD
 
Jan. 1, 1956, base cost..............       6,500         100      6,500
Dec. 31, 1956, increment.............         650         110        715
Dec. 31, 1958, increment.............       3,250         120      3,900
Dec. 31, 1960, increment.............       2,600         125      3,250
                                      ------------            ----------
      Total..........................      13,000  ..........     14,365
------------------------------------------------------------------------

    (iii) Where the taxpayer is permitted or required to combine two or 
more pools having the same base year, they shall be combined into one 
pool in the following manner: The LIFO value of the base-year inventory 
of each of the former pools is combined to obtain a LIFO value of the 
base-year inventory for the new pool. Then, any layers of increment in 
the various pools which occurred in the same taxable year are combined 
into one total layer of increment for that taxable year. However, layers 
of increment which occurred in different taxable years may not be 
combined. In combining the layers of increment a new ratio of current-
year cost to base-year cost is computed for each of the combined layers 
of increment. The foregoing may be illustrated by the following example:

    Example. (a) Assume the taxpayer has two pools at December 31, 1960. 
Under the provisions of this section the taxpayer combines these pools 
into a single pool as of January 1, 1961. The LIFO inventory value of 
each pool at December 31, 1960, is shown as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1957, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
              Pool No. 1
Jan. 1, 1956, base cost..............     $10,000         100    $10,000
Dec. 31, 1957, increment.............       2,000         110      2,200
Dec. 31, 1960, increment.............       1,000         120      1,200
                                      ------------            ----------
      Total..........................      13,000  ..........     13,400
                                      ==================================
              Pool No. 2
 
Jan. 1, 1957, base cost..............       5,000         100      5,000
Dec. 31, 1960, increment.............       3,000         140      4,200
                                      ------------            ----------
      Total..........................       8,000  ..........      9,200
------------------------------------------------------------------------

    (b) The computation of the ratio of the total current-year cost to 
the total base-year cost for the base year and each yearly layer of 
increment in the new pool is as follows:

[[Page 626]]



------------------------------------------------------------------------
                                                          Increments
                                              Base   -------------------
                   Pool                       year    Dec. 31,  Dec. 31,
                                              1957      1957      1960
------------------------------------------------------------------------
No. 1:
  Base-year cost..........................   $10,000    $2,000    $1,000
  LIFO value..............................    10,000     2,200     1,200
No. 2:
  Base-year cost..........................     5,000  ........     3,000
  LIFO value..............................     5,000  ........     4,200
                                           -----------------------------
  Total, base-year cost...................    15,000     2,000     4,000
  Total, LIFO value.......................    15,000     2,200     5,400
                                           =============================
Ratio of total current-year cost to total        100       110       135
 base-year cost (percent).................
------------------------------------------------------------------------

    (c) On the basis of the foregoing computations, the LIFO inventory 
of the new pool at December 31, 1960, is restated as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1957, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
Jan. 1, 1957, base cost..............     $15,000         100    $15,000
Dec. 31, 1957, increment.............       2,000         110      2,200
Dec. 31, 1960, increment.............       4,000         135      5,400
                                      ------------            ----------
      Total..........................      21,000  ..........     22,600
------------------------------------------------------------------------

    (iv) In combining pools having different base years, the principles 
set forth in subdivision (iii) of this subparagraph are to be applied, 
except that all base years subsequent to the earliest base year shall be 
treated as increments, and the base-year costs for all pools having a 
base year subsequent to the earliest base year of any pool shall be 
redetermined in terms of the base cost for the earliest base year. The 
foregoing may be illustrated by the following example:

    Example. (a) Assume that the taxpayer has two pools at December 31, 
1960. Under the provisions of this section the taxpayer combines these 
pools into a single pool as of January 1, 1961. The LIFO inventory value 
of each pool at December 31, 1960, is shown as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,      current    Dec. 31,
                                        inventory   rent-year    1960,
                                       at Jan. 1,    cost to   inventory
                                       1956, base- total base-  at LIFO
                                        year cost   year cost    value
                                                    (percent)
------------------------------------------------------------------------
              Pool No. 1
Jan. 1, 1956, base cost..............      $7,000         100     $7,000
Dec. 31, 1956, increment.............       1,000         105      1,050
Dec. 31, 1957, increment.............         500         110        550
Dec. 31, 1958, increment.............         500         110        550
Dec. 31, 1960, increment.............       1,000         120      1,200
                                      ------------            ----------
      Total..........................      10,000  ..........     10,350
                                      ==================================
              Pool No. 2
 
Jan. 1, 1958, base cost..............       3,500         100      3,500
Dec. 31, 1958, increment.............       1,000         110      1,100
Dec. 31, 1959, increment.............         500         115        575
      Total..........................       5,000  ..........      5,175
------------------------------------------------------------------------

    (b) The next step is to redetermine the 1958 base-year cost for Pool 
No. 2 in terms of 1956 base-year cost. January 1, 1956 base-year unit 
cost must be reconstructed or established in accordance with paragraph 
(e)(2) of this section for each item in Pool No. 2. Such costs are 
assumed to be $9.00 for item A, $20.00 for item B, and $1.80 for item C. 
A ratio of the 1958 total base-year cost to the 1956 total base-year 
cost for Pool No. 2 is computed as follows:

------------------------------------------------------------------------
                                                       Jan. 1,
                                                        1956,    Jan. 1,
                                                        base-     1956,
                   Item                     Quantity    year      base-
                                                        unit      year
                                                        cost      cost
------------------------------------------------------------------------
A.........................................      250      $9.00    $2,250
B.........................................       75      20.00     1,500
C.........................................      500       1.80       900
                                                               ---------
      Total...............................  ........  ........     4,650
                                           -----------------------------
A.........................................      250      10.00     2,500
B.........................................       75      20.00     1,500
C.........................................      500       2.00     1,000
                                                               ---------
      Total...............................  ........  ........     5,000
------------------------------------------------------------------------

    (c) The ratio of the 1956 total base-year cost to the 1958 total 
base-year cost for Pool No. 2 is 4,650/5,000 or 93 percent. The January 
1, 1958 base cost and each yearly layer of increment at 1958 base-year 
cost is multiplied by this ratio. Such computation is as follows:

[[Page 627]]



------------------------------------------------------------------------
                                                               Dec. 31,
                                        Dec. 31,                 1960,
                                          1960,                inventory
                                        inventory    Ratio     restated
                                       at Jan. 1,  (percent)  at Jan. 1,
                                       1958, base-            1956, base-
                                        year cost              year cost
------------------------------------------------------------------------
Jan. 1, 1958, base cost..............      $3,500         93      $3,255
Dec. 31, 1958, increment.............       1,000         93         930
Dec. 31, 1959, increment.............         500         93         465
                                                             -----------
      Total..........................  ..........  .........       4,650
------------------------------------------------------------------------

    (d) The computation of the ratio of the total current-year cost to 
the total base-year cost for the base year (1956) and each yearly layer 
of increment in the new pool is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                 Increments
                                                Base year ------------------------------------------------------
                     Pool                         1956      Dec. 31,   Dec. 31,   Dec. 31,   Dec. 31,   Dec. 31,
                                                              1956       1957       1958       1959       1960
----------------------------------------------------------------------------------------------------------------
No. 1:
  Base-year cost.............................      $7,000     $1,000       $500       $500  .........     $1,000
  LIFO value.................................       7,000      1,050        550        550  .........      1,200
No. 2:
  Base-year cost as restated.................  ..........  .........      3,255        930       $465  .........
  LIFO value.................................  ..........  .........      3,500      1,100        575  .........
                                              ------------------------------------------------------------------
      Total, base-year cost..................       7,000      1,000      3,755      1,430        465      1,000
      Total, LIFO value......................       7,000      1,050      4,050      1,650        575      1,200
                                              ==================================================================
  Ratio of total current-year cost to total        100.00     105.00     107.86     115.38     133.66     120.00
   base-year cost (percent)..................
----------------------------------------------------------------------------------------------------------------

    (e) On the basis of the foregoing computation, the LIFO inventory of 
the new pool at December 31, 1960, is restated as follows:

------------------------------------------------------------------------
                                                    Ratio of
                                        Dec. 31,      total
                                          1960,     current-    Dec. 31,
                                        inventory   year cost    1960,
                                       at Jan. 1,   to total   inventory
                                       1956, base-  base-year   at LIFO
                                        year cost     cost       value
                                                    (percent)
------------------------------------------------------------------------
Jan. 1, 1956, base cost..............      $7,000      100.00     $7,000
Dec. 31, 1956, increment.............       1,000      105.00      1,050
Dec. 31, 1957, increment.............       3,755      107.86      4,050
Dec. 31, 1958, increment.............       1,430      115.38      1,650
Dec. 31, 1959, increment.............         465      123.66        575
Dec. 31, 1960, increment.............       1,000      120.00      1,200
                                      ------------            ----------
      Total..........................      14,650  ..........     15,525
------------------------------------------------------------------------

    (3) Change in methods of computation at the LIFO value of a dollar-
value pool. For the first taxable year beginning after December 31, 
1960, the taxpayer must use a method authorized by paragraph (e)(1) of 
this section in computing the base-year cost and current-year cost of a 
dollar-value inventory pool for the end of such year. If the taxpayer 
had previously used any methods other than one authorized by paragraph 
(e)(1) of this section, he shall not be required to recompute his LIFO 
inventories for taxable years beginning on or before December 31, 1960, 
under a method authorized by such paragraph. The base cost and layers of 
increment previously computed by such other method shall be retained and 
treated as if such base cost and layers of increment had been computed 
under a method authorized by paragraph (e)(1) of this section. The 
taxpayer shall use the year of change as the base year in applying the 
double-extension method or other method approved by the Commissioner, 
instead of the earliest year for which he adopted the LIFO method for 
any items in the pool.
    (h) LIFO inventories received in certain nonrecognition 
transactions--(1) In general. Except as provided in paragraph (h)(3) of 
this section, if inventory items accounted for under the LIFO method are 
received in a transaction described in paragraph (h)(2) of this section, 
then, for the purpose of determining future increments and liquidations, 
the transferee must use the year of transfer as the base year and must 
use its current-year cost (computed under the

[[Page 628]]

transferee's method of accounting) of those items as their new base-year 
cost. If the transferee had opening inventories in the year of transfer, 
then, for the purpose of determining future increments and liquidations, 
the transferee must use its current-year cost (computed under the 
transferee's method of accounting) of those inventories as their new 
base-year cost. For this purpose, ``opening inventory'' refers to all 
items owned by the transferee before the transfer for which the 
transferee uses, or elects to use, the LIFO method. The total new base-
year cost of the transferee's inventory as of the beginning of the year 
of transfer is equal to the new base-year cost of the inventory received 
from the transferor and the new base-year cost of the transferee's 
opening inventory. The index (or, the cumulative index in the case of 
the link-chain method) for the year immediately preceding the year of 
transfer is 1.00. The base-year cost of any layers in the dollar-value 
pool, as determined after the transfer, must be recomputed accordingly. 
See paragraph (e)(3)(iv)(B)(1) of this section for an example of this 
computation.
    (2) Transactions to which this paragraph (h) applies. The rules in 
this paragraph (h) apply to a transaction in which--
    (i) The transferee determines its basis in the inventories, in whole 
or in part, by reference to the basis of the inventories in the hands of 
the transferor;
    (ii) The transferor used the dollar-value LIFO method to account for 
the transferred inventories;
    (iii) The transferee uses the dollar-value LIFO method to account 
for the inventories in the year of the transfer; and
    (iv) The transaction is not described in section 381(a).
    (3) Anti-avoidance rule. The rules in this paragraph (h) do not 
apply to a transaction entered into with the principal purpose to avail 
the transferee of a method of accounting that would be unavailable to 
the transferor (or would be unavailable to the transferor without 
securing consent from the Commissioner). In determining the principal 
purpose of a transfer, consideration will be given to all of the facts 
and circumstances. However, a transfer is deemed made with the principal 
purpose to avail the transferee of a method of accounting that would be 
unavailable to the transferor without securing consent from the 
Commissioner if the transferor acquired inventory in a bargain purchase 
within the five taxable years preceding the year of the transfer and 
used a dollar-value LIFO method to account for that inventory that did 
not treat the bargain purchase inventory and physically identical 
inventory acquired at market prices as separate items. Inventory is 
deemed acquired in a bargain purchase if the actual cost of the 
inventory (or, if appropriate, the allocated cost of the inventory) was 
less than or equal to 50 percent of the replacement cost of physically 
identical inventory. Inventory is not considered acquired in a bargain 
purchase if the actual cost of the inventory (or, if appropriate, the 
allocated cost of the inventory) was greater than or equal to 75 percent 
of the replacement cost of physically identical inventory.
    (4) Effective date. The rules of this paragraph (h) are applicable 
for transfers that occur during a taxable year ending on or after 
December 31, 2001.

[T.D. 6539, 26 FR 518, Jan. 20, 1961, as amended by T.D. 7814, 47 FR 
11272, Mar. 16, 1982; T.D. 8976, 67 FR 1082, Jan. 9, 2002; 67 FR 5062, 
5148, Feb. 4, 2002]



Sec.  1.475-0  Table of contents.

    This section lists the major captions in Sec. Sec.  1.475(a)-3, 
1.475(a)-4, 1.475(b)-1, 1.475(b)-2, 1.475(c)-1, 1.475(c)-2, 1.475(d)-1 
and 1.475(g)-1.

              Sec. Sec.  1.475(a)-1--1.475(a)-2 [Reserved]

     Sec.  1.475(a)-3 Acquisition by a dealer of a security with a 
                           substituted basis.

    (a) Scope.
    (b) Rules.

      Sec.  1.475(a)-4 Safe Harbor for Valuation Under Section 475.

    (a) Overview.
    (1) Purpose.
    (2) Dealer business model.
    (3) Summary of paragraphs.
    (b) Safe harbor.
    (1) General rule.
    (2) Example. Use of eligible and non-eligible methods.
    (3) Scope of the safe harbor.

[[Page 629]]

    (c) Eligible taxpayer.
    (d) Eligible method.
    (1) Sufficient consistency.
    (2) General requirements.
    (i) Frequency.
    (ii) Recognition at the mark.
    (iii) Recognition on disposition.
    (iv) Fair value standard.
    (3) Limitations.
    (i) Bid-ask method.
    (A) General Rule.
    (B) Safe harbor.
    (ii) Valuations based on present values of projected cash flows.
    (iii) Accounting for costs and risks.
    (4) Examples.
    (e) Compliance with other rules.
    (f) Election.
    (1) Making the election.
    (2) Duration of the election.
    (3) Revocation.
    (i) By the taxpayer.
    (ii) By the Commissioner.
    (4) Re-election.
    (g) Eligible positions.
    (h) Applicable financial statement.
    (1) Definition.
    (2) Primary financial statement.
    (i) Statement required to be filed with Securities and Exchange 
Commission (SEC).
    (ii) Statement filed with a Federal agency other than the IRS.
    (iii) Certified audited financial statement.
    (3) Example. Primary financial statement.
    (4) Financial statements of equal priority.
    (5) Consolidated groups.
    (6) Supplement or amendment to a financial statement.
    (7) Certified audited financial statement.
    (i) [Reserved]
    (j) Significant business use.
    (1) In general.
    (2) Financial statement value.
    (3) Management of a business as a dealer.
    (4) Significant use.
    (k) Retention and production of records.
    (1) In general.
    (2) Specific requirements.
    (i) Reconciliation.
    (A) In general.
    (B) Values on books and records with supporting schedules.
    (C) Consolidation schedules.
    (ii) Instructions provided by the Commissioner.
    (3) Time for producing records.
    (4) Retention period for records.
    (5) Agreements with the Commissioner.
    (l) [Reserved]
    (m) Use of different values.

  Sec.  1.475(b)-1 Scope of exemptions from mark-to-market requirement.

    (a) Securities held for investment or not held for sale.
    (b) Securities deemed identified as held for investment.
    (1) In general.
    (2) Relationships.
    (i) General rule.
    (ii) Attribution.
    (iii) Trusts treated as partnerships.
    (3) Securities traded on certain established financial markets.
    (4) Changes in status.
    (i) Onset of prohibition against marking.
    (ii) Termination of prohibition against marking.
    (iii) Examples.
    (c) Securities deemed not held for investment; dealers in notional 
principal contracts and derivatives.
    (d) Special rule for hedges of another member's risk.
    (e) Transitional rules.
    (1) Stock, partnership, and beneficial ownership interests in 
certain controlled corporations, partnerships, and trusts before January 
23, 1997.
    (i) In general.
    (ii) Control defined.
    (iii) Applicability.
    (2) Dealers in notional principal contracts and derivatives acquired 
before January 23, 1997.
    (i) General rule.
    (ii) Exception for securities not acquired in dealer capacity.
    (iii) Applicability.

        Sec.  1.475(b)-2 Exemptions--identification requirements.

    (a) Identification of the basis for exemption.
    (b) Time for identifying a security with a substituted basis.
    (c) Integrated transactions under Sec.  1.1275-6.
    (1) Definitions.
    (2) Synthetic debt held by a taxpayer as a result of legging in.
    (3) Securities held after legging out.

                       Sec.  1.475(b)-3 [Reserved]

           Sec.  1.475(c)-1 Definitions--dealer in securities.

    (a) Dealer-customer relationship.
    (1) [Reserved]
    (2) Transactions described in section 475(c)(1)(B).
    (i) In general.
    (ii) Examples.
    (3) Related parties.
    (i) General rule.
    (ii) Special rule for members of a consolidated group.
    (iii) The intragroup-customer election.
    (A) Effect of election.
    (B) Making and revoking the election.
    (iv) Examples.
    (b) Sellers of nonfinancial goods and services.
    (1) Purchases and sales of customer paper.
    (2) Definition of customer paper.
    (3) Exceptions.

[[Page 630]]

    (4) Election not to be governed by the exception for sellers of 
nonfinancial goods or services.
    (i) Method of making the election.
    (A) Taxable years ending after December 24, 1996.
    (B) Taxable years ending on or before December 24, 1996.
    (ii) Continued applicability of an election.
    (c) Taxpayers that purchase securities from customers but engage in 
no more than negligible sales of the securities.
    (1) Exemption from dealer status.
    (i) General rule.
    (ii) Election to be treated as a dealer.
    (2) Negligible sales.
    (3) Special rules for members of a consolidated group.
    (i) Intragroup-customer election in effect.
    (ii) Intragroup-customer election not in effect.
    (4) Special rules.
    (5) Example.
    (d) Issuance of life insurance products.

                 Sec.  1.475(c)-2 Definitions--security.

    (a) Items that are not securities.
    (b) Synthetic debt that Sec.  1.1275-6(b) treats the taxpayer as 
holding.
    (c) Negative value REMIC residuals acquired before January 4, 1995.
    (1) Description.
    (2) Special rules applicable to negative value REMIC residuals 
acquired before January 4, 1995.

               Sec.  1.475(d)-1 Character of gain or loss.

    (a) Securities never held in connection with the taxpayer's 
activities as a dealer in securities.
    (b) Ordinary treatment for notional principal contracts and 
derivatives held by dealers in notional principal contracts and 
derivatives.

                    Sec.  1.475(g)-1 Effective dates.

[T.D. 8700, 61 FR 67719, Dec. 24, 1996, as amended by T.D. 9328, 72 FR 
32177, June 12, 2007; T.D. 9849, 84 FR 9235, Mar. 14, 2019]



Sec. Sec.  1.475(a)-1--1.475(a)-2  [Reserved]



Sec.  1.475(a)-3  Acquisition by a dealer of a security 
with a substituted basis.

    (a) Scope. This section applies if--
    (1) A dealer in securities acquires a security that is subject to 
section 475(a) and the dealer's basis in the security is determined, in 
whole or in part, by reference to the basis of that security in the 
hands of the person from whom the security was acquired; or
    (2) A dealer in securities acquires a security that is subject to 
section 475(a) and the dealer's basis in the security is determined, in 
whole or in part, by reference to other property held at any time by the 
dealer.
    (b) Rules. If this section applies to a security--
    (1) Section 475(a) applies only to changes in value of the security 
occurring after the acquisition; and
    (2) Any built-in gain or loss with respect to the security (based on 
the difference between the fair market value of the security on the date 
the dealer acquired it and its basis to the dealer on that date) is 
taken into account at the time, and has the character, provided by the 
sections of the Internal Revenue Code that would apply to the built-in 
gain or loss if section 475(a) did not apply to the security.

[T.D. 8700, 61 FR 67720, Dec. 24, 1996]



Sec.  1.475(a)-4  Valuation safe harbor.

    (a) Overview--(1) Purpose. This section sets forth a safe harbor 
that, under certain circumstances, permits taxpayers to elect to use the 
values of positions reported on certain financial statements as the fair 
market values of those positions for purposes of section 475. This safe 
harbor is based on the principle that, if a mark-to-market method used 
for financial reporting is sufficiently consistent with the requirements 
of section 475 and if the financial statement employing that method has 
certain indicia of reliability, then the values used on that financial 
statement may be used for purposes of section 475. If other provisions 
of the Internal Revenue Code or regulations require adjustments to fair 
market value, use of the safe harbor does not eliminate the need for 
those adjustments. See paragraph (e) of this section.
    (2) Dealer business model. The safe harbor is based on the business 
model for a derivatives dealer. Under this model, the dealer seeks to 
capture and profit from bid-ask spreads in the marketplace by entering 
into substantially offsetting positions with customers that will remain 
on the derivatives dealer's books over their terms. Because the 
positions in the aggregate tend to offset each other, the dealer

[[Page 631]]

has achieved a predictable net cash flow (for example, a synthetic 
annuity) that reflects the captured bid-ask spread. This net cash flow 
is generally impervious to market fluctuations in the values on which 
the component derivatives are based. Section 475 requires current 
recognition of the present value of the net cash flow attributable to 
the capture of these spreads.
    (3) Summary of paragraphs. Paragraph (b) of this section sets forth 
the safe harbor. To determine who may use the safe harbor, paragraph (c) 
of this section defines the term ``eligible taxpayer.'' Paragraph (d) of 
this section sets forth the basic requirements for determining whether 
the method used for financial reporting is sufficiently consistent with 
the requirements of section 475. Paragraph (e) of this section describes 
adjustments to the financial statement values that may be required for 
purposes of applying this safe harbor. Paragraph (f) of this section 
describes the procedure for making the safe harbor election and the 
conditions under which the election may be revoked. Paragraph (g) of 
this section provides that the Commissioner will issue a revenue 
procedure that lists the types of securities and commodities that are 
eligible positions for purposes of the safe harbor. Using rules for 
determining priorities among financial statements, paragraph (h) of this 
section defines the term ``applicable financial statement'' and so 
describes the financial statement, if any, whose values may be used in 
the safe harbor. In some cases, as required by paragraph (j) of this 
section, the safe harbor is available only if the taxpayer's operations 
make significant business use of financial statement values. Paragraph 
(k) of this section sets forth requirements for record retention and 
record production. Paragraph (m) of this section provides that the 
Commissioner may use fair market values that clearly reflect income, but 
which differ from values used on the applicable financial statement, if 
an electing taxpayer fails to comply with the recordkeeping and record 
production requirements of paragraph (k) of this section.
    (b) Safe harbor--(1) General rule. Subject to any adjustment 
required by paragraph (e) of this section, if an eligible taxpayer uses 
an eligible method for the valuation of an eligible position on its 
applicable financial statement and the eligible taxpayer is subject to 
the election described in paragraph (f) of this section, the value that 
the eligible taxpayer assigns to that eligible position on its 
applicable financial statement is the fair market value of the eligible 
position for purposes of section 475 and must be used for purposes of 
section 475, even if that value is not the fair market value of the 
position for any other purpose of the internal revenue laws. 
Notwithstanding the rule set forth in this paragraph, the Commissioner 
may, in certain circumstances, use fair market values that clearly 
reflect income but differ from the values used on the applicable 
financial statement. See paragraph (m) of this section.
    (2) Example. Use of eligible and non-eligible methods. X uses 
eligible methods on its applicable financial statement for some, but not 
all, securities and commodities that are eligible positions. When X 
elects into the safe harbor, the election applies to all eligible 
positions for which X has an eligible method. Therefore, once the 
election is in effect, the financial statement values for eligible 
positions for which X has an eligible method are the fair market values 
of those eligible positions for purposes of section 475. Since X, 
however, does not have an eligible method for all eligible positions, 
those eligible positions for which X does not have an eligible method 
remain subject to the fair market value requirements of section 475 as 
set out in case law and otherwise.
    (3) Scope of the safe harbor. The safe harbor may be used only to 
determine values for eligible positions that are properly marked to 
market under section 475. It does not determine whether any positions 
may or may not be subject to mark-to-market accounting under section 
475.
    (c) Eligible taxpayer. An eligible taxpayer is--
    (1) A dealer in securities, as defined in section 475(c)(1); or

[[Page 632]]

    (2) A dealer in commodities, as defined in section 475(e), that is 
subject to an election under section 475(e).
    (d) Eligible method--(1) Sufficient consistency. An eligible method 
is a mark-to-market method that is sufficiently consistent with the 
requirements of a mark-to-market method under section 475. To be 
sufficiently consistent with the requirements of a mark-to-market method 
under section 475, the eligible method must satisfy all of the 
requirements of paragraph (d)(2) and paragraph (d)(3) of this section.
    (2) General requirements. The method--
    (i) Frequency. Must require a valuation of the eligible position no 
less frequently than annually, including a valuation as of the last 
business day of the taxable year;
    (ii) Recognition at the mark. Must recognize into income on the 
income statement for each taxable year mark-to-market gain or loss based 
upon the valuation or valuations described in paragraph (d)(2)(i) of 
this section;
    (iii) Recognition on disposition. Must require, on disposition of 
the eligible position, recognition into income (on the income statement 
for the taxable year of disposition) as if a year-end mark occurred 
immediately before such disposition; and
    (iv) Fair value standard. Must require use of a valuation standard 
that arrives at fair value in accordance with U.S. Generally Accepted 
Accounting Principles (U.S. GAAP).
    (3) Limitations--(i) Bid-ask method--(A) General rule. Except for 
eligible positions that are traded on a qualified board or exchange, as 
defined in section 1256(g)(7), or eligible positions that the 
Commissioner designates in a revenue procedure or other published 
guidance, the valuation standard used must not, other than on a de 
minimis portion of a taxpayer's positions, permit values at or near the 
bid or ask value. Consequently, the valuation method described in Sec.  
1.471-4(a)(1) fails to satisfy this paragraph (d)(3)(i)(A).
    (B) Safe harbor. The restriction in paragraph (d)(3)(i)(A) of this 
section is satisfied if the method consistently produces values that are 
closer to the mid-market values than they are to the bid or ask values.
    (ii) Valuations based on present values of projected cash flows. If 
the method of valuation consists of projecting cash flows from an 
eligible position or positions and determining the present value of 
those cash flows, the method must not take into account any cash flows 
attributable to a period or time on or before the valuation date. In 
addition, adjustment of the gain or loss recognized on the mark may be 
required with respect to payments that will be made after the valuation 
date to the extent that portions of the payments have been recognized 
for tax purposes before the valuation and appropriate adjustment has not 
been made for purposes of determining financial statement value.
    (iii) Accounting for costs and risks. Valuations may account for 
appropriate costs and risks, but no cost or risk may be accounted for 
more than once, either directly or indirectly. Further, no valuation 
adjustment for any cost or risk may be made for purposes of this safe 
harbor if that valuation adjustment is not also permitted by, and taken 
for, U.S. GAAP purposes on the taxpayer's applicable financial 
statement. If appropriate, the costs and risks that may be accounted for 
include, but are not limited to, credit risk (appropriately adjusted for 
any credit enhancement), future administrative costs, and model risk. An 
adjustment for credit risk is implicit in computing the present value of 
cash flows using a discount rate greater than a risk-free rate. 
Accordingly, a determination of whether any further downward adjustment 
to value for credit risk is warranted, or whether an upward adjustment 
is required, must take that implicit adjustment into consideration.
    (4) Examples. The following examples illustrate this paragraph (d):

    Example 1. (i) X, a calendar year taxpayer, is a dealer in 
securities within the meaning of section 475(c)(1). X generally 
maintains a balanced portfolio of interest rate swaps and other interest 
rate derivatives, capturing bid-ask spreads and keeping its market 
exposure within desired limits (using, if necessary, additional 
derivatives for this purpose). X uses a mark-to-market method on a 
statement that it is required to file with the United States Securities 
and Exchange Commission and that satisfies paragraph (d)(2) of

[[Page 633]]

this section with respect to both the contracts with customers and the 
additional derivatives. When determining the amount of any gain or loss 
realized on a sale, exchange, or termination of a position, X makes a 
proper adjustment for amounts taken into account respecting payments or 
receipts. X and all of its counterparties on the derivatives have the 
same general credit quality as each other.
    (ii) Under X's valuation method, as of each valuation date, X 
determines a mid-market probability distribution of future cash flows 
under the derivatives and computes the present values of these cash 
flows. In computing these present values, X uses an industry standard 
yield curve that is appropriate for obligations by persons with this 
same general credit quality. In addition, based on information that 
includes its own knowledge about the counterparties, X adjusts some of 
these present values either upward or downward to reflect X's reasonable 
judgment about the extent to which the true credit status of each 
counterparty's obligation, taking credit enhancements into account, 
differs from the general credit quality used in the yield curve to 
present value the derivatives.
    (iii) X's methodology does not violate the requirement in paragraph 
(d)(3)(iii) of this section that the same cost or risk not be taken into 
account, directly or indirectly, more than once.
    (iv) Applicability date. This Example 1 applies to valuations of 
securities on or after July 6, 2011.
    Example 2. (i) The facts are the same as in Example 1, except that X 
uses a better credit quality in determining the yield curve to discount 
the payments to be received under the derivatives. Based on information 
that includes its own knowledge about the counterparties, X adjusts 
these present values to reflect X's reasonable judgment about the extent 
to which the true credit status of each counterparty's obligation, 
taking credit enhancements into account, differs from this better credit 
quality obligation.
    (ii) X's methodology does not violate the requirement in paragraph 
(d)(3)(iii) of this section that the same cost or risk not be taken into 
account, directly or indirectly, more than once.
    (iii) Applicability date. This Example 2 applies to valuations of 
securities on or after July 6, 2011.
    Example 3. (i) The facts are the same as in Example 1, except that, 
after computing present values using the discount rates that are 
appropriate for obligors with the same general credit quality, and based 
on information that includes X's own knowledge about the counterparties, 
X adjusts some of these present values either upward or downward to 
reflect X's reasonable judgment about the extent to which the true 
credit status of each counterparty's obligation, taking credit 
enhancements into account, differs from a better credit quality.
    (ii) X's methodology violates the requirement in paragraph 
(d)(3)(iii) of this section that the same cost or risk not be taken into 
account, directly or indirectly, more than once. By using the same 
general credit quality discount rate, X's method takes into account the 
difference between risk-free obligations and obligations with that lower 
credit quality. By adjusting values for the difference between a higher 
credit quality and that lower credit quality, X takes into account risks 
that it had already accounted for through the discount rates that it 
used. The same result would occur if X judged some of its 
counterparties' obligations to be of a higher credit quality but X 
failed to adjust the values of those obligations to reflect the 
difference between a higher credit quality and the lower credit quality.
    (iii) Applicability date. This Example 3 applies to valuations of 
securities on or after July 6, 2011.
    Example 4. (i) The facts are the same as in Example 1, except that X 
determines the mid-market value for each derivative and then subtracts 
the corresponding part of the bid-ask spread.
    (ii) X's methodology violates the rule in paragraph (d)(3)(i) of 
this section that forbids valuing positions at or near the bid or ask 
value.
    Example 5. (i) The facts are the same as in Example 1, and, in 
addition, X's adjustments for all risks and costs, including credit 
risk, future administrative costs and model risk, may occasionally cause 
the adjusted value of an eligible position to be at or near the bid 
value or ask value.
    (ii) X's methodology does not violate the rule in paragraph 
(d)(3)(i)(A) of this section that forbids valuing eligible positions at 
or near the bid or ask value.

    (e) Compliance with other rules. Notwithstanding any other 
provisions of this section, the fair market values for purposes of the 
safe harbor must be consistent with section 482, or rules that adopt 
section 482 principles, when applicable. For example, if a notional 
principal contract is subject to section 482 or section 482 principles, 
the values of future cash flows taken into account in determining the 
value of the contract for purposes of section 475 must be consistent 
with section 482.
    (f) Election--(1) Making the election. Unless the Commissioner 
prescribes otherwise, an eligible taxpayer elects under this section by 
filing with the Commissioner a statement declaring

[[Page 634]]

that the taxpayer makes the safe harbor election in this section for all 
eligible positions for which it has an eligible method. In addition to 
any other information that the Commissioner may require, the statement 
must describe the taxpayer's applicable financial statement for the 
first taxable year for which the election is effective and must state 
that the taxpayer agrees to provide upon the request of the Commissioner 
all information, records, and schedules in the manner required by 
paragraph (k) of this section. The statement must be attached to a 
timely filed Federal income tax return (including extensions) for the 
taxable year for which the election is first effective.
    (2) Duration of the election. Once made, the election continues in 
effect for all subsequent taxable years unless revoked.
    (3) Revocation--(i) By the taxpayer. An eligible taxpayer that is 
subject to an election under this section may revoke the election only 
with the consent of the Commissioner.
    (ii) By the Commissioner. The Commissioner, after consideration of 
the relevant facts and circumstances, may revoke an election under this 
section, effective beginning with the first open year for which the 
election is effective or with any subsequent year, if--
    (A) The taxpayer fails to comply with paragraph (k) of this section 
(concerning record retention and production) and the taxpayer does not 
show reasonable cause for this failure;
    (B) The taxpayer ceases to have an applicable financial statement or 
ceases to use an eligible method; or
    (C) For any other reason, no more than a de minimis number of 
eligible positions, or no more than a de minimis fraction of the 
taxpayer's eligible positions, are covered by the safe harbor in 
paragraph (b) of this section.
    (4) Re-election. If an election is revoked, either by the 
Commissioner or by the taxpayer, the taxpayer (or any successor in 
interest of the taxpayer) may not make the election without the consent 
of the Commissioner for any taxable year that begins before the date 
that is six years after the first day of the earliest taxable year 
affected by the revocation.
    (g) Eligible positions. For any taxpayer, an eligible position is 
any security or commodity that the Commissioner in a revenue procedure 
or other published guidance designates as an eligible position with 
respect to that taxpayer for purposes of this safe harbor.
    (h) Applicable financial statement--(1) Definition. An eligible 
taxpayer's applicable financial statement for a taxable year is the 
taxpayer's primary financial statement for that year if that primary 
financial statement is described in paragraph (h)(2)(i) of this section 
(concerning statements required to be filed with the SEC) or if that 
primary financial statement both meets the requirements of paragraph (j) 
of this section (concerning significant business use) and is described 
in either paragraph (h)(2)(ii) or (iii) of this section. Otherwise, or 
if the taxpayer does not have a primary financial statement for the 
taxable year, the taxpayer does not have an applicable financial 
statement for the taxable year.
    (2) Primary financial statement. For any taxable year, an eligible 
taxpayer's primary financial statement is the financial statement, if 
any, described in one or more of paragraphs (h)(2)(i), (ii), and (iii) 
of this section. If more than one financial statement of the taxpayer 
for the year is so described, the primary financial statement is the one 
first described in paragraphs (h)(2)(i), (ii), and (iii) of this 
section. A taxpayer has only one primary financial statement for any 
taxable year.
    (i) Statement required to be filed with the Securities and Exchange 
Commission (SEC). A financial statement that is prepared in accordance 
with U.S. GAAP and that is required to be filed with the SEC, such as 
the 10--K or the Annual Statement to Shareholders.
    (ii) Statement filed with a Federal agency other than the Internal 
Revenue Service. A financial statement that is prepared in accordance 
with U.S. GAAP and that is required to be provided to the Federal 
government or any of its agencies other than the Internal Revenue 
Service (IRS).
    (iii) Certified audited financial statement. A certified audited 
financial statement that is prepared in accordance with U.S. GAAP; that 
is given to

[[Page 635]]

creditors for purposes of making lending decisions, given to equity 
holders for purposes of evaluating their investment in the eligible 
taxpayer, or provided for other substantial non-tax purposes; and that 
the taxpayer reasonably anticipates will be directly relied on for the 
purposes for which it was given or provided.
    (3) Example. Primary financial statement. X prepares financial 
statement FS1, which is required to be filed with a Federal government 
agency other than the SEC or the IRS. FS1 is thus described in paragraph 
(h)(2)(ii) of this section. X also prepares financial statement FS2, 
which is a certified audited financial statement that is given to 
creditors and that X reasonably anticipates will be relied on for 
purposes of making lending decisions. FS2 is thus described in paragraph 
(h)(2)(iii) of this section. Because FS1, which is described in 
paragraph (h)(2)(ii) of this section, is described before FS2, which is 
described in paragraph (h)(2)(iii) of this section, FS1 is X's primary 
financial statement.
    (4) Financial statements of equal priority. If the rules of 
paragraph (h)(2) of this section cause two or more financial statements 
to be of equal priority, then the statement that results in the highest 
aggregate valuation of eligible positions being marked to market under 
section 475 is the primary financial statement.
    (5) Consolidated groups. If the taxpayer is a member of an 
affiliated group that files a consolidated return, the primary financial 
statement of the taxpayer is the primary financial statement, if any, of 
the common parent (within the meaning of section 1504(a)(1)) of the 
consolidated group.
    (6) Supplement or amendment to a financial statement. A financial 
statement includes any supplement or amendment to the financial 
statement.
    (7) Certified audited financial statement. For purposes of this 
paragraph (h), a financial statement is a certified audited financial 
statement if it is certified by an independent certified public 
accountant from a Registered Public Accounting firm, as defined in 
section 2(a)(12) of the Sarbanes-Oxley Act of 2002, Public Law 107-204, 
116 Stat. 746 (July 30, 2002), 15 U.S.C. Sec.  7201(a)(12), and rules 
promulgated under that Act, and is--
    (i) Certified to be fairly presented (a ``clean'' opinion);
    (ii) Certified to be fairly presented subject to a concern about a 
contingency, other than a contingency relating to the value of eligible 
positions (a qualified ``subject to'' opinion); or
    (iii) Certified to be fairly presented except for a method of 
accounting with which the Certified Public Accountant disagrees and 
which is not a method used to determine the value of an eligible 
position held by the eligible taxpayer (a qualified ``except for'' 
opinion).
    (i) [Reserved]
    (j) Significant business use--(1) In general. A financial statement 
is described in this paragraph (j) if--
    (i) The financial statement contains values for eligible positions;
    (ii) The eligible taxpayer makes significant use of financial 
statement values in most of the significant management functions of its 
business; and
    (iii) That use is related to the management of all or substantially 
all of the eligible taxpayer's business.
    (2) Financial statement value. For purposes of this paragraph (j), 
the term financial statement value means--
    (i) A value that is taken from the financial statement; or
    (ii) A value that is produced by a process that is in all respects 
identical to the process that produces the values that appear on the 
financial statement but that is not taken from the statement because 
either--
    (A) The value was determined as of a date for which the financial 
statement does not value eligible positions; or
    (B) The value is used in the management of the business before the 
financial statement has been prepared.
    (3) Management functions of a business. For purposes of this 
paragraph (j), the term management functions of a business refers to the 
financial and commercial oversight of the business. Oversight includes, 
but is not limited to, senior management review of business-unit 
profitability, market risk measurement or management, credit risk 
measurement or management, internal allocation of capital, and 
compensation of personnel. Management functions of

[[Page 636]]

a business do not include either tax accounting or reporting the results 
of operations to persons other than directors or employees.
    (4) Significant use. If an eligible taxpayer uses financial 
statement values for some significant management functions and uses 
values that are not financial statement values for other significant 
management functions, then the determination of whether the taxpayer has 
made significant use of the financial statement values is made on the 
basis of all the facts and circumstances. This determination must 
particularly take into account whether the taxpayer's reliance on the 
financial statement values exposes the taxpayer to material adverse 
economic consequences if the values are incorrect.
    (k) Retention and production of records--(1) In general. In addition 
to all records that section 6001 otherwise requires to be retained, an 
eligible taxpayer subject to the election provided by this section must 
keep, and timely provide to the Commissioner upon request, records and 
books of account that are sufficient to establish that the financial 
statement to which the income tax return conforms is the taxpayer's 
applicable financial statement, that the method used on that statement 
is an eligible method, and that the values used for eligible positions 
for purposes of section 475 are the values used in the applicable 
financial statement. This obligation extends to all records and books 
that are required to be maintained for any period for financial or 
regulatory reporting purposes, even if these records or books may not 
otherwise be specifically covered by section 6001. All records and books 
described in this paragraph (k) must be maintained for the period 
described in paragraph (k)(4) of this section, even if a lesser period 
of retention applies for financial statement or regulatory purposes.
    (2) Specific requirements--(i) Verification and reconciliation. 
Unless the Commissioner otherwise provides--
    (A) In general. An eligible taxpayer must provide books and records 
to verify the appropriate use of the safe harbor and reconciliation 
schedules between the applicable financial statement for the taxable 
year and the Federal income tax return for that year. The required 
verification materials and reconciliation schedules include all 
supporting schedules, exhibits, computer programs, and any other 
information used in producing the values and schedules, including the 
documentation of rules and procedures governing determination of the 
values. The required reconciliation schedules must also include a 
detailed explanation of any adjustments necessitated by the imperfect 
overlap between the eligible positions that the taxpayer marks to market 
under section 475 and the eligible positions for which the applicable 
financial statement uses an eligible method. In the time and manner 
provided by the Commissioner, a corporate taxpayer subject to this 
paragraph (k) must reconcile the net income amount reported on its 
applicable financial statement to the amount reported on the applicable 
forms and schedules on its Federal income tax return (such as the 
Schedule M-1, ``Net Income(Loss) Reconciliation for Corporations With 
Total Assets of $10 Million or More''; Schedule M-3, ``Net Income(Loss) 
Reconciliation for Corporations With Total Assets of $10 Million or 
More''; and Form 1120F, ``U.S. Income Tax Return of a Foreign 
Corporation''). Eligible taxpayers that are not otherwise required to 
file a Schedule M-1 or Schedule M-3 must reconcile net income using 
substitute schedules similar to Schedule M-1 and Schedule M-3, and these 
substitute schedules must be attached to the return.
    (B) Values on books and records with supporting schedules. The books 
and records must state the value used for each eligible position 
separately from the value used for any other eligible position. However, 
an eligible taxpayer may make adjustments to values on a pooled basis, 
if the taxpayer demonstrates that it can compute gain or loss 
attributable to the sale or other disposition of an individual eligible 
position.
    (C) Consolidation schedules. An eligible taxpayer must provide a 
schedule showing the consolidation and de-consolidation that is used in 
preparing the applicable financial statement, along

[[Page 637]]

with exhibits and subordinate schedules. This schedule must provide 
information that addresses the differences for consolidation and de-
consolidation between the applicable financial statement and the Federal 
income tax return.
    (ii) Instructions provided by the Commissioner. The Commissioner may 
provide an alternative time or manner in which an eligible taxpayer 
subject to this paragraph (k) must establish that the same values used 
for eligible positions on the applicable financial statement are also 
the values used for purposes of section 475 on the Federal income tax 
return.
    (3) Time for producing records. All documents described in this 
paragraph (k) must be produced within 30 days of a request by the 
Commissioner, unless the Commissioner grants a written extension. 
Generally, the Commissioner will exercise his discretion to excuse a 
minor or inadvertent failure to provide requested documents if the 
taxpayer shows reasonable cause for the failure, has made a good faith 
effort to comply with the requirement to produce records, and promptly 
remedies the failure. For failures to maintain, or timely produce, 
records, see paragraph (f)(3)(ii) of this section (allowing the 
Commissioner to revoke the election), and see paragraph (m) of this 
section (allowing the Commissioner, but not the taxpayer, to use for 
eligible positions that otherwise might be subject to the safe harbor 
fair market values that clearly reflect income but that are different 
from the values used on the applicable financial statement).
    (4) Retention period for records. All materials required by this 
paragraph (k) and section 6001 must be retained as long as their 
contents may become material in the administration of any internal 
revenue law.
    (5) Agreements with the Commissioner. The Commissioner and an 
eligible taxpayer may enter into a written agreement that establishes, 
for purposes of this paragraph (k), which records must be maintained, 
how they must be maintained, and for how long they must be maintained.
    (l) [Reserved]
    (m) Use of different values. If, with respect to the records that 
relate to certain eligible positions for a taxable year, the taxpayer 
fails to satisfy paragraph (k) of this section (concerning record 
retention and record production), then, for those eligible positions for 
that year, the Commissioner may use values that the Commissioner 
determines to be fair market values that are appropriate to clearly 
reflect income, even if the values so determined are different from the 
values reported for those positions on the applicable financial 
statement. See also paragraph (f)(3)(ii) of this section (concerning 
revocation of the election by the Commissioner when a taxpayer does not 
produce required records and fails to demonstrate reasonable cause for 
the failure).

[T.D. 9328, 72 FR 32177, June 12, 2007, as amended by T.D. 9533, 76 FR 
39281, July 6, 2011; T.D. 9637, 78 FR 54760, Sept. 6, 2013]



Sec.  1.475(b)-1  Scope of exemptions from mark-to-market requirement.

    (a) Securities held for investment or not held for sale. Except as 
otherwise provided by this section and subject to the identification 
requirements of section 475(b)(2), a security is held for investment 
(within the meaning of section 475(b)(1)(A)) or not held for sale 
(within the meaning of section 475(b)(1)(B)) if it is not held by the 
taxpayer primarily for sale to customers in the ordinary course of the 
taxpayer's trade or business.
    (b) Securities deemed identified as held for investment--(1) In 
general. The following items held by a dealer in securities are per se 
held for investment within the meaning of section 475(b)(1)(A) and are 
deemed to be properly identified as such for purposes of section 
475(b)(2)--
    (i) Except as provided in paragraph (b)(3) of this section, stock in 
a corporation, or a partnership or beneficial ownership interest in a 
widely held or publicly traded partnership or trust, to which the 
taxpayer has a relationship specified in paragraph (b)(2) of this 
section; or
    (ii) A contract that is treated for federal income tax purposes as 
an annuity, endowment, or life insurance contract (see sections 72, 817, 
and 7702).

[[Page 638]]

    (2) Relationships--(i) General rule. The relationships specified in 
this paragraph (b)(2) are--
    (A) Those described in section 267(b) (2), (3), (10), (11), or (12); 
or
    (B) Those described in section 707(b)(1)(A) or (B).
    (ii) Attribution. The relationships described in paragraph (b)(2)(i) 
of this section are determined taking into account sections 267(c) and 
707(b)(3), as appropriate.
    (iii) Trusts treated as partnerships. For purposes of this paragraph 
(b)(2), the phrase partnership or trust is substituted for the word 
partnership in sections 707(b) (1) and (3), and a reference to 
beneficial ownership interest is added to each reference to capital 
interest or profits interest in those sections.
    (3) Securities traded on certain established financial markets. 
Paragraph (b)(1)(i) of this section does not apply to a security if--
    (i) The security is actively traded within the meaning of Sec.  
1.1092(d)-1(a) taking into account only established financial markets 
identified in Sec.  1.1092(d)-1(b)(1) (i) or (ii) (describing national 
securities exchanges and interdealer quotation systems);
    (ii) Less than 15 percent of all of the outstanding shares or 
interests in the same class are held by the taxpayer and all persons 
having a relationship to the taxpayer that is specified in paragraph 
(b)(2) of this section; and
    (iii) If the security was acquired (e.g., on original issue) from a 
person having a relationship to the taxpayer that is specified in 
paragraph (b)(2) of this section, then, after the time the security was 
acquired--
    (A) At least one full business day has passed; and
    (B) There has been significant trading involving persons not having 
a relationship to the taxpayer that is specified in paragraph (b)(2) of 
this section.
    (4) Changes in status--(i) Onset of prohibition against marking. (A) 
Once paragraph (b)(1) of this section begins to apply to the security 
and for so long as it continues to apply, section 475(a) does not apply 
to the security in the hands of the taxpayer.
    (B) If a security has not been timely identified under section 
475(b)(2) and, after the last day on which such an identification would 
have been timely, paragraph (b)(1) of this section begins to apply to 
the security, then the dealer must recognize gain or loss on the 
security as if it were sold for its fair market value as of the close of 
business of the last day before paragraph (b)(1) of this section begins 
to apply to the security, and gain or loss is taken into account at that 
time.
    (ii) Termination of prohibition against marking. If a taxpayer did 
not timely identify a security under section 475(b)(2), and paragraph 
(b)(1) of this section applies to the security on the last day on which 
such an identification would have been timely but thereafter ceases to 
apply--
    (A) An identification of the security under section 475(b)(2) is 
timely if made on or before the close of the day paragraph (b)(1) of 
this section ceases to apply; and
    (B) Unless the taxpayer timely identifies the security under section 
475(b)(2) (taking into account the additional time for identification 
that is provided by paragraph (b)(4)(ii)(A) of this section), section 
475(a) applies to changes in value of the security after the cessation 
in the same manner as under section 475(b)(3).
    (iii) Examples. These examples illustrate this paragraph (b)(4):

    Example 1. Onset of prohibition against marking. (A) Facts. 
Corporation H owns 75 percent of the stock of corporation D, a dealer in 
securities within the meaning of section 475(c)(1). On December 1, 1995, 
D acquired less than half of the stock in corporation X. D did not 
identify the stock for purposes of section 475(b)(2). On July 17, 1996, 
H acquired from other persons 70 percent of the stock of X. As a result, 
D and X became related within the meaning of paragraph (b)(2)(i) of this 
section. The stock of X is not described in paragraph (b)(3) of this 
section (concerning some securities traded on certain established 
financial markets).
    (B) Holding. Under paragraph (b)(4)(i) of this section, D recognizes 
gain or loss on its X stock as if the stock were sold for its fair 
market value at the close of business on July 16, 1996, and the gain or 
loss is taken into account at that time. As with any application of 
section 475(a), proper adjustment is made in the amount of any gain or 
loss subsequently realized. After July 16, 1996, section 475(a) does not 
apply to D's X stock while paragraph (b)(1)(i) of this section 
(concerning

[[Page 639]]

the relationship between X and D) continues to apply.
    Example 2. Termination of prohibition against marking; retained 
securities identified as held for investment. (A) Facts. On July 1, 
1996, corporation H owned 60 percent of the stock of corporation Y and 
all of the stock of corporation D, a dealer in securities within the 
meaning of section 475(c)(1). Thus, D and Y are related within the 
meaning of paragraph (b)(2)(i) of this section. Also on July 1, 1996, D 
acquired, as an investment, 10 percent of the stock of Y. The stock of Y 
is not described in paragraph (b)(3) of this section (concerning some 
securities traded on certain established financial markets). When D 
acquired its shares of Y stock, it did not identify them for purposes of 
section 475(b)(2). On December 24, 1996, D identified its shares of Y 
stock as held for investment under section 475(b)(2). On December 30, 
1996, H sold all of its shares of stock in Y to an unrelated party. As a 
result, D and Y ceased to be related within the meaning of paragraph 
(b)(2)(i) of this section.
    (B) Holding. Under paragraph (b)(4)(ii)(A) of this section, 
identification of the Y shares is timely if done on or before the close 
of December 30, 1996. Because D timely identified its Y shares under 
section 475(b)(2), it continues after December 30, 1996, to refrain from 
marking to market its Y stock.
    Example 3. Termination of prohibition against marking; retained 
securities not identified as held for investment. (A) Facts. The facts 
are the same as in Example 2 above, except that D did not identify its 
stock in Y for purposes of section 475(b)(2) on or before December 30, 
1996. Thus, D did not timely identify these securities under section 
475(b)(2) (taking into account the additional time for identification 
provided in paragraph (b)(4)(ii)(A) of this section).
    (B) Holding. Under paragraph (b)(4)(ii)(B) of this section, section 
475(a) applies to changes in value of D's Y stock after December 30, 
1996, in the same manner as under section 475(b)(3).
    Thus, any appreciation or depreciation that occurred while the 
securities were prohibited from being marked to market is suspended. 
Further, section 475(a) applies only to those changes occurring after 
December 30, 1996.
    Example 4. Acquisition of actively traded stock from related party. 
(A) Facts. Corporation P is the parent of a consolidated group whose 
taxable year is the calendar year, and corporation M, a member of that 
group, is a dealer in securities within the meaning of section 
475(c)(1). Corporation M regularly acts as a market maker with respect 
to common and preferred stock of corporation P. Corporation P has 
outstanding 2,000,000 shares of series X preferred stock, which are 
traded on a national securities exchange. During the business day on 
December 29, 1997, corporation P sold 100,000 shares of series X 
preferred stock to corporation M for $100 per share. Subsequently, also 
on December 29, 1997, persons not related to corporation M engaged in 
significant trading of the series X preferred stock. At the close of 
business on December 30, 1997, the fair market value of series X stock 
was $99 per share. At the close of business on December 31, 1997, the 
fair market value of series X stock was $98.50 per share. Corporation M 
sold the series X stock on the exchange on January 2, 1998. At all 
relevant times, corporation M and all persons related to M owned less 
than 15% of the outstanding series X preferred stock.
    (B) Holding. The 100,000 shares of series X preferred stock held by 
corporation M are not subject to mark-to-market treatment under section 
475(a) on December 29, 1997, because at that time the stock was held for 
less than one full business day and is therefore treated as properly 
identified as held for investment. At the close of business on December 
30, 1997, that prohibition on marking ceases to apply, and section 
475(b)(3) begins to apply. The built-in loss is suspended, and 
subsequent appreciation and depreciation are subject to section 475(a). 
Accordingly, when corporation M marks the series X stock to market at 
the close of business on December 31, 1997, under section 475(a) it 
recognizes and takes into account a loss of $.50 per share. Under 
section 475(b)(3), when corporation M sells the series X stock on 
January 2, 1998, it takes into account the suspended loss, that is, the 
difference between the $100 per share it paid corporation P for that 
stock and the $99-per-share fair market value when section 475(b)(1) 
ceased to be applied to the stock. No deduction, however, is allowed for 
that loss. (See Sec.  1.1502-13(f)(6), under which no deduction is 
allowed to a member of a consolidated group for a loss with respect to a 
share of stock of the parent of that consolidated group, if the member 
does not take the gain or loss into account pursuant to section 475(a).)

    (c) Securities deemed not held for investment; dealers in notional 
principal contracts and derivatives. (1) Except as otherwise determined 
by the Commissioner in a revenue ruling, revenue procedure, or letter 
ruling, section 475(b)(1)(A) (exempting from mark-to-market accounting 
certain securities that are held for investment) does not apply to a 
security if--
    (i) The security is described in section 475(c)(2) (D) or (E) 
(describing certain notional principal contracts and derivative 
securities); and
    (ii) The taxpayer is a dealer in such securities.

[[Page 640]]

    (2) See Sec.  1.475(d)-1(b) for a rule concerning the character of 
gain or loss on securities described in this paragraph (c).
    (d) Special rule for hedges of another member's risk. A taxpayer may 
identify under section 475(b)(1)(C) (exempting certain hedges from mark-
to-market accounting) a security that hedges a position of another 
member of the taxpayer's consolidated group if the security meets the 
following requirements--
    (1) The security is a hedging transaction within the meaning of 
Sec.  1.1221-2(b);
    (2) The security is timely identified as a hedging transaction under 
Sec.  1.1221-2(f) (including identification of the hedged item); and
    (3) The security hedges a position that is not marked to market 
under section 475(a).
    (e) Transitional rules--(1) Stock, partnership, and beneficial 
ownership interests in certain controlled corporations, partnerships, 
and trusts before January 23, 1997--(i) In general. The following items 
held by a dealer in securities are per se held for investment within the 
meaning of section 475(b)(1)(A) and are deemed to be properly identified 
as such for purposes of section 475(b)(2)--
    (A) Stock in a corporation that the taxpayer controls (within the 
meaning of paragraph (e)(1)(ii) of this section); or
    (B) A partnership or beneficial ownership interest in a widely held 
or publicly traded partnership or trust that the taxpayer controls 
(within the meaning of paragraph (e)(1)(ii) of this section).
    (ii) Control defined. Control means the ownership, directly or 
indirectly through persons described in section 267(b) (taking into 
account section 267(c)), of--
    (A) 50 percent or more of the total combined voting power of all 
classes of stock entitled to vote; or
    (B) 50 percent or more of the capital interest, the profits 
interest, or the beneficial ownership interest in the widely held or 
publicly traded partnership or trust.
    (iii) Applicability. The rules of this paragraph (e)(1) apply only 
before January 23, 1997.
    (2) Dealers in notional principal contracts and derivatives acquired 
before January 23, 1997--(i) General rule. Section 475(b)(1)(A) 
(exempting certain securities from mark-to-market accounting) does not 
apply to a security if--
    (A) The security is described in section 475(c)(2) (D) or (E) 
(describing certain notional principal contracts and derivative 
securities); and
    (B) The taxpayer is a dealer in such securities.
    (ii) Exception for securities not acquired in dealer capacity. This 
paragraph (e)(2) does not apply if the taxpayer establishes 
unambiguously that the security was not acquired in the taxpayer's 
capacity as a dealer in such securities.
    (iii) Applicability. The rules of paragraph (e)(2) apply only to 
securities acquired before January 23, 1997.

[T.D. 8700, 61 FR 67720, Dec. 24, 1996, as amended by T.D. 8985, 67 FR 
12865, Mar. 20, 2002]



Sec.  1.475(b)-2  Exemptions--identification requirements.

    (a) Identification of the basis for exemption. An identification of 
a security as exempt from mark to market does not satisfy section 
475(b)(2) if it fails to state whether the security is described in--
    (1) Either of the first two subparagraphs of section 475(b)(1) 
(identifying a security as held for investment or not held for sale); or
    (2) The third subparagraph thereof (identifying a security as a 
hedge).
    (b) Time for identifying a security with a substituted basis. For 
purposes of determining the timeliness of an identification under 
section 475(b)(2), the date that a dealer acquires a security is not 
affected by whether the dealer's basis in the security is determined, in 
whole or in part, either by reference to the basis of the security in 
the hands of the person from whom the security was acquired or by 
reference to other property held at any time by the dealer. See Sec.  
1.475(a)-3 for rules governing how the dealer accounts for such a 
security if this identification is not made.
    (c) Integrated transactions under Sec.  1.1275-6--(1) Definitions. 
The following terms are used in this paragraph (c) with the meanings 
that are given to

[[Page 641]]

them by Sec.  1.1275-6: integrated transaction, legging into, legging 
out, qualifying debt instrument, Sec.  1.1275-6 hedge, and synthetic 
debt instrument.
    (2) Synthetic debt held by a taxpayer as a result of legging in. If 
a taxpayer is treated as the holder of a synthetic debt instrument as 
the result of legging into an integrated transaction, then, for purposes 
of the timeliness of an identification under section 475(b)(2), the 
synthetic debt instrument is treated as having the same acquisition date 
as the qualifying debt instrument. A pre-leg-in identification of the 
qualifying debt instrument under section 475(b)(2) applies to the 
integrated transaction as well.
    (3) Securities held after legging out. If a taxpayer legs out of an 
integrated transaction, then, for purposes of the timeliness of an 
identification under section 475(b)(2), the qualifying debt instrument, 
or the Sec.  1.1275-6 hedge, that remains in the taxpayer's hands is 
generally treated as having been acquired, originated, or entered into, 
as the case may be, immediately after the leg-out. If any loss or 
deduction determined under Sec.  1.1275-6(d)(2)(ii)(B) is disallowed by 
Sec.  1.1275-6(d)(2)(ii)(D) (which disallows deductions when a taxpayer 
legs out of an integrated transaction within 30 days of legging in), 
then, for purposes of this section and section 475(b)(2), the qualifying 
debt instrument that remains in the taxpayer's hands is treated as 
having been acquired on the same date that the synthetic debt instrument 
was treated as having been acquired.

[T.D. 8700, 61 FR 67722, Dec. 24, 1996]



Sec.  1.475(b)-3  [Reserved]



Sec.  1.475(c)-1  Definitions--dealer in securities.

    (a) Dealer-customer relationship. Whether a taxpayer is transacting 
business with customers is determined on the basis of all of the facts 
and circumstances.
    (1) [Reserved]
    (2) Transactions described in section 475(c)(1)(B)--(i) In general. 
For purposes of section 475(c)(1)(B), the term dealer in securities 
includes, but is not limited to, a taxpayer that, in the ordinary course 
of the taxpayer's trade or business, regularly holds itself out as being 
willing and able to enter into either side of a transaction enumerated 
in section 475(c)(1)(B).
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (a)(2). In the following examples, B is a bank and is not a 
member of a consolidated group:

    Example 1. B regularly offers to enter into interest rate swaps with 
other persons in the ordinary course of its trade or business. B is 
willing to enter into interest rate swaps under which it either pays a 
fixed interest rate and receives a floating rate or pays a floating rate 
and receives a fixed rate. B is a dealer in securities under section 
475(c)(1)(B), and the counterparties are its customers.
    Example 2. B, in the ordinary course of its trade or business, 
regularly holds itself out as being willing and able to enter into 
either side of positions in a foreign currency with other banks in the 
interbank market. B's activities in the foreign currency make it a 
dealer in securities under section 475(c)(1)(B), and the other banks in 
the interbank market are its customers.
    Example 3. B engages in frequent transactions in a foreign currency 
in the interbank market. Unlike the facts in Example 2, however, B does 
not regularly hold itself out as being willing and able to enter into 
either side of positions in the foreign currency, and all of B's 
transactions are driven by its internal need to adjust its position in 
the currency. No other circumstances are present to suggest that B is a 
dealer in securities for purposes of section 475(c)(1)(B). B's activity 
in the foreign currency does not qualify it as a dealer in securities 
for purposes of section 475(c)(1)(B), and its transactions in the 
interbank market are not transactions with customers.

    (3) Related parties--(i) General rule. Except as provided in 
paragraph (a)(3)(ii) of this section (concerning transactions between 
members of a consolidated group, as defined in Sec.  1.1502-1(h)), a 
taxpayer's transactions with related persons may be transactions with 
customers for purposes of section 475. For example, if a taxpayer, in 
the ordinary course of the taxpayer's trade or business, regularly holds 
itself out to its foreign subsidiaries or other related persons as being 
willing and able to enter into either side of transactions enumerated in 
section 475(c)(1)(B), the taxpayer is a dealer in securities within the 
meaning of section 475(c)(1), even if it engages in no other 
transactions with customers.

[[Page 642]]

    (ii) Special rule for members of a consolidated group. Solely for 
purposes of paragraph (c)(1) of section 475 (concerning the definition 
of dealer in securities) and except as provided in paragraph (a)(3)(iii) 
of this section, a taxpayer's transactions with other members of its 
consolidated group are not with customers. Accordingly, notwithstanding 
paragraph (a)(2) of this section, the fact that a taxpayer regularly 
holds itself out to other members of its consolidated group as being 
willing and able to enter into either side of a transaction enumerated 
in section 475(c)(1)(B) does not cause the taxpayer to be a dealer in 
securities within the meaning of section 475(c)(1)(B).
    (iii) The intragroup-customer election--(A) Effect of election. If a 
consolidated group makes the intragroup-customer election, paragraph 
(a)(3)(ii) of this section (special rule for members of a consolidated 
group) does not apply to the members of the group. Thus, a member of a 
group that has made this election may be a dealer in securities within 
the meaning of section 475(c)(1) even if its only customer transactions 
are with other members of its consolidated group.
    (B) Making and revoking the election. Unless the Commissioner 
otherwise prescribes, the intragroup-customer election is made by filing 
a statement that says, ``[Insert name and employer identification number 
of common parent] hereby makes the Intragroup-Customer Election (as 
described in Sec.  1.475(c)-1(a)(3)(iii) of the income tax regulations) 
for the taxable year ending [describe the last day of the year] and for 
subsequent taxable years.'' The statement must be signed by the common 
parent and attached to the timely filed federal income tax return for 
the consolidated group for that taxable year. The election applies for 
that year and continues in effect for subsequent years until revoked. 
The election may be revoked only with the consent of the Commissioner.
    (iv) Examples. The following examples illustrate this paragraph 
(a)(3):

    General Facts. HC, a hedging center, provides interest rate hedges 
to all of the members of its affiliated group (as defined in section 
1504(a)(1)). Because of the efficiencies created by having a centralized 
risk manager, group policy prohibits members other than HC from entering 
into derivative interest rate positions with outside parties. HC 
regularly holds itself out as being willing and able to, and in fact 
does, enter into either side of interest rate swaps with its fellow 
members. HC periodically computes its aggregate position and hedges the 
net risk with an unrelated party. HC does not otherwise enter into 
interest rate positions with persons that are not members of the 
affiliated group. HC attempts to operate at cost, and the terms of its 
swaps do not factor in any risk of default by the affiliate. Thus, HC's 
affiliates receive somewhat more favorable terms then they would receive 
from an unrelated swaps dealer (a fact that may subject HC and its 
fellow members to reallocation of income under section 482). No other 
circumstances are present to suggest that HC is a dealer in securities 
for purposes of section 475(c)(1)(B).
    Example 1. General rule for related persons. In addition to the 
General Facts stated above, assume that HC's affiliated group has not 
elected under section 1501 to file a consolidated return. Under 
paragraph (a)(3)(i) of this section, HC's transactions with its 
affiliates can be transactions with customers for purposes of section 
475(c)(1). Thus, under paragraph (a)(2)(i) of this section, HC is a 
dealer in securities within the meaning of section 475(c)(1)(B), and the 
members of the group with which it does business are its customers.

    Example 2. Special rule for members of a consolidated group. In 
addition to the General Facts stated above, assume that HC's affiliated 
group has elected to file consolidated returns and has not made the 
intragroup-customer election. Under paragraph (a)(3)(ii) of this 
section, HC's interest rate swap transactions with the members of its 
consolidated group are not transactions with customers for purposes of 
determining whether HC is a dealer in securities within the meaning of 
section 475(c)(1). Further, the fact that HC regularly holds itself out 
to members of its consolidated group as being willing and able to enter 
into either side of a transaction enumerated in section 475(c)(1)(B) 
does not cause HC to be a dealer in securities within the meaning of 
section 475(c)(1)(B). Because no other circumstances are present to 
suggest that HC is a dealer in securities for purposes of section 
475(c)(1)(B), HC is not a dealer in securities.
    Example 3. Intragroup-customer election. In addition to the General 
Facts stated above, assume that HC's affiliated group has elected to 
file a consolidated return but has also made the intragroup-customer 
election under paragraph (a)(3)(iii) of this section. Thus, the analysis 
and result are the same as in Example 1.


[[Page 643]]


    (b) Sellers of nonfinancial goods and services--(1) Purchases and 
sales of customer paper. Except as provided in paragraph (b)(3) of this 
section, if a taxpayer would not be a dealer in securities within the 
meaning of section 475(c)(1) but for its purchases and sales of debt 
instruments that, at the time of purchase or sale, are customer paper 
with respect to either the taxpayer or a corporation that is a member of 
the same consolidated group (as defined in Sec.  1.1502-1(h)) as the 
taxpayer, then for purposes of section 475 the taxpayer is not a dealer 
in securities.
    (2) Definition of customer paper. A debt instrument is customer 
paper with respect to a person at a point in time if--
    (i) The person's principal activity is selling nonfinancial goods or 
providing nonfinancial services;
    (ii) The debt instrument was issued by a purchaser of the goods or 
services at the time of the purchase of those goods or services in order 
to finance the purchase; and
    (iii) At all times since the debt instrument was issued, it has been 
held either by the person selling those goods or services or by a 
corporation that is a member of the same consolidated group as that 
person.
    (3) Exceptions. Paragraph (b)(1) of this section does not apply if--
    (i) For purposes of section 471, the taxpayer accounts for any 
security (as defined in section 475(c)(2)) as inventory;
    (ii) The taxpayer is subject to an election under paragraph (b)(4) 
of this section; or
    (iii) The taxpayer is not described in paragraph (b)(2)(i) of this 
section and one or more debt instruments that are customer paper with 
respect to a corporation that is a member of the same consolidated group 
as the taxpayer are accounted for by the taxpayer, or by a corporation 
that is a member of the same consolidated group as the taxpayer, in a 
manner that allows recognition of unrealized gains or losses or 
deductions for additions to a reserve for bad debts.
    (4) Election not to be governed by the exception for sellers of 
nonfinancial goods or services--(i) Method of making the election. 
Unless the Commissioner otherwise prescribes, an election under this 
paragraph (b)(4) must be made in the manner, and at the time, prescribed 
in this paragraph (b)(4)(i). The taxpayer must file with the Internal 
Revenue Service a statement that says, ``[Insert name and taxpayer 
identification number of the taxpayer] hereby elects not to be governed 
by Sec.  1.475(c)-1(b)(1) of the income tax regulations for the taxable 
year ending [describe the last day of the year] and for subsequent 
taxable years.''
    (A) Taxable years ending after December 24, 1996. If the first 
taxable year subject to an election under this paragraph (b)(4) ends 
after December 24, 1996, the statement must be attached to a timely 
filed federal income tax return for that taxable year.
    (B) Taxable years ending on or before December 24, 1996. If the 
first taxable year subject to an election under this paragraph (b)(4) 
ends on or before December 24, 1996 and the election changes the 
taxpayer's taxable income for any taxable year the federal income tax 
return for which was filed before February 24, 1997, the statement must 
be attached to an amended return for the earliest such year that is so 
affected, and that amended return (and an amended return for any other 
such year that is so affected) must be filed not later than June 23, 
1997. If the first taxable year subject to an election under this 
paragraph (b)(4) ends on or before December 24, 1996 but the taxpayer is 
not described in the preceding sentence, the statement must be attached 
to the first federal income tax return that is for a taxable year 
subject to the election and that is filed on or after February 24, 1997.
    (ii) Continued applicability of an election. An election under this 
paragraph (b)(4) continues in effect for subsequent taxable years until 
revoked. The election may be revoked only with the consent of the 
Commissioner.
    (c) Taxpayers that purchase securities from customers but engage in 
no more than negligible sales of the securities--(1) Exemption from 
dealer status--(i) General rule. A taxpayer that regularly purchases 
securities from customers in the ordinary course of a trade or business 
(including regularly making loans to customers in the ordinary course of 
a trade or business of making loans) but

[[Page 644]]

engages in no more than negligible sales of the securities so acquired 
is not a dealer in securities within the meaning of section 475(c)(1) 
unless the taxpayer elects to be so treated or, for purposes of section 
471, the taxpayer accounts for any security (as defined in section 
475(c)(2)) as inventory.
    (ii) Election to be treated as a dealer. A taxpayer described in 
paragraph (c)(1)(i) of this section elects to be treated as a dealer in 
securities by filing a federal income tax return reflecting the 
application of section 475(a) in computing its taxable income.
    (2) Negligible sales. Solely for purposes of paragraph (c)(1) of 
this section, a taxpayer engages in negligible sales of debt instruments 
that it regularly purchases from customers in the ordinary course of its 
business if, and only if, during the taxable year, either--
    (i) The taxpayer sells all or part of fewer than 60 debt 
instruments, regardless how acquired; or
    (ii) The total adjusted basis of the debt instruments (or parts of 
debt instruments), regardless how acquired, that the taxpayer sells is 
less than 5 percent of the total basis, immediately after acquisition, 
of the debt instruments that it acquires in that year.
    (3) Special rules for members of a consolidated group--(i) 
Intragroup-customer election in effect. If a taxpayer is a member of a 
consolidated group that has made the intragroup-customer election 
(described in paragraph (a)(3)(iii) of this section), the negligible 
sales test in paragraph (c)(2) of this section takes into account all of 
the taxpayer's sales of debt instruments to other group members.
    (ii) Intragroup-customer election not in effect. If a taxpayer is a 
member of a consolidated group that has not made the intragroup-customer 
election (described in paragraph (a)(3)(iii) of this section), the 
taxpayer satisfies the negligible sales test in paragraph (c)(2) of this 
section if either--
    (A) The test is satisfied by the taxpayer, taking into account sales 
of debt instruments to other group members (as in paragraph (c)(3)(i) of 
this section); or
    (B) The test is satisfied by the group, treating the members of the 
group as if they were divisions of a single corporation.
    (4) Special rules. Whether sales of securities are negligible is 
determined without regard to--
    (i) Sales of securities that are necessitated by exceptional 
circumstances and that are not undertaken as recurring business 
activities;
    (ii) Sales of debt instruments that decline in quality while in the 
taxpayer's hands and that are sold pursuant to an established policy of 
the taxpayer to dispose of debt instruments below a certain quality; or
    (iii) Acquisitions and sales of debt instruments that are 
qualitatively different from all debt instruments that the taxpayer 
purchases from customers in the ordinary course of its business.
    (5) Example. The following example illustrates paragraph (c)(4)(iii) 
of this section:

    Example. I, an insurance company, regularly makes policy loans to 
its customers but does not sell them. I, however, actively trades 
Treasury securities. No other circumstances are present to suggest that 
I is a dealer in securities for purposes of section 475(c)(1). Since the 
Treasuries are qualitatively different from the policy loans that I 
originates, under paragraph (c)(4)(iii) of this section, I disregards 
the purchases and sales of Treasuries in applying the negligible sales 
test in paragraph (c)(2) of this section.

    (d) Issuance of life insurance products. A life insurance company 
that is not otherwise a dealer in securities within the meaning of 
section 475(c)(1) does not become a dealer in securities solely because 
it regularly issues life insurance products to its customers in the 
ordinary course of a trade or business. For purposes of the preceding 
sentence, the term life insurance product means a contract that is 
treated for federal income tax purposes as an annuity, endowment, or 
life insurance contract. See sections 72, 817, and 7702.

[T.D. 8700, 61 FR 67723, Dec. 24, 1996]



Sec.  1.475(c)-2  Definitions--security.

    (a) Items that are not securities. The following items are not 
securities within the meaning of section 475(c)(2) with respect to a 
taxpayer and, therefore, are not subject to section 475--
    (1) A security (determined without regard to this paragraph (a)) if 
section

[[Page 645]]

1032 prevents the taxpayer from recognizing gain or loss with respect to 
that security;
    (2) A debt instrument issued by the taxpayer (including a synthetic 
debt instrument, within the meaning of Sec.  1.1275-6(b)(4), that Sec.  
1.1275-6(b) treats the taxpayer as having issued); or
    (3) A REMIC residual interest, or an interest or arrangement that is 
determined by the Commissioner to have substantially the same economic 
effect, if the residual interest or the interest or arrangement is 
acquired on or after January 4, 1995.
    (b) Synthetic debt that Sec.  1.1275-6(b) treats the taxpayer as 
holding. If Sec.  1.1275-6 treats a taxpayer as the holder of a 
synthetic debt instrument (within the meaning of Sec.  1.1275-6(b)(4)), 
the synthetic debt instrument is a security held by the taxpayer within 
the meaning of section 475(c)(2)(C).
    (c) Negative value REMIC residuals acquired before January 4, 1995. 
A REMIC residual interest that is described in paragraph (c)(1) of this 
section or an interest or arrangement that is determined by the 
Commissioner to have substantially the same economic effect is not a 
security within the meaning of section 475(c)(2).
    (1) Description. A residual interest in a REMIC is described in this 
paragraph (c)(1) if, on the date the taxpayer acquires the residual 
interest, the present value of the anticipated tax liabilities 
associated with holding the interest exceeds the sum of--
    (i) The present value of the expected future distributions on the 
interest; and
    (ii) The present value of the anticipated tax savings associated 
with holding the interest as the REMIC generates losses.
    (2) Special rules applicable to negative value REMIC residuals 
acquired before January 4, 1995. Solely for purposes of this paragraph 
(c)--
    (i) If a transferee taxpayer acquires a residual interest with a 
basis determined by reference to the transferor's basis, then the 
transferee is deemed to acquire the interest on the date the transferor 
acquired it (or is deemed to acquire it under this paragraph (c)(2)(i)).
    (ii) Anticipated tax liabilities, expected future distributions, and 
anticipated tax savings are determined under the rules in Sec.  1.860E-
2(a)(3) and without regard to the operation of section 475.
    (iii) Present values are determined under the rules in Sec.  1.860E-
2(a)(4).

[T.D. 8700, 61 FR 67725, Dec. 24, 1996]



Sec.  1.475(d)-1  Character of gain or loss.

    (a) Securities never held in connection with the taxpayer's 
activities as a dealer in securities. If a security is never held in 
connection with the taxpayer's activities as a dealer in securities, 
section 475(d)(3)(A) does not affect the character of gain or loss from 
the security, even if the taxpayer fails to identify the security under 
section 475(b)(2).
    (b) Ordinary treatment for notional principal contracts and 
derivatives held by dealers in notional principal contracts and 
derivatives. Section 475(d)(3)(B)(ii) (concerning the character of gain 
or loss with respect to a security held by a person other than in 
connection with its activities as a dealer in securities) does not apply 
to a security if Sec.  1.475(b)-1(c) and the absence of a determination 
by the Commissioner prevent section 475(b)(1)(A) from applying to the 
security.

[T.D. 8700, 61 FR 67725, Dec. 24, 1996]



Sec.  1.475(g)-1  Effective dates.

    (a)-(b) [Reserved]
    (c) Section 1.475(a)-3 (concerning acquisition by a dealer of a 
security with a substituted basis) applies to securities acquired, 
originated, or entered into on or after January 4, 1995.
    (d) Section 1.475(a)-4 (concerning a safe harbor to use applicable 
financial statement values for purposes of section 475) applies to 
taxable years ending on or after June 12, 2007.
    (e) Except as provided elsewhere in this paragraph (d), Sec.  
1.475(b)-1 (concerning the scope of exemptions from the mark-to-market 
requirement) applies to taxable years ending on or after December 31, 
1993.
    (1) Section 1.475(b)-1(b) applies as follows:
    (i) Section 1.475(b)-1(b)(1)(i) (concerning equity interests issued 
by a related person) applies beginning June 19,

[[Page 646]]

1996. If, on June 18, 1996, a security is subject to mark-to-market 
accounting and, on June 19, 1996, Sec.  1.475(b)-1(b)(1) begins to apply 
to the security solely because of the effective dates in this paragraph 
(d) (rather than because of a change in facts), then the rules of Sec.  
1.475(b)-1(b)(4)(i)(A) (concerning the prohibition against marking) 
apply, but Sec.  1.475(b)-1(b)(4)(i)(B) (imposing a mark-to-market on 
the day before the onset of the prohibition) does not apply.
    (ii) Section 1.475(b)-1(b)(2) (concerning relevant relationships for 
purposes of determining whether equity interests in related persons are 
prohibited from being marked to market) applies beginning June 19, 1996.
    (iii) Section 1.475(b)-1(b)(3) (concerning certain actively traded 
securities) applies beginning June 19, 1996, to securities held on or 
after that date, except for securities described in Sec.  1.475(b)-
1(e)(1)(i) (concerning equity interests issued by controlled entities). 
If a security is described in Sec.  1.475(b)-1(e)(1)(i), Sec.  1.475(b)-
1(b)(3) applies only on or after January 23, 1997 if the security is 
held on or after that date. If Sec.  1.475(b)-1(b)(1) ceases to apply to 
a security by virtue of the operation of this paragraph (d)(1)(iii), the 
rules of Sec.  1.475(b)-1(b)(4)(ii) apply to the cessation.
    (iv) Except to the extent provided in paragraph (d)(1) of this 
section, Sec.  1.475(b)-1(b)(4) (concerning changes in status) applies 
beginning June 19, 1996.
    (2) Section 1.475(b)-1(c) (concerning securities deemed not held for 
investment by dealers in notional principal contracts and derivatives) 
applies to securities acquired on or after January 23, 1997.
    (3) Section 1.475(b)-1(d) (concerning the special rule for hedges of 
another member's risk) is effective for securities acquired, originated, 
or entered into on or after January 23, 1997.
    (f) Section 1.475(b)-2 (concerning identification of securities that 
are exempt from mark-to-market treatment) applies as follows:
    (1) Section 1.475(b)-2(a) (concerning the general rules for 
identification of basis for exemption from mark to market treatment) 
applies to identifications made on or after July 1, 1997.
    (2) Section 1.475(b)-2(b) (concerning time for identifying a 
security with a substituted basis) applies to securities acquired, 
originated, or entered into on or after January 4, 1995.
    (3) Section 1.475(b)-2(c) (concerning identification in the context 
of integrated transactions under Sec.  1.1275-6) applies on and after 
August 13, 1996 (the effective date of Sec.  1.1275-6).
    (g)-(h) [Reserved]
    (i) Section 1.475(c)-1 applies as follows:
    (1) Except as otherwise provided in this paragraph (h)(1), Sec.  
1.475(c)-1(a) (concerning the dealer-customer relationship) applies to 
taxable years beginning on or after January 1, 1995.
    (i) [Reserved]
    (ii) Section 1.475(c)-1(a)(2)(ii) (illustrating rules concerning the 
dealer-customer relationship) applies to taxable years beginning on or 
after June 20, 1996.
    (iii)(A) Section 1.475(c)-1(a)(3) applies to taxable years beginning 
on or after June 20, 1996, except for transactions between members of 
the same consolidated group.
    (B) For transactions between members of the same consolidated group, 
paragraph Sec.  1.475(c)-1(a)(3) applies to taxable years beginning on 
or after December 24, 1996.
    (2) Section 1.475(c)-1(b) (concerning sellers of nonfinancial goods 
and services) applies to taxable years ending on or after December 31, 
1993.
    (3) Except as otherwise provided in this paragraph (h)(3), section 
1.475(c)-1(c) (concerning taxpayers that purchase securities but engage 
in no more than negligible sales of the securities) applies to taxable 
years ending on or after December 31, 1993.
    (i) Section 1.475(c)-1(c)(3) (special rules for members of a 
consolidated group) is effective for taxable years beginning on or after 
December 24, 1996.
    (ii) A taxpayer may rely on the rules set out in Sec.  1.475(c)-
1T(b) (as contained in 26 CFR part 1 revised April 1, 1996) for taxable 
years beginning before January 23, 1997, provided the taxpayer applies 
that paragraph reasonably and consistently.
    (4) Section 1.475(c)-1(d) (concerning the issuance of life insurance 
products)

[[Page 647]]

applies to taxable years beginning on or after January 1, 1995.
    (j) Section 1.475(c)-2 (concerning the definition of security) 
applies to taxable years ending on or after December 31, 1993. By its 
terms, however, Sec.  1.475(c)-2(a)(3) applies only to residual 
interests or to interests or arrangements that are acquired on or after 
January 4, 1995; and the integrated transactions that are referred to in 
Sec. Sec.  1.475(c)-2(a)(2) and 1.475(c)-2(b) exist only after August 
13, 1996 (the effective date of Sec.  1.1275-6).
    (k) Section 1.475(d)-1 (concerning the character of gain or loss) 
applies to taxable years ending on or after December 31, 1993.

[T.D. 8700, 61 FR 67725, Dec. 24, 1996. Redesignated and amended by T.D. 
9328, 72 FR 32181, June 12, 2007; T.D. 9849, 84 FR 9235, Mar. 14, 2019]

                               Adjustments



Sec.  1.481-1  Adjustments in general.

    (a)(1) Section 481 prescribes the rules to be followed in computing 
taxable income in cases where the taxable income of the taxpayer is 
computed under a method of accounting different from that under which 
the taxable income was previously computed. A change in method of 
accounting to which section 481 applies includes a change in the over-
all method of accounting for gross income or deductions, or a change in 
the treatment of a material item. For rules relating to changes in 
methods of accounting, see section 446(e) and paragraph (e) of Sec.  
1.446-1. In computing taxable income for the taxable year of the change, 
there shall be taken into account those adjustments which are determined 
to be necessary solely by reason of such change in order to prevent 
amounts from being duplicated or omitted. The ``year of the change'' is 
the taxable year for which the taxable income of the taxpayer is 
computed under a method of accounting different from that used for the 
preceding taxable year.
    (2) Unless the adjustments are attributable to a change in method of 
accounting initiated by the taxpayer, no part of the adjustments 
required by subparagraph (1) of this paragraph shall be based on amounts 
which were taken into account in computing income (or which should have 
been taken into account had the new method of accounting been used) for 
taxable years beginning before January 1, 1954, or ending before August 
17, 1954 (hereinafter referred to as pre-1954 years).
    (b) The adjustments specified in section 481(a) and this section 
shall take into account inventories, accounts receivable, accounts 
payable, and any other item determined to be necessary in order to 
prevent amounts from being duplicated or omitted.
    (c)(1) The term ``adjustments'', as used in section 481, has 
reference to the net amount of the adjustments required by section 
481(a) and paragraph (b) of this section. In the case of a change in the 
over-all method of accounting, such as from the cash receipts and 
disbursements method to an accrual method, the term ``net amount of the 
adjustments'' means the consolidation of adjustments (whether the 
amounts thereof represent increases or decreases in items of income or 
deductions) arising with respect to balances in various accounts, such 
as inventory, accounts receivable, and accounts payable, at the 
beginning of the taxable year of the change in method of accounting. 
With respect to the portion of the adjustments attributable to pre-1954 
years, it is immaterial that the same items or class of items with 
respect to which adjustments would have to be made (for the first 
taxable year to which section 481 applies) do not exist at the time the 
actual change in method of accounting occurs. For purposes of section 
481, only the net dollar balance is to be taken into account. In the 
case of a change in the treatment of a single material item, the amount 
of the adjustment shall be determined with reference only to the net 
dollar balances in that particular account.
    (2) If a change in method of accounting is voluntary (i.e., 
initiated by the taxpayer), the entire amount of the adjustments 
required by section 481(a) is generally taken into account in computing 
taxable income in the taxable year of the change, regardless of whether 
the adjustments increase or decrease taxable income. See, however, 
Sec. Sec.  1.446-1(e)(3) and 1.481-4 which provide

[[Page 648]]

that the Commissioner may prescribe the taxable year or years in which 
the adjustments are taken into account.
    (3) If the change in method of accounting is involuntary (i.e., not 
initiated by the taxpayer), then only the amount of the adjustments 
required by section 481(a) that is attributable to taxable years 
beginning after December 31, 1953, and ending after August 16, 1954, 
(hereinafter referred to as post-1953 years) is taken into account. This 
amount is generally taken into account in computing taxable income in 
the taxable year of the change, regardless of whether the adjustments 
increase or decrease taxable income. See, however, Sec. Sec.  1.446-
1(e)(3) and 1.481-4 which provide that the Commissioner may prescribe 
the taxable year or years in which the adjustments are taken into 
account. See also Sec.  1.481-3 for rules relating to adjustments 
attributable to pre-1954 years.
    (4) For any adjustments attributable to post-1953 years that are 
taken into account entirely in the year of change and that increase 
taxable income by more than $3,000, the limitations on tax provided in 
section 481(b) (1) or (2) apply. See Sec.  1.481-2 for rules relating to 
the limitations on tax provided by sections 481(b) (1) and (2).
    (5) A change in the method of accounting initiated by the taxpayer 
includes not only a change which he originates by securing the consent 
of the Commissioner, but also a change from one method of accounting to 
another made without the advance approval of the Commissioner. A change 
in the taxpayer's method of accounting required as a result of an 
examination of the taxpayer's income tax return will not be considered 
as initiated by the taxpayer. On the other hand, a taxpayer who, on his 
own initiative, changes his method of accounting in order to conform to 
the requirements of any Federal income tax regulation or ruling shall 
not, merely because of such fact, be considered to have made an 
involuntary change.
    (d) Any adjustments required under section 481(a) that are taken 
into account during a taxable year must be properly taken into account 
for purposes of computing gross income, adjusted gross income, or 
taxable income in determining the amount of any item of gain, loss, 
deduction, or credit that depends on gross income, adjusted gross 
income, or taxable income.

[T.D. 6500, 25 FR 11731, Nov. 26, 1960, as amended by T.D. 8608, 60 FR 
40078, Aug. 7, 1995]



Sec.  1.481-2  Limitation on tax.

    (a) Three-year allocation. Section 481(b)(1) provides a limitation 
on the tax under chapter 1 of the Internal Revenue Code for the taxable 
year of change that is attributable to the adjustments required under 
section 481(a) and Sec.  1.481-1 if the entire amount of the adjustments 
is taken into account in the year of change. If such adjustments 
increase the taxpayer's taxable income for the taxable year of the 
change by more than $3,000, then the tax for such taxable year that is 
attributable to the adjustments shall not exceed the lesser of the tax 
attributable to taking such adjustments into account in computing 
taxable income for the taxable year of the change under section 481(a) 
and Sec.  1.481-1, or the aggregate of the increases in tax that would 
result if the adjustments were included ratably in the taxable year of 
the change and the two preceding taxable years. For the purpose of 
computing the limitation on tax under section 481(b)(1), the adjustments 
shall be allocated ratably to the taxable year of the change and the two 
preceding taxable years, whether or not the adjustments are in fact 
attributable in whole or in part to such years. The limitation on the 
tax provided in this paragraph shall be applicable only if the taxpayer 
used the method of accounting from which the change was made in 
computing taxable income for the two taxable years preceding the taxable 
year of the change.
    (b) Allocation under new method of accounting. Section 481(b)(2) 
provides a second alternative limitation on the tax for the taxable year 
of change under chapter 1 of the Internal Revenue Code that is 
attributable to the adjustments required under section 481(a) and Sec.  
1.481-1 where such adjustments increase taxable income for the taxable 
year of change by more than $3,000. If the taxpayer establishes from his 
books of account and other records what his taxable income would have

[[Page 649]]

been under the new method of accounting for one or more consecutive 
taxable years immediately preceding the taxable year of the change, and 
if the taxpayer in computing taxable income for such years used the 
method of accounting from which the change was made, then the tax 
attributable to the adjustments shall not exceed the smallest of the 
following amounts:
    (1) The tax attributable to taking the adjustments into account in 
computing taxable income for the taxable year of the change under 
section 481(a) and Sec.  1.481-1;
    (2) The tax attributable to such adjustments computed under the 3-
year allocation provided in section 481(b)(1), if applicable; or
    (3) The net increase in the taxes under chapter 1 (or under 
corresponding provisions of prior revenue laws) which would result from 
allocating that portion of the adjustments to the one or more 
consecutive preceding taxable years to which properly allocable under 
the new method of accounting and from allocating the balance thereof to 
the taxable year of the change.
    (c) Rules for computation of tax. (1) The first step in determining 
whether either of the limitations described in section 481(b) (1) or (2) 
applies is to compute the increase in tax for the taxable year of the 
change that is attributable to the increase in taxable income for such 
year resulting solely from the adjustments required under section 481(a) 
and Sec.  1.481-1. This increase in tax is the excess of the tax for the 
taxable year computed by taking into account such adjustments under 
section 481(a) over the tax computed for such year without taking the 
adjustments into account.
    (2) The next step is to compute under section 481(b)(1) the tax 
attributable to the adjustments referred to in paragraph (c)(1) of this 
section for the taxable year of the change and the two preceding taxable 
years as if an amount equal to one-third of the net amount of such 
adjustments had been received or accrued in each of such taxable years. 
The increase in tax attributable to the adjustments for each such 
taxable year is the excess of the tax for such year computed with the 
allocation of one-third of the net adjustments to such taxable year over 
the tax computed without the allocation of any part of the adjustments 
to such year. For the purpose of computing the aggregate increase in 
taxes for such taxable years, there shall be taken into account the 
increase or decrease in tax for any taxable year preceding the taxable 
year of the change to which no adjustment is allocated under section 
481(b)(1) but which is affected by a net operating loss under section 
172 or by a capital loss carryback or carryover under section 1212, 
determined with reference to taxable years with respect to which 
adjustments under section 481(b)(1) are allocated.
    (3) In the event that the taxpayer satisfies the conditions set 
forth in section 481(b)(2), the next step is to determine the amount of 
the net increase in tax attributable to the adjustments referred to in 
paragraph (c)(1) of this section for:
    (i) The taxable year of the change,
    (ii) The consecutive taxable year or years immediately preceding the 
taxable year of the change for which the taxpayer can establish his 
taxable income under the new method of accounting, and
    (iii) Any taxable year preceding the taxable year of the change to 
which no adjustment is allocated under section 481(b)(2), but which is 
affected by a net operating loss or by a capital loss carryback or 
carryover determined with reference to taxable years with respect to 
which such adjustments are allocated.

The net increase in tax for the taxable years specified in subdivisions 
(i), (ii), and (iii) of this subparagraph shall be computed as if the 
amount of the adjustments for the prior taxable years to which properly 
allocable in accordance with section 481(b)(2) had been received or 
accrued, or paid or incurred, as the case may be, in such prior years 
and the balance of the adjustments in the taxable year of the change. 
The amount of tax attributable to such adjustments for the taxable years 
specified in subdivisions (i), (ii), and (iii) of this subparagraph is 
the aggregate of the differences (increases and decreases) between the 
tax for each such year computed by taking into account

[[Page 650]]

the allocable portion of the adjustments in computing taxable income and 
the tax computed without taking into account any portion of the 
adjustments in computing taxable income. Generally, where there is an 
increase in taxable income for a preceding consecutive taxable year 
established under the new method of accounting, computed without regard 
to adjustments attributable to any preceding taxable year, the amount of 
the adjustments to be allocated to each such year shall be an amount 
equal to such increase. However, where the amount of the adjustments to 
be allocated to a prior taxable year is less than the increase in 
taxable income for such year established under the new method of 
accounting, the amount of the increase in such taxable income for 
purposes of determining the increase in tax under section 481(b)(2) for 
such year shall be considered to be the amount so allocated. For 
example, if the amount of the adjustments required by section 481(a) for 
1958 (the taxable year of the change) is $60,000, and the increase in 
taxable income is determined by the taxpayer to be $40,000, $5,000, and 
$35,000, computed under the new method of accounting, for the taxable 
years 1957, 1956, and 1955, respectively, then the amount of the 
adjustments to be allocated to 1955 will be the balance of the 
adjustments, or $15,000.
    (4) The tax for the taxable year of the change shall be the tax for 
such year, computed without taking any of the adjustments referred to in 
paragraph (c)(1) of this section into account, increased by the smallest 
of the following amounts--
    (i) The amount of tax for the taxable year of the change 
attributable solely to taking into account the entire amount of the 
adjustments required by section 481(a) and Sec.  1.481-1;
    (ii) The sum of the increases in tax liability for the taxable year 
of the change and the two immediately preceding taxable years that would 
have resulted solely from taking into account one-third of the amount of 
such adjustments required for each of such years as though such amounts 
had been properly attributable to such years (computed in accordance 
with paragraph (c)(2) of this section); or
    (iii) The net increase in tax attributable to allocating such 
adjustments under the new method of accounting (computed in accordance 
with paragraph (c)(3) of this section).
    (5)(i) In the case of a change in method of accounting by a 
partnership, the adjustments required by section 481 shall be made with 
respect to the taxable income of the partnership but the limitations on 
tax under section 481(b) shall apply to the individual partners. Each 
partner shall take into account his distributive share of the 
partnership items, as so adjusted, for the taxable year of the change. 
Section 481(b) applies to a partner whose taxable income is so increased 
by more than $3,000 as a result of such adjustments to the partnership 
taxable income. It is not necessary for the partner to have been a 
member of the partnership for the two taxable years immediately 
preceding the taxable year of the change of the partnership's accounting 
method in order to have the limitation provided by section 481(b)(1) 
apply. Further, a partner may apply section 481(b)(2) even though he was 
not a member of the partnership for all the taxable years affected by 
the computation thereunder.
    (ii) In the case of a change in method of accounting by an electing 
small business corporation under subchapter S, chapter 1 of the Code, 
the adjustments required by section 481 shall be made with respect to 
the taxable income of such electing corporation in the year of the 
change, but the limitations on tax under section 481(b) shall apply to 
the individual shareholders. Section 481(b) applies to a shareholder of 
an electing small business corporation whose taxable income is so 
increased by more than $3,000 as a result of such adjustments to such 
corporation's taxable income. It is not necessary for the shareholder to 
have been a member of the electing small business corporation, or for 
such corporation to have been an electing small business corporation, 
for the two taxable years immediately preceding the taxable year of the 
change of the corporation's accounting method in order to have the 
limitation provided by section 481(b)(1) apply. Further, a shareholder 
may apply section 481(b)(2), even

[[Page 651]]

though he was not a shareholder, or the corporation was not an electing 
small business corporation, for all the taxable years affected by the 
computation thereunder.
    (6) For the purpose of the successive computations of the 
limitations on tax under section 481(b) (1) or (2), if the treatment of 
any item under the provisions of the Internal Revenue Code of 1986 (or 
corresponding provisions of prior internal revenue laws) depends upon 
the amount of gross income, adjusted gross income, or taxable income 
(for example, medical expenses, charitable contributions, or credits 
against the tax), such item shall be determined for the purpose of each 
such computation by taking into account the proper portion of the amount 
of any adjustments required to be taken into account under section 481 
in each such computation.
    (7) The increase or decrease in the tax for any taxable year for 
which an assessment of any deficiency, or a credit or refund of any 
overpayment, is prevented by any law or rule of law, shall be determined 
by reference to the tax previously determined (within the meaning 
section 1314(a) for such year.
    (8) In applying section 7807(b)(1), the provisions of chapter 1 
(other than subchapter E, relating to tax on self-employment income) and 
chapter 2 of the Internal Revenue Code of 1939 shall be treated as the 
corresponding provisions of the Internal Revenue Code of 1939.
    (d) Examples. The application of section 481(b) (1) and (2) may be 
illustrated by the following examples. Although the examples in this 
paragraph are based upon adjustments required in the case of a change in 
the over-all method of accounting, the principles illustrated would be 
equally applicable to adjustments required in the case of a change in 
method of accounting for a particular material item, provided the 
treatment of such adjustments is not specifically subject to some other 
provision of the Internal Revenue Code of 1986.

    Example 1. An unmarried individual taxpayer using the cash receipts 
and disbursements method of accounting for the calendar year is required 
by the Commissioner to change to an accrual method effective with the 
year 1958. As of January 1, 1958, he had an opening inventory of 
$11,000. On December 31, 1958, he had a closing inventory of $12,500. 
Merchandise purchases during the year amounted to $22,500, and net sales 
were $32,000. Total deductible business expenses were $5,000. There were 
no receivables or payables at January 1, 1958. The computation of 
taxable income for 1958, assuming no other adjustments, using the new 
method of accounting follows:

Net sales...........................................  ........   $32,000
Opening inventory...................................   $11,000
Purchases...........................................    22,500
                                                     -----------
   Total............................................    33,500
Less closing inventory..............................    12,500
                                                     -----------
Cost of goods sold..................................  ........    21,000
                                                               ---------
   Gross profit.....................................  ........    11,000
Business expenses...................................  ........     5,000
                                                               ---------
  Business income...................................  ........     6,000
Personal exemption and itemized deductions..........  ........     1,600
                                                               ---------
   Taxable income...................................  ........     4,400
 


Under the cash receipts and disbursements method of accounting, only 
$9,000 of the $11,000 opening inventory had been included in the cost of 
goods sold and claimed as a deduction for the taxable years 1954 through 
1957; the remaining $2,000 had been so accounted for in pre-1954 years. 
In order to prevent the same item from reducing taxable income twice, an 
adjustment of $9,000 must be made to the taxable income of 1958 under 
the provisions of section 481(a) and Sec.  1.481-1. Since the change in 
method of accounting was not initiated by the taxpayer, the $2,000 of 
opening inventory which had been included in cost of goods sold in pre-
1954 years is not taken into account. Taxable income for 1958 is 
accordingly increased by $9,000 under section 481(a) to $13,400. 
Assuming that the tax on $13,400 is $4,002 and that the tax on $4,400 
(income without the adjustment) is $944, the increase in tax 
attributable to the adjustment, if taken into account for the taxable 
year of the change, would be the difference between the two, or $3,058. 
Since the adjustment required by section 481(a) and Sec.  1.481-1 
($9,000) increases taxable income by more than $3,000, the increase in 
tax for the taxable year 1958 attributable to the adjustment of $9,000 
(i.e., $3,058) may be limited under the provisions of section 481(b) (1) 
or (2). See examples (2) and (3).
    Example 2. Assume that the taxpayer in Example 1 used the cash 
receipts and disbursements method of accounting in computing taxable 
income for the years 1956 and 1957 and that the taxable income for these 
years determined under such method was $4,000 and $6,000, respectively. 
The section 481(b)(1) limitation on tax with a pro rata three-year 
allocation of the $9,000 adjustment is computed as follows:

[[Page 652]]



----------------------------------------------------------------------------------------------------------------
                                                                                                     Increase in
                                                   Taxable      Taxable                Assumed tax       tax
                  Taxable year                      income    income with    Assume       before    attributable
                                                    before     adjustment   total tax   adjustment       to
                                                  adjustment                                         adjustment
----------------------------------------------------------------------------------------------------------------
1956...........................................       $4,000       $7,000      $1,660         $840          $820
1957...........................................        6,000        9,000       2,300        1,360           940
1958...........................................        4,400        7,400       1,780          944           836
                                                ----------------------------------------------------------------
   Total.......................................  ...........  ...........  ..........  ...........         2,596
----------------------------------------------------------------------------------------------------------------


Since this increase in tax of $2,596 is less than the increase in tax 
attributable to the inclusion of the entire adjustment in the income for 
the taxable year of the change ($3,058), the limitation provided by 
section 481(b)(1) applies, and the total tax for 1958, the taxable year 
of the change, if section 481(b)(2) does not apply, is determined as 
follows:

Tax without any portion of adjustment..........................     $944
Increase in tax attributable to adjustment computed under          2,596
 section 481(b)(1).............................................
                                                                --------
   Total tax for taxable year of the change....................    3,540
 

    Example 3. (i) Assume the same facts as in Example 1 and, in 
addition, assume that the taxpayer used the cash receipts and 
disbursements method of accounting in computing taxable income for the 
years 1953 through 1957; that he established his taxable income under 
the new method for the taxable years 1953, 1954, and 1957, but did not 
have sufficient records to establish his taxable income under such 
method for the taxable years 1955 and 1956. The original taxable income 
and taxable income as redetermined are as follows:

------------------------------------------------------------------------
                                        Taxable income
                                 ----------------------------  Increase
                                    Determined                    or
          Taxable year              under cash   Established  (decrease)
                                   receipts and   under new   in taxable
                                  disbursements     method      income
                                      method
------------------------------------------------------------------------
1953............................        $5,000       $7,000       $2,000
1954............................         6,000        7,000        1,000
1955............................         5,500        (\1\)   ..........
1956............................         4,000        (\1\)   ..........
1957............................         6,000       10,000        4,000
------------------------------------------------------------------------
\1\ Undetermined.


As in examples (1) and (2), the total adjustment under section 481(a) is 
$9,000. Of the $9,000 adjustment, $4,000 may be allocated to 1957, which 
is the only year consecutively preceding the taxable year of the change 
for which the taxpayer was able to establish his income under the new 
method. Since the income cannot be established under the new method for 
1956 and 1955, no allocation may be made to 1954 or 1953, even though 
the taxpayer has established his income for those years under the new 
method of accounting. The balance of $5,000 ($9,000 minus $4,000) must 
be allocated to 1958.
    (ii) The limitation provided by section 481(b)(2) is computed as 
follows: The tax for 1957, based on taxable income of $6,000, is assumed 
to be $1,360. Under the new method, based on taxable income of $10,000, 
the tax for 1957 is assumed to be $2,640, the increase attributable to 
$4,000 of the $9,000 section 481(a) adjustment being $1,280, ($2,640 
minus $1,360). The tax for 1958, computed on the basis of taxable income 
of $4,400 (determined under the new method), is assumed to be $944. The 
tax computed for 1958 on taxable income of $9,400 ($4,400 plus the 
$5,000 adjustment allocated to 1958) is assumed to be $2,436, leaving a 
difference of $1,492 ($2,436 minus $944) attributable to the inclusion 
in 1958 of the portion of the total adjustment to be taken into account 
which could not be properly allocated to the taxable year or years 
consecutively preceding 1958.
    (iii) The tax attributable to the adjustment is determined by 
selecting the smallest of the three following amounts:

Increase in tax attributable to adjustment computed under         $2,772
 section 481(b)(2) ($1,280 + $1,492)...........................
Increase in tax attributable to adjustment computed under          2,596
 section 481(b)(1) (Example 2).................................
Increase in tax if the entire adjustment is taken into account     3,058
 in the taxable year of the change (Example 1).................
 

    The final tax for 1958 is then $3,540 computed as follows:

Tax before inclusion of any adjustment.........................     $944
Increase in tax attributable to adjustments (smallest of           2,596
 $2,772, $2,596 or $3,058).....................................
                                                                --------
   Total tax for 1958 (limited in accordance with section          3,540
   481(b)(1))..................................................
 

    Example 4. Assume that X Corporation has maintained its books of 
account and filed its income tax returns using the cash receipts and 
disbursements method of accounting for the years 1953 through 1957. The 
corporation secures permission to change to an accrual method of 
accounting for the calendar year 1958. The following tabulation presents 
the data with respect to the taxpayer's income for the years involved:

[[Page 653]]



----------------------------------------------------------------------------------------------------------------
                                                 Taxable income under the
                                                     cash receipts and
                                                   disbursements method      Taxable                  Changes in
                                                --------------------------    income     Increase or    taxable
                                                    Before       After     established   (decrease)   income due
                      Year                       application  application     under     attributable  to changes
                                                    of net       of net      accrual      to change     in net
                                                  operating    operating      method                     loss
                                                     loss         loss                                 carryback
                                                  carryback    carryback
----------------------------------------------------------------------------------------------------------------
1953...........................................       $2,000            0        (\1\)  ............      $2,000
1954...........................................        4,000       $1,000        (\1\)  ............       3,000
1955...........................................      (5,000)  ...........       $1,000       $6,000   ..........
1956...........................................       80,000       80,000       77,000      (3,000)   ..........
1957...........................................       90,000       90,000       96,000        6,000   ..........
1958...........................................  ...........  ...........      100,000  ............  ..........
----------------------------------------------------------------------------------------------------------------
\1\ Not established.


As indicated above, taxable income for 1953 and 1954, as determined 
under the cash receipts and disbursements method of accounting, was 
$2,000 and $4,000, respectively, and after application of the net 
operating loss carryback from 1955, the taxable income was reduced to 
zero in 1953 and to $1,000 in 1954. The taxpayer was unable to establish 
taxable income for these years under an accrual method of accounting; 
however, under section 481(b)(3)(A), increases or decreases in the tax 
for taxable years to which no adjustment is allocated must, 
nevertheless, be taken into account to the extent the tax for such years 
would be affected by a net operating loss determined with reference to 
taxable years to which adjustments are allocated. The total amount of 
the adjustments required under section 481(a) and attributable to the 
taxable years 1953 through 1957 in this example is assumed to be 
$10,000. The redetermination of taxable income established by the 
taxpayer for the taxable years 1955, 1956, and 1957 appears under the 
heading ``Taxable income established under accrual method'' in the above 
tabulation. The tabulation assumes that the taxpayer has been able to 
recompute the income for those years so as to establish a net adjustment 
of $9,000, which leaves a balance of $1,000 unaccounted for. In 
accordance with the requirements of section 481(b)(2), the $1,000 amount 
is allocated to 1958, the taxable year of the change. The following 
computations are necessary in order to determine the tax attributable to 
the adjustments under section 481(a):

 Increase in tax attributable to inclusion in 1958 of the entire $10,000
                               adjustment
Tax on income of 1958 increased by entire amount of adjustment   $51,700
 ($100,000 + $10,000).........................................
Tax on income of 1958 without adjustment ($100,000)...........    46,500
                                                               ---------
Increase in tax attributable to inclusion of entire adjustment     5,200
 in year of the change........................................
 


                    Increase in tax attributed to adjustment computed under section 481(b)(1)
----------------------------------------------------------------------------------------------------------------
                                                                                                     Increase in
                                                                                                         tax
                                                                 Amount of  Tax before   Tax after    liability
                             Year                               adjustment  adjustment  adjustment  attributable
                                                                                                         to
                                                                                                     adjustment
----------------------------------------------------------------------------------------------------------------
1958..........................................................      $3,334     $46,500     $48,234       $1,734
1957..........................................................       3,333      41,300      43,033        1,733
1956..........................................................       3,333      36,100      37,833        1,733
                                                                                                   -------------
  Increase in tax attributable to adjustment computed under     ..........  ..........  ..........        5,200
   section 481(b)(1)..........................................
----------------------------------------------------------------------------------------------------------------
                    Increase in tax attributed to adjustment computed under section 481(b)(2)
----------------------------------------------------------------------------------------------------------------
1953..........................................................  \1\ $2,000           0    \1\ $600         $600
1954..........................................................   \1\ 3,000        $300    \1\1,200          900
1955..........................................................       6,000           0         300          300
1956..........................................................     (3,000)      36,100      34,540      (1,560)
1957..........................................................      96,000      41,300      44,420        3,120
1958..........................................................   \2\ 1,000      46,500  \2\ 47,020          520
                                                                                                   -------------
  Increase in tax attributable to the adjustment computed       ..........  ..........  ..........        3,880
   under section 481(b)(2)....................................
----------------------------------------------------------------------------------------------------------------
\1\ Attributable to recomputations of net operating loss carrybacks determined with reference to net operating
  loss in 1955.
\2\ Attributable to the inclusion of $1,000 in the year of the change which represents the portion of the
  $10,000 adjustment not allocated to taxable years prior to the year of the change for which taxable income is
  established under the new method.


[[Page 654]]

Since the limitation under section 481(b)(2) ($3,880) on the amount of 
tax attributable to the adjustments is applicable, the final tax for the 
taxable year of the change is computed by adding such amount to the tax 
for that year computed without the inclusion of any amount attributable 
to the adjustments, that is, $46,500 plus $3,880, or $50,380.

[T.D. 6500, 25 FR 11732, Nov. 26, 1960, as amended by T.D. 6490, 25 FR 
8374, Sept. 1, 1960; T.D. 7301, 39 FR 963, Jan. 4, 1974; T.D. 8608, 60 
FR 40078, Aug. 7, 1995]



Sec.  1.481-3  Adjustments attributable to pre-1954 years where change 
was not initiated by taxpayer.

    If the adjustments required by section 481(a) and Sec.  1.481-1 are 
attributable to a change in method of accounting which was not initiated 
by the taxpayer, no portion of any adjustments which is attributable to 
pre-1954 years shall be taken into account in computing taxable income. 
For example, if the total adjustments in the case of a change in method 
of accounting which is not initiated by the taxpayer amount to $10,000, 
of which $4,000 is attributable to pre-1954 years, only $6,000 of the 
$10,000 total adjustments is required to be taken into account under 
section 481 in computing taxable income. The portion of the adjustments 
which is attributable to pre-1954 years is the net amount of the 
adjustments which would have been required if the taxpayer had changed 
his method of accounting in his first taxable year which began after 
December 31, 1953, and ended after August 16, 1954.

[T.D. 6500, 25 FR 11735, Nov. 26, 1960, as amended by T.D. 8608, 60 FR 
40079, Aug. 7, 1995]



Sec.  1.481-4  Adjustments taken into account with consent.

    (a) In addition to the terms and conditions prescribed by the 
Commissioner under Sec.  1.446-1(e)(3) for effecting a change in method 
of accounting, including the taxable year or years in which the amount 
of the adjustments required by section 481(a) is to be taken into 
account, or the methods of allocation described in section 481(b), a 
taxpayer may request approval of an alternative method of allocating the 
amount of the adjustments under section 481. See section 481(c). 
Requests for approval of an alternative method of allocation shall set 
forth in detail the facts and circumstances upon which the taxpayer 
bases its request. Permission will be granted only if the taxpayer and 
the Commissioner agree to the terms and conditions under which the 
allocation is to be effected. See Sec.  1.446-1(e) for the rules 
regarding how to secure the Commissioner's consent to a change in method 
of accounting.
    (b) An agreement to the terms and conditions of a change in method 
of accounting under Sec.  1.446-1(e)(3), including the taxable year or 
years prescribed by the Commissioner under that section (or an 
alternative method described in paragraph (a) of this section) for 
taking the amount of the adjustments under section 481(a) into account, 
shall be in writing and shall be signed by the Commissioner and the 
taxpayer. It shall set forth the items to be adjusted, the amount of the 
adjustments, the taxable year or years for which the adjustments are to 
be taken into account, and the amount of the adjustments allocable to 
each year. The agreement shall be binding on the parties except upon a 
showing of fraud, malfeasance, or misrepresentation of material fact.

[T.D. 8608, 60 FR 40079, Aug. 7, 1995]



Sec.  1.481-5  Eligible terminated S corporation.

    (a) Scope. Section 481(d)(2) of the Internal Revenue Code (Code) and 
this section provide rules relating to the qualification of a 
corporation as an eligible terminated S corporation (ETSC). Paragraph 
(b) of this section sets forth the requirements a corporation must meet 
to qualify as an ETSC. Paragraph (c) of this section describes certain 
transfers and other events that are disregarded for purposes of 
determining whether a corporation qualifies as an ETSC, as well as the 
treatment of revocations for which the effective date is the first day 
of the taxable year during which the revocation is made. Paragraph (d) 
of this section contains examples illustrating the rules of this 
section.
    (b) ETSC qualification. For a C corporation to qualify as an ETSC, 
it must satisfy the following requirements:

[[Page 655]]

    (1) The corporation must have been an S corporation on December 21, 
2017;
    (2) During the 2-year period beginning on December 22, 2017, the 
corporation must have made a valid revocation of its S election under 
section 1362(d)(1) and the regulatory provisions in this part under 
section 1362 of the Code (revocation); and
    (3) Except as provided in paragraph (c) of this section, the owners 
of the shares of stock of the corporation must be the same (and in 
identical proportions) on both:
    (i) December 22, 2017; and
    (ii) The day on which the revocation is made.
    (c) Special rules--(1) Certain disregarded events. The following 
events are disregarded for purposes of determining whether the 
requirement in paragraph (b)(3) of this section is satisfied:
    (i) Transfers of stock between a shareholder and that shareholder's 
trust treated as wholly owned by that shareholder under subpart E of 
subchapter J of chapter 1 of the Code;
    (ii) Transfers of stock between a shareholder and an entity owned by 
that shareholder that is disregarded as separate from its owner under 
Sec.  301.7701-2(c)(2)(i) of the Procedure and Administration 
Regulations;
    (iii) An election by a shareholder trust to be treated as part of a 
decedent's estate under section 645 of the Code or the termination of an 
election under that section;
    (iv) A change in the status of a shareholder trust from one type of 
eligible S corporation shareholder trust described in section 
1361(c)(2)(A) of the Code to another type of eligible S corporation 
shareholder trust; for example, a trust to which the shares of stock 
were transferred pursuant to the terms of a will (testamentary trust) 
described in section 1361(c)(2)(A)(iii) that elects to become an 
electing small business trust described in section 1361(c)(2)(A)(v) and 
(e); and
    (v) A transaction that includes more than one of the events 
described in this paragraph (c)(1).
    (2) Certain revocations. For purposes of paragraphs (b)(2) and 
(b)(3)(ii) of this section, a revocation with an effective date that is 
the first day of the taxable year during which the revocation is made 
pursuant to section 1362(d)(1)(C)(i) may be treated as having been made 
on the day the revocation was made or on the effective date of the 
revocation.
    (d) Examples. Paragraphs (d)(1) through (3) of this section 
(Examples 1 through 3) illustrate the rules of this section. For 
purposes of paragraphs (d)(1) through (3) of this section (Examples 1 
through 3), as of December 1, 2017, X is a calendar year S corporation 
with 100 shares of stock outstanding that is owned equally by unrelated 
individuals A and B. Pursuant to section 1362(d)(1) and Sec. Sec.  
1.1362-2 and 1.1362-6, X made a valid revocation of its S election on 
March 15, 2019, effective on January 1, 2019. X treats the revocation as 
having been made on March 15, 2019, for purposes of paragraphs (b)(2) 
and (b)(3)(ii). At all times, X has a single class of stock outstanding. 
Paragraphs (d)(1) through (3) of this section (Examples 1 through 3) 
describe all relevant transactions involving the X stock from December 
1, 2017, until March 15, 2019.
    (1) Example 1--(i) Facts. On June 5, 2018, A contributed 20 of its 
shares of X stock to Y, a wholly owned limited liability company that is 
disregarded as an entity separate from A pursuant to Sec.  301.7701-
2(c)(2)(i). On June 14, 2018, A contributed all of its interest in Y to 
Trust, which was a revocable trust treated as a wholly owned grantor 
trust of A pursuant to sections 671 and 676 of the Code. On December 27, 
2018, B sold 10 shares of its X stock to C, an unrelated person.
    (ii) Analysis. X is an ETSC if it satisfies the requirements of 
paragraph (b) of this section.
    (A) S corporation. X was an S corporation on December 21, 2017. 
Therefore, X satisfies the requirement of paragraph (b)(1) of this 
section.
    (B) Date of revocation. X made a valid revocation of its S election 
pursuant to section 1362(d)(1) on March 15, 2019, which is during the 
two-year period specified in paragraph (b)(2) of this section. 
Therefore, X satisfies the requirement of paragraph (b)(2) of this 
section.
    (C) Ownership. For purposes of the requirement in paragraph (b)(3) 
of this

[[Page 656]]

section, the relevant dates are: December 22, 2017, and March 15, 2019 
(the date X made a revocation of its S corporation status).
    (1) A's ownership interest. As of December 22, 2017, A owned 50 
shares of the outstanding shares of X stock. On June 5, 2018, A 
contributed 20 of its shares of X stock to Y (Transfer). On June 14, 
2018, A contributed all of its interest in Y to Trust (Contribution). 
Both the Transfer and the Contribution are disregarded for purposes of 
determining whether the requirement of paragraph (b)(3) of this section 
is satisfied. See paragraphs (c)(2) and (1) of this section, 
respectively. Therefore, A owns 50 shares of the outstanding stock of X 
on March 15, 2019.
    (2) B's ownership interest. As of December 22, 2017, B owned 50 
shares of the outstanding shares of X stock. On December 27, 2018, B 
sold 10 shares to C. Therefore, B owns 40 shares of the outstanding 
stock of X on March 15, 2019.
    (3) C's ownership interest. As of December 22, 2017, C owned no 
shares of X stock. On December 27, 2018, C purchased 10 shares from B. 
Therefore, C owns 10 shares of the outstanding stock of X on March 15, 
2019.
    (4) Failure to satisfy the requirement in paragraph (b)(3) of this 
section. As described in paragraphs (d)(1)(ii)(C)(2) and (3) of this 
section, B's and C's interest in X were not in the same proportions on 
December 22, 2017, and March 15, 2019. Therefore, X does not satisfy the 
requirement of paragraph (b)(3) of this section and does not qualify as 
an ETSC.
    (iii) Restoration of interests prior to end of PTTP. If C 
transferred its shares of X stock back to B on February 1, 2019, then on 
December 22, 2017, and March 15, 2019, A and B will have owned 50 shares 
of the outstanding stock of X. Under these facts, X satisfies the 
requirement of paragraph (b)(3) of this section and qualifies as an 
ETSC.
    (2) Example 2--(i) Facts. The facts are the same as in paragraph 
(d)(1)(i) of this section, except that B sold 10 shares of its X stock 
to C on December 18, 2017, in addition to the sale of 10 shares of X 
stock on December 27, 2018.
    (ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) and (B) of 
this section remains the same regarding the requirements of paragraph 
(b)(1) and (2) of this section. With respect to the requirement of 
paragraph (b)(3) of this section, on December 22, 2017, A owned 50%, B 
owned 40%, and C owned 10% of the outstanding stock of X. As in 
paragraph (d)(1)(ii)(C)(1) of this section, the Transfer and the 
Contribution are disregarded for purposes of determining whether the 
requirement of paragraph (b)(3) of this section is satisfied. Therefore, 
on March 15, 2019, A owned 50% (50 shares), B owned 30% (30 shares), and 
C owned 20% (20 shares) of the outstanding shares of X. Even though A, 
B, and C owned shares of X on December 22, 2017, B's and C's 
proportionate ownership interest of X stock was not the same on December 
22, 2017, and March 15, 2019. Therefore, X does not satisfy the 
requirement of paragraph (b)(3) of this section and does not qualify as 
an ETSC.
    (3) Example 3--(i) Facts. The facts are the same as in paragraph 
(d)(1)(i) of this section, except that X made a valid revocation of its 
S election on November 1, 2019, effective on January 1, 2020.
    (ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) through (C) 
of this section remains the same regarding the requirements of paragraph 
(b)(1) through (3) of this section, except that the relevant dates are: 
December 22, 2017, and November 1, 2019 (the date X made a revocation of 
its S corporation status). Although the effective date of X's revocation 
of its S election (January 1, 2020) occurs after the conclusion of the 
two-year period specified in paragraph (b)(2) of this section, it is 
irrelevant for purposes of determining whether the requirements of 
paragraph (b)(2) and (3) of this section are satisfied.

[T.D. 9914, 85 FR 66476, Oct. 20, 2020]



Sec.  1.481-6  Effective dates; applicability dates.

    (a) Sections 1.481-1, 1.481-2, 1.481-3, and 1.481-4 are effective 
for Consent Agreements signed on or after December 27, 1994. For Consent 
Agreements signed before December 27, 1994, see Sec. Sec.  1.481-1, 
1.481-2, 1.481-3, 1.481-4, and 1.481-5 as contained in 26 CFR part 1, 
revised as of April 1, 1995.

[[Page 657]]

    (b) Section 1.481-5 applies to taxable years beginning October 20, 
2020. However, a corporation may choose to apply the rules in Sec. Sec.  
1.481-5, 1.1371-1, and 1.1371-2 in their entirety to taxable years 
beginning on or before October 20, 2020. If a corporation makes the 
choice described in the previous sentence, the corporation must continue 
to apply the rules in Sec. Sec.  1.481-5, 1.1371-1, and 1.1371-2 in 
their entirety for the corporation's subsequent taxable years.

[T.D. 9914, 85 FR 66478, Oct. 20, 2020]



Sec.  1.482-0  Outline of regulations under section 482.

    This section contains major captions for Sec. Sec.  1.482-1 through 
1.482-9.

   Sec.  1.482-1 Allocation of income and deductions among taxpayers.

    (a) In general.
    (1) Purpose and scope.
    (2) Authority to make allocations.
    (3) Taxpayer's use of section 482.
    (b) Arm's length standard.
    (1) In general.
    (2) Arm's length methods.
    (i) Methods.
    (ii) Selection of category of method applicable to transaction.
    (iii) Coordination of methods applicable to certain intangible 
development arrangements.
    (c) Best method rule.
    (1) In general.
    (2) Determining the best method.
    (i) Comparability.
    (ii) Data and assumptions.
    (A) Completeness and accuracy of data.
    (B) Reliability of assumptions.
    (C) Sensitivity of results to deficiencies in data and assumptions.
    (iii) Confirmation of results by another method.
    (d) Comparability.
    (1) In general.
    (2) Standard of comparability.
    (3) Factors for determining comparability.
    (i) Functional analysis.
    (ii) Contractual terms.
    (A) In general.
    (B) Identifying contractual terms.
    (1) Written agreement.
    (2) No written agreement.
    (C) Examples.
    (iii) Risk.
    (A) In general.
    (B) Identification of party that bears risk.
    (C) Examples.
    (iv) Economic conditions.
    (v) Property or services.
    (4) Special circumstances.
    (i) Market share strategy.
    (ii) Different geographic markets.
    (A) In general.
    (B) Example.
    (C) Location savings.
    (D) Example.
    (iii) Transactions ordinarily not accepted as comparables.
    (A) In general.
    (B) Examples.
    (e) Arm's length range.
    (1) In general.
    (2) Determination of arm's length range.
    (i) Single method.
    (ii) Selection of comparables.
    (iii) Comparables included in arm's length range.
    (A) In general.
    (B) Adjustment of range to increase reliability.
    (C) Interquartile range.
    (3) Adjustment if taxpayer's results are outside arm's length range.
    (4) Arm's length range not prerequisite to allocation.
    (5) Examples.
    (f) Scope of review.
    (1) In general.
    (i) Intent to evade or avoid tax not a prerequisite.
    (ii) Realization of income not a prerequisite.
    (A) In general.
    (B) Example.
    (iii) Nonrecognition provisions may not bar allocation.
    (A) In general.
    (B) Example.
    (iv) Consolidated returns.
    (2) Rules relating to determination of true taxable income.
    (i) [Reserved]
    (ii) Allocation based on taxpayer's actual transactions.
    (A) In general.
    (B) [Reserved]
    (iii) Multiple year data.
    (A) In general.
    (B) Circumstances warranting consideration of multiple year data.
    (C) Comparable effect over comparable period.
    (D) Applications of methods using multiple year averages.
    (E) Examples.
    (iv) Product lines and statistical techniques.
    (v) Allocations apply to results, not methods.
    (A) In general.
    (B) Example.
    (g) Collateral adjustments with respect to allocations under section 
482.
    (1) In general.
    (2) Correlative allocations.
    (i) In general.
    (ii) Manner of carrying out correlative allocation.

[[Page 658]]

    (iii) Events triggering correlative allocation.
    (iv) Examples.
    (3) Adjustments to conform accounts to reflect section 482 
allocations.
    (i) In general.
    (ii) Example.
    (4) Setoffs.
    (i) In general.
    (ii) Requirements.
    (iii) Examples.
    (h) Special rules.
    (1) Small taxpayer safe harbor. [Reserved]
    (2) Effect of foreign legal restrictions.
    (i) In general.
    (ii) Applicable legal restrictions.
    (iii) Requirement for electing the deferred income method of 
accounting.
    (iv) Deferred income method of accounting.
    (v) Examples.
    (3) Coordination with section 936.
    (i) Cost sharing under section 936.
    (ii) Use of terms.
    (i) Definitions.
    (j) Effective/applicability date.

  Sec.  1.482-2 Determination of taxable income in specific situations.

    (a) Loans or advances.
    (1) Interest on bona fide indebtedness.
    (i) In general.
    (ii) Application of paragraph (a) of this section.
    (A) Interest on bona fide indebtedness.
    (B) Alleged indebtedness.
    (iii) Period for which interest shall be charged.
    (A) General rule.
    (B) Exception for certain intercompany transactions in the ordinary 
course of business.
    (C) Exception for trade or business of debtor member located outside 
the United States.
    (D) Exception for regular trade practice of creditor member or 
others in creditor's industry.
    (E) Exception for property purchased for resale in a foreign 
country.
    (1) General rule.
    (2) Interest-free period.
    (3) Average collection period.
    (4) Illustration.
    (iv) Payment; book entries.
    (2) Arm's length interest rate.
    (i) In general.
    (ii) Funds obtained at situs of borrower.
    (iii) Safe haven interest rates for certain loans and advances made 
after May 8, 1986.
    (A) Applicability.
    (1) General rule.
    (2) Grandfather rule for existing loans.
    (B) Safe haven interest rate based on applicable Federal rate.
    (C) Applicable Federal rate.
    (D) Lender in business of making loans.
    (E) Foreign currency loans.
    (3) Coordination with interest adjustments required under certain 
other Internal Revenue Code sections.
    (4) Examples.
    (b) Rendering of services.
    (c) Use of tangible property.
    (1) General rule.
    (2) Arm's length charge.
    (i) In general.
    (ii) Safe haven rental charge.
    (iii) Subleases.
    (d) Transfer of property.
    (e) Cost sharing arrangement.
    (f) Effective/applicability Date.
    (1) In general.
    (2) Election to apply paragraph (b) to earlier taxable years.

 Sec.  1.482-3 Methods to determine taxable income in connection with a 
                     transfer of tangible property.

    (a) In general.
    (b) Comparable uncontrolled price method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) In general.
    (B) Adjustments for differences between controlled and uncontrolled 
transactions.
    (iii) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
    (5) Indirect evidence of comparable uncontrolled transactions.
    (i) In general.
    (ii) Limitations.
    (iii) Examples.
    (c) Resale price method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Applicable resale price.
    (iii) Appropriate gross profit.
    (iv) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions.
    (D) Sales agent.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (d) Cost plus method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Appropriate gross profit.
    (iii) Arm's length range.
    (3) Comparability and reliability considerations.

[[Page 659]]

    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions.
    (D) Purchasing agent.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (e) Unspecified methods.
    (1) In general.
    (2) Example.
    (f) Coordination with intangible property rules.

 Sec.  1.482-4 Methods to determine taxable income in connection with a 
                    transfer of intangible property.

    (a) In general.
    (b) Definition of intangible.
    (c) Comparable uncontrolled transaction method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Reliability.
    (iii) Comparability.
    (A) In general.
    (B) Factors to be considered in determining comparability.
    (1) Comparable intangible property.
    (2) Comparable circumstances.
    (iv) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
    (d) Unspecified methods.
    (1) In general.
    (2) Example.
    (e) Coordination with tangible property rules.
    (f) Special rules for transfers of intangible property.
    (1) Form of consideration.
    (2) Periodic adjustments.
    (i) General rule.
    (ii) Exceptions.
    (A) Transactions involving the same intangible.
    (B) Transactions involving comparable intangible.
    (C) Methods other than comparable uncontrolled transaction.
    (D) Extraordinary events.
    (E) Five-year period.
    (iii) Examples.
    (3) Ownership of intangible property.
    (i) Identification of owner.
    (A) In general.
    (B) Cost sharing arrangements.
    (ii) Examples.
    (4) Contribution to the value of intangible property owned by 
another.
    (i) In general.
    (ii) Examples.
    (5) Consideration not artificially limited.
    (6) Lump sum payments
    (i) In general.
    (ii) Exceptions.
    (iii) Example.
    (g) Coordination with rules governing cost sharing arrangements.
    (h) Effective/applicability date.
    (1) In general.
    (2) Election to apply regulation to earlier taxable years.

                Sec.  1.482-5 Comparable profits method.

    (a) In general.
    (b) Determination of arm's length result.
    (1) In general.
    (2) Tested party.
    (i) In general.
    (ii) Adjustments for tested party.
    (3) Arm's length range.
    (4) Profit level indicators.
    (i) Rate of return on capital employed.
    (ii) Financial ratios.
    (iii) Other profit level indicators.
    (c) Comparability and reliability considerations.
    (1) In general.
    (2) Comparability.
    (i) In general.
    (ii) Functional, risk and resource comparability.
    (iii) Other comparability factors.
    (iv) Adjustments for differences between tested party and the 
uncontrolled taxpayers.
    (3) Data and assumptions.
    (i) In general.
    (ii) Consistency in accounting.
    (iii) Allocations between the relevant business activity and other 
activities.
    (d) Definitions.
    (e) Examples.

                   Sec.  1.482-6 Profit split method.

    (a) In general.
    (b) Appropriate share of profits and losses.
    (c) Application.
    (1) In general.
    (2) Comparable profit split.
    (i) In general.
    (ii) Comparability and reliability considerations.
    (A) In general.
    (B) Comparability.
    (1) In general.
    (2) Adjustments for differences between the controlled and 
uncontrolled taxpayers.
    (C) Data and assumptions.
    (D) Other factors affecting reliability.
    (3) Residual profit split.
    (i) In general.
    (A) Allocate income to routine contributions.
    (B) Allocate residual profit.
    (1) Nonroutine contributions generally.
    (2) Nonroutine contributions of intangible property.

[[Page 660]]

    (ii) Comparability and reliability considerations.
    (A) In general.
    (B) Comparability.
    (C) Data and assumptions.
    (D) Other factors affecting reliability
    (d) Effective/applicability date.
    (iii) Example.

 Sec.  1.482-7 Methods to determine taxable income in connection with a 
                        cost sharing arrangement.

    (a) In general.
    (1) RAB share method for cost sharing transactions (CSTs).
    (2) Methods for platform contribution transactions (PCTs).
    (3) Methods for other controlled transactions.
    (i) Contribution to a CSA by a controlled taxpayer that is not a 
controlled participant.
    (ii) Transfer of interest in a cost shared intangible.
    (iii) Other controlled transactions in connection with a CSA.
    (iv) Controlled transactions in the absence of a CSA.
    (4) Coordination with the arm's length standard.
    (b) Cost sharing arrangement.
    (1) Substantive requirements.
    (i) CSTs.
    (ii) PCTs.
    (iii) Divisional interests.
    (iv) Examples.
    (2) Administrative requirements.
    (3) Date of a PCT.
    (4) Divisional interests.
    (i) In general.
    (ii) Territorial based divisional interests.
    (iii) Field of use based divisional interests.
    (iv) Other divisional bases.
    (v) Examples.
    (5) Treatment of certain arrangements as CSAs.
    (i) Situation in which Commissioner must treat arrangement as a CSA.
    (ii) Situation in which Commissioner may treat arrangement as a CSA.
    (iii) Examples.
    (6) Entity classification of CSAs.
    (c) Platform contributions.
    (1) In general.
    (2) Terms of platform contributions.
    (i) Presumed to be exclusive.
    (ii) Rebuttal of Exclusivity.
    (iii) Proration of PCT Payments to the extent allocable to other 
business activities.
    (A) In general.
    (B) Determining the proration of PCT Payments.
    (3) Categorization of the PCT.
    (4) Certain make-or-sell rights excluded.
    (i) In general.
    (ii) Examples.
    (5) Examples.
    (d) Intangible development costs.
    (1) Determining whether costs are IDCs.
    (i) Definition and scope of the IDA.
    (ii) Reasonably anticipated cost shared intangible.
    (iii) Costs included in IDCs.
    (iv) Examples.
    (2) Allocation of costs.
    (3) Stock-based compensation.
    (i) In general.
    (ii) Identification of stock-based compensation with the IDA.
    (iii) Measurement and timing of stock-based compensation IDC.
    (A) In general.
    (1) Transfers to which section 421 applies.
    (2) Deductions of foreign controlled participants.
    (3) Modification of stock option.
    (4) Expiration or termination of CSA.
    (B) Election with respect to options on publicly traded stock.
    (1) In general.
    (2) Publicly traded stock.
    (3) Generally accepted accounting principles.
    (4) Time and manner of making the election.
    (C) Consistency.
    (4) IDC share.
    (5) Examples.
    (e) Reasonably anticipated benefits share.
    (1) Definition.
    (i) In general.
    (ii) Reliability.
    (iii) Examples.
    (2) Measure of benefits.
    (i) In general.
    (ii) Indirect bases for measuring anticipated benefits.
    (A) Units used, produced, or sold.
    (B) Sales.
    (C) Operating profit.
    (D) Other bases for measuring anticipated benefits.
    (E) Examples.
    (iii) Projections used to estimate benefits.
    (A) In general.
    (B) Examples.
    (f) Changes in participation under a CSA.
    (1) In general.
    (2) Controlled transfer of interests.
    (3) Capability variation.
    (4) Arm's length consideration for a change in participation.
    (5) Examples.
    (g) Supplemental guidance on methods applicable to PCTs.
    (1) In general.
    (2) Best method analysis applicable for evaluation of a PCT pursuant 
to a CSA.
    (i) In general.
    (ii) Consistency with upfront contractual terms and risk 
allocation--the investor model.
    (A) In general.
    (B) Example.
    (iii) Consistency of evaluation with realistic alternatives.

[[Page 661]]

    (A) In general.
    (B) Examples.
    (iv) Aggregation of transactions.
    (v) Discount rate.
    (A) In general.
    (B) Considerations in best method analysis of discount rate.
    (1) Discount rate variation between realistic alternatives.
    (2) [Reserved]
    (3) Discount rate variation between forms of payment.
    (4) Post-tax rate.
    (C) Example.
    (vi) Financial projections.
    (vii) Accounting principles.
    (A) In general.
    (B) Examples.
    (viii) Valuations of subsequent PCTs.
    (A) Date of subsequent PCT.
    (B) Best method analysis for subsequent PCT.
    (ix) Arm's length range.
    (A) In general.
    (B) Methods based on two or more input parameters.
    (C) Variable input parameters.
    (D) Determination of arm's length PCT Payment.
    (1) No variable input parameters.
    (2) One variable input parameter.
    (3) More than one variable input parameter.
    (E) Adjustments.
    (x) Valuation undertaken on a pre-tax basis.
    (3) Comparable uncontrolled transaction method.
    (4) Income method.
    (i) In general.
    (A) Equating cost sharing and licensing alternatives.
    (B) Cost sharing alternative.
    (C) Licensing alternative.
    (D) Only one controlled participant with nonroutine platform 
contributions.
    (E) Income method payment forms.
    (F) Discount rates appropriate to cost sharing and licensing 
alternatives.
    (G) The effect of taxation on determining the arm's length amount.
    (ii) Evaluation of PCT Payor's cost sharing alternative.
    (iii) Evaluation of PCT Payor's licensing alternative.
    (A) Evaluation based on CUT.
    (B) Evaluation based on CPM.
    (iv) Lump sum payment form.
    (v) [Reserved]
    (vi) Best method analysis considerations.
    (A) Coordination with Sec.  1.482-1(c).
    (B) Assumptions Concerning Tax Rates.
    (C) Coordination with Sec.  1.482-4(c)(2).
    (D) Coordination with Sec.  1.482-5(c).
    (E) Certain Circumstances Concerning PCT Payor.
    (F) Discount rates.
    (1) Reflection of similar risk profiles of cost sharing alternative 
and licensing alternative.
    (2) [Reserved]
    (vii) Routine platform and operating contributions.
    (viii) Examples.
    (5) Acquisition Price Method.
    (i) In general.
    (ii) Determination of arm's length charge.
    (iii) Adjusted acquisition price.
    (iv) Best method analysis considerations.
    (v) Example.
    (6) Market capitalization method.
    (i) In general.
    (ii) Determination of arm's length charge.
    (iii) Average market capitalization.
    (iv) Adjusted average market capitalization.
    (v) Best method analysis considerations.
    (vi) Examples.
    (7) Residual profit split method.
    (i) In general.
    (ii) Appropriate share of profits and losses.
    (iii) Profit split.
    (A) In general.
    (B) Determine nonroutine residual divisional profit or loss.
    (C) Allocate nonroutine residual divisional profit or loss.
    (1) In general.
    (2) Relative value determination.
    (3) Determination of PCT Payments.
    (4) Routine platform and operating contributions.
    (iv) Best method analysis considerations.
    (A) In general.
    (B) Comparability.
    (C) Data and assumptions.
    (D) Other factors affecting reliability.
    (v) Examples.
    (8) Unspecified methods.
    (h) Form of payment rules.
    (1) CST Payments.
    (2) PCT Payments.
    (i) In general.
    (ii) No PCT Payor stock.
    (iii) Specified form of payment.
    (A) In general.
    (B) Contingent payments.
    (C) Examples.
    (iv) Conversion from fixed to contingent form of payment.
    (3) Coordination of best method rule and form of payment.
    (i) Allocations by the Commissioner in connection with a CSA.
    (1) In general.
    (2) CST allocations.
    (i) In general.
    (ii) Adjustments to improve the reliability of projections used to 
estimate RAB shares.
    (A) Unreliable projections.
    (B) Foreign-to-foreign adjustments.
    (C) Correlative adjustments to PCTs.
    (D) Examples.
    (iii) Timing of CST allocations.

[[Page 662]]

    (3) PCT allocations.
    (4) Allocations regarding changes in participation under a CSA.
    (5) Allocations when CSTs are consistently and materially 
disproportionate to RAB shares.
    (6) Periodic adjustments.
    (i) In general.
    (ii) PRRR.
    (iii) AERR.
    (A) In general.
    (B) PVTP.
    (C) PVI.
    (iv) ADR.
    (A) In general.
    (B) Publicly traded companies.
    (C) Publicly traded.
    (D) PCT Payor WACC.
    (E) Generally accepted accounting principles.
    (v) Determination of periodic adjustments.
    (A) In general.
    (B) Adjusted RPSM as of Determination Date.
    (vi) Exceptions to periodic adjustments.
    (A) Controlled participants establish periodic adjustment not 
warranted.
    (1) Transactions involving the same platform contribution as in the 
Trigger PCT.
    (2) Results not reasonably anticipated.
    (3) Reduced AERR does not cause Periodic Trigger.
    (4) Increased AERR does not cause Periodic Trigger.
    (B) Circumstances in which Periodic Trigger deemed not to occur.
    (1) 10-year period.
    (2) 5-year period.
    (vii) Examples.
    (j) Definitions and special rules.
    (1) Definitions.
    (i) In general.
    (ii) Examples.
    (2) Special rules.
    (i) Consolidated group.
    (ii) Trade or business.
    (iii) Partnership.
    (3) Character.
    (i) CST Payments.
    (ii) PCT Payments.
    (iii) Examples.
    (k) CSA administrative requirements.
    (1) CSA contractual requirements.
    (i) In general.
    (ii) Contractual provisions.
    (iii) Meaning of contemporaneous.
    (A) In general.
    (B) Example.
    (iv) Interpretation of contractual provisions.
    (A) In general.
    (B) Examples.
    (2) CSA documentation requirements.
    (i) In general.
    (ii) Additional CSA documentation requirements.
    (iii) Coordination rules and production of documents.
    (A) Coordination with penalty regulations.
    (B) Production of documentation.
    (3) CSA accounting requirements.
    (i) In general.
    (ii) Reliance on financial accounting.
    (4) CSA reporting requirements.
    (i) CSA Statement.
    (ii) Content of CSA Statement.
    (iii) Time for filing CSA Statement.
    (A) 90-day rule.
    (B) Annual return requirement.
    (1) In general.
    (2) Special filing rule for annual return requirement.
    (iv) Examples.
    (l) Effective/applicability date.
    (m) Transition rule.
    (1) In general.
    (2) Transitional modification of applicable provisions.
    (3) Special rule for certain periodic adjustments.

             Sec.  1.482-8 Examples of the best method rule.

    (a) Introduction.
    (b) Examples.
    (c) Effective/applicability date.

 Sec.  1.482-9 Methods to determine taxable income in connection with a 
                    controlled services transaction.

    (a) In general.
    (b) Services cost method.
    (1) In general.
    (2) Eligibility for the services cost method.
    (3) Covered services.
    (i) Specified covered services.
    (ii) Low margin covered services.
    (4) Excluded activities.
    (5) Not services that contribute significantly to fundamental risks 
of business success or failure.
    (6) Adequate books and records.
    (7) Shared services arrangement.
    (i) In general.
    (ii) Requirements for shared services arrangement.
    (A) Eligibility.
    (B) Allocation.
    (C) Documentation.
    (iii) Definitions and special rules.
    (A) Participant.
    (B) Aggregation.
    (C) Coordination with cost sharing arrangements.
    (8) Examples.
    (c) Comparable uncontrolled services price method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) In general.

[[Page 663]]

    (B) Adjustments for differences between controlled and uncontrolled 
transactions.
    (iii) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
    (5) Indirect evidence of the price of a comparable uncontrolled 
services transaction.
    (i) In general.
    (ii) Example.
    (d) Gross services margin method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Relevant uncontrolled transaction.
    (iii) Applicable uncontrolled price.
    (iv) Appropriate gross services profit.
    (v) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions.
    (D) Buy-sell distributor.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (e) Cost of services plus method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Appropriate gross services profit.
    (iii) Comparable transactional costs.
    (iv) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between the controlled and 
uncontrolled transactions.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (f) Comparable profits method.
    (1) In general.
    (2) Determination of arm's length result.
    (i) Tested party.
    (ii) Profit level indicators.
    (iii) Comparability and reliability considerations--Data and 
assumptions--Consistency in accounting.
    (3) Examples.
    (g) Profit split method.
    (1) In general.
    (2) Examples.
    (h) Unspecified methods.
    (i) Contingent-payment contractual terms for services.
    (1) Contingent-payment contractual terms recognized in general.
    (2) Contingent-payment arrangement.
    (i) General requirements.
    (A) Written contract.
    (B) Specified contingency.
    (C) Basis for payment.
    (ii) Economic substance and conduct.
    (3) Commissioner's authority to impute contingent-payment terms.
    (4) Evaluation of arm's length charge.
    (5) Examples.
    (j) Total services costs.
    (k) Allocation of costs.
    (1) In general.
    (2) Appropriate method of allocation and apportionment.
    (i) Reasonable method standard.
    (ii) Use of general practices.
    (3) Examples.
    (l) Controlled services transaction.
    (1) In general.
    (2) Activity.
    (3) Benefit.
    (i) In general.
    (ii) Indirect or remote benefit.
    (iii) Duplicative activities.
    (iv) Shareholder activities.
    (v) Passive association.
    (4) Disaggregation of transactions.
    (5) Examples.
    (m) Coordination with transfer pricing rules for other transactions.
    (1) Services transactions that include other types of transactions.
    (2) Services transactions that effect a transfer of intangible 
property.
    (3) Coordination with rules governing cost sharing arrangements.
    (4) Other types of transactions that include controlled services 
transactions.
    (5) Examples.
    (n) Effective/applicability dates.
    (1) In general.
    (2) Election to apply regulations to earlier taxable years.

[T.D. 8552, 59 FR 34988, July 8, 1994, as amended by T.D. 8632, 60 FR 
65557, Dec. 20, 1995; 61 FR 7157, Feb. 26, 1996; T.D. 8670, 61 FR 21956, 
May 13, 1996; T.D. 9088, 68 FR 51177, Aug. 26, 2003; T.D. 9278, 71 FR 
44479, Aug. 4, 2006; T.D. 9441, 74 FR 348, Jan. 5, 2009, 74 FR 9571, 
Mar. 5, 2009; T.D. 9456, 74 FR 38837, Aug. 4, 2009; T.D. 9568, 76 FR 
80087, Dec. 22, 2011; T.D. 9738, 80 FR 55540, Sept. 16, 2015]



Sec.  1.482-1  Allocation of income and deductions among taxpayers.

    (a) In general--(1) Purpose and scope. The purpose of section 482 is 
to ensure that taxpayers clearly reflect income attributable to 
controlled transactions and to prevent the avoidance of taxes with 
respect to such transactions. Section 482 places a controlled taxpayer 
on a tax parity with an uncontrolled taxpayer by determining the true 
taxable

[[Page 664]]

income of the controlled taxpayer. This section sets forth general 
principles and guidelines to be followed under section 482. Section 
1.482-2 provides rules for the determination of the true taxable income 
of controlled taxpayers in specific situations, including controlled 
transactions involving loans or advances or the use of tangible 
property. Sections 1.482-3 through 1.482-6 provide rules for the 
determination of the true taxable income of controlled taxpayers in 
cases involving the transfer of property. Section 1.482-7T sets forth 
the cost sharing provisions applicable to taxable years beginning on or 
after January 5, 2009. Section 1.482-8 provides examples illustrating 
the application of the best method rule. Finally, Sec.  1.482-9 provides 
rules for the determination of the true taxable income of controlled 
taxpayers in cases involving the performance of services.
    (2) Authority to make allocations. The district director may make 
allocations between or among the members of a controlled group if a 
controlled taxpayer has not reported its true taxable income. In such 
case, the district director may allocate income, deductions, credits, 
allowances, basis, or any other item or element affecting taxable income 
(referred to as allocations). The appropriate allocation may take the 
form of an increase or decrease in any relevant amount.
    (3) Taxpayer's use of section 482. If necessary to reflect an arm's 
length result, a controlled taxpayer may report on a timely filed U.S. 
income tax return (including extensions) the results of its controlled 
transactions based upon prices different from those actually charged. 
Except as provided in this paragraph, section 482 grants no other right 
to a controlled taxpayer to apply the provisions of section 482 at will 
or to compel the district director to apply such provisions. Therefore, 
no untimely or amended returns will be permitted to decrease taxable 
income based on allocations or other adjustments with respect to 
controlled transactions. See Sec.  1.6662-6T(a)(2) or successor 
regulations.
    (b) Arm's length standard--(1) In general. In determining the true 
taxable income of a controlled taxpayer, the standard to be applied in 
every case is that of a taxpayer dealing at arm's length with an 
uncontrolled taxpayer. A controlled transaction meets the arm's length 
standard if the results of the transaction are consistent with the 
results that would have been realized if uncontrolled taxpayers had 
engaged in the same transaction under the same circumstances (arm's 
length result). However, because identical transactions can rarely be 
located, whether a transaction produces an arm's length result generally 
will be determined by reference to the results of comparable 
transactions under comparable circumstances. See Sec.  1.482-1(d)(2) 
(Standard of comparability). Evaluation of whether a controlled 
transaction produces an arm's length result is made pursuant to a method 
selected under the best method rule described in Sec.  1.482-1(c).
    (2) Arm's length methods--(i) Methods. Sections 1.482-2 through 
1.482-7 and 1.482-9 provide specific methods to be used to evaluate 
whether transactions between or among members of the controlled group 
satisfy the arm's length standard, and if they do not, to determine the 
arm's length result. This section provides general principles applicable 
in determining arm's length results of such controlled transactions, but 
do not provide methods, for which reference must be made to those other 
sections in accordance with paragraphs (b)(2)(ii) and (iii) of this 
section. Section 1.482-7 provides the specific methods to be used to 
evaluate whether a cost sharing arrangement as defined in Sec.  1.482-7 
produces results consistent with an arm's length result.
    (ii) Selection of category of method applicable to transaction. The 
methods listed in Sec.  1.482-2 apply to different types of 
transactions, such as transfers of property, services, loans or 
advances, and rentals. Accordingly, the method or methods most 
appropriate to the calculation of arm's length results for controlled 
transactions must be selected, and different methods may be applied to 
interrelated transactions if such transactions are most reliably 
evaluated on a separate basis. For example, if services are provided in 
connection with the transfer of property, it may be appropriate to 
separately

[[Page 665]]

apply the methods applicable to services and property in order to 
determine an arm's length result. But see Sec.  1.482-1(f)(2)(i) 
(Aggregation of transactions). In addition, other applicable provisions 
of the Code may affect the characterization of a transaction, and 
therefore affect the methods applicable under section 482. See for 
example section 467.
    (iii) Coordination of methods applicable to certain intangible 
development arrangements. Section 1.482-7 provides the specific methods 
to be used to determine arm's length results of controlled transactions 
in connection with a cost sharing arrangement as defined in Sec.  1.482-
7. Sections 1.482-4 and 1.482-9, as appropriate, provide the specific 
methods to be used to determine arm's length results of arrangements, 
including partnerships, for sharing the costs and risks of developing 
intangibles, other than a cost sharing arrangement covered by Sec.  
1.482-7. See also Sec. Sec.  1.482-4(g) (Coordination with rules 
governing cost sharing arrangements) and 1.482-9(m)(3) (Coordination 
with rules governing cost sharing arrangements).
    (c) Best method rule--(1) In general. The arm's length result of a 
controlled transaction must be determined under the method that, under 
the facts and circumstances, provides the most reliable measure of an 
arm's length result. Thus, there is no strict priority of methods, and 
no method will invariably be considered to be more reliable than others. 
An arm's length result may be determined under any method without 
establishing the inapplicability of another method, but if another 
method subsequently is shown to produce a more reliable measure of an 
arm's length result, such other method must be used. Similarly, if two 
or more applications of a single method provide inconsistent results, 
the arm's length result must be determined under the application that, 
under the facts and circumstances, provides the most reliable measure of 
an arm's length result. See Sec.  1.482-8 for examples of the 
application of the best method rule. See Sec.  1.482-7 for the 
applicable methods in the case of a cost sharing arrangement.
    (2) Determining the best method. Data based on the results of 
transactions between unrelated parties provides the most objective basis 
for determining whether the results of a controlled transaction are 
arm's length. Thus, in determining which of two or more available 
methods (or applications of a single method) provides the most reliable 
measure of an arm's length result, the two primary factors to take into 
account are the degree of comparability between the controlled 
transaction (or taxpayer) and any uncontrolled comparables, and the 
quality of the data and assumptions used in the analysis. In addition, 
in certain circumstances, it also may be relevant to consider whether 
the results of an analysis are consistent with the results of an 
analysis under another method. These factors are explained in paragraphs 
(c)(2)(i), (ii), and (iii) of this section.
    (i) Comparability. The relative reliability of a method based on the 
results of transactions between unrelated parties depends on the degree 
of comparability between the controlled transaction or taxpayers and the 
uncontrolled comparables, taking into account the factors described in 
Sec.  1.482-1(d)(3) (Factors for determining comparability), and after 
making adjustments for differences, as described in Sec.  1.482-1(d)(2) 
(Standard of comparability). As the degree of comparability increases, 
the number and extent of potential differences that could render the 
analysis inaccurate is reduced. In addition, if adjustments are made to 
increase the degree of comparability, the number, magnitude, and 
reliability of those adjustments will affect the reliability of the 
results of the analysis. Thus, an analysis under the comparable 
uncontrolled price method will generally be more reliable than analyses 
obtained under other methods if the analysis is based on closely 
comparable uncontrolled transactions, because such an analysis can be 
expected to achieve a higher degree of comparability and be susceptible 
to fewer differences than analyses under other methods. See Sec.  1.482-
3(b)(2)(ii)(A). An analysis will be relatively less reliable, however, 
as the uncontrolled transactions become less comparable to the 
controlled transaction.
    (ii) Data and assumptions. Whether a method provides the most 
reliable measure of an arm's length result also

[[Page 666]]

depends upon the completeness and accuracy of the underlying data, the 
reliability of the assumptions, and the sensitivity of the results to 
possible deficiencies in the data and assumptions. Such factors are 
particularly relevant in evaluating the degree of comparability between 
the controlled and uncontrolled transactions. These factors are 
discussed in paragraphs (c)(2)(ii) (A), (B), and (C) of this section.
    (A) Completeness and accuracy of data. The completeness and accuracy 
of the data affects the ability to identify and quantify those factors 
that would affect the result under any particular method. For example, 
the completeness and accuracy of data will determine the extent to which 
it is possible to identify differences between the controlled and 
uncontrolled transactions, and the reliability of adjustments that are 
made to account for such differences. An analysis will be relatively 
more reliable as the completeness and accuracy of the data increases.
    (B) Reliability of assumptions. All methods rely on certain 
assumptions. The reliability of the results derived from a method 
depends on the soundness of such assumptions. Some assumptions are 
relatively reliable. For example, adjustments for differences in payment 
terms between controlled and uncontrolled transactions may be based on 
the assumption that at arm's length such differences would lead to price 
differences that reflect the time value of money. Although selection of 
the appropriate interest rate to use in making such adjustments involves 
some judgement, the economic analysis on which the assumption is based 
is relatively sound. Other assumptions may be less reliable. For 
example, the residual profit split method may be based on the assumption 
that capitalized intangible development expenses reflect the relative 
value of the intangible property contributed by each party. Because the 
costs of developing an intangible may not be related to its market 
value, the soundness of this assumption will affect the reliability of 
the results derived from this method.
    (C) Sensitivity of results to deficiencies in data and assumptions. 
Deficiencies in the data used or assumptions made may have a greater 
effect on some methods than others. In particular, the reliability of 
some methods is heavily dependent on the similarity of property or 
services involved in the controlled and uncontrolled transaction. For 
certain other methods, such as the resale price method, the analysis of 
the extent to which controlled and uncontrolled taxpayers undertake the 
same or similar functions, employ similar resources, and bear similar 
risks is particularly important. Finally, under other methods, such as 
the profit split method, defining the relevant business activity and 
appropriate allocation of costs, income, and assets may be of particular 
importance. Therefore, a difference between the controlled and 
uncontrolled transactions for which an accurate adjustment cannot be 
made may have a greater effect on the reliability of the results derived 
under one method than the results derived under another method. For 
example, differences in management efficiency may have a greater effect 
on a comparable profits method analysis than on a comparable 
uncontrolled price method analysis, while differences in product 
characteristics will ordinarily have a greater effect on a comparable 
uncontrolled price method analysis than on a comparable profits method 
analysis.
    (iii) Confirmation of results by another method. If two or more 
methods produce inconsistent results, the best method rule will be 
applied to select the method that provides the most reliable measure of 
an arm's length result. If the best method rule does not clearly 
indicate which method should be selected, an additional factor that may 
be taken into account in selecting a method is whether any of the 
competing methods produce results that are consistent with the results 
obtained from the appropriate application of another method. Further, in 
evaluating different applications of the same method, the fact that a 
second method (or another application of the first method) produces 
results that are consistent with one of the competing applications may 
be taken into account.

[[Page 667]]

    (d) Comparability--(1) In general. Whether a controlled transaction 
produces an arm's length result is generally evaluated by comparing the 
results of that transaction to results realized by uncontrolled 
taxpayers engaged in comparable transactions under comparable 
circumstances. For this purpose, the comparability of transactions and 
circumstances must be evaluated considering all factors that could 
affect prices or profits in arm's length dealings (comparability 
factors). While a specific comparability factor may be of particular 
importance in applying a method, each method requires analysis of all of 
the factors that affect comparability under that method. Such factors 
include the following--
    (i) Functions;
    (ii) Contractual terms;
    (iii) Risks;
    (iv) Economic conditions; and
    (v) Property or services.
    (2) Standard of comparability. In order to be considered comparable 
to a controlled transaction, an uncontrolled transaction need not be 
identical to the controlled transaction, but must be sufficiently 
similar that it provides a reliable measure of an arm's length result. 
If there are material differences between the controlled and 
uncontrolled transactions, adjustments must be made if the effect of 
such differences on prices or profits can be ascertained with sufficient 
accuracy to improve the reliability of the results. For purposes of this 
section, a material difference is one that would materially affect the 
measure of an arm's length result under the method being applied. If 
adjustments for material differences cannot be made, the uncontrolled 
transaction may be used as a measure of an arm's length result, but the 
reliability of the analysis will be reduced. Generally, such adjustments 
must be made to the results of the uncontrolled comparable and must be 
based on commercial practices, economic principles, or statistical 
analyses. The extent and reliability of any adjustments will affect the 
relative reliability of the analysis. See Sec.  1.482-1(c)(1) (Best 
method rule). In any event, unadjusted industry average returns 
themselves cannot establish arm's length results.
    (3) Factors for determining comparability. The comparability factors 
listed in Sec.  1.482-1(d)(1) are discussed in this section. Each of 
these factors must be considered in determining the degree of 
comparability between transactions or taxpayers and the extent to which 
comparability adjustments may be necessary. In addition, in certain 
cases involving special circumstances, the rules under paragraph (d)(4) 
of this section must be considered.
    (i) Functional analysis. Determining the degree of comparability 
between controlled and uncontrolled transactions requires a comparison 
of the functions performed, and associated resources employed, by the 
taxpayers in each transaction. This comparison is based on a functional 
analysis that identifies and compares the economically significant 
activities undertaken, or to be undertaken, by the taxpayers in both 
controlled and uncontrolled transactions. A functional analysis should 
also include consideration of the resources that are employed, or to be 
employed, in conjunction with the activities undertaken, including 
consideration of the type of assets used, such as plant and equipment, 
or the use of valuable intangibles. A functional analysis is not a 
pricing method and does not itself determine the arm's length result for 
the controlled transaction under review. Functions that may need to be 
accounted for in determining the comparability of two transactions 
include--
    (A) Research and development;
    (B) Product design and engineering;
    (C) Manufacturing, production and process engineering;
    (D) Product fabrication, extraction, and assembly;
    (E) Purchasing and materials management;
    (F) Marketing and distribution functions, including inventory 
management, warranty administration, and advertising activities;
    (G) Transportation and warehousing; and
    (H) Managerial, legal, accounting and finance, credit and 
collection, training, and personnel management services.
    (ii) Contractual terms--(A) In general. Determining the degree of 
comparability between the controlled and

[[Page 668]]

uncontrolled transactions requires a comparison of the significant 
contractual terms that could affect the results of the two transactions. 
These terms include--
    (1) The form of consideration charged or paid;
    (2) Sales or purchase volume;
    (3) The scope and terms of warranties provided;
    (4) Rights to updates, revisions or modifications;
    (5) The duration of relevant license, contract or other agreements, 
and termination or renegotiation rights;
    (6) Collateral transactions or ongoing business relationships 
between the buyer and the seller, including arrangements for the 
provision of ancillary or subsidiary services; and
    (7) Extension of credit and payment terms. Thus, for example, if the 
time for payment of the amount charged in a controlled transaction 
differs from the time for payment of the amount charged in an 
uncontrolled transaction, an adjustment to reflect the difference in 
payment terms should be made if such difference would have a material 
effect on price. Such comparability adjustment is required even if no 
interest would be allocated or imputed under Sec.  1.482-2(a) or other 
applicable provisions of the Internal Revenue Code or regulations.
    (B) Identifying contractual terms--(1) Written agreement. The 
contractual terms, including the consequent allocation of risks, that 
are agreed to in writing before the transactions are entered into will 
be respected if such terms are consistent with the economic substance of 
the underlying transactions. In evaluating economic substance, greatest 
weight will be given to the actual conduct of the parties, and the 
respective legal rights of the parties (see, for example, Sec.  1.482-
4(f)(3) (Ownership of intangible property)). If the contractual terms 
are inconsistent with the economic substance of the underlying 
transaction, the district director may disregard such terms and impute 
terms that are consistent with the economic substance of the 
transaction.
    (2) No written agreement. In the absence of a written agreement, the 
district director may impute a contractual agreement between the 
controlled taxpayers consistent with the economic substance of the 
transaction. In determining the economic substance of the transaction, 
greatest weight will be given to the actual conduct of the parties and 
their respective legal rights (see, for example, Sec.  1.482-4(f)(3) 
(Ownership of intangible property)). For example, if, without a written 
agreement, a controlled taxpayer operates at full capacity and regularly 
sells all of its output to another member of its controlled group, the 
district director may impute a purchasing contract from the course of 
conduct of the controlled taxpayers, and determine that the producer 
bears little risk that the buyer will fail to purchase its full output. 
Further, if an established industry convention or usage of trade assigns 
a risk or resolves an issue, that convention or usage will be followed 
if the conduct of the taxpayers is consistent with it. See UCC 1-205. 
For example, unless otherwise agreed, payment generally is due at the 
time and place at which the buyer is to receive goods. See UCC 2-310.
    (C) Examples. The following examples illustrate this paragraph 
(d)(3)(ii).

    Example 1. Differences in volume. USP, a United States agricultural 
exporter, regularly buys transportation services from FSub, its foreign 
subsidiary, to ship its products from the United States to overseas 
markets. Although FSub occasionally provides transportation services to 
URA, an unrelated domestic corporation, URA accounts for only 10% of the 
gross revenues of FSub, and the remaining 90% of FSub's gross revenues 
are attributable to FSub's transactions with USP. In determining the 
degree of comparability between FSub's uncontrolled transaction with URA 
and its controlled transaction with USP, the difference in volumes 
involved in the two transactions and the regularity with which these 
services are provided must be taken into account if such difference 
would have a material effect on the price charged. Inability to make 
reliable adjustments for these differences would affect the reliability 
of the results derived from the uncontrolled transaction as a measure of 
the arm's length result.
    Example 2. Reliability of adjustment for differences in volume. (i) 
FS manufactures product XX and sells that product to its parent 
corporation, P. FS also sells product XX to uncontrolled taxpayers at a 
price of $100 per unit. Except for the volume of each transaction, the 
sales to P and to uncontrolled taxpayers take place under substantially 
the

[[Page 669]]

same economic conditions and contractual terms. In uncontrolled 
transactions, FS offers a 2% discount for quantities of 20 per order, 
and a 5% discount for quantities of 100 per order. If P purchases 
product XX in quantities of 60 per order, in the absence of other 
reliable information, it may reasonably be concluded that the arm's 
length price to P would be $100, less a discount of 3.5%.
    (ii) If P purchases product XX in quantities of 1,000 per order, a 
reliable estimate of the appropriate volume discount must be based on 
proper economic or statistical analysis, not necessarily a linear 
extrapolation from the 2% and 5% catalog discounts applicable to sales 
of 20 and 100 units, respectively.
    Example 3. Contractual terms imputed from economic substance. (i) 
FP, a foreign producer of wristwatches, is the registered holder of the 
YY trademark in the United States and in other countries worldwide. In 
year 1, FP enters the United States market by selling YY wristwatches to 
its newly organized United States subsidiary, USSub, for distribution in 
the United States market. USSub pays FP a fixed price per wristwatch. 
USSub and FP undertake, without separate compensation, marketing 
activities to establish the YY trademark in the United States market. 
Unrelated foreign producers of trademarked wristwatches and their 
authorized United States distributors respectively undertake similar 
marketing activities in independent arrangements involving distribution 
of trademarked wristwatches in the United States market. In years 1 
through 6, USSub markets and sells YY wristwatches in the United States. 
Further, in years 1 through 6, USSub undertakes incremental marketing 
activities in addition to the activities similar to those observed in 
the independent distribution transactions in the United States market. 
FP does not directly or indirectly compensate USSub for performing these 
incremental activities during years 1 through 6. Assume that, aside from 
these incremental activities, and after any adjustments are made to 
improve the reliability of the comparison, the price paid per wristwatch 
by the independent, authorized distributors of wristwatches would 
provide the most reliable measure of the arm's length price paid per YY 
wristwatch by USSub.
    (ii) By year 7, the wristwatches with the YY trademark generate a 
premium return in the United States market, as compared to wristwatches 
marketed by the independent distributors. In year 7, substantially all 
the premium return from the YY trademark in the United States market is 
attributed to FP, for example through an increase in the price paid per 
watch by USSub, or by some other means.
    (iii) In determining whether an allocation of income is appropriate 
in year 7, the Commissioner may consider the economic substance of the 
arrangements between USSub and FP, and the parties' course of conduct 
throughout their relationship. Based on this analysis, the Commissioner 
determines that it is unlikely that, ex ante, an uncontrolled taxpayer 
operating at arm's length would engage in the incremental marketing 
activities to develop or enhance intangible property owned by another 
party unless it received contemporaneous compensation or otherwise had a 
reasonable anticipation of receiving a future benefit from those 
activities. In this case, USSub's undertaking the incremental marketing 
activities in years 1 through 6 is a course of conduct that is 
inconsistent with the parties' attribution to FP in year 7 of 
substantially all the premium return from the enhanced YY trademark in 
the United States market. Therefore, the Commissioner may impute one or 
more agreements between USSub and FP, consistent with the economic 
substance of their course of conduct, which would afford USSub an 
appropriate portion of the premium return from the YY trademark 
wristwatches. For example, the Commissioner may impute a separate 
services agreement that affords USSub contingent-payment compensation 
for its incremental marketing activities in years 1 through 6, which 
benefited FP by contributing to the value of the trademark owned by FP. 
In the alternative, the Commissioner may impute a long-term, exclusive 
agreement to exploit the YY trademark in the United States that allows 
USSub to benefit from the incremental marketing activities it performed. 
As another alternative, the Commissioner may require FP to compensate 
USSub for terminating USSub's imputed long-term, exclusive agreement to 
exploit the YY trademark in the United States, an agreement that USSub 
made more valuable at its own expense and risk. The taxpayer may present 
additional facts that could indicate which of these or other alternative 
agreements best reflects the economic substance of the underlying 
transactions, consistent with the parties' course of conduct in the 
particular case.
    Example 4. Contractual terms imputed from economic substance. (i) 
FP, a foreign producer of athletic gear, is the registered holder of the 
AA trademark in the United States and in other countries worldwide. In 
year 1, FP enters into a licensing agreement that affords its newly 
organized United States subsidiary, USSub, exclusive rights to certain 
manufacturing and marketing intangible property (including the AA 
trademark) for purposes of manufacturing and marketing athletic gear in 
the United States under the AA trademark. The contractual terms of this 
agreement obligate USSub to pay FP a royalty based on sales, and also 
obligate both FP and USSub to undertake without separate compensation 
specified types and levels

[[Page 670]]

of marketing activities. Unrelated foreign businesses license 
independent United States businesses to manufacture and market athletic 
gear in the United States, using trademarks owned by the unrelated 
foreign businesses. The contractual terms of these uncontrolled 
transactions require the licensees to pay royalties based on sales of 
the merchandise, and obligate the licensors and licensees to undertake 
without separate compensation specified types and levels of marketing 
activities. In years 1 through 6, USSub manufactures and sells athletic 
gear under the AA trademark in the United States. Assume that, after 
adjustments are made to improve the reliability of the comparison for 
any material differences relating to marketing activities, manufacturing 
or marketing intangible property, and other comparability factors, the 
royalties paid by independent licensees would provide the most reliable 
measure of the arm's length royalty owed by USSub to FP, apart from the 
additional facts in paragraph (ii) of this Example 4.
    (ii) In years 1 through 6, USSub performs incremental marketing 
activities with respect to the AA trademark athletic gear, in addition 
to the activities required under the terms of the license agreement with 
FP, that are also incremental as compared to those observed in the 
comparables. FP does not directly or indirectly compensate USSub for 
performing these incremental activities during years 1 through 6. By 
year 7, AA trademark athletic gear generates a premium return in the 
United States, as compared to similar athletic gear marketed by 
independent licensees. In year 7, USSub and FP enter into a separate 
services agreement under which FP agrees to compensate USSub on a cost 
basis for the incremental marketing activities that USSub performed 
during years 1 through 6, and to compensate USSub on a cost basis for 
any incremental marketing activities it may perform in year 7 and 
subsequent years. In addition, the parties revise the license agreement 
executed in year 1, and increase the royalty to a level that attributes 
to FP substantially all the premium return from sales of the AA 
trademark athletic gear in the United States.
    (iii) In determining whether an allocation of income is appropriate 
in year 7, the Commissioner may consider the economic substance of the 
arrangements between USSub and FP and the parties' course of conduct 
throughout their relationship. Based on this analysis, the Commissioner 
determines that it is unlikely that, ex ante, an uncontrolled taxpayer 
operating at arm's length would engage in the incremental marketing 
activities to develop or enhance intangible property owned by another 
party unless it received contemporaneous compensation or otherwise had a 
reasonable anticipation of a future benefit. In this case, USSub's 
undertaking the incremental marketing activities in years 1 through 6 is 
a course of conduct that is inconsistent with the parties' adoption in 
year 7 of contractual terms by which FP compensates USSub on a cost 
basis for the incremental marketing activities that it performed. 
Therefore, the Commissioner may impute one or more agreements between 
USSub and FP, consistent with the economic substance of their course of 
conduct, which would afford USSub an appropriate portion of the premium 
return from the AA trademark athletic gear. For example, the 
Commissioner may impute a separate services agreement that affords USSub 
contingent-payment compensation for the incremental activities it 
performed during years 1 through 6, which benefited FP by contributing 
to the value of the trademark owned by FP. In the alternative, the 
Commissioner may impute a long-term, exclusive United States license 
agreement that allows USSub to benefit from the incremental activities. 
As another alternative, the Commissioner may require FP to compensate 
USSub for terminating USSub's imputed long-term United States license 
agreement, a license that USSub made more valuable at its own expense 
and risk. The taxpayer may present additional facts that could indicate 
which of these or other alternative agreements best reflects the 
economic substance of the underlying transactions, consistent with the 
parties' course of conduct in this particular case.
    Example 5. Non-arm's length compensation. (i) The facts are the same 
as in paragraph (i) of Example 4. As in Example 4, assume that, after 
adjustments are made to improve the reliability of the comparison for 
any material differences relating to marketing activities, manufacturing 
or marketing intangible property, and other comparability factors, the 
royalties paid by independent licensees would provide the most reliable 
measure of the arm's length royalty owed by USSub to FP, apart from the 
additional facts described in paragraph (ii) of this Example 5.
    (ii) In years 1 through 4, USSub performs certain incremental 
marketing activities with respect to the AA trademark athletic gear, in 
addition to the activities required under the terms of the basic license 
agreement, that are also incremental as compared with those activities 
observed in the comparables. At the start of year 1, FP enters into a 
separate services agreement with USSub, which states that FP will 
compensate USSub quarterly, in an amount equal to specified costs plus 
X%, for these incremental marketing functions. Further, these written 
agreements reflect the intent of the parties that USSub receive such 
compensation from FP throughout the term of the agreement, without 
regard to the success

[[Page 671]]

or failure of the promotional activities. During years 1 through 4, 
USSub performs marketing activities pursuant to the separate services 
agreement and in each year USSub receives the specified compensation 
from FP on a cost of services plus basis.
    (iii) In evaluating year 4, the Commissioner performs an analysis of 
independent parties that perform promotional activities comparable to 
those performed by USSub and that receive separately-stated compensation 
on a current basis without contingency. The Commissioner determines that 
the magnitude of the specified cost plus X% is outside the arm's length 
range in each of years 1 through 4. Based on an evaluation of all the 
facts and circumstances, the Commissioner makes an allocation to require 
payment of compensation to USSub for the promotional activities 
performed in year 4, based on the median of the interquartile range of 
the arm's length markups charged by the uncontrolled comparables 
described in paragraph (e)(3) of this section.
    (iv) Given that based on facts and circumstances, the terms agreed 
by the controlled parties were that FP would bear all risks associated 
with the promotional activities performed by USSub to promote the AA 
trademark product in the United States market, and given that the 
parties' conduct during the years examined was consistent with this 
allocation of risk, the fact that the cost of services plus markup on 
USSub's services was outside the arm's length range does not, without 
more, support imputation of additional contractual terms based on 
alternative views of the economic substance of the transaction, such as 
terms indicating that USSub, rather than FP, bore the risk associated 
with these activities.
    Example 6. Contractual terms imputed from economic substance. (i) 
Company X is a member of a controlled group that has been in operation 
in the pharmaceutical sector for many years. In years 1 through 4, 
Company X undertakes research and development activities. As a result of 
those activities, Company X developed a compound that may be more 
effective than existing medications in the treatment of certain 
conditions.
    (ii) Company Y is acquired in year 4 by the controlled group that 
includes Company X. Once Company Y is acquired, Company X makes 
available to Company Y a large amount of technical data concerning the 
new compound, which Company Y uses to register patent rights with 
respect to the compound in several jurisdictions, making Company Y the 
legal owner of such patents. Company Y then enters into licensing 
agreements with group members that afford Company Y 100% of the premium 
return attributable to use of the intangible property by its 
subsidiaries.
    (iii) In determining whether an allocation is appropriate in year 4, 
the Commissioner may consider the economic substance of the arrangements 
between Company X and Company Y, and the parties' course of conduct 
throughout their relationship. Based on this analysis, the Commissioner 
determines that it is unlikely that an uncontrolled taxpayer operating 
at arm's length would make available the results of its research and 
development or perform services that resulted in transfer of valuable 
know how to another party unless it received contemporaneous 
compensation or otherwise had a reasonable anticipation of receiving a 
future benefit from those activities. In this case, Company X's 
undertaking the research and development activities and then providing 
technical data and know-how to Company Y in year 4 is inconsistent with 
the registration and subsequent exploitation of the patent by Company Y. 
Therefore, the Commissioner may impute one or more agreements between 
Company X and Company Y consistent with the economic substance of their 
course of conduct, which would afford Company X an appropriate portion 
of the premium return from the patent rights. For example, the 
Commissioner may impute a separate services agreement that affords 
Company X contingent-payment compensation for its services in year 4 for 
the benefit of Company Y, consisting of making available to Company Y 
technical data, know-how, and other fruits of research and development 
conducted in previous years. These services benefited Company Y by 
giving rise to and contributing to the value of the patent rights that 
were ultimately registered by Company Y. In the alternative, the 
Commissioner may impute a transfer of patentable intangible property 
rights from Company X to Company Y immediately preceding the 
registration of patent rights by Company Y. The taxpayer may present 
additional facts that could indicate which of these or other alternative 
agreements best reflects the economic substance of the underlying 
transactions, consistent with the parties' course of conduct in the 
particular case.

    (iii) Risk--(A) Comparability. Determining the degree of 
comparability between controlled and uncontrolled transactions requires 
a comparison of the significant risks that could affect the prices that 
would be charged or paid, or the profit that would be earned, in the two 
transactions. Relevant risks to consider include--
    (1) Market risks, including fluctuations in cost, demand, pricing, 
and inventory levels;
    (2) Risks associated with the success or failure of research and 
development activities;

[[Page 672]]

    (3) Financial risks, including fluctuations in foreign currency 
rates of exchange and interest rates;
    (4) Credit and collection risks;
    (5) Product liability risks; and
    (6) General business risks related to the ownership of property, 
plant, and equipment.
    (B) Identification of taxpayer that bears risk. In general, the 
determination of which controlled taxpayer bears a particular risk will 
be made in accordance with the provisions of Sec.  1.482-1(d)(3)(ii)(B) 
(Identifying contractual terms). Thus, the allocation of risks specified 
or implied by the taxpayer's contractual terms will generally be 
respected if it is consistent with the economic substance of the 
transaction. An allocation of risk between controlled taxpayers after 
the outcome of such risk is known or reasonably knowable lacks economic 
substance. In considering the economic substance of the transaction, the 
following facts are relevant--
    (1) Whether the pattern of the controlled taxpayer's conduct over 
time is consistent with the purported allocation of risk between the 
controlled taxpayers; or where the pattern is changed, whether the 
relevant contractual arrangements have been modified accordingly;
    (2) Whether a controlled taxpayer has the financial capacity to fund 
losses that might be expected to occur as the result of the assumption 
of a risk, or whether, at arm's length, another party to the controlled 
transaction would ultimately suffer the consequences of such losses; and
    (3) The extent to which each controlled taxpayer exercises 
managerial or operational control over the business activities that 
directly influence the amount of income or loss realized. In arm's 
length dealings, parties ordinarily bear a greater share of those risks 
over which they have relatively more control.
    (C) Examples. The following examples illustrate this paragraph 
(d)(3)(iii).

    Example 1. FD, the wholly-owned foreign distributor of USM, a U.S. 
manufacturer, buys widgets from USM under a written contract. Widgets 
are a generic electronic appliance. Under the terms of the contract, FD 
must buy and take title to 20,000 widgets for each of the five years of 
the contract at a price of $10 per widget. The widgets will be sold 
under FD's label, and FD must finance any marketing strategies to 
promote sales in the foreign market. There are no rebate or buy back 
provisions. FD has adequate financial capacity to fund its obligations 
under the contract under any circumstances that could reasonably be 
expected to arise. In Years 1, 2 and 3, FD sold only 10,000 widgets at a 
price of $11 per unit. In Year 4, FD sold its entire inventory of 
widgets at a price of $25 per unit. Since the contractual terms 
allocating market risk were agreed to before the outcome of such risk 
was known or reasonably knowable, FD had the financial capacity to bear 
the market risk that it would be unable to sell all of the widgets it 
purchased currently, and its conduct was consistent over time, FD will 
be deemed to bear the risk.
    Example 2. The facts are the same as in Example 1, except that in 
Year 1 FD had only $100,000 in total capital, including loans. In 
subsequent years USM makes no additional contributions to the capital of 
FD, and FD is unable to obtain any capital through loans from an 
unrelated party. Nonetheless, USM continues to sell 20,000 widgets 
annually to FD under the terms of the contract, and USM extends credit 
to FD to enable it to finance the purchase. FD does not have the 
financial capacity in Years 1, 2 and 3 to finance the purchase of the 
widgets given that it could not sell most of the widgets it purchased 
during those years. Thus, notwithstanding the terms of the contract, USM 
and not FD assumed the market risk that a substantial portion of the 
widgets could not be sold, since in that event FD would not be able to 
pay USM for all of the widgets it purchased.
    Example 3. S, a Country X corporation, manufactures small motors 
that it sells to P, its U.S. parent. P incorporates the motors into 
various products and sells those products to uncontrolled customers in 
the United States. The contract price for the motors is expressed in 
U.S. dollars, effectively allocating the currency risk for these 
transactions to S for any currency fluctuations between the time the 
contract is signed and payment is made. As long as S has adequate 
financial capacity to bear this currency risk (including by hedging all 
or part of the risk) and the conduct of S and P is consistent with the 
terms of the contract (i.e., the contract price is not adjusted to 
reflect exchange rate movements), the agreement of the parties to 
allocate the exchange risk to S will be respected.
    Example 4. USSub is the wholly-owned U.S. subsidiary of FP, a 
foreign manufacturer. USSub acts as a distributor of goods manufactured 
by FP. FP and USSub execute an agreement providing that FP will bear any 
ordinary product liability costs arising from

[[Page 673]]

defects in the goods manufactured by FP. In practice, however, when 
ordinary product liability claims are sustained against USSub and FP, 
USSub pays the resulting damages. Therefore, the district director 
disregards the contractual arrangement regarding product liability costs 
between FP and USSub, and treats the risk as having been assumed by 
USSub.

    (iv) Economic conditions. Determining the degree of comparability 
between controlled and uncontrolled transactions requires a comparison 
of the significant economic conditions that could affect the prices that 
would be charged or paid, or the profit that would be earned in each of 
the transactions. These factors include--
    (A) The similarity of geographic markets;
    (B) The relative size of each market, and the extent of the overall 
economic development in each market;
    (C) The level of the market (e.g., wholesale, retail, etc.);
    (D) The relevant market shares for the products, properties, or 
services transferred or provided;
    (E) The location-specific costs of the factors of production and 
distribution;
    (F) The extent of competition in each market with regard to the 
property or services under review;
    (G) The economic condition of the particular industry, including 
whether the market is in contraction or expansion; and
    (H) The alternatives realistically available to the buyer and 
seller.
    (v) Property or services. Evaluating the degree of comparability 
between controlled and uncontrolled transactions requires a comparison 
of the property or services transferred in the transactions. This 
comparison may include any intangible property that is embedded in 
tangible property or services being transferred (embedded intangibles). 
The comparability of the embedded intangibles will be analyzed using the 
factors listed in Sec.  1.482-4(c)(2)(iii)(B)(1) (comparable intangible 
property). The relevance of product comparability in evaluating the 
relative reliability of the results will depend on the method applied. 
For guidance concerning the specific comparability considerations 
applicable to transfers of tangible and intangible property and 
performance of services, see Sec. Sec.  1.482-3 through 1.482-6 and 
Sec.  1.482-9; see also Sec. Sec.  1.482-3(f), 1.482-4(f)(4), and 1.482-
9(m), dealing with the coordination of intangible and tangible property 
and performance of services rules.
    (4) Special circumstances--(i) Market share strategy. In certain 
circumstances, taxpayers may adopt strategies to enter new markets or to 
increase a product's share of an existing market (market share 
strategy). Such a strategy would be reflected by temporarily increased 
market development expenses or resale prices that are temporarily lower 
than the prices charged for comparable products in the same market. 
Whether or not the strategy is reflected in the transfer price depends 
on which party to the controlled transaction bears the costs of the 
pricing strategy. In any case, the effect of a market share strategy on 
a controlled transaction will be taken into account only if it can be 
shown that an uncontrolled taxpayer engaged in a comparable strategy 
under comparable circumstances for a comparable period of time, and the 
taxpayer provides documentation that substantiates the following--
    (A) The costs incurred to implement the market share strategy are 
borne by the controlled taxpayer that would obtain the future profits 
that result from the strategy, and there is a reasonable likelihood that 
the strategy will result in future profits that reflect an appropriate 
return in relation to the costs incurred to implement it;
    (B) The market share strategy is pursued only for a period of time 
that is reasonable, taking into consideration the industry and product 
in question; and
    (C) The market share strategy, the related costs and expected 
returns, and any agreement between the controlled taxpayers to share the 
related costs, were established before the strategy was implemented.
    (ii) Different geographic markets--(A) In general. Uncontrolled 
comparables ordinarily should be derived from the geographic market in 
which the controlled taxpayer operates, because there may be significant 
differences in economic conditions in different markets. If information 
from the same

[[Page 674]]

market is not available, an uncontrolled comparable derived from a 
different geographic market may be considered if adjustments are made to 
account for differences between the two markets. If information 
permitting adjustments for such differences is not available, then 
information derived from uncontrolled comparables in the most similar 
market for which reliable data is available may be used, but the extent 
of such differences may affect the reliability of the method for 
purposes of the best method rule. For this purpose, a geographic market 
is any geographic area in which the economic conditions for the relevant 
product or service are substantially the same, and may include multiple 
countries, depending on the economic conditions.
    (B) Example. The following example illustrates this paragraph 
(d)(4)(ii).

    Example. Manuco, a wholly-owned foreign subsidiary of P, a U.S. 
corporation, manufactures products in Country Z for sale to P. No 
uncontrolled transactions are located that would provide a reliable 
measure of the arm's length result under the comparable uncontrolled 
price method. The district director considers applying the cost plus 
method or the comparable profits method. Information on uncontrolled 
taxpayers performing comparable functions under comparable circumstances 
in the same geographic market is not available. Therefore, adjusted data 
from uncontrolled manufacturers in other markets may be considered in 
order to apply the cost plus method. In this case, comparable 
uncontrolled manufacturers are found in the United States. Accordingly, 
data from the comparable U.S. uncontrolled manufacturers, as adjusted to 
account for differences between the United States and Country Z's 
geographic market, is used to test the arm's length price paid by P to 
Manuco. However, the use of such data may affect the reliability of the 
results for purposes of the best method rule. See Sec.  1.482-1(c).

    (C) Location savings. If an uncontrolled taxpayer operates in a 
different geographic market than the controlled taxpayer, adjustments 
may be necessary to account for significant differences in costs 
attributable to the geographic markets. These adjustments must be based 
on the effect such differences would have on the consideration charged 
or paid in the controlled transaction given the relative competitive 
positions of buyers and sellers in each market. Thus, for example, the 
fact that the total costs of operating in a controlled manufacturer's 
geographic market are less than the total costs of operating in other 
markets ordinarily justifies higher profits to the manufacturer only if 
the cost differences would increase the profits of comparable 
uncontrolled manufacturers operating at arm's length, given the 
competitive positions of buyers and sellers in that market.
    (D) Example. The following example illustrates the principles of 
this paragraph (d)(4)(ii)(C).

    Example. Couture, a U.S. apparel design corporation, contracts with 
Sewco, its wholly owned Country Y subsidiary, to manufacture its 
clothes. Costs of operating in Country Y are significantly lower than 
the operating costs in the United States. Although clothes with the 
Couture label sell for a premium price, the actual production of the 
clothes does not require significant specialized knowledge that could 
not be acquired by actual or potential competitors to Sewco at 
reasonable cost. Thus, Sewco's functions could be performed by several 
actual or potential competitors to Sewco in geographic markets that are 
similar to Country Y. Thus, the fact that production is less costly in 
Country Y will not, in and of itself, justify additional profits derived 
from lower operating costs in Country Y inuring to Sewco, because the 
competitive positions of the other actual or potential producers in 
similar geographic markets capable of performing the same functions at 
the same low costs indicate that at arm's length such profits would not 
be retained by Sewco.

    (iii) Transactions ordinarily not accepted as comparables--(A) In 
general. Transactions ordinarily will not constitute reliable measures 
of an arm's length result for purposes of this section if--
    (1) They are not made in the ordinary course of business; or
    (2) One of the principal purposes of the uncontrolled transaction 
was to establish an arm's length result with respect to the controlled 
transaction.
    (B) Examples. The following examples illustrate the principle of 
this paragraph (d)(4)(iii).

    Example 1. Not in the ordinary course of business. USP, a United 
States manufacturer of computer software, sells its products to FSub, 
its foreign distributor in country X. Compco, a United States competitor 
of USP, also sells its products in X through unrelated

[[Page 675]]

distributors. However, in the year under review, Compco is forced into 
bankruptcy, and Compco liquidates its inventory by selling all of its 
products to unrelated distributors in X for a liquidation price. Because 
the sale of its entire inventory was not a sale in the ordinary course 
of business, Compco's sale cannot be used as an uncontrolled comparable 
to determine USP's arm's length result from its controlled transaction.
    Example 2. Principal purpose of establishing an arm's length result. 
USP, a United States manufacturer of farm machinery, sells its products 
to FSub, its wholly-owned distributor in Country Y. USP, operating at 
nearly full capacity, sells 95% of its inventory to FSub. To make use of 
its excess capacity, and also to establish a comparable uncontrolled 
price for its transfer price to FSub, USP increases its production to 
full capacity. USP sells its excess inventory to Compco, an unrelated 
foreign distributor in Country X. Country X has approximately the same 
economic conditions as that of Country Y. Because one of the principal 
purposes of selling to Compco was to establish an arm's length price for 
its controlled transactions with FSub, USP's sale to Compco cannot be 
used as an uncontrolled comparable to determine USP's arm's length 
result from its controlled transaction.

    (e) Arm's length range--(1) In general. In some cases, application 
of a pricing method will produce a single result that is the most 
reliable measure of an arm's length result. In other cases, application 
of a method may produce a number of results from which a range of 
reliable results may be derived. A taxpayer will not be subject to 
adjustment if its results fall within such range (arm's length range).
    (2) Determination of arm's length range--(i) Single method. The 
arm's length range is ordinarily determined by applying a single pricing 
method selected under the best method rule to two or more uncontrolled 
transactions of similar comparability and reliability. Use of more than 
one method may be appropriate for the purposes described in paragraph 
(c)(2)(iii) of this section (Best method rule).
    (ii) Selection of comparables. Uncontrolled comparables must be 
selected based upon the comparability criteria relevant to the method 
applied and must be sufficiently similar to the controlled transaction 
that they provide a reliable measure of an arm's length result. If 
material differences exist between the controlled and uncontrolled 
transactions, adjustments must be made to the results of the 
uncontrolled transaction if the effect of such differences on price or 
profits can be ascertained with sufficient accuracy to improve the 
reliability of the results. See Sec.  1.482-1(d)(2) (Standard of 
comparability). The arm's length range will be derived only from those 
uncontrolled comparables that have, or through adjustments can be 
brought to, a similar level of comparability and reliability, and 
uncontrolled comparables that have a significantly lower level of 
comparability and reliability will not be used in establishing the arm's 
length range.
    (iii) Comparables included in arm's length range--(A) In general. 
The arm's length range will consist of the results of all of the 
uncontrolled comparables that meet the following conditions: the 
information on the controlled transaction and the uncontrolled 
comparables is sufficiently complete that it is likely that all material 
differences have been identified, each such difference has a definite 
and reasonably ascertainable effect on price or profit, and an 
adjustment is made to eliminate the effect of each such difference.
    (B) Adjustment of range to increase reliability. If there are no 
uncontrolled comparables described in paragraph (e)(2)(iii)(A) of this 
section, the arm's length range is derived from the results of all the 
uncontrolled comparables, selected pursuant to paragraph (e)(2)(ii) of 
this section, that achieve a similar level of comparability and 
reliability. In such cases the reliability of the analysis must be 
increased, where it is possible to do so, by adjusting the range through 
application of a valid statistical method to the results of all of the 
uncontrolled comparables so selected. The reliability of the analysis is 
increased when statistical methods are used to establish a range of 
results in which the limits of the range will be determined such that 
there is a 75 percent probability of a result falling above the lower 
end of the range and a 75 percent probability of a result falling below 
the upper end of the range. The interquartile range ordinarily provides 
an acceptable measure of this range; however a different statistical

[[Page 676]]

method may be applied if it provides a more reliable measure.
    (C) Interquartile range. For purposes of this section, the 
interquartile range is the range from the 25th to the 75th percentile of 
the results derived from the uncontrolled comparables. For this purpose, 
the 25th percentile is the lowest result derived from an uncontrolled 
comparable such that at least 25 percent of the results are at or below 
the value of that result. However, if exactly 25 percent of the results 
are at or below a result, then the 25th percentile is equal to the 
average of that result and the next higher result derived from the 
uncontrolled comparables. The 75th percentile is determined analogously.
    (3) Adjustment if taxpayer's results are outside arm's length range. 
If the results of a controlled transaction fall outside the arm's length 
range, the district director may make allocations that adjust the 
controlled taxpayer's result to any point within the arm's length range. 
If the interquartile range is used to determine the arm's length range, 
such adjustment will ordinarily be to the median of all the results. The 
median is the 50th percentile of the results, which is determined in a 
manner analogous to that described in paragraph (e)(2)(iii)(C) of this 
section (Interquartile range). In other cases, an adjustment normally 
will be made to the arithmetic mean of all the results. See Sec.  1.482-
1(f)(2)(iii)(D) for determination of an adjustment when a controlled 
taxpayer's result for a multiple year period falls outside an arm's 
length range consisting of the average results of uncontrolled 
comparables over the same period.
    (4) Arm's length range not prerequisite to allocation. The rules of 
this paragraph (e) do not require that the district director establish 
an arm's length range prior to making an allocation under section 482. 
Thus, for example, the district director may properly propose an 
allocation on the basis of a single comparable uncontrolled price if the 
comparable uncontrolled price method, as described in Sec.  1.482-3(b), 
has been properly applied. However, if the taxpayer subsequently 
demonstrates that the results claimed on its income tax return are 
within the range established by additional equally reliable comparable 
uncontrolled prices in a manner consistent with the requirements set 
forth in Sec.  1.482-1(e)(2)(iii), then no allocation will be made.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (e).

    Example 1. Selection of comparables. (i) To evaluate the arm's 
length result of a controlled transaction between USSub, the United 
States taxpayer under review, and FP, its foreign parent, the district 
director considers applying the resale price method. The district 
director identifies ten potential uncontrolled transactions. The 
distributors in all ten uncontrolled transactions purchase and resell 
similar products and perform similar functions to those of USSub.
    (ii) Data with respect to three of the uncontrolled transactions is 
very limited, and although some material differences can be identified 
and adjusted for, the level of comparability of these three uncontrolled 
comparables is significantly lower than that of the other seven. 
Further, of those seven, adjustments for the identified material 
differences can be reliably made for only four of the uncontrolled 
transactions. Therefore, pursuant to Sec.  1.482-1(e)(2)(ii) only these 
four uncontrolled comparables may be used to establish an arm's length 
range.
    Example 2. Arm's length range consists of all the results. (i) The 
facts are the same as in Example 1. Applying the resale price method to 
the four uncontrolled comparables, and making adjustments to the 
uncontrolled comparables pursuant to Sec.  1.482-1(d)(2), the district 
director derives the following results:

------------------------------------------------------------------------
                                                                 Result
                          Comparable                            (price)
------------------------------------------------------------------------
1............................................................     $44.00
2............................................................      45.00
3............................................................      45.00
4............................................................      45.50
------------------------------------------------------------------------

    (ii) The district director determines that data regarding the four 
uncontrolled transactions is sufficiently complete and accurate so that 
it is likely that all material differences between the controlled and 
uncontrolled transactions have been identified, such differences have a 
definite and reasonably ascertainable effect, and appropriate 
adjustments were made for such differences. Accordingly, if the resale 
price method is determined to be the best method pursuant to Sec.  
1.482-1(c), the arm's length range for the controlled transaction will 
consist of the results of all of the uncontrolled comparables, pursuant 
to paragraph (e)(2)(iii)(A) of this section. Thus, the arm's length 
range in this case would be the range from $44 to $45.50.

[[Page 677]]

    Example 3. Arm's length range limited to interquartile range. (i) 
The facts are the same as in Example 2, except in this case there are 
some product and functional differences between the four uncontrolled 
comparables and USSub. However, the data is insufficiently complete to 
determine the effect of the differences. Applying the resale price 
method to the four uncontrolled comparables, and making adjustments to 
the uncontrolled comparables pursuant to Sec.  1.482-1(d)(2), the 
district director derives the following results:

------------------------------------------------------------------------
                                                                 Result
                   Uncontrolled comparable                      (price)
------------------------------------------------------------------------
1............................................................     $42.00
2............................................................      44.00
3............................................................      45.00
4............................................................      47.50
------------------------------------------------------------------------

    (ii) It cannot be established in this case that all material 
differences are likely to have been identified and reliable adjustments 
made for those differences. Accordingly, if the resale price method is 
determined to be the best method pursuant to Sec.  1.482-1(c), the arm's 
length range for the controlled transaction must be established pursuant 
to paragraph (e)(2)(iii)(B) of this section. In this case, the district 
director uses the interquartile range to determine the arm's length 
range, which is the range from $43 to $46.25. If USSub's price falls 
outside this range, the district director may make an allocation. In 
this case that allocation would be to the median of the results, or 
$44.50.
    Example 4. Arm's length range limited to interquartile range. (i) To 
evaluate the arm's length result of controlled transactions between USP, 
a United States manufacturing company, and FSub, its foreign subsidiary, 
the district director considers applying the comparable profits method. 
The district director identifies 50 uncontrolled taxpayers within the 
same industry that potentially could be used to apply the method.
    (ii) Further review indicates that only 20 of the uncontrolled 
manufacturers engage in activities requiring similar capital investments 
and technical know-how. Data with respect to five of the uncontrolled 
manufacturers is very limited, and although some material differences 
can be identified and adjusted for, the level of comparability of these 
five uncontrolled comparables is significantly lower than that of the 
other 15. In addition, for those five uncontrolled comparables it is not 
possible to accurately allocate costs between the business activity 
associated with the relevant transactions and other business activities. 
Therefore, pursuant to Sec.  1.482-1(e)(2)(ii) only the other fifteen 
uncontrolled comparables may be used to establish an arm's length range.
    (iii) Although the data for the fifteen remaining uncontrolled 
comparables is relatively complete and accurate, there is a significant 
possibility that some material differences may remain. The district 
director has determined, for example, that it is likely that there are 
material differences in the level of technical expertise or in 
management efficiency. Accordingly, if the comparable profits method is 
determined to be the best method pursuant to Sec.  1.482-1(c), the arm's 
length range for the controlled transaction may be established only 
pursuant to paragraph (e)(2)(iii)(B) of this section.

    (f) Scope of review--(1) In general. The authority to determine true 
taxable income extends to any case in which either by inadvertence or 
design the taxable income, in whole or in part, of a controlled taxpayer 
is other than it would have been had the taxpayer, in the conduct of its 
affairs, been dealing at arm's length with an uncontrolled taxpayer.
    (i) Intent to evade or avoid tax not a prerequisite. In making 
allocations under section 482, the district director is not restricted 
to the case of improper accounting, to the case of a fraudulent, 
colorable, or sham transaction, or to the case of a device designed to 
reduce or avoid tax by shifting or distorting income, deductions, 
credits, or allowances.
    (ii) Realization of income not a prerequisite--(A) In general. The 
district director may make an allocation under section 482 even if the 
income ultimately anticipated from a series of transactions has not been 
or is never realized. For example, if a controlled taxpayer sells a 
product at less than an arm's length price to a related taxpayer in one 
taxable year and the second controlled taxpayer resells the product to 
an unrelated party in the next taxable year, the district director may 
make an appropriate allocation to reflect an arm's length price for the 
sale of the product in the first taxable year, even though the second 
controlled taxpayer had not realized any gross income from the resale of 
the product in the first year. Similarly, if a controlled taxpayer lends 
money to a related taxpayer in a taxable year, the district director may 
make an appropriate allocation to reflect an arm's length charge for 
interest during such

[[Page 678]]

taxable year even if the second controlled taxpayer does not realize 
income during such year. Finally, even if two controlled taxpayers 
realize an overall loss that is attributable to a particular controlled 
transaction, an allocation under section 482 is not precluded.
    (B) Example. The following example illustrates this paragraph 
(f)(1)(ii).

    Example. USSub is a U.S. subsidiary of FP, a foreign corporation. 
Parent manufactures product X and sells it to USSub. USSub functions as 
a distributor of product X to unrelated customers in the United States. 
The fact that FP may incur a loss on the manufacture and sale of product 
X does not by itself establish that USSub, dealing with FP at arm's 
length, also would incur a loss. An independent distributor acting at 
arm's length with its supplier would in many circumstances be expected 
to earn a profit without regard to the level of profit earned by the 
supplier.

    (iii) Nonrecognition provisions may not bar allocation--(A) In 
general. If necessary to prevent the avoidance of taxes or to clearly 
reflect income, the district director may make an allocation under 
section 482 with respect to transactions that otherwise qualify for 
nonrecognition of gain or loss under applicable provisions of the 
Internal Revenue Code (such as section 351 or 1031).
    (B) Example. The following example illustrates this paragraph 
(f)(1)(iii).

    Example. (i) In Year 1 USP, a United States corporation, bought 100 
shares of UR, an unrelated corporation, for $100,000. In Year 2, when 
the value of the UR stock had decreased to $40,000, USP contributed all 
100 shares of UR stock to its wholly-owned subsidiary in exchange for 
subsidiary's capital stock. In Year 3, the subsidiary sold all of the UR 
stock for $40,000 to an unrelated buyer, and on its U.S. income tax 
return, claimed a loss of $60,000 attributable to the sale of the UR 
stock. USP and its subsidiary do not file a consolidated return.
    (ii) In determining the true taxable income of the subsidiary, the 
district director may disallow the loss of $60,000 on the ground that 
the loss was incurred by USP. National Securities Corp. v Commissioner, 
137 F.2d 600 (3rd Cir. 1943), cert. denied, 320 U.S. 794 (1943).

    (iv) Consolidated returns. Section 482 and the regulations 
thereunder apply to all controlled taxpayers, whether the controlled 
taxpayer files a separate or consolidated U.S. income tax return. If a 
controlled taxpayer files a separate return, its true separate taxable 
income will be determined. If a controlled taxpayer is a party to a 
consolidated return, the true consolidated taxable income of the 
affiliated group and the true separate taxable income of the controlled 
taxpayer must be determined consistently with the principles of a 
consolidated return.
    (2) Rules relating to determination of true taxable income. The 
following rules must be taken into account in determining the true 
taxable income of a controlled taxpayer.
    (i)(A) through (E) [Reserved]. For further guidance see Sec.  1.482-
1T(f)(2)(i)(A) through (E).
    (ii) Allocation based on taxpayer's actual transactions--(A) In 
general. The Commissioner will evaluate the results of a transaction as 
actually structured by the taxpayer unless its structure lacks economic 
substance. However, the Commissioner may consider the alternatives 
available to the taxpayer in determining whether the terms of the 
controlled transaction would be acceptable to an uncontrolled taxpayer 
faced with the same alternatives and operating under comparable 
circumstances. In such cases the Commissioner may adjust the 
consideration charged in the controlled transaction based on the cost or 
profit of an alternative as adjusted to account for material differences 
between the alternative and the controlled transaction, but will not 
restructure the transaction as if the alternative had been adopted by 
the taxpayer. See paragraph (d)(3) of this section (factors for 
determining comparability; contractual terms and risk); Sec. Sec.  
1.482-3(e), 1.482-4(d), and 1.482-9(h) (unspecified methods).
    (B) [Reserved]. For further guidance see Sec.  1.482-
1T(f)(2)(ii)(B).
    (iii) Multiple year data--(A) In general. The results of a 
controlled transaction ordinarily will be compared with the results of 
uncontrolled comparables occurring in the taxable year under review. It 
may be appropriate, however, to consider data relating to the 
uncontrolled comparables or the controlled taxpayer for one or more 
years before or after the year under review. If data relating to 
uncontrolled comparables

[[Page 679]]

from multiple years is used, data relating to the controlled taxpayer 
for the same years ordinarily must be considered. However, if such data 
is not available, reliable data from other years, as adjusted under 
paragraph (d)(2) (Standard of comparability) of this section may be 
used.
    (B) Circumstances warranting consideration of multiple year data. 
The extent to which it is appropriate to consider multiple year data 
depends on the method being applied and the issue being addressed. 
Circumstances that may warrant consideration of data from multiple years 
include the extent to which complete and accurate data are available for 
the taxable year under review, the effect of business cycles in the 
controlled taxpayer's industry, or the effects of life cycles of the 
product or intangible property being examined. Data from one or more 
years before or after the taxable year under review must ordinarily be 
considered for purposes of applying the provisions of paragraph 
(d)(3)(iii) of this section (risk), paragraph (d)(4)(i) of this section 
(market share strategy), Sec.  1.482-4(f)(2) (periodic adjustments), 
Sec.  1.482-5 (comparable profits method), Sec.  1.482-9(f) (comparable 
profits method for services), and Sec.  1.482-9(i) (contingent-payment 
contractual terms for services). On the other hand, multiple year data 
ordinarily will not be considered for purposes of applying the 
comparable uncontrolled price method of Sec.  1.482-3(b) or the 
comparable uncontrolled services price method of Sec.  1.482-9(c) 
(except to the extent that risk or market share strategy issues are 
present).
    (C) Comparable effect over comparable period. Data from multiple 
years may be considered to determine whether the same economic 
conditions that caused the controlled taxpayer's results had a 
comparable effect over a comparable period of time on the uncontrolled 
comparables that establish the arm's length range. For example, given 
that uncontrolled taxpayers enter into transactions with the ultimate 
expectation of earning a profit, persistent losses among controlled 
taxpayers may be an indication of non-arm's length dealings. Thus, if a 
controlled taxpayer that realizes a loss with respect to a controlled 
transaction seeks to demonstrate that the loss is within the arm's 
length range, the district director may take into account data from 
taxable years other than the taxable year of the transaction to 
determine whether the loss was attributable to arm's length dealings. 
The rule of this paragraph (f)(2)(iii)(C) is illustrated by Example 3 of 
paragraph (f)(2)(iii)(E) of this section.
    (D) Applications of methods using multiple year averages. If a 
comparison of a controlled taxpayer's average result over a multiple 
year period with the average results of uncontrolled comparables over 
the same period would reduce the effect of short-term variations that 
may be unrelated to transfer pricing, it may be appropriate to establish 
a range derived from the average results of uncontrolled comparables 
over a multiple year period to determine if an adjustment should be 
made. In such a case the district director may make an adjustment if the 
controlled taxpayer's average result for the multiple year period is not 
within such range. Such a range must be determined in accordance with 
Sec.  1.482-1(e) (Arm's length range). An adjustment in such a case 
ordinarily will be equal to the difference, if any, between the 
controlled taxpayer's result for the taxable year and the mid-point of 
the uncontrolled comparables' results for that year. If the 
interquartile range is used to determine the range of average results 
for the multiple year period, such adjustment will ordinarily be made to 
the median of all the results of the uncontrolled comparables for the 
taxable year. See Example 2 of Sec.  1.482-5(e). In other cases, the 
adjustment normally will be made to the arithmetic mean of all the 
results of the uncontrolled comparables for the taxable year. However, 
an adjustment will be made only to the extent that it would move the 
controlled taxpayer's multiple year average closer to the arm's length 
range for the multiple year period or to any point within such range. In 
determining a controlled taxpayer's average result for a multiple year 
period, adjustments made under this section for prior years will be 
taken into account only if such adjustments have been finally 
determined, as

[[Page 680]]

described in Sec.  1.482-1(g)(2)(iii). See Example 3 of Sec.  1.482-
5(e).
    (E) Examples. The following examples, in which S and P are 
controlled taxpayers, illustrate this paragraph (f)(2)(iii). Examples 1 
and 4 also illustrate the principle of the arm's length range of 
paragraph (e) of this section.

    Example 1. P sold product Z to S for $60 per unit in 1995. Applying 
the resale price method to data from uncontrolled comparables for the 
same year establishes an arm's length range of prices for the controlled 
transaction from $52 to $59 per unit. Since the price charged in the 
controlled transaction falls outside the range, the district director 
would ordinarily make an allocation under section 482. However, in this 
case there are cyclical factors that affect the results of the 
uncontrolled comparables (and that of the controlled transaction) that 
cannot be adequately accounted for by specific adjustments to the data 
for 1995. Therefore, the district director considers results over 
multiple years to account for these factors. Under these circumstances, 
it is appropriate to average the results of the uncontrolled comparables 
over the years 1993, 1994, and 1995 to determine an arm's length range. 
The averaged results establish an arm's length range of $56 to $58 per 
unit. For consistency, the results of the controlled taxpayers must also 
be averaged over the same years. The average price in the controlled 
transaction over the three years is $57. Because the controlled transfer 
price of product Z falls within the arm's length range, the district 
director makes no allocation.
    Example 2. (i) FP, a Country X corporation, designs and manufactures 
machinery in Country X. FP's costs are incurred in Country X currency. 
USSub is the exclusive distributor of FP's machinery in the United 
States. The price of the machinery sold by FP to USSub is expressed in 
Country X currency. Thus, USSub bears all of the currency risk 
associated with fluctuations in the exchange rate between the time the 
contract is signed and the payment is made. The prices charged by FP to 
USSub for 1995 are under examination. In that year, the value of the 
dollar depreciated against the currency of Country X, and as a result, 
USSub's gross margin was only 8%.
    (ii) UD is an uncontrolled distributor of similar machinery that 
performs distribution functions substantially the same as those 
performed by USSub, except that UD purchases and resells machinery in 
transactions where both the purchase and resale prices are denominated 
in U.S. dollars. Thus, UD had no currency exchange risk. UD's gross 
margin in 1995 was 10%. UD's average gross margin for the period 1990 to 
1998 has been 12%.
    (iii) In determining whether the price charged by FP to USSub in 
1995 was arm's length, the district director may consider USSub's 
average gross margin for an appropriate period before and after 1995 to 
determine whether USSub's average gross margin during the period was 
sufficiently greater than UD's average gross margin during the same 
period such that USSub was sufficiently compensated for the currency 
risk it bore throughout the period. See Sec.  1.482- 1(d)(3)(iii) 
(Risk).
    Example 3. FP manufactures product X in Country M and sells it to 
USSub, which distributes X in the United States. USSub realizes losses 
with respect to the controlled transactions in each of five consecutive 
taxable years. In each of the five consecutive years a different 
uncontrolled comparable realized a loss with respect to comparable 
transactions equal to or greater than USSub's loss. Pursuant to 
paragraph (f)(3)(iii)(C) of this section, the district director examines 
whether the uncontrolled comparables realized similar losses over a 
comparable period of time, and finds that each of the five comparables 
realized losses in only one of the five years, and their average result 
over the five-year period was a profit. Based on this data, the district 
director may conclude that the controlled taxpayer's results are not 
within the arm's length range over the five year period, since the 
economic conditions that resulted in the controlled taxpayer's loss did 
not have a comparable effect over a comparable period of time on the 
uncontrolled comparables.
    Example 4. (i) USP, a U.S. corporation, manufactures product Y in 
the United States and sells it to FSub, which acts as USP's exclusive 
distributor of product Y in Country N. The resale price method described 
in Sec.  1.482-3(c) is used to evaluate whether the transfer price 
charged by USP to FSub for the 1994 taxable year for product Y was arm's 
length. For the period 1992 through 1994, FSub had a gross profit margin 
for each year of 13%. A, B, C and D are uncontrolled distributors of 
products that compete directly with product Y in country N. After making 
appropriate adjustments in accordance with Sec. Sec.  1.482-1(d)(2) and 
1.482-3(c), the gross profit margins for A, B, C, and D are as follows:

------------------------------------------------------------------------
                                        1992     1993     1994   Average
------------------------------------------------------------------------
A...................................       13        3        8     8.00
B...................................       11       13        2     8.67
7C..................................        4        7       13     8.00
7D..................................        7        9        6     7.33
------------------------------------------------------------------------

    (ii) Applying the provisions of Sec.  1.482-1(e), the district 
director determines that the arm's length range of the average gross 
profit margins is between 7.33 and 8.67. The district director concludes 
that FSub's average gross margin of 13% is not within the arm's

[[Page 681]]

length range, despite the fact that C's gross profit margin for 1994 was 
also 13%, since the economic conditions that caused S's result did not 
have a comparable effect over a comparable period of time on the results 
of C or the other uncontrolled comparables. In this case, the district 
director makes an allocation equivalent to adjusting FSub's gross profit 
margin for 1994 from 13% to the mean of the uncontrolled comparables' 
results for 1994 (7.25%).

    (iv) Product lines and statistical techniques. The methods described 
in Sec. Sec.  1.482-2 through 1.482-6 are generally stated in terms of 
individual transactions. However, because a taxpayer may have controlled 
transactions involving many different products, or many separate 
transactions involving the same product, it may be impractical to 
analyze every individual transaction to determine its arm's length 
price. In such cases, it is permissible to evaluate the arm's length 
results by applying the appropriate methods to the overall results for 
product lines or other groupings. In addition, the arm's length results 
of all related party transactions entered into by a controlled taxpayer 
may be evaluated by employing sampling and other valid statistical 
techniques.
    (v) Allocations apply to results, not methods--(A) In general. In 
evaluating whether the result of a controlled transaction is arm's 
length, it is not necessary for the district director to determine 
whether the method or procedure that a controlled taxpayer employs to 
set the terms for its controlled transactions corresponds to the method 
or procedure that might have been used by a taxpayer dealing at arm's 
length with an uncontrolled taxpayer. Rather, the district director will 
evaluate the result achieved rather than the method the taxpayer used to 
determine its prices.
    (B) Example. The following example illustrates this paragraph 
(f)(2)(v).

    Example. (i) FS is a foreign subsidiary of P, a U.S. corporation. P 
manufactures and sells household appliances. FS operates as P's 
exclusive distributor in Europe. P annually establishes the price for 
each of its appliances sold to FS as part of its annual budgeting, 
production allocation and scheduling, and performance evaluation 
processes. FS's aggregate gross margin earned in its distribution 
business is 18%.
    (ii) ED is an uncontrolled European distributor of competing 
household appliances. After adjusting for minor differences in the level 
of inventory, volume of sales, and warranty programs conducted by FS and 
ED, ED's aggregate gross margin is also 18%. Thus, the district director 
may conclude that the aggregate prices charged by P for its appliances 
sold to FS are arm's length, without determining whether the budgeting, 
production, and performance evaluation processes of P are similar to 
such processes used by ED.

    (g) Collateral adjustments with respect to allocations under section 
482--(1) In general. The district director will take into account 
appropriate collateral adjustments with respect to allocations under 
section 482. Appropriate collateral adjustments may include correlative 
allocations, conforming adjustments, and setoffs, as described in this 
paragraph (g).
    (2) Correlative allocations--(i) In general. When the district 
director makes an allocation under section 482 (referred to in this 
paragraph (g)(2) as the primary allocation), appropriate correlative 
allocations will also be made with respect to any other member of the 
group affected by the allocation. Thus, if the district director makes 
an allocation of income, the district director will not only increase 
the income of one member of the group, but correspondingly decrease the 
income of the other member. In addition, where appropriate, the district 
director may make such further correlative allocations as may be 
required by the initial correlative allocation.
    (ii) Manner of carrying out correlative allocation. The district 
director will furnish to the taxpayer with respect to which the primary 
allocation is made a written statement of the amount and nature of the 
correlative allocation. The correlative allocation must be reflected in 
the documentation of the other member of the group that is maintained 
for U.S. tax purposes, without regard to whether it affects the U.S. 
income tax liability of the other member for any open year. In some 
circumstances the allocation will have an immediate U.S. tax effect, by 
changing the taxable income computation of the other member (or the 
taxable income computation of a shareholder of the other member, for 
example, under the

[[Page 682]]

provisions of subpart F of the Internal Revenue Code). Alternatively, 
the correlative allocation may not be reflected on any U.S. tax return 
until a later year, for example when a dividend is paid.
    (iii) Events triggering correlative allocation. For purposes of this 
paragraph (g)(2), a primary allocation will not be considered to have 
been made (and therefore, correlative allocations are not required to be 
made) until the date of a final determination with respect to the 
allocation under section 482. For this purpose, a final determination 
includes--
    (A) Assessment of tax following execution by the taxpayer of a Form 
870 (Waiver of Restrictions on Assessment and Collection of Deficiency 
in Tax and Acceptance of Overassessment) with respect to such 
allocation;
    (B) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on 
Assessment and Collection of Deficiency in Tax and Acceptance of 
Overassessment);
    (C) Payment of the deficiency;
    (D) Stipulation in the Tax Court of the United States; or
    (E) Final determination of tax liability by offer-in-compromise, 
closing agreement, or final resolution (determined under the principles 
of section 7481) of a judicial proceeding.
    (iv) Examples. The following examples illustrate this paragraph 
(g)(2). In each example, X and Y are members of the same group of 
controlled taxpayers and each regularly computes its income on a 
calendar year basis.

    Example 1. (i) In 1996, Y, a U.S. corporation, rents a building 
owned by X, also a U.S. corporation. In 1998 the district director 
determines that Y did not pay an arm's length rental charge. The 
district director proposes to increase X's income to reflect an arm's 
length rental charge. X consents to the assessment reflecting such 
adjustment by executing Form 870, a Waiver of Restrictions on Assessment 
and Collection of Deficiency in Tax and Acceptance of Overassessment. 
The assessment of the tax with respect to the adjustment is made in 
1998. Thus, the primary allocation, as defined in paragraph (g)(2)(i) of 
this section, is considered to have been made in 1998.
    (ii) The adjustment made to X's income under section 482 requires a 
correlative allocation with respect to Y's income. The district director 
notifies X in writing of the amount and nature of the adjustment made 
with respect to Y. Y had net operating losses in 1993, 1994, 1995, 1996, 
and 1997. Although a correlative adjustment will not have an effect on 
Y's U.S. income tax liability for 1996, an adjustment increasing Y's net 
operating loss for 1996 will be made for purposes of determining Y's 
U.S. income tax liability for 1998 or a later taxable year to which the 
increased net operating loss may be carried.
    Example 2. (i) In 1995, X, a U.S. construction company, provided 
engineering services to Y, a U.S. corporation, in the construction of 
Y's factory. In 1997, the district director determines that the fees 
paid by Y to X for its services were not arm's length and proposes to 
make an adjustment to the income of X. X consents to an assessment 
reflecting such adjustment by executing Form 870. An assessment of the 
tax with respect to such adjustment is made in 1997. The district 
director notifies X in writing of the amount and nature of the 
adjustment to be made with respect to Y.
    (ii) The fees paid by Y for X's engineering services properly 
constitute a capital expenditure. Y does not place the factory into 
service until 1998. Therefore, a correlative adjustment increasing Y's 
basis in the factory does not affect Y's U.S. income tax liability for 
1997. However, the correlative adjustment must be made in the books and 
records maintained by Y for its U.S. income tax purposes and such 
adjustment will be taken into account in computing Y's allowable 
depreciation or gain or loss on a subsequent disposition of the factory.
    Example 3. In 1995, X, a U.S. corporation, makes a loan to Y, its 
foreign subsidiary not engaged in a U.S. trade or business. In 1997, the 
district director, upon determining that the interest charged on the 
loan was not arm's length, proposes to adjust X's income to reflect an 
arm's length interest rate. X consents to an assessment reflecting such 
allocation by executing Form 870, and an assessment of the tax with 
respect to the section 482 allocation is made in 1997. The district 
director notifies X in writing of the amount and nature of the 
correlative allocation to be made with respect to Y. Although the 
correlative adjustment does not have an effect on Y's U.S. income tax 
liability, the adjustment must be reflected in the documentation of Y 
that is maintained for U.S. tax purposes. Thus, the adjustment must be 
reflected in the determination of the amount of Y's earnings and profits 
for 1995 and subsequent years, and the adjustment must be made to the 
extent it has an effect on any person's U.S. income tax liability for 
any taxable year.

    (3) Adjustments to conform accounts to reflect section 482 
allocations--(i) In general. Appropriate adjustments must be made to 
conform a taxpayer's accounts

[[Page 683]]

to reflect allocations made under section 482. Such adjustments may 
include the treatment of an allocated amount as a dividend or a capital 
contribution (as appropriate), or, in appropriate cases, pursuant to 
such applicable revenue procedures as may be provided by the 
Commissioner (see Sec.  601.601(d)(2) of this chapter), repayment of the 
allocated amount without further income tax consequences.
    (ii) Example. The following example illustrates the principles of 
this paragraph (g)(3).

    Example. Conforming cash accounts. (i) USD, a United States 
corporation, buys Product from its foreign parent, FP. In reviewing 
USD's income tax return, the district director determines that the arm's 
length price would have increased USD's taxable income by $5 million. 
The district director accordingly adjusts USD's income to reflect its 
true taxable income.
    (ii) To conform its cash accounts to reflect the section 482 
allocation made by the district director, USD applies for relief under 
Rev. Proc. 65-17, 1965-1 C.B. 833 (see Sec.  601.601(d)(2)(ii)(b) of 
this chapter), to treat the $5 million adjustment as an account 
receivable from FP, due as of the last day of the year of the 
transaction, with interest accruing therefrom.

    (4) Setoffs--(i) In general. If an allocation is made under section 
482 with respect to a transaction between controlled taxpayers, the 
Commissioner will take into account the effect of any other non-arm's 
length transaction between the same controlled taxpayers in the same 
taxable year which will result in a setoff against the original section 
482 allocation. Such setoff, however, will be taken into account only if 
the requirements of paragraph (g)(4)(ii) of this section are satisfied. 
If the effect of the setoff is to change the characterization or source 
of the income or deductions, or otherwise distort taxable income, in 
such a manner as to affect the U.S. tax liability of any member, 
adjustments will be made to reflect the correct amount of each category 
of income or deductions. For purposes of this setoff provision, the term 
arm's length refers to the amount defined in paragraph (b) of this 
section (arm's length standard), without regard to the rules in Sec.  
1.482-2(a) that treat certain interest rates as arm's length rates of 
interest.
    (ii) Requirements. The district director will take a setoff into 
account only if the taxpayer--
    (A) Establishes that the transaction that is the basis of the setoff 
was not at arm's length and the amount of the appropriate arm's length 
charge;
    (B) Documents, pursuant to paragraph (g)(2) of this section, all 
correlative adjustments resulting from the proposed setoff; and
    (C) Notifies the district director of the basis of any claimed 
setoff within 30 days after the earlier of the date of a letter by which 
the district director transmits an examination report notifying the 
taxpayer of proposed adjustments or the date of the issuance of the 
notice of deficiency.
    (iii) Examples. The following examples illustrate this paragraph 
(g)(4).

    Example 1. P, a U.S. corporation, renders construction services to 
S, its foreign subsidiary in Country Y, in connection with the 
construction of S's factory. An arm's length charge for such services 
determined under Sec.  1.482-9 would be $100,000. During the same 
taxable year P makes available to S the use of a machine to be used in 
the construction of the factory, and the arm's length rental value of 
the machine is $25,000. P bills S $125,000 for the services, but does 
not charge S for the use of the machine. No allocation will be made with 
respect to the undercharge for the machine if P notifies the district 
director of the basis of the claimed setoff within 30 days after the 
date of the letter from the district director transmitting the 
examination report notifying P of the proposed adjustment, establishes 
that the excess amount charged for services was equal to an arm's length 
charge for the use of the machine and that the taxable income and income 
tax liabilities of P are not distorted, and documents the correlative 
allocations resulting from the proposed setoff.
    Example 2. The facts are the same as in Example 1, except that, if P 
had reported $25,000 as rental income and $25,000 less as service 
income, it would have been subject to the tax on personal holding 
companies. Allocations will be made to reflect the correct amounts of 
rental income and service income.

    (h) Special rules--(1) Small taxpayer safe harbor. [Reserved]
    (2) Effect of foreign legal restrictions--(i) In general. The 
district director will take into account the effect of a foreign legal 
restriction to the extent that such restriction affects the results of 
transactions at arm's length. Thus,

[[Page 684]]

a foreign legal restriction will be taken into account only to the 
extent that it is shown that the restriction affected an uncontrolled 
taxpayer under comparable circumstances for a comparable period of time. 
In the absence of evidence indicating the effect of the foreign legal 
restriction on uncontrolled taxpayers, the restriction will be taken 
into account only to the extent provided in paragraphs (h)(2) (iii) and 
(iv) of this section (Deferred income method of accounting).
    (ii) Applicable legal restrictions. Foreign legal restrictions 
(whether temporary or permanent) will be taken into account for purposes 
of this paragraph (h)(2) only if, and so long as, the conditions set 
forth in paragraphs (h)(2)(ii) (A) through (D) of this section are met.
    (A) The restrictions are publicly promulgated, generally applicable 
to all similarly situated persons (both controlled and uncontrolled), 
and not imposed as part of a commercial transaction between the taxpayer 
and the foreign sovereign;
    (B) The taxpayer (or other member of the controlled group with 
respect to which the restrictions apply) has exhausted all remedies 
prescribed by foreign law or practice for obtaining a waiver of such 
restrictions (other than remedies that would have a negligible prospect 
of success if pursued);
    (C) The restrictions expressly prevented the payment or receipt, in 
any form, of part or all of the arm's length amount that would otherwise 
be required under section 482 (for example, a restriction that applies 
only to the deductibility of an expense for tax purposes is not a 
restriction on payment or receipt for this purpose); and
    (D) The related parties subject to the restriction did not engage in 
any arrangement with controlled or uncontrolled parties that had the 
effect of circumventing the restriction, and have not otherwise violated 
the restriction in any material respect.
    (iii) Requirement for electing the deferred income method of 
accounting. If a foreign legal restriction prevents the payment or 
receipt of part or all of the arm's length amount that is due with 
respect to a controlled transaction, the restricted amount may be 
treated as deferrable if the following requirements are met--
    (A) The controlled taxpayer establishes to the satisfaction of the 
district director that the payment or receipt of the arm's length amount 
was prevented because of a foreign legal restriction and circumstances 
described in paragraph (h)(2)(ii) of this section; and
    (B) The controlled taxpayer whose U.S. tax liability may be affected 
by the foreign legal restriction elects the deferred income method of 
accounting, as described in paragraph (h)(2)(iv) of this section, on a 
written statement attached to a timely U.S. income tax return (or an 
amended return) filed before the IRS first contacts any member of the 
controlled group concerning an examination of the return for the taxable 
year to which the foreign legal restriction applies. A written statement 
furnished by a taxpayer subject to the Coordinated Examination Program 
will be considered an amended return for purposes of this paragraph 
(h)(2)(iii)(B) if it satisfies the requirements of a qualified amended 
return for purposes of Sec.  1.6664-2(c)(3) as set forth in those 
regulations or as the Commissioner may prescribe by applicable revenue 
procedures. The election statement must identify the affected 
transactions, the parties to the transactions, and the applicable 
foreign legal restrictions.
    (iv) Deferred income method of accounting. If the requirements of 
paragraph (h)(2)(ii) of this section are satisfied, any portion of the 
arm's length amount, the payment or receipt of which is prevented 
because of applicable foreign legal restrictions, will be treated as 
deferrable until payment or receipt of the relevant item ceases to be 
prevented by the foreign legal restriction. For purposes of the deferred 
income method of accounting under this paragraph (h)(2)(iv), deductions 
(including the cost or other basis of inventory and other assets sold or 
exchanged) and credits properly chargeable against any amount so 
deferred, are subject to deferral under the provisions of Sec.  1.461- 
1(a)(4). In addition, income is deferrable under this deferred income 
method of accounting only to the extent that it exceeds the related 
deductions already claimed in open

[[Page 685]]

taxable years to which the foreign legal restriction applied.
    (v) Examples. The following examples, in which Sub is a Country FC 
subsidiary of U.S. corporation, Parent, illustrate this paragraph 
(h)(2).

    Example 1. Parent licenses an intangible to Sub. FC law generally 
prohibits payments by any person within FC to recipients outside the 
country. The FC law meets the requirements of paragraph (h)(2)(ii) of 
this section. There is no evidence of unrelated parties entering into 
transactions under comparable circumstances for a comparable period of 
time, and the foreign legal restrictions will not be taken into account 
in determining the arm's length amount. The arm's length royalty rate 
for the use of the intangible property in the absence of the foreign 
restriction is 10% of Sub's sales in country FC. However, because the 
requirements of paragraph (h)(2)(ii) of this section are satisfied, 
Parent can elect the deferred income method of accounting by attaching 
to its timely filed U.S. income tax return a written statement that 
satisfies the requirements of paragraph (h)(2)(iii)(B) of this section.
    Example 2. (i) The facts are the same as in Example 1, except that 
Sub, although it makes no royalty payment to Parent, arranges with an 
unrelated intermediary to make payments equal to an arm's length amount 
on its behalf to Parent.
    (ii) The district director makes an allocation of royalty income to 
Parent, based on the arm's length royalty rate of 10%. Further, the 
district director determines that because the arrangement with the third 
party had the effect of circumventing the FC law, the requirements of 
paragraph (h)(2)(ii)(D) of this section are not satisfied. Thus, Parent 
could not validly elect the deferred income method of accounting, and 
the allocation of royalty income cannot be treated as deferrable. In 
appropriate circumstances, the district director may permit the amount 
of the distribution to be treated as payment by Sub of the royalty 
allocated to Parent, under the provisions of Sec.  1.482-1(g) 
(Collateral adjustments).
    Example 3. The facts are the same as in Example 1, except that the 
laws of FC do not prevent distributions from corporations to their 
shareholders. Sub distributes an amount equal to 8% of its sales in 
country FC. Because the laws of FC did not expressly prevent all forms 
of payment from Sub to Parent, Parent cannot validly elect the deferred 
income method of accounting with respect to any of the arm's length 
royalty amount. In appropriate circumstances, the district director may 
permit the 8% that was distributed to be treated as payment by Sub of 
the royalty allocated to Parent, under the provisions of Sec.  1.482-
1(g) (Collateral adjustments).
    Example 4. The facts are the same as in Example 1, except that 
Country FC law permits the payment of a royalty, but limits the amount 
to 5% of sales, and Sub pays the 5% royalty to Parent. Parent 
demonstrates the existence of a comparable uncontrolled transaction for 
purposes of the comparable uncontrolled transaction method in which an 
uncontrolled party accepted a royalty rate of 5%. Given the evidence of 
the comparable uncontrolled transaction, the 5% royalty rate is 
determined to be the arm's length royalty rate.

    (3) Coordination with section 936--(i) Cost sharing under section 
936. If a possessions corporation makes an election under section 
936(h)(5)(C)(i)(I), the corporation must make a section 936 cost sharing 
payment that is at least equal to the payment that would be required 
under section 482 if the electing corporation were a foreign 
corporation. In determining the payment that would be required under 
section 482 for this purpose, the provisions of Sec. Sec.  1.482-1 and 
1.482-4 will be applied, and to the extent relevant to the valuation of 
intangibles, Sec. Sec.  1.482-5 and 1.482-6 will be applied. The 
provisions of section 936(h)(5)(C)(i)(II) (Effect of Election--electing 
corporation treated as owner of intangible property) do not apply until 
the payment that would be required under section 482 has been 
determined.
    (ii) Use of terms. A cost sharing payment, for the purposes of 
section 936(h)(5)(C)(i)(I), is calculated using the provisions of 
section 936 and the regulations thereunder and the provisions of this 
paragraph (h)(3). The provisions relating to cost sharing under section 
482 do not apply to payments made pursuant to an election under section 
936(h)(5)(C)(i)(I). Similarly, a profit split payment, for the purposes 
of section 936(h)(5)(C)(ii)(I), is calculated using the provisions of 
section 936 and the regulations thereunder, not section 482 and the 
regulations thereunder.
    (i) Definitions. The definitions set forth in paragraphs (i)(1) 
through (i)(10) of this section apply to this section and Sec. Sec.  
1.482-2 through 1.482-9.
    (1) Organization includes an organization of any kind, whether a 
sole proprietorship, a partnership, a trust, an estate, an association, 
or a corporation

[[Page 686]]

(as each is defined or understood in the Internal Revenue Code or the 
regulations thereunder), irrespective of the place of organization, 
operation, or conduct of the trade or business, and regardless of 
whether it is a domestic or foreign organization, whether it is an 
exempt organization, or whether it is a member of an affiliated group 
that files a consolidated U.S. income tax return, or a member of an 
affiliated group that does not file a consolidated U.S. income tax 
return.
    (2) Trade or business includes a trade or business activity of any 
kind, regardless of whether or where organized, whether owned 
individually or otherwise, and regardless of the place of operation. 
Employment for compensation will constitute a separate trade or business 
from the employing trade or business.
    (3) Taxpayer means any person, organization, trade or business, 
whether or not subject to any internal revenue tax.
    (4) Controlled includes any kind of control, direct or indirect, 
whether legally enforceable or not, and however exercisable or 
exercised, including control resulting from the actions of two or more 
taxpayers acting in concert or with a common goal or purpose. It is the 
reality of the control that is decisive, not its form or the mode of its 
exercise. A presumption of control arises if income or deductions have 
been arbitrarily shifted.
    (5) Controlled taxpayer means any one of two or more taxpayers owned 
or controlled directly or indirectly by the same interests, and includes 
the taxpayer that owns or controls the other taxpayers. Uncontrolled 
taxpayer means any one of two or more taxpayers not owned or controlled 
directly or indirectly by the same interests.
    (6) Group, controlled group, and group of controlled taxpayers mean 
the taxpayers owned or controlled directly or indirectly by the same 
interests.
    (7) Transaction means any sale, assignment, lease, license, loan, 
advance, contribution, or any other transfer of any interest in or a 
right to use any property (whether tangible or intangible, real or 
personal) or money, however such transaction is effected, and whether or 
not the terms of such transaction are formally documented. A transaction 
also includes the performance of any services for the benefit of, or on 
behalf of, another taxpayer.
    (8) Controlled transaction or controlled transfer means any 
transaction or transfer between two or more members of the same group of 
controlled taxpayers. The term uncontrolled transaction means any 
transaction between two or more taxpayers that are not members of the 
same group of controlled taxpayers.
    (9) True taxable income means, in the case of a controlled taxpayer, 
the taxable income that would have resulted had it dealt with the other 
member or members of the group at arm's length. It does not mean the 
taxable income resulting to the controlled taxpayer by reason of the 
particular contract, transaction, or arrangement the controlled taxpayer 
chose to make (even though such contract, transaction, or arrangement is 
legally binding upon the parties thereto).
    (10) Uncontrolled comparable means the uncontrolled transaction or 
uncontrolled taxpayer that is compared with a controlled transaction or 
taxpayer under any applicable pricing methodology. Thus, for example, 
under the comparable profits method, an uncontrolled comparable is any 
uncontrolled taxpayer from which data is used to establish a comparable 
operating profit.
    (j) Effective dates--(1) The regulations in this are generally 
effective for taxable years beginning after October 6, 1994.
    (2) Taxpayers may elect to apply retroactively all of the provisions 
of these regulations for any open taxable year. Such election will be 
effective for the year of the election and all subsequent taxable years.
    (3) Although these regulations are generally effective for taxable 
years as stated, the final sentence of section 482 (requiring that the 
income with respect to transfers or licenses of intangible property be 
commensurate with the income attributable to the intangible) is 
generally effective for taxable years beginning after December 31, 1986. 
For the period prior to the effective date of these regulations, the 
final sentence of section 482 must be applied using any reasonable 
method not inconsistent

[[Page 687]]

with the statute. The IRS considers a method that applies these 
regulations or their general principles to be a reasonable method.
    (4) These regulations will not apply with respect to transfers made 
or licenses granted to foreign persons before November 17, 1985, or 
before August 17, 1986, for transfers or licenses to others. 
Nevertheless, they will apply with respect to transfers or licenses 
before such dates if, with respect to property transferred pursuant to 
an earlier and continuing transfer agreement, such property was not in 
existence or owned by the taxpayer on such date.
    (5) The last sentences of paragraphs (b)(2)(i) and (c)(1) of this 
section and of paragraph (c)(2)(iv) of Sec.  1.482-5 apply for taxable 
years beginning on or after August 26, 2003.
    (6)(i) The provisions of paragraphs (a)(1), (d)(3)(ii)(C) Example 3, 
Example 4, Example 5, and Example 6, (d)(3)(v), (f)(2)(ii)(A), 
(f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii), and (i) of this section are 
generally applicable for taxable years beginning after July 31, 2009. 
The provision of paragraph (b)(2)(iii) of this section is generally 
applicable on January 5, 2009.
    (ii) A person may elect to apply the provisions of paragraphs 
(a)(1), (b)(2)(i), (d)(3)(ii)(C) Example 3, Example 4, Example 5, and 
Example 6, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), 
(g)(4)(iii), and (i) of this section to earlier taxable years in 
accordance with the rules set forth in Sec.  1.482-9(n)(2).
    (7) [Reserved]. For further guidance see Sec.  1.482-1T(j)(7).

[T.D. 8552, 59 FR 34990, July 8, 1994, as amended by T.D. 9088, 68 FR 
51177, Aug. 26, 2003; T.D. 9278, 71 FR 44481, Aug. 4, 2006; 71 FR 76903, 
Dec. 22, 2006; T.D. 9441, 74 FR 351, Jan. 5, 2009; T.D. 9456, 74 FR 
38839, Aug. 4, 2009; 74 FR 46345, Sept. 9, 2009; T.D. 9568, 76 FR 80089, 
Dec. 22, 2011; 77 FR 3606, Jan. 25, 2012; T.D. 9738, 80 FR 55541, Sept. 
16, 2015]



Sec.  1.482-1T  Allocation of income and deductions among taxpayers 
(temporary).

    (a) through (f)(2) [Reserved]. For further guidance see Sec.  1.482-
1(a) through (f)(2).
    (i) Compensation independent of the form or character of controlled 
transaction--(A) In general. All value provided between controlled 
taxpayers in a controlled transaction requires an arm's length amount of 
compensation determined under the best method rule of Sec.  1.482-1(c). 
Such amount must be consistent with, and must account for all of, the 
value provided between the parties in the transaction, without regard to 
the form or character of the transaction. For this purpose, it is 
necessary to consider the entire arrangement between the parties, as 
determined by the contractual terms, whether written or imputed in 
accordance with the economic substance of the arrangement, in light of 
the actual conduct of the parties. See, e.g., Sec.  1.482-1(d)(3)(ii)(B) 
(identifying contractual terms) and (f)(2)(ii)(A) (regarding reference 
to realistic alternatives).
    (B) Aggregation. The combined effect of two or more separate 
transactions (whether before, during, or after the year under review), 
including for purposes of an analysis under multiple provisions of the 
Code or regulations, may be considered if the transactions, taken as a 
whole, are so interrelated that an aggregate analysis of the 
transactions provides the most reliable measure of an arm's length 
result determined under the best method rule of Sec.  1.482-1(c). 
Whether two or more transactions are evaluated separately or in the 
aggregate depends on the extent to which the transactions are 
economically interrelated and on the relative reliability of the measure 
of an arm's length result provided by an aggregate analysis of the 
transactions as compared to a separate analysis of each transaction. For 
example, consideration of the combined effect of two or more 
transactions may be appropriate to determine whether the overall 
compensation in the transactions is consistent with the value provided, 
including any synergies among items and services provided.
    (C) Coordinated best method analysis and evaluation. Consistent with 
the principles of paragraphs (f)(2)(i)(A) and (B) of this section, a 
coordinated best method analysis and evaluation of two or more 
controlled transactions to which one or more provisions of the Code or 
regulations apply may be necessary to ensure that the overall value 
provided, including any synergies, is

[[Page 688]]

properly taken into account. A coordinated best method analysis would 
include a consistent consideration of the facts and circumstances of the 
functions performed, resources employed, and risks assumed in the 
relevant transactions, and a consistent measure of the arm's length 
results, for purposes of all relevant statutory and regulatory 
provisions.
    (D) Allocations of value. In some cases, it may be necessary to 
allocate one or more portions of the arm's length result that was 
properly determined under a coordinated best method analysis described 
in paragraph (f)(2)(i)(C) of this section. Any such allocation of the 
arm's length result determined under the coordinated best method 
analysis must be made using the method that, under the facts and 
circumstances, provides the most reliable measure of an arm's length 
result for each allocated amount. For example, if the full value of 
compensation due in controlled transactions whose tax treatment is 
governed by multiple provisions of the Code or regulations has been most 
reliably determined on an aggregate basis, then that full value must be 
allocated in a manner that provides the most reliable measure of each 
allocated amount.
    (E) Examples. The following examples illustrate the provisions of 
this paragraph (f)(2)(i). For purposes of the examples in this paragraph 
(E), P is a domestic corporation, and S1, S2, and S3 are foreign 
corporations that are wholly owned by P.

    Example 1. Aggregation of interrelated licensing, manufacturing, and 
selling activities. P enters into a license agreement with S1 that 
permits S1 to use a proprietary manufacturing process and to sell the 
output from this process throughout a specified region. S1 uses the 
manufacturing process and sells its output to S2, which in turn resells 
the output to uncontrolled parties in the specified region. In 
evaluating whether the royalty paid by S1 to P is an arm's length 
amount, it may be appropriate to evaluate the royalty in combination 
with the transfer prices charged by S1 to S2 and the aggregate profits 
earned by S1 and S2 from the use of the manufacturing process and the 
sale to uncontrolled parties of the products produced by S1.
    Example 2. Aggregation of interrelated manufacturing, marketing, and 
services activities. S1 is the exclusive Country Z distributor of 
computers manufactured by P. S2 provides marketing services in 
connection with sales of P computers in Country Z and in this regard 
uses significant marketing intangibles provided by P. S3 administers the 
warranty program with respect to P computers in Country Z, including 
maintenance and repair services. In evaluating whether the transfer 
prices paid by S1 to P, the fees paid by S2 to P for the use of P 
marketing intangibles, and the service fees earned by S2 and S3 are 
arm's length amounts, it would be appropriate to perform an aggregate 
analysis that considers the combined effects of these interrelated 
transactions if they are most reliably analyzed on an aggregated basis.
    Example 3. Aggregation and reliability of comparable uncontrolled 
transactions. The facts are the same as in Example 2. In addition, U1, 
U2, and U3 are uncontrolled taxpayers that carry out functions 
comparable to those of S1, S2, and S3, respectively, with respect to 
computers produced by unrelated manufacturers. R1, R2, and R3 constitute 
a controlled group of taxpayers (unrelated to the P controlled group) 
that carry out functions comparable to those of S1, S2, and S3 with 
respect to computers produced by their common parent. Prices charged to 
uncontrolled customers of the R group differ from the prices charged to 
customers of U1, U2, and U3. In determining whether the transactions of 
U1, U2, and U3, or the transactions of R1, R2, and R3, would provide a 
more reliable measure of the arm's length result, it is determined that 
the interrelated R group transactions are more reliable than the wholly 
independent transactions of U1, U2, and U3, given the interrelationship 
of the P group transactions.
    Example 4. Non-aggregation of transactions that are not 
interrelated. P enters into a license agreement with S1 that permits S1 
to use a proprietary process for manufacturing product X and to sell 
product X to uncontrolled parties throughout a specified region. P also 
sells to S1 product Y, which is manufactured by P in the United States 
and unrelated to product X. Product Y is resold by S1 to uncontrolled 
parties in the specified region. There is no connection between product 
X and product Y other than the fact that they are both sold in the same 
specified region. In evaluating whether the royalty paid by S1 to P for 
the use of the manufacturing process for product X and the transfer 
prices charged for unrelated product Y are arm's length amounts, it 
would not be appropriate to consider the combined effects of these 
separate and unrelated transactions.
    Example 5. Aggregation of interrelated patents. P owns 10 individual 
patents that, in combination, can be used to manufacture and sell a 
successful product. P anticipates that it could earn profits of $25x 
from the patents based on a discounted cash flow

[[Page 689]]

analysis that provides a more reliable measure of the value of the 
patents exploited as a bundle rather than separately. P licenses all 10 
patents to S1 to be exploited as a bundle. Evidence of uncontrolled 
licenses of similar individual patents indicates that, exploited 
separately, each license of each patent would warrant a price of $1x, 
implying a total price for the patents of $10x. Under paragraph 
(f)(2)(i)(B) of this section, in determining the arm's length royalty 
for the license of the bundle of patents, it would not be appropriate to 
use the uncontrolled licenses as comparables for the license of the 
bundle of patents, because, unlike the discounted cash flow analysis, 
the uncontrolled licenses considered separately do not reliably reflect 
the enhancement to value resulting from the interrelatedness of the 10 
patents exploited as a bundle.
    Example 6. Consideration of entire arrangement, including imputed 
contractual terms--(i) P conducts a business (``Business'') from the 
United States, with a worldwide clientele, but until Date X has no 
foreign operations. The success of Business significantly depends on 
intangibles (including marketing, manufacturing, technological, and 
goodwill or going concern value intangibles, collectively the ``IP''), 
as well as ongoing support activities performed by P (including related 
research and development, central marketing, manufacturing process 
enhancement, and oversight activities, collectively ``Support''), to 
maintain and improve the IP and otherwise maximize the profitability of 
Business.
    (ii) On Date X, Year 1, P contributes the foreign rights to conduct 
Business, including the foreign rights to the IP, to newly incorporated 
S1. S1, utilizing the IP of which it is now the owner, commences foreign 
operations consisting of local marketing, manufacturing, and back office 
activities in order to conduct and expand Business in the foreign 
market.
    (iii) Later, on Date Y, Year 1, P and S1 enter into a cost sharing 
arrangement (``CSA'') to develop and exploit the rights to conduct the 
Business. Under the CSA, P is entitled to the U.S. rights to conduct the 
Business, and S1 is entitled to the rest-of-the-world (``ROW'') rights 
to conduct the Business. P continues after Date Y to perform the 
Support, employing resources, capabilities, and rights that as a factual 
matter were not contributed to S1 in the Date X transaction, for the 
benefit of the Business worldwide. Pursuant to the CSA, P and S1 share 
the costs of P's Support in proportion to their reasonably anticipated 
benefit shares from their respective rights to the Business.
    (iv) P treats the Date X transaction as a transfer described in 
section 351 that is subject to 367 and treats the Date Y transaction as 
the commencement of a CSA subject to section 482 and Sec.  1.482-7. P 
takes the position that the only platform contribution transactions 
(``PCTs'') in connection with the Date Y CSA consist of P's contribution 
of the U.S. Business IP rights and S1's contribution of the ROW Business 
IP rights of which S1 had become the owner on account of the prior Date 
X transaction.
    (v) Pursuant to paragraph (f)(2)(i)(A) of this section, in 
determining whether an allocation of income is appropriate in Year 1 or 
subsequent years, the Commissioner may consider the economic substance 
of the entire arrangement between P and S1, including the parties' 
actual conduct throughout their relationship, regardless of the form or 
character of the contractual arrangement the parties have expressly 
adopted. The Commissioner determines that the parties' formal 
arrangement fails to reflect the full scope of the value provided 
between the parties in accordance with the economic substance of their 
arrangement. Therefore, the Commissioner may impute one or more 
agreements between P and S1, consistent with the economic substance of 
their arrangement, that fully reflect their respective reasonably 
anticipated commitments in terms of functions performed, resources 
employed, and risks assumed over time. For example, because P continues 
after Date Y to perform the Support, employing resources, capabilities, 
and rights not contributed to S1, for the benefit of the Business 
worldwide, the Commissioner may impute another PCT on Date Y pursuant to 
which P commits to so continuing the Support. See Sec.  1.482-
7(b)(1)(ii). The taxpayer may present additional facts that could 
indicate whether this or another alternative agreement best reflects the 
economic substance of the underlying transactions and course of conduct, 
provided that the taxpayer's position fully reflects the value of the 
entire arrangement consistent with the realistic alternatives principle.
    Example 7. Distinguishing provision of value from characterization--
(i) P developed a collection of resources, capabilities, and rights 
(``Collection'') that it uses on an interrelated basis in ongoing 
research and development of computer code that is used to create a 
successful line of software products. P can continue to use the 
Collection on such interrelated basis in the future to further develop 
computer code and, thus, further build on its successful line of 
software products. Under Sec.  1.482-7(g)(2)(ix), P determines that the 
interquartile range of the net present value of its own use of the 
Collection in future research and development and software product 
marketing is between $1000x and $1100x, and this range provides the most 
reliable measure of the value to P of continuing to use the Collection 
on an interrelated basis in future research, development, and 
exploitation. Instead, P enters into an exchange described in section 
351 in which it transfers

[[Page 690]]

certain intangible property related to the Collection to S1 for use in 
future research, development, and exploitation but continues to perform 
the same development functions that it did prior to the exchange, now on 
behalf of S1, under express or implied commitments in connection with 
S1's use of the intangible property. P takes the position that a portion 
of the Collection, consisting of computer code and related instruction 
manuals and similar intangible property (Portion 1), was transferrable 
intangible property and was the subject of the section 351 exchange and 
compensable under section 367(d). P claims that another portion of the 
Collection consists of items that either do not constitute property for 
purposes of section 367 or are not transferrable (Portion 2). P then 
takes the position that the value of Portion 2 does not give rise to 
income under section 367(d) or gain under section 367(a).
    (ii) Under paragraphs (f)(2)(i)(A) and (C) of this section, any part 
of the value in Portion 2 that is not taken into account in an exchange 
under section 367 must nonetheless be evaluated under section 482 and 
the regulations thereunder to determine arm's length compensation for 
any value provided to S1. Accordingly, even if P's assertion that 
certain items were either not property or not capable of being 
transferred were correct, arm's length compensation is nonetheless 
required for all of the value associated with P's contributions under 
the section 482 regulations. Alternatively, the Commissioner may 
determine under all the facts and circumstances that P's assertion is 
incorrect and that the transaction in fact constitutes an exchange of 
property subject to, and therefore to be taken into account under, 
section 367. Thus, whether any item that P identifies as being within 
Portion 2 is properly characterized as property under section 367 
(transferable or otherwise) is irrelevant because any value in Portion 2 
that is provided to S1 must be compensated by S1 in a manner consistent 
with the $1000x to $1100x interquartile range of the overall value.
    Example 8. Arm's length compensation for equivalent provisions of 
intangibles under sections 351 and 482. P owns the worldwide rights to 
manufacturing and marketing intangibles that it uses to manufacture and 
market a product in the United States (``US intangibles'') and the rest 
of the world (``ROW intangibles''). P transfers all the ROW intangibles 
to S1 in an exchange described in section 351 and retains the US 
intangibles. Immediately after the exchange, P and S1 entered into a CSA 
described in Sec.  1.482-7(b) that covers all research and development 
of intangibles conducted by the parties. A realistic alternative that 
was available to P and that would have involved the controlled parties 
performing similar functions, employing similar resources, and assuming 
similar risks as in the controlled transaction, was to transfer all ROW 
intangibles to S1 upon entering into the CSA in a platform contribution 
transaction described in Sec.  1.482-7(c), rather than in an exchange 
described in section 351 immediately before entering into the CSA. Under 
paragraph (f)(2)(i)(A) of this section, the arm's length compensation 
for the ROW intangibles must correspond to the value provided between 
the parties, regardless of the form of the transaction. Accordingly, the 
arm's length compensation for the ROW intangibles is the same in both 
scenarios, and the analysis of the amount to be taken into account under 
section 367(d) pursuant to Sec. Sec.  1.367(d)-1T(c) and 1.482-4 should 
include consideration of the amount that P would have charged for the 
realistic alternative determined under Sec.  1.482-7(g) (and Sec.  
1.482-4, to the extent of any make-or-sell rights transferred). See 
Sec. Sec.  1.482-1(b)(2)(iii) and 1.482-4(g).
    Example 9. Aggregation of interrelated manufacturing and marketing 
intangibles governed by different statutes and regulations. The facts 
are the same as in Example 8 except that P transfers only the ROW 
intangibles related to manufacturing to S1 in an exchange described in 
section 351 and, upon entering into the CSA, then transfers the ROW 
intangibles related to marketing to S1 in a platform contribution 
transaction described in Sec.  1.482-7(c) (rather than transferring all 
ROW intangibles only upon entering into the CSA or only in a prior 
exchange described in section 351). The value of the ROW intangibles 
that P transferred in the two transactions is greater in the aggregate, 
due to synergies among the different types of ROW intangibles, than if 
valued as two separate transactions. Under paragraph (f)(2)(i)(B) of 
this section, the arm's length standard requires these synergies to be 
taken into account in determining the arm's length results for the 
transactions.
    Example 10. Services provided using intangibles.--(i) P's worldwide 
group produces and markets Product X and subsequent generations of 
products, which result from research and development performed by P's 
R&D Team. Through this collaboration with respect to P's proprietary 
products, the members of the R&D Team have individually and as a group 
acquired specialized knowledge and expertise subject to non-disclosure 
agreements (collectively, ``knowhow'').
    (ii) P arranges for the R&D Team to provide research and development 
services to create a new line of products, building on the Product X 
platform, to be owned and exploited by S1 in the overseas market. P 
asserts that the arm's length charge for the services is only 
reimbursement to P of its associated R&D Team compensation costs.
    (iii) Even though P did not transfer the platform or the R&D Team to 
S1, P is providing value associated with the use of the platform, along 
with the value associated

[[Page 691]]

with the use of the knowhow, to S1 by way of the services performed by 
the R&D Team for S1 using the platform and the knowhow. The R&D Team's 
use of intangible property, and any other valuable resources, in P's 
provision of services (regardless of whether the service effects a 
transfer of intangible property or valuable resources and regardless of 
whether the property is relatively high or low value) must be evaluated 
under the section 482 regulations, including the regulations 
specifically applicable to controlled services transactions in Sec.  
1.482-9, to ensure that P receives arm's length compensation for any 
value (attributable to such property or services) provided to S1 in a 
controlled transaction. See Sec. Sec.  1.482-4 and 1.482-9(m). Under 
paragraph (f)(2)(i)(A) of this section, the arm's length compensation 
for the services performed by the R&D Team for S1 must be consistent 
with the value provided to S1, including the value of the knowhow and 
any synergies with the platform. Under paragraphs (f)(2)(i)(B) and (C) 
of this section, the best method analysis may determine that the 
compensation is most reliably determined on an aggregate basis 
reflecting the interrelated value of the services and embedded value of 
the platform and knowhow.
    (iv) In the alternative, the facts are the same as above, except 
that P assigns to S1 all or a pertinent portion of the R&D Team and the 
relevant rights in the platform. P takes the position that, although the 
transferred platform rights must be compensated, the knowhow does not 
have substantial value independent of the services of any individual on 
the R&D Team and therefore is not an intangible within the meaning of 
Sec.  1.482-4(b). In P's view, S1 owes no compensation to P on account 
of the R&D Team, as S1 will directly bear the cost of the relevant R&D 
Team compensation. However, in assembling and arranging to assign the 
relevant R&D Team, and thereby making available the value of the knowhow 
to S1, rather than other employees without the knowhow, P is performing 
services for S1 under imputed contractual terms based on the parties' 
course of conduct. Therefore, even if P's position were correct that the 
knowhow is not an intangible under Sec.  1.482-4(b), a position that the 
Commissioner may challenge, arm's length compensation is required for 
all of the value that P provides to S1 through the interrelated 
provision of platform rights, knowhow, and services under paragraphs 
(f)(2)(i)(A), (B), and (C) of this section.
    Example 11. Allocating arm's length compensation determined under an 
aggregate analysis--(i) P provides services to S1, which is incorporated 
in Country A. In connection with those services, P licenses intellectual 
property to S2, which is incorporated in Country B. S2 sublicenses the 
intellectual property to S1.
    (ii) Under paragraph (f)(2)(i)(B) of this section, if an aggregate 
analysis of the service and license transactions provides the most 
reliable measure of an arm's length result, then an aggregate analysis 
must be performed. Under paragraph (f)(2)(i)(D) of this section, if an 
allocation of the value that results from such an aggregate analysis is 
necessary, for example, for purposes of sourcing the services income 
that P receives from S1 or determining deductible expenses incurred by 
S1, then the value determined under the aggregate analysis must be 
allocated using the method that provides the most reliable measure of 
the services income and deductible expenses.

    (ii)(A) [Reserved]. For further guidance see Sec.  1.482-
1(f)(2)(ii)(A).
    (B) Example. The following example illustrates this paragraph 
(f)(2)(ii):

    Example. P and S are controlled taxpayers. P licenses a proprietary 
process to S for S's use in manufacturing product X. Using its sales and 
marketing employees, S sells product X to related and unrelated 
customers outside the United States. If the license between P and S has 
economic substance, the Commissioner ordinarily will not restructure the 
taxpayer's transaction to treat P as if it had elected to exploit 
directly the manufacturing process. However, because P could have 
directly exploited the manufacturing process and manufactured product X 
itself, this realistic alternative may be taken into account under Sec.  
1.482-4(d) in determining the arm's length consideration for the 
controlled transaction. For examples of such an analysis, see Examples 7 
and 8 in paragraph (f)(2)(i)(E) of this section and the Example in Sec.  
1.482-4(d)(2).

    (iii) through (j)(6) [Reserved]. For further guidance see Sec.  
1.482-1(f)(2)(iii) through (j)(6).
    (7) Certain effective/applicability dates--(i) Paragraphs 
(f)(2)(i)(A) through (E) and (f)(2)(ii)(B) of this section apply to 
taxable years ending on or after September 14, 2015.
    (ii) Expiration date. The applicability of paragraphs (f)(2)(i)(A) 
through (E) and (f)(2)(ii)(B) of this section expires on or before 
September 14, 2018.

[T.D. 9738, 80 FR 55541, Sept. 16, 2015]



Sec.  1.482-2  Determination of taxable income in specific situations.

    (a) Loans or advances--(1) Interest on bona fide indebtedness--(i) 
In general.

[[Page 692]]

Where one member of a group of controlled entities makes a loan or 
advance directly or indirectly to, or otherwise becomes a creditor of, 
another member of such group and either charges no interest, or charges 
interest at a rate which is not equal to an arm's length rate of 
interest (as defined in paragraph (a)(2) of this section) with respect 
to such loan or advance, the district director may make appropriate 
allocations to reflect an arm's length rate of interest for the use of 
such loan or advance.
    (ii) Application of paragraph (a) of this section--(A) Interest on 
bona fide indebtedness. Paragraph (a) of this section applies only to 
determine the appropriateness of the rate of interest charged on the 
principal amount of a bona fide indebtedness between members of a group 
of controlled entities, including--
    (1) Loans or advances of money or other consideration (whether or 
not evidenced by a written instrument); and
    (2) Indebtedness arising in the ordinary course of business from 
sales, leases, or the rendition of services by or between members of the 
group, or any other similar extension of credit.
    (B) Alleged indebtedness. This paragraph (a) does not apply to so 
much of an alleged indebtedness which is not in fact a bona fide 
indebtedness, even if the stated rate of interest thereon would be 
within the safe haven rates prescribed in paragraph (a)(2)(iii) of this 
section. For example, paragraph (a) of this section does not apply to 
payments with respect to all or a portion of such alleged indebtedness 
where in fact all or a portion of an alleged indebtedness is a 
contribution to the capital of a corporation or a distribution by a 
corporation with respect to its shares. Similarly, this paragraph (a) 
does not apply to payments with respect to an alleged purchase-money 
debt instrument given in consideration for an alleged sale of property 
between two controlled entities where in fact the transaction 
constitutes a lease of the property. Payments made with respect to 
alleged indebtedness (including alleged stated interest thereon) shall 
be treated according to their substance. See Sec.  1.482-2(a)(3)(i).
    (iii) Period for which interest shall be charged--(A) General rule. 
This paragraph (a)(1)(iii) is effective for indebtedness arising after 
June 30, 1988. See Sec.  1.482-2(a)(3) (26 CFR Part 1 edition revised as 
of April 1, 1988) for indebtedness arising before July 1, 1988. Except 
as otherwise provided in paragraphs (a)(1)(iii)(B) through (E) of this 
section, the period for which interest shall be charged with respect to 
a bona fide indebtedness between controlled entities begins on the day 
after the day the indebtedness arises and ends on the day the 
indebtedness is satisfied (whether by payment, offset, cancellation, or 
otherwise). Paragraphs (a)(1)(iii)(B) through (E) of this section 
provide certain alternative periods during which interest is not 
required to be charged on certain indebtedness. These exceptions apply 
only to indebtedness described in paragraph (a)(1)(ii)(A)(2) of this 
section (relating to indebtedness incurred in the ordinary course of 
business from sales, services, etc., between members of the group) and 
not evidenced by a written instrument requiring the payment of interest. 
Such amounts are hereinafter referred to as intercompany trade 
receivables. The period for which interest is not required to be charged 
on intercompany trade receivables under this paragraph (a)(1)(iii) is 
called the interest-free period. In general, an intercompany trade 
receivable arises at the time economic performance occurs (within the 
meaning of section 461(h) and the regulations thereunder) with respect 
to the underlying transaction between controlled entities. For purposes 
of this paragraph (a)(1)(iii), the term United States includes any 
possession of the United States, and the term foreign country excludes 
any possession of the United States.
    (B) Exception for certain intercompany transactions in the ordinary 
course of business. Interest is not required to be charged on an 
intercompany trade receivable until the first day of the third calendar 
month following the month in which the intercompany trade receivable 
arises.
    (C) Exception for trade or business of debtor member located outside 
the United States. In the case of an intercompany

[[Page 693]]

trade receivable arising from a transaction in the ordinary course of a 
trade or business which is actively conducted outside the United States 
by the debtor member, interest is not required to be charged until the 
first day of the fourth calendar month following the month in which such 
intercompany trade receivable arises.
    (D) Exception for regular trade practice of creditor member or 
others in creditor's industry. If the creditor member or unrelated 
persons in the creditor member's industry, as a regular trade practice, 
allow unrelated parties a longer period without charging interest than 
that described in paragraph (a)(1)(iii)(B) or (C) of this section 
(whichever is applicable) with respect to transactions which are similar 
to transactions that give rise to intercompany trade receivables, such 
longer interest-free period shall be allowed with respect to a 
comparable amount of intercompany trade receivables.
    (E) Exception for property purchased for resale in a foreign 
country--(1) General rule. If in the ordinary course of business one 
member of the group (related purchaser) purchases property from another 
member of the group (related seller) for resale to unrelated persons 
located in a particular foreign country, the related purchaser and the 
related seller may use as the interest-free period for the intercompany 
trade receivables arising during the related seller's taxable year from 
the purchase of such property within the same product group an interest-
free period equal the sum of--
    (i) The number of days in the related purchaser's average collection 
period (as determined under paragraph (a)(1)(iii)(E)(2) of this section) 
for sales of property within the same product group sold in the ordinary 
course of business to unrelated persons located in the same foreign 
country; plus
    (ii) Ten (10) calendar days.
    (2) Interest-free period. The interest-free period under this 
paragraph (a)(1)(iii)(E), however, shall in no event exceed 183 days. 
The related purchaser does not have to conduct business outside the 
United States in order to be eligible to use the interest-free period of 
this paragraph (a)(1)(iii)(E). The interest-free period under this 
paragraph (a)(1)(iii)(E) shall not apply to intercompany trade 
receivables attributable to property which is manufactured, produced, or 
constructed (within the meaning of Sec.  1.954-3(a)(4)) by the related 
purchaser. For purposes of this paragraph (a)(1)(iii)(E) a product group 
includes all products within the same three-digit Standard Industrial 
Classification (SIC) Code (as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President.)
    (3) Average collection period. An average collection period for 
purposes of this paragraph (a)(1)(iii)(E) is determined as follows--
    (i) Step 1. Determine total sales (less returns and allowances) by 
the related purchaser in the product group to unrelated persons located 
in the same foreign country during the related purchaser's last taxable 
year ending on or before the first day of the related seller's taxable 
year in which the intercompany trade receivable arises.
    (ii) Step 2. Determine the related purchaser's average month-end 
accounts receivable balance with respect to sales described in paragraph 
(a)(1)(iii)(E)(2)(i) of this section for the related purchaser's last 
taxable year ending on or before the first day of the related seller's 
taxable year in which the intercompany trade receivable arises.
    (iii) Step 3. Compute a receivables turnover rate by dividing the 
total sales amount described in paragraph (a)(1)(iii)(E)(2)(i) of this 
section by the average receivables balance described in paragraph 
(a)(1)(iii)(E)(2)(ii) of this section.
    (iv) Step 4. Divide the receivables turnover rate determined under 
paragraph (a)(1)(iii)(E)(2)(iii) of this section into 365, and round the 
result to the nearest whole number to determine the number of days in 
the average collection period.
    (v) Other considerations. If the related purchaser makes sales in 
more than one foreign country, or sells property in more than one 
product group in any foreign country, separate computations of an 
average collection period, by product group within each country, are 
required. If the related purchaser resells fungible property in more 
than

[[Page 694]]

one foreign country and the intercompany trade receivables arising from 
the related party purchase of such fungible property cannot reasonably 
be identified with resales in particular foreign countries, then solely 
for the purpose of assigning an interest-free period to such 
intercompany trade receivables under this paragraph (a)(1)(iii)(E), an 
amount of each such intercompany trade receivable shall be treated as 
allocable to a particular foreign country in the same proportion that 
the related purchaser's sales of such fungible property in such foreign 
country during the period described in paragraph (a)(1)(iii)(E)(2)(i) of 
this section bears to the related purchaser's sales of all such fungible 
property in all such foreign countries during such period. An interest-
free period under this paragraph (a)(1)(iii)(E) shall not apply to any 
intercompany trade receivables arising in a taxable year of the related 
seller if the related purchaser made no sales described in paragraph 
(a)(1)(iii)(E)(2)(i) of this section from which the appropriate 
interest-free period may be determined.
    (4) Illustration. The interest-free period provided under paragraph 
(a)(1)(iii)(E) of this section may be illustrated by the following 
example:

    Example. (i)Facts. X and Y use the calendar year as the taxable year 
and are members of the same group of controlled entities within the 
meaning of section 482. For Y's 1988 calendar taxable year X and Y 
intend to use the interest-free period determined under this paragraph 
(a)(1)(iii)(E) for intercompany trade receivables attributable to X's 
purchases of certain products from Y for resale by X in the ordinary 
course of business to unrelated persons in country Z. For its 1987 
calendar taxable year all of X's sales in country Z were of products 
within a single product group based upon a three-digit SIC code, were 
not manufactured, produced, or constructed (within the meaning of Sec.  
1.954-3(a)(4)) by X, and were sold in the ordinary course of X's trade 
or business to unrelated persons located only in country Z. These sales 
and the month-end accounts receivable balances (for such sales and for 
such sales uncollected from prior months) are as follows:

------------------------------------------------------------------------
                                                             Accounts
                   Month                        Sales       receivable
------------------------------------------------------------------------
Jan. 1987..................................     $500,000      $2,835,850
Feb........................................      600,000       2,840,300
Mar........................................      450,000       2,850,670
Apr........................................      550,000       2,825,700
May........................................      650,000       2,809,360
June.......................................      525,000       2,803,200
July.......................................      400,000       2,825,850
Aug........................................      425,000       2,796,240
Sept.......................................      475,000       2,839,390
Oct........................................      525,000       2,650,550
Nov........................................      450,000       2,775,450
Dec. 1987..................................      650,000       2,812,600
                                            ----------------------------
      Totals...............................    6,200,000      33,665,160
------------------------------------------------------------------------

    (ii) Average collection period. X's total sales within the same 
product group to unrelated persons within country Z for the period are 
$6,200,000. The average receivables balance for the period is $2,805,430 
($33,665,160/12). The average collection period in whole days is 
determined as follows:
[GRAPHIC] [TIFF OMITTED] TR08JY94.000

[GRAPHIC] [TIFF OMITTED] TR08JY94.001

    (iii) Interest-free period. Accordingly, for intercompany trade 
receivables incurred by X during Y's 1988 calendar taxable year 
attributable to the purchase of property from Y for resale to unrelated 
persons located in country Z and included in the product group, X may 
use an interest-free period of 175 days (165 days in the average 
collection period plus 10 days, but not in excess of a maximum of 183 
days). All other intercompany trade receivables incurred by X are 
subject to the interest-free periods described in paragraphs (a)(1)(iii) 
(B), (C), or (D), whichever are applicable. If X makes sales in other 
foreign countries in addition to country Z or makes sales of property in 
more than one product group in any foreign country, separate 
computations

[[Page 695]]

of X's average collection period, by product group within each country, 
are required in order for X and Y to determine an interest-free period 
for such product groups in such foreign countries under this paragraph 
(a)(1)(iii)(E).
    (iv) Payment; book entries--(A) Except as otherwise provided in this 
paragraph (a)(1)(iv), in determining the period of time for which an 
amount owed by one member of the group to another member is outstanding, 
payments or other credits to an account are considered to be applied 
against the earliest amount outstanding, that is, payments or credits 
are applied against amounts in a first-in, first-out (FIFO) order. Thus, 
tracing payments to individual intercompany trade receivables is 
generally not required in order to determine whether a particular 
intercompany trade receivable has been paid within the applicable 
interest-free period determined under paragraph (a)(1)(iii) of this 
section. The application of this paragraph (a)(1)(iv)(A) may be 
illustrated by the following example:

    Example. (i) Facts. X and Y are members of a group of controlled 
entities within the meaning of section 482. Assume that the balance of 
intercompany trade receivables owed by X to Y on June 1 is $100, and 
that all of the $100 balance represents amounts incurred by X to Y 
during the month of May. During the month of June X incurs an additional 
$200 of intercompany trade receivables to Y. Assume that on July 15, $60 
is properly credited against X's intercompany account to Y, and that 
$240 is properly credited against the intercompany account on August 31. 
Assume that under paragraph (a)(1)(iii)(B) of this section interest must 
be charged on X's intercompany trade receivables to Y beginning with the 
first day of the third calendar month following the month the 
intercompany trade receivables arise, and that no alternative interest-
free period applies. Thus, the interest-free period for intercompany 
trade receivables incurred during the month of May ends on July 31, and 
the interest-free period for intercompany trade receivables incurred 
during the month of June ends on August 31.
    (ii) Application of payments. Using a FIFO payment order, the 
aggregate payments of $300 are applied first to the opening June 
balance, and then to the additional amounts incurred during the month of 
June. With respect to X's June opening balance of $100, no interest is 
required to be accrued on $60 of such balance paid by X on July 15, 
because such portion was paid within its interest-free period. Interest 
for 31 days, from August 1 to August 31 inclusive, is required to be 
accrued on the $40 portion of the opening balance not paid until August 
31. No interest is required to be accrued on the $200 of intercompany 
trade receivables X incurred to Y during June because the $240 credited 
on August 31, after eliminating the $40 of indebtedness remaining from 
periods before June, also eliminated the $200 incurred by X during June 
prior to the end of the interest-free period for that amount. The amount 
of interest incurred by X to Y on the $40 amount during August creates 
bona fide indebtedness between controlled entities and is subject to the 
provisions of paragraph (a)(1)(iii)(A) of this section without regard to 
any of the exceptions contained in paragraphs (a)(1)(iii)(B) through 
(E).

    (B) Notwithstanding the first-in, first-out payment application rule 
described in paragraph (a)(1)(iv)(A) of this section, the taxpayer may 
apply payments or credits against amounts owed in some other order on 
its books in accordance with an agreement or understanding of the 
related parties if the taxpayer can demonstrate that either it or others 
in its industry, as a regular trade practice, enter into such agreements 
or understandings in the case of similar balances with unrelated 
parties.
    (2) Arm's length interest rate--(i) In general. For purposes of 
section 482 and paragraph (a) of this section, an arm's length rate of 
interest shall be a rate of interest which was charged, or would have 
been charged, at the time the indebtedness arose, in independent 
transactions with or between unrelated parties under similar 
circumstances. All relevant factors shall be considered, including the 
principal amount and duration of the loan, the security involved, the 
credit standing of the borrower, and the interest rate prevailing at the 
situs of the lender or creditor for comparable loans between unrelated 
parties.
    (ii) Funds obtained at situs of borrower. Notwithstanding the other 
provisions of paragraph (a)(2) of this section, if the loan or advance 
represents the proceeds of a loan obtained by the lender at the situs of 
the borrower, the arm's length rate for any taxable year shall be equal 
to the rate actually paid by the lender increased by an amount which 
reflects the costs or deductions incurred by the lender in borrowing 
such amounts and making such loans,

[[Page 696]]

unless the taxpayer establishes a more appropriate rate under the 
standards set forth in paragraph (a)(2)(i) of this section.
    (iii) Safe haven interest rates for certain loans and advances made 
after May 8, 1986--(A) Applicability--(1) General rule. Except as 
otherwise provided in paragraph (a)(2) of this section, paragraph 
(a)(2)(iii)(B) applies with respect to the rate of interest charged and 
to the amount of interest paid or accrued in any taxable year--
    (i) Under a term loan or advance between members of a group of 
controlled entities where (except as provided in paragraph 
(a)(2)(iii)(A)(2)(ii) of this section) the loan or advance is entered 
into after May 8, 1986; and
    (ii) After May 8, 1986 under a demand loan or advance between such 
controlled entities.
    (2) Grandfather rule for existing loans. The safe haven rates 
prescribed in paragraph (a)(2)(iii)(B) of this section shall not apply, 
and the safe haven rates prescribed in Sec.  1.482-2(a)(2)(iii) (26 CFR 
part 1 edition revised as of April 1, 1985), shall apply to--
    (i) Term loans or advances made before May 9, 1986; and
    (ii) Term loans or advances made before August 7, 1986, pursuant to 
a binding written contract entered into before May 9, 1986.
    (B) Safe haven interest rate based on applicable Federal rate. 
Except as otherwise provided in this paragraph (a)(2), in the case of a 
loan or advance between members of a group of controlled entities, an 
arm's length rate of interest referred to in paragraph (a)(2)(i) of this 
section shall be for purposes of chapter 1 of the Internal Revenue 
Code--
    (1) The rate of interest actually charged if that rate is--
    (i) Not less than 100 percent of the applicable Federal rate (lower 
limit); and
    (ii) Not greater than 130 percent of the applicable Federal rate 
(upper limit); or
    (2) If either no interest is charged or if the rate of interest 
charged is less than the lower limit, then an arm's length rate of 
interest shall be equal to the lower limit, compounded semiannually; or
    (3) If the rate of interest charged is greater than the upper limit, 
then an arm's length rate of interest shall be equal to the upper limit, 
compounded semiannually, unless the taxpayer establishes a more 
appropriate compound rate of interest under paragraph (a)(2)(i) of this 
section. However, if the compound rate of interest actually charged is 
greater than the upper limit and less than the rate determined under 
paragraph (a)(2)(i) of this section, or if the compound rate actually 
charged is less than the lower limit and greater than the rate 
determined under paragraph (a)(2)(i) of this section, then the compound 
rate actually charged shall be deemed to be an arm's length rate under 
paragraph (a)(2)(i). In the case of any sale-leaseback described in 
section 1274(e), the lower limit shall be 110 percent of the applicable 
Federal rate, compounded semiannually.
    (C) Applicable Federal rate. For purposes of paragraph 
(a)(2)(iii)(B) of this section, the term applicable Federal rate means, 
in the case of a loan or advance to which this section applies and 
having a term of--
    (1) Not over 3 years, the Federal short-term rate;
    (2) Over 3 years but not over 9 years, the Federal mid-term rate; or
    (3) Over 9 years, the Federal long-term rate, as determined under 
section 1274(d) in effect on the date such loan or advance is made. In 
the case of any sale or exchange between controlled entities, the lower 
limit shall be the lowest of the applicable Federal rates in effect for 
any month in the 3-calendar- month period ending with the first calendar 
month in which there is a binding written contract in effect for such 
sale or exchange (lowest 3-month rate, as defined in section 
1274(d)(2)). In the case of a demand loan or advance to which this 
section applies, the applicable Federal rate means the Federal short-
term rate determined under section 1274(d) (determined without regard to 
the lowest 3-month short term rate determined under section 1274(d)(2)) 
in effect for each day on which any amount of such loan or advance 
(including unpaid accrued interest determined under paragraph (a)(2) of 
this section) is outstanding.

[[Page 697]]

    (D) Lender in business of making loans. If the lender in a loan or 
advance transaction to which paragraph (a)(2) of this section applies is 
regularly engaged in the trade or business of making loans or advances 
to unrelated parties, the safe haven rates prescribed in paragraph 
(a)(2)(iii)(B) of this section shall not apply, and the arm's length 
interest rate to be used shall be determined under the standards 
described in paragraph (a)(2)(i) of this section, including reference to 
the interest rates charged in such trade or business by the lender on 
loans or advances of a similar type made to unrelated parties at and 
about the time the loan or advance to which paragraph (a)(2) of this 
section applies was made.
    (E) Foreign currency loans. The safe haven interest rates prescribed 
in paragraph (a)(2)(iii)(B) of this section do not apply to any loan or 
advance the principal or interest of which is expressed in a currency 
other than U.S. dollars.
    (3) Coordination with interest adjustments required under certain 
other Code sections. If the stated rate of interest on the stated 
principal amount of a loan or advance between controlled entities is 
subject to adjustment under section 482 and is also subject to 
adjustment under any other section of the Internal Revenue Code (for 
example, section 467, 483, 1274 or 7872), section 482 and paragraph (a) 
of this section may be applied to such loan or advance in addition to 
such other Internal Revenue Code section. After the enactment of the Tax 
Reform Act of 1964, Pub. L. 98-369, and the enactment of Pub. L. 99-121, 
such other Internal Revenue Code sections include sections 467, 483, 
1274 and 7872. The order in which the different provisions shall be 
applied is as follows--
    (i) First, the substance of the transaction shall be determined; for 
this purpose, all the relevant facts and circumstances shall be 
considered and any law or rule of law (assignment of income, step 
transaction, etc.) may apply. Only the rate of interest with respect to 
the stated principal amount of the bona fide indebtedness (within the 
meaning of paragraph (a)(1) of this section), if any, shall be subject 
to adjustment under section 482, paragraph (a) of this section, and any 
other Internal Revenue Code section.
    (ii) Second, the other Internal Revenue Code section shall be 
applied to the loan or advance to determine whether any amount other 
than stated interest is to be treated as interest, and if so, to 
determine such amount according to the provisions of such other Internal 
Revenue Code section.
    (iii) Third, whether or not the other Internal Revenue Code section 
applies to adjust the amounts treated as interest under such loan or 
advance, section 482 and paragraph (a) of this section may then be 
applied by the district director to determine whether the rate of 
interest charged on the loan or advance, as adjusted by any other Code 
section, is greater or less than an arm's length rate of interest, and 
if so, to make appropriate allocations to reflect an arm's length rate 
of interest.
    (iv) Fourth, section 482 and paragraphs (b) through (d) of this 
section and Sec. Sec.  1.482-3 through 1.482-7, if applicable, may be 
applied by the district director to make any appropriate allocations, 
other than an interest rate adjustment, to reflect an arm's length 
transaction based upon the principal amount of the loan or advance and 
the interest rate as adjusted under paragraph (a)(3) (i), (ii) or (iii) 
of this section. For example, assume that two commonly controlled 
taxpayers enter into a deferred payment sale of tangible property and no 
interest is provided, and assume also that section 483 is applied to 
treat a portion of the stated sales price as interest, thereby reducing 
the stated sales price. If after this recharacterization of a portion of 
the stated sales price as interest, the recomputed sales price does not 
reflect an arm's length sales price under the principles of Sec.  1.482-
3, the district director may make other appropriate allocations (other 
than an interest rate adjustment) to reflect an arm's length sales 
price.
    (4) Examples. The principles of paragraph (a)(3) of this section may 
be illustrated by the following examples:

    Example 1. An individual, A, transfers $20,000 to a corporation 
controlled by A in exchange for the corporation's note which bears 
adequate stated interest. The district director recharacterizes the 
transaction as a

[[Page 698]]

contribution to the capital of the corporation in exchange for preferred 
stock. Under paragraph (a)(3)(i) of this section, section 1.482-2(a) 
does not apply to the transaction because there is no bona fide 
indebtedness.
    Example 2. B, an individual, is an employee of Z corporation, and is 
also the controlling shareholder of Z. Z makes a term loan of $15,000 to 
B at a rate of interest that is less than the applicable Federal rate. 
In this instance the other operative Code section is section 7872. Under 
section 7872(b), the difference between the amount loaned and the 
present value of all payments due under the loan using a discount rate 
equal to 100 percent of the applicable Federal rate is treated as an 
amount of cash transferred from the corporation to B and the loan is 
treated as having original issue discount equal to such amount. Under 
paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of 
this section may also be applied by the district director to determine 
if the rate of interest charged on this $15,000 loan (100 percent of the 
AFR, compounded semiannually, as adjusted by section 7872) is an arm's 
length rate of interest. Because the rate of interest on the loan, as 
adjusted by section 7872, is within the safe haven range of 100-130 
percent of the AFR, compounded semiannually, no further interest rate 
adjustments under section 482 and paragraph (a) of this section will be 
made to this loan.
    Example 3. The facts are the same as in Example 2 except that the 
amount lent by Z to B is $9,000, and that amount is the aggregate 
outstanding amount of loans between Z and B. Under the $10,000 de 
minimis exception of section 7872(c)(3), no adjustment for interest will 
be made to this $9,000 loan under section 7872. Under paragraph 
(a)(3)(iii) of this section, the district director may apply section 482 
and paragraph (a) of this section to this $9,000 loan to determine 
whether the rate of interest charged is less than an arm's length rate 
of interest, and if so, to make appropriate allocations to reflect an 
arm's length rate of interest.
    Example 4. X and Y are commonly controlled taxpayers. At a time when 
the applicable Federal rate is 12 percent, compounded semiannually, X 
sells property to Y in exchange for a note with a stated rate of 
interest of 18 percent, compounded semiannually. Assume that the other 
applicable Code section to the transaction is section 483. Section 483 
does not apply to this transaction because, under section 483(d), there 
is no total unstated interest under the contract using the test rate of 
interest equal to 100 percent of the applicable Federal rate. Under 
paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of 
this section may be applied by the district director to determine 
whether the rate of interest under the note is excessive, that is, to 
determine whether the 18 percent stated interest rate under the note 
exceeds an arm's length rate of interest.
    Example 5. Assume that A and B are commonly controlled taxpayers and 
that the applicable Federal rate is 10 percent, compounded semiannually. 
On June 30, 1986, A sells property to B and receives in exchange B's 
purchase-money note in the amount of $2,000,000. The stated interest 
rate on the note is 9%, compounded semiannually, and the stated 
redemption price at maturity on the note is $2,000,000. Assume that the 
other applicable Code section to this transaction is section 1274. As 
provided in section 1274A(a) and (b), the discount rate for purposes of 
section 1274 will be nine percent, compounded semiannually, because the 
stated principal amount of B's note does not exceed $2,800,000. Section 
1274 does not apply to this transaction because there is adequate stated 
interest on the debt instrument using a discount rate equal to 9%, 
compounded semiannually, and the stated redemption price at maturity 
does not exceed the stated principal amount. Under paragraph (a)(3)(iii) 
of this section, the district director may apply section 482 and 
paragraph (a) of this section to this $2,000,000 note to determine 
whether the 9% rate of interest charged is less than an arm's length 
rate of interest, and if so, to make appropriate allocations to reflect 
an arm's length rate of interest.

    (b) Rendering of services. For rules governing allocations under 
section 482 to reflect an arm's length charge for controlled 
transactions involving the rendering of services, see Sec.  1.482-9.
    (c) Use of tangible property--(1) General rule. Where possession, 
use, or occupancy of tangible property owned or leased by one member of 
a group of controlled entities (referred to in this paragraph as the 
owner) is transferred by lease or other arrangement to another member of 
such group (referred to in this paragraph as the user) without charge or 
at a charge which is not equal to an arm's length rental charge (as 
defined in paragraph (c)(2)(i) of this section) the district director 
may make appropriate allocations to properly reflect such arm's length 
charge. Where possession, use, or occupancy of only a portion of such 
property is transferred, the determination of the arm's length charge 
and the allocation shall be made with reference to the portion 
transferred.
    (2) Arm's length charge--(i) In general. For purposes of paragraph 
(c) of this section, an arm's length rental charge shall be the amount 
of rent which was

[[Page 699]]

charged, or would have been charged for the use of the same or similar 
property, during the time it was in use, in independent transactions 
with or between unrelated parties under similar circumstances 
considering the period and location of the use, the owner's investment 
in the property or rent paid for the property, expenses of maintaining 
the property, the type of property involved, its condition, and all 
other relevant facts.
    (ii) Safe haven rental charge. See Sec.  1.482-2(c)(2)(ii) (26 CFR 
Part 1 revised as of April 1, 1985), for the determination of safe haven 
rental charges in the case of certain leases entered into before May 9, 
1986, and for leases entered into before August 7, 1986, pursuant to a 
binding written contract entered into before May 9, 1986.
    (iii) Subleases--(A) Except as provided in paragraph (c)(2)(iii)(B) 
of this section, where possession, use, or occupancy of tangible 
property, which is leased by the owner (lessee) from an unrelated party 
is transferred by sublease or other arrangement to the user, an arm's 
length rental charge shall be considered to be equal to all the 
deductions claimed by the owner (lessee) which are attributable to the 
property for the period such property is used by the user. Where only a 
portion of such property was transferred, any allocations shall be made 
with reference to the portion transferred. The deductions to be 
considered include the rent paid or accrued by the owner (lessee) during 
the period of use and all other deductions directly and indirectly 
connected with the property paid or accrued by the owner (lessee) during 
such period. Such deductions include deductions for maintenance and 
repair, utilities, management and other similar deductions.
    (B) The provisions of paragraph (c)(2)(iii)(A) of this section shall 
not apply if either--
    (1) The taxpayer establishes a more appropriate rental charge under 
the general rule set forth in paragraph (c)(2)(i) of this section; or
    (2) During the taxable year, the owner (lessee) or the user was 
regularly engaged in the trade or business of renting property of the 
same general type as the property in question to unrelated persons.
    (d) Transfer of property. For rules governing allocations under 
section 482 to reflect an arm's length consideration for controlled 
transactions involving the transfer of property, see Sec. Sec.  1.482-3 
through 1.482-6.
    (e) Cost sharing arrangement. For rules governing allocations under 
section 482 to reflect an arm's length consideration for controlled 
transactions involving a cost sharing arrangement, see Sec.  1.482-7.
    (f) Effective/applicability date--(1) In general. The provision of 
paragraph (b) of this section is generally applicable for taxable years 
beginning after December 31, 2006. The provision of paragraph (e) of 
this section is generally applicable on January 5, 2009.
    (2) Election to apply paragraph (b) to earlier taxable years. A 
person may elect to apply the provisions of paragraph (b) of this 
section to earlier taxable years in accordance with the rules set forth 
in Sec.  1.482-9(n)(2).

[T.D. 8552, 59 FR 35002, July 8, 1994; 60 FR 16381, 16382, Mar. 30, 
1995; T.D. 9278, 71 FR 44484, Aug. 4, 2006; T.D. 9456, 74 FR 38842, Aug. 
4, 2009; T.D. 9568, 76 FR 80090, Dec. 22, 2011]



Sec.  1.482-3  Methods to determine taxable income in connection 
with a transfer of tangible property.

    (a) In general. The arm's length amount charged in a controlled 
transfer of tangible property must be determined under one of the six 
methods listed in this paragraph (a). Each of the methods must be 
applied in accordance with all of the provisions of Sec.  1.482-1, 
including the best method rule of Sec.  1.482-1(c), the comparability 
analysis of Sec.  1.482-1(d), and the arm's length range of Sec.  1.482-
1(e). The methods are--
    (1) The comparable uncontrolled price method, described in paragraph 
(b) of this section;
    (2) The resale price method, described in paragraph (c) of this 
section;
    (3) The cost plus method, described in paragraph (d) of this 
section;
    (4) The comparable profits method, described in Sec.  1.482-5;
    (5) The profit split method, described in Sec.  1.482-6; and
    (6) Unspecified methods, described in paragraph (e) of this section.

[[Page 700]]

    (b) Comparable uncontrolled price method--(1) In general. The 
comparable uncontrolled price method evaluates whether the amount 
charged in a controlled transaction is arm's length by reference to the 
amount charged in a comparable uncontrolled transaction.
    (2) Comparability and reliability considerations--(i) In general. 
Whether results derived from applications of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec.  1.482-1(c). The 
application of these factors under the comparable uncontrolled price 
method is discussed in paragraph (b)(2)(ii) and (iii) of this section.
    (ii) Comparability--(A) In general. The degree of comparability 
between controlled and uncontrolled transactions is determined by 
applying the provisions of Sec.  1.482-1(d). Although all of the factors 
described in Sec.  1.482-1(d)(3) must be considered, similarity of 
products generally will have the greatest effect on comparability under 
this method. In addition, because even minor differences in contractual 
terms or economic conditions could materially affect the amount charged 
in an uncontrolled transaction, comparability under this method depends 
on close similarity with respect to these factors, or adjustments to 
account for any differences. The results derived from applying the 
comparable uncontrolled price method generally will be the most direct 
and reliable measure of an arm's length price for the controlled 
transaction if an uncontrolled transaction has no differences with the 
controlled transaction that would affect the price, or if there are only 
minor differences that have a definite and reasonably ascertainable 
effect on price and for which appropriate adjustments are made. If such 
adjustments cannot be made, or if there are more than minor differences 
between the controlled and uncontrolled transactions, the comparable 
uncontrolled price method may be used, but the reliability of the 
results as a measure of the arm's length price will be reduced. Further, 
if there are material product differences for which reliable adjustments 
cannot be made, this method ordinarily will not provide a reliable 
measure of an arm's length result.
    (B) Adjustments for differences between controlled and uncontrolled 
transactions. If there are differences between the controlled and 
uncontrolled transactions that would affect price, adjustments should be 
made to the price of the uncontrolled transaction according to the 
comparability provisions of Sec.  1.482-1(d)(2). Specific examples of 
the factors that may be particularly relevant to this method include--
    (1) Quality of the product;
    (2) Contractual terms (e.g., scope and terms of warranties provided, 
sales or purchase volume, credit terms, transport terms);
    (3) Level of the market (i.e., wholesale, retail, etc.);
    (4) Geographic market in which the transaction takes place;
    (5) Date of the transaction;
    (6) Intangible property associated with the sale;
    (7) Foreign currency risks; and
    (8) Alternatives realistically available to the buyer and seller.
    (iii) Data and assumptions. The reliability of the results derived 
from the comparable uncontrolled price method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply the method. See Sec.  1.482-1(c) (Best method 
rule).
    (3) Arm's length range. See Sec.  1.482-1(e)(2) for the 
determination of an arm's length range.
    (4) Examples. The principles of this paragraph (b) are illustrated 
by the following examples.

    Example 1. Comparable Sales of Same Product. USM, a U.S. 
manufacturer, sells the same product to both controlled and uncontrolled 
distributors. The circumstances surrounding the controlled and 
uncontrolled transactions are substantially the same, except that the 
controlled sales price is a delivered price and the uncontrolled sales 
are made f.o.b. USM's factory. Differences in the contractual terms of 
transportation and insurance generally have a definite and reasonably 
ascertainable effect on price, and adjustments are made to the results 
of the uncontrolled transaction to account for such differences. No 
other material difference has been identified between the controlled and 
uncontrolled transactions. Because USM sells in both the controlled and 
uncontrolled transactions, it is likely that all material

[[Page 701]]

differences between the two transactions have been identified. In 
addition, because the comparable uncontrolled price method is applied to 
an uncontrolled comparable with no product differences, and there are 
only minor contractual differences that have a definite and reasonably 
ascertainable effect on price, the results of this application of the 
comparable uncontrolled price method will provide the most direct and 
reliable measure of an arm's length result. See Sec.  1.482-
3(b)(2)(ii)(A).
    Example 2. Effect of Trademark. The facts are the same as in Example 
1, except that USM affixes its valuable trademark to the property sold 
in the controlled transactions, but does not affix its trademark to the 
property sold in the uncontrolled transactions. Under the facts of this 
case, the effect on price of the trademark is material and cannot be 
reliably estimated. Because there are material product differences for 
which reliable adjustments cannot be made, the comparable uncontrolled 
price method is unlikely to provide a reliable measure of the arm's 
length result. See Sec.  1.482-3(b)(2)(ii)(A).
    Example 3. Minor Product Differences. The facts are the same as in 
Example 1, except that USM, which manufactures business machines, makes 
minor modifications to the physical properties of the machines to 
satisfy specific requirements of a customer in controlled sales, but 
does not make these modifications in uncontrolled sales. If the minor 
physical differences in the product have a material effect on prices, 
adjustments to account for these differences must be made to the results 
of the uncontrolled transactions according to the provisions of Sec.  
1.482- 1(d)(2), and such adjusted results may be used as a measure of 
the arm's length result.
    Example 4. Effect of Geographic Differences. FM, a foreign specialty 
radio manufacturer, sells its radios to a controlled U.S. distributor, 
AM, that serves the West Coast of the United States. FM sells its radios 
to uncontrolled distributors to serve other regions in the United 
States. The product in the controlled and uncontrolled transactions is 
the same, and all other circumstances surrounding the controlled and 
uncontrolled transactions are substantially the same, other than the 
geographic differences. If the geographic differences are unlikely to 
have a material effect on price, or they have definite and reasonably 
ascertainable effects for which adjustments are made, then the adjusted 
results of the uncontrolled sales may be used under the comparable 
uncontrolled price method to establish an arm's length range pursuant to 
Sec.  1.482-1(e)(2)(iii)(A). If the effects of the geographic 
differences would be material but cannot be reliably ascertained, then 
the reliability of the results will be diminished. However, the 
comparable uncontrolled price method may still provide the most reliable 
measure of an arm's length result, pursuant to the best method rule of 
Sec.  1.482-1(c), and, if so, an arm's length range may be established 
pursuant to Sec.  1.482-1(e)(2)(iii)(B).

    (5) Indirect evidence of comparable uncontrolled transactions--(i) 
In general. A comparable uncontrolled price may be derived from data 
from public exchanges or quotation media, but only if the following 
requirements are met--
    (A) The data is widely and routinely used in the ordinary course of 
business in the industry to negotiate prices for uncontrolled sales;
    (B) The data derived from public exchanges or quotation media is 
used to set prices in the controlled transaction in the same way it is 
used by uncontrolled taxpayers in the industry; and
    (C) The amount charged in the controlled transaction is adjusted to 
reflect differences in product quality and quantity, contractual terms, 
transportation costs, market conditions, risks borne, and other factors 
that affect the price that would be agreed to by uncontrolled taxpayers.
    (ii) Limitation. Use of data from public exchanges or quotation 
media may not be appropriate under extraordinary market conditions.
    (iii) Examples. The following examples illustrate this paragraph 
(b)(5).

    Example 1. Use of Quotation Medium. (i) On June 1, USOil, a United 
States corporation, enters into a contract to purchase crude oil from 
its foreign subsidiary, FS, in Country Z. USOil and FS agree to base 
their sales price on the average of the prices published for that crude 
in a quotation medium in the five days before August 1, the date set for 
delivery. USOil and FS agree to adjust the price for the particular 
circumstances of their transactions, including the quantity of the crude 
sold, contractual terms, transportation costs, risks borne, and other 
factors that affect the price.
    (ii) The quotation medium used by USOil and FS is widely and 
routinely used in the ordinary course of business in the industry to 
establish prices for uncontrolled sales. Because USOil and FS use the 
data to set their sales price in the same way that unrelated parties use 
the data from the quotation medium to set their sales prices, and 
appropriate adjustments were made to account for differences, the price 
derived from the quotation medium used by USOil and FS to set their 
transfer prices will be considered evidence of a comparable uncontrolled 
price.

[[Page 702]]

    Example 2. Extraordinary Market Conditions. The facts are the same 
as in Example 1, except that before USOil and FS enter into their 
contract, war breaks out in Countries X and Y, major oil producing 
countries, causing significant instability in world petroleum markets. 
As a result, given the significant instability in the price of oil, the 
prices listed on the quotation medium may not reflect a reliable measure 
of an arm's length result. See Sec.  1.482-3(b)(5)(ii).

    (c) Resale price method--(1) In general. The resale price method 
evaluates whether the amount charged in a controlled transaction is 
arm's length by reference to the gross profit margin realized in 
comparable uncontrolled transactions. The resale price method measures 
the value of functions performed, and is ordinarily used in cases 
involving the purchase and resale of tangible property in which the 
reseller has not added substantial value to the tangible goods by 
physically altering the goods before resale. For this purpose, 
packaging, repackaging, labelling, or minor assembly do not ordinarily 
constitute physical alteration. Further the resale price method is not 
ordinarily used in cases where the controlled taxpayer uses its 
intangible property to add substantial value to the tangible goods.
    (2) Determination of arm's length price--(i) In general. The resale 
price method measures an arm's length price by subtracting the 
appropriate gross profit from the applicable resale price for the 
property involved in the controlled transaction under review.
    (ii) Applicable resale price. The applicable resale price is equal 
to either the resale price of the particular item of property involved 
or the price at which contemporaneous resales of the same property are 
made. If the property purchased in the controlled sale is resold to one 
or more related parties in a series of controlled sales before being 
resold in an uncontrolled sale, the applicable resale price is the price 
at which the property is resold to an uncontrolled party, or the price 
at which contemporaneous resales of the same property are made. In such 
case, the determination of the appropriate gross profit will take into 
account the functions of all members of the group participating in the 
series of controlled sales and final uncontrolled resales, as well as 
any other relevant factors described in Sec.  1.482-1(d)(3).
    (iii) Appropriate gross profit. The appropriate gross profit is 
computed by multiplying the applicable resale price by the gross profit 
margin (expressed as a percentage of total revenue derived from sales) 
earned in comparable uncontrolled transactions.
    (iv) Arm's length range. See Sec.  1.482-1(e)(2) for determination 
of the arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from applications of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec.  1.482-1(c). The 
application of these factors under the resale price method is discussed 
in paragraphs (c)(3) (ii) and (iii) of this section.
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between an uncontrolled transaction and a controlled 
transaction is determined by applying the comparability provisions of 
Sec.  1.482-1(d). A reseller's gross profit provides compensation for 
the performance of resale functions related to the product or products 
under review, including an operating profit in return for the reseller's 
investment of capital and the assumption of risks. Therefore, although 
all of the factors described in Sec.  1.482-1(d)(3) must be considered, 
comparability under this method is particularly dependent on similarity 
of functions performed, risks borne, and contractual terms, or 
adjustments to account for the effects of any such differences. If 
possible, appropriate gross profit margins should be derived from 
comparable uncontrolled purchases and resales of the reseller involved 
in the controlled sale, because similar characteristics are more likely 
to be found among different resales of property made by the same 
reseller than among sales made by other resellers. In the absence of 
comparable uncontrolled transactions involving the same reseller, an 
appropriate gross profit margin may be derived from comparable 
uncontrolled transactions of other resellers.

[[Page 703]]

    (B) Other comparability factors. Comparability under this method is 
less dependent on close physical similarity between the products 
transferred than under the comparable uncontrolled price method. For 
example, distributors of a wide variety of consumer durables might 
perform comparable distribution functions without regard to the specific 
durable goods distributed. Substantial differences in the products may, 
however, indicate significant functional differences between the 
controlled and uncontrolled taxpayers. Thus, it ordinarily would be 
expected that the controlled and uncontrolled transactions would involve 
the distribution of products of the same general type (e.g., consumer 
electronics). Furthermore, significant differences in the value of the 
distributed goods due, for example, to the value of a trademark, may 
also affect the reliability of the comparison. Finally, the reliability 
of profit measures based on gross profit may be adversely affected by 
factors that have less effect on prices. For example, gross profit may 
be affected by a variety of other factors, including cost structures (as 
reflected, for example, in the age of plant and equipment), business 
experience (such as whether the business is in a start-up phase or is 
mature), or management efficiency (as indicated, for example, by 
expanding or contracting sales or executive compensation over time). 
Accordingly, if material differences in these factors are identified 
based on objective evidence, the reliability of the analysis may be 
affected.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions. If there are material differences between the controlled 
and uncontrolled transactions that would affect the gross profit margin, 
adjustments should be made to the gross profit margin earned with 
respect to the uncontrolled transaction according to the comparability 
provisions of Sec.  1.482-1(d)(2). For this purpose, consideration of 
operating expenses associated with functions performed and risks assumed 
may be necessary, because differences in functions performed are often 
reflected in operating expenses. If there are differences in functions 
performed, however, the effect on gross profit of such differences is 
not necessarily equal to the differences in the amount of related 
operating expenses. Specific examples of the factors that may be 
particularly relevant to this method include--
    (1) Inventory levels and turnover rates, and corresponding risks, 
including any price protection programs offered by the manufacturer;
    (2) Contractual terms (e.g., scope and terms of warranties provided, 
sales or purchase volume, credit terms, transport terms);
    (3) Sales, marketing, advertising programs and services, (including 
promotional programs, rebates, and co-op advertising);
    (4) The level of the market (e.g., wholesale, retail, etc.); and
    (5) Foreign currency risks.
    (D) Sales agent. If the controlled taxpayer is comparable to a sales 
agent that does not take title to goods or otherwise assume risks with 
respect to ownership of such goods, the commission earned by such sales 
agent, expressed as a percentage of the uncontrolled sales price of the 
goods involved, may be used as the comparable gross profit margin.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the resale price method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec.  1.482-1(c) (Best method 
rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect the gross profit margin 
affects the reliability of the result. Thus, for example, if differences 
in inventory and other cost accounting practices would materially affect 
the gross profit margin, the ability to make reliable adjustments for 
such differences would affect the reliability of the results. Further, 
the controlled transaction and the uncontrolled comparable should be 
consistent in the reporting of items (such as discounts, returns and 
allowances, rebates, transportation costs, insurance, and packaging) 
between cost of goods sold and operating expenses.

[[Page 704]]

    (4) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. A controlled taxpayer sells property to another member of 
its controlled group that resells the property in uncontrolled sales. 
There are no changes in the beginning and ending inventory for the year 
under review. Information regarding an uncontrolled comparable is 
sufficiently complete to conclude that it is likely that all material 
differences between the controlled and uncontrolled transactions have 
been identified and adjusted for. If the applicable resale price of the 
property involved in the controlled sale is $100 and the appropriate 
gross profit margin is 20%, then an arm's length result of the 
controlled sale is a price of $80 ($100 minus (20% x $100)).
    Example 2. (i) S, a U.S. corporation, is the exclusive distributor 
for FP, its foreign parent. There are no changes in the beginning and 
ending inventory for the year under review. S's total reported cost of 
goods sold is $800, consisting of $600 for property purchased from FP 
and $200 of other costs of goods sold incurred to unrelated parties. S's 
applicable resale price and reported gross profit are as follows:

Applicable resale price.........................................   $1000
Cost of goods sold:
    Cost of purchases from FP...................................     600
    Costs incurred to unrelated parties.........................     200
Reported gross profit...........................................     200
 

    (ii) The district director determines that the appropriate gross 
profit margin is 25%. Therefore, S's appropriate gross profit is $250 
(i.e., 25% of the applicable resale price of $1000). Because S is 
incurring costs of sales to unrelated parties, an arm's length price for 
property purchased from FP must be determined under a two-step process. 
First, the appropriate gross profit ($250) is subtracted from the 
applicable resale price ($1000). The resulting amount ($750) is then 
reduced by the costs of sales incurred to unrelated parties ($200). 
Therefore, an arm's length price for S's cost of sales of FP's product 
in this case equals $550 (i.e., $750 minus $200).
    Example 3. FP, a foreign manufacturer, sells Product to USSub, its 
U.S. subsidiary, which in turn sells Product to its domestic affiliate 
Sister. Sister sells Product to unrelated buyers. In this case, the 
applicable resale price is the price at which Sister sells Product in 
uncontrolled transactions. The determination of the appropriate gross 
profit margin for the sale from FP to USSub will take into account the 
functions performed by USSub and Sister, as well as other relevant 
factors described in Sec.  1.482-1(d)(3).
    Example 4. USSub, a U.S. corporation, is the exclusive distributor 
of widgets for its foreign parent. To determine whether the gross profit 
margin of 25% earned by USSub is an arm's length result, the district 
director considers applying the resale price method. There are several 
uncontrolled distributors that perform similar functions under similar 
circumstances in uncontrolled transactions. However, the uncontrolled 
distributors treat certain costs such as discounts and insurance as cost 
of goods sold, while USSub treats such costs as operating expenses. In 
such cases, accounting reclassifications, pursuant to Sec.  1.482-
3(c)(3)(iii)(B), must be made to ensure consistent treatment of such 
material items. Inability to make such accounting reclassifications will 
decrease the reliability of the results of the uncontrolled 
transactions.
    Example 5. (i) USP, a U.S. corporation, manufactures Product X, an 
unbranded widget, and sells it to FSub, its wholly owned foreign 
subsidiary. FSub acts as a distributor of Product X in country M, and 
sells it to uncontrolled parties in that country. Uncontrolled 
distributors A, B, C, D, and E distribute competing products of 
approximately similar value in country M. All such products are 
unbranded.
    (ii) Relatively complete data is available regarding the functions 
performed and risks borne by the uncontrolled distributors and the 
contractual terms under which they operate in the uncontrolled 
transactions. In addition, data is available to ensure accounting 
consistency between all of the uncontrolled distributors and FSub. 
Because the available data is sufficiently complete and accurate to 
conclude that it is likely that all material differences between the 
controlled and uncontrolled transactions have been identified, such 
differences have a definite and reasonably ascertainable effect, and 
reliable adjustments are made to account for such differences, the 
results of each of the uncontrolled distributors may be used to 
establish an arm's length range pursuant to Sec.  1.482-1(e)(2)(iii)(A).
    Example 6. The facts are the same as Example 5, except that 
sufficient data is not available to determine whether any of the 
uncontrolled distributors provide warranties or to determine the payment 
terms of the contracts. Because differences in these contractual terms 
could materially affect price or profits, the inability to determine 
whether these differences exist between the controlled and uncontrolled 
transactions diminishes the reliability of the results of the 
uncontrolled comparables. However, the reliability of the results may be 
enhanced by the application of a statistical method when establishing an 
arm's length range pursuant to Sec.  1.482-1(e)(2)(iii)(B).
    Example 7. The facts are the same as in Example 5, except that 
Product X is branded with a valuable trademark that is owned by P. A, B, 
and C distribute unbranded competing products, while D and E distribute 
products branded with other trademarks. D

[[Page 705]]

and E do not own any rights in the trademarks under which their products 
are sold. The value of the products that A, B, and C sold are not 
similar to the value of the products sold by S. The value of products 
sold by D and E, however, is similar to that of Product X. Although 
close product similarity is not as important for a reliable application 
of the resale price method as for the comparable uncontrolled price 
method, significant differences in the value of the products involved in 
the controlled and uncontrolled transactions may affect the reliability 
of the results. In addition, because in this case it is difficult to 
determine the effect the trademark will have on price or profits, 
reliable adjustments for the differences cannot be made. Because D and E 
have a higher level of comparability than A, B, and C with respect to S, 
pursuant to Sec.  1.482-1(e)(2)(ii), only D and E may be included in an 
arm's length range.

    (d) Cost plus method--(1) In general. The cost plus method evaluates 
whether the amount charged in a controlled transaction is arm's length 
by reference to the gross profit markup realized in comparable 
uncontrolled transactions. The cost plus method is ordinarily used in 
cases involving the manufacture, assembly, or other production of goods 
that are sold to related parties.
    (2) Determination of arm's length price--(i) In general. The cost 
plus method measures an arm's length price by adding the appropriate 
gross profit to the controlled taxpayer's costs of producing the 
property involved in the controlled transaction.
    (ii) Appropriate gross profit. The appropriate gross profit is 
computed by multiplying the controlled taxpayer's cost of producing the 
transferred property by the gross profit markup, expressed as a 
percentage of cost, earned in comparable uncontrolled transactions.
    (iii) Arm's length range. See Sec.  1.482-1(e)(2) for determination 
of an arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from the application of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec.  1.482-1(c).
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between controlled and uncontrolled transactions is 
determined by applying the comparability provisions of Sec.  1.482-1(d). 
A producer's gross profit provides compensation for the performance of 
the production functions related to the product or products under 
review, including an operating profit for the producer's investment of 
capital and assumption of risks. Therefore, although all of the factors 
described in Sec.  1.482-1(d)(3) must be considered, comparability under 
this method is particularly dependent on similarity of functions 
performed, risks borne, and contractual terms, or adjustments to account 
for the effects of any such differences. If possible, the appropriate 
gross profit markup should be derived from comparable uncontrolled 
transactions of the taxpayer involved in the controlled sale, because 
similar characteristics are more likely to be found among sales of 
property by the same producer than among sales by other producers. In 
the absence of such sales, an appropriate gross profit markup may be 
derived from comparable uncontrolled sales of other producers whether or 
not such producers are members of the same controlled group.
    (B) Other comparability factors. Comparability under this method is 
less dependent on close physical similarity between the products 
transferred than under the comparable uncontrolled price method. 
Substantial differences in the products may, however, indicate 
significant functional differences between the controlled and 
uncontrolled taxpayers. Thus, it ordinarily would be expected that the 
controlled and uncontrolled transactions involve the production of goods 
within the same product categories. Furthermore, significant differences 
in the value of the products due, for example, to the value of a 
trademark, may also affect the reliability of the comparison. Finally, 
the reliability of profit measures based on gross profit may be 
adversely affected by factors that have less effect on prices. For 
example, gross profit may be affected by a variety of other factors, 
including cost structures (as reflected, for example, in the age of 
plant and equipment), business experience (such as whether the business 
is in a start-up phase or is mature), or management efficiency (as 
indicated, for

[[Page 706]]

example, by expanding or contracting sales or executive compensation 
over time). Accordingly, if material differences in these factors are 
identified based on objective evidence, the reliability of the analysis 
may be affected.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions. If there are material differences between the controlled 
and uncontrolled transactions that would affect the gross profit markup, 
adjustments should be made to the gross profit markup earned in the 
comparable uncontrolled transaction according to the provisions of Sec.  
1.482-1(d)(2). For this purpose, consideration of the operating expenses 
associated with the functions performed and risks assumed may be 
necessary, because differences in functions performed are often 
reflected in operating expenses. If there are differences in functions 
performed, however, the effect on gross profit of such differences is 
not necessarily equal to the differences in the amount of related 
operating expenses. Specific examples of the factors that may be 
particularly relevant to this method include--
    (1) The complexity of manufacturing or assembly;
    (2) Manufacturing, production, and process engineering;
    (3) Procurement, purchasing, and inventory control activities;
    (4) Testing functions;
    (5) Selling, general, and administrative expenses;
    (6) Foreign currency risks; and
    (7) Contractual terms (e.g., scope and terms of warranties provided, 
sales or purchase volume, credit terms, transport terms).
    (D) Purchasing agent. If a controlled taxpayer is comparable to a 
purchasing agent that does not take title to property or otherwise 
assume risks with respect to ownership of such goods, the commission 
earned by such purchasing agent, expressed as a percentage of the 
purchase price of the goods, may be used as the appropriate gross profit 
markup.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the cost plus method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec.  1.482-1(c) (Best method 
rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect the gross profit markup 
affects the reliability of the result. Thus, for example, if differences 
in inventory and other cost accounting practices would materially affect 
the gross profit markup, the ability to make reliable adjustments for 
such differences would affect the reliability of the results. Further, 
the controlled transaction and the comparable uncontrolled transaction 
should be consistent in the reporting of costs between cost of goods 
sold and operating expenses. The term cost of producing includes the 
cost of acquiring property that is held for resale.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (d).

    Example 1. (i) USP, a domestic manufacturer of computer components, 
sells its products to FS, its foreign distributor. UT1, UT2, and UT3 are 
domestic computer component manufacturers that sell to uncontrolled 
foreign purchasers.
    (ii) Relatively complete data is available regarding the functions 
performed and risks borne by UT1, UT2, and UT3, and the contractual 
terms in the uncontrolled transactions. In addition, data is available 
to ensure accounting consistency between all of the uncontrolled 
manufacturers and USP. Because the available data is sufficiently 
complete to conclude that it is likely that all material differences 
between the controlled and uncontrolled transactions have been 
identified, the effect of the differences are definite and reasonably 
ascertainable, and reliable adjustments are made to account for the 
differences, an arm's length range can be established pursuant to Sec.  
1.482-1(e)(2)(iii)(A).
    Example 2. The facts are the same as in Example 1, except that USP 
accounts for supervisory, general, and administrative costs as operating 
expenses, which are not allocated to its sales to FS. The gross profit 
markups of UT1, UT2, and UT3, however, reflect supervisory, general, and 
administrative expenses because they are accounted for as costs of goods 
sold. Accordingly, the gross profit markups of UT1, UT2, and UT3 must be 
adjusted as provided in paragraph (d)(3)(iii)(B) of this section to 
provide accounting consistency. If data is not sufficient to determine 
whether such accounting differences exist

[[Page 707]]

between the controlled and uncontrolled transactions, the reliability of 
the results will be decreased.
    Example 3. The facts are the same as in Example 1, except that under 
its contract with FS, USP uses materials consigned by FS. UT1, UT2, and 
UT3, on the other hand, purchase their own materials, and their gross 
profit markups are determined by including the costs of materials. The 
fact that USP does not carry an inventory risk by purchasing its own 
materials while the uncontrolled producers carry inventory is a 
significant difference that may require an adjustment if the difference 
has a material effect on the gross profit markups of the uncontrolled 
producers. Inability to reasonably ascertain the effect of the 
difference on the gross profit markups will affect the reliability of 
the results of UT1, UT2, and UT3.
    Example 4. (i) FS, a foreign corporation, produces apparel for USP, 
its U.S. parent corporation. FS purchases its materials from unrelated 
suppliers and produces the apparel according to designs provided by USP. 
The district director identifies 10 uncontrolled foreign apparel 
producers that operate in the same geographic market and are similar in 
many respect to FS.
    (ii) Relatively complete data is available regarding the functions 
performed and risks borne by the uncontrolled producers. In addition, 
data is sufficiently detailed to permit adjustments for differences in 
accounting practices. However, sufficient data is not available to 
determine whether it is likely that all material differences in 
contractual terms have been identified. For example, it is not possible 
to determine which parties in the uncontrolled transactions bear 
currency risks. Because differences in these contractual terms could 
materially affect price or profits, the inability to determine whether 
differences exist between the controlled and uncontrolled transactions 
will diminish the reliability of these results. Therefore, the 
reliability of the results of the uncontrolled transactions must be 
enhanced by the application of a statistical method in establishing an 
arm's length range pursuant to Sec.  1.482-1(e)(2)(iii)(B).

    (e) Unspecified methods--(1) In general. Methods not specified in 
paragraphs (a)(1), (2), (3), (4), and (5) of this section may be used to 
evaluate whether the amount charged in a controlled transaction is arm's 
length. Any method used under this paragraph (e) must be applied in 
accordance with the provisions of Sec.  1.482-1. Consistent with the 
specified methods, an unspecified method should take into account the 
general principle that uncontrolled taxpayers evaluate the terms of a 
transaction by considering the realistic alternatives to that 
transaction, and only enter into a particular transaction if none of the 
alternatives is preferable to it. For example, the comparable 
uncontrolled price method compares a controlled transaction to similar 
uncontrolled transactions to provide a direct estimate of the price to 
which the parties would have agreed had they resorted directly to a 
market alternative to the controlled transaction. Therefore, in 
establishing whether a controlled transaction achieved an arm's length 
result, an unspecified method should provide information on the prices 
or profits that the controlled taxpayer could have realized by choosing 
a realistic alternative to the controlled transaction. As with any 
method, an unspecified method will not be applied unless it provides the 
most reliable measure of an arm's length result under the principles of 
the best method rule. See Sec.  1.482-1(c). Therefore, in accordance 
with Sec.  1.482-1(d) (Comparability), to the extent that a method 
relies on internal data rather than uncontrolled comparables, its 
reliability will be reduced. Similarly, the reliability of a method will 
be affected by the reliability of the data and assumptions used to apply 
the method, including any projections used.
    (2) Example. The following example illustrates an application of the 
principle of this paragraph (e).

    Example. Amcan, a U.S. company, produces unique vessels for storing 
and transporting toxic waste, toxicans, at its U.S. production facility. 
Amcan agrees by contract to supply its Canadian subsidiary, Cancan, with 
4000 toxicans per year to serve the Canadian market for toxicans. Prior 
to entering into the contract with Cancan, Amcan had received a bona 
fide offer from an independent Canadian waste disposal company, Cando, 
to serve as the Canadian distributor for toxicans and to purchase a 
similar number of toxicans at a price of $5,000 each. If the 
circumstances and terms of the Cancan supply contract are sufficiently 
similar to those of the Cando offer, or sufficiently reliable 
adjustments can be made for differences between them, then the Cando 
offer price of $5,000 may provide reliable information indicating that 
an arm's length consideration under the Cancan contract will not be less 
than $5,000 per toxican.


[[Page 708]]


    (f) Coordination with intangible property rules. The value of an 
item of tangible property may be affected by the value of intangible 
property, such as a trademark affixed to the tangible property (embedded 
intangible). Ordinarily, the transfer of tangible property with an 
embedded intangible will not be considered a transfer of such intangible 
if the controlled purchaser does not acquire any rights to exploit the 
intangible property other than rights relating to the resale of the 
tangible property under normal commercial practices. Pursuant to Sec.  
1.482-1(d)(3)(v), however, the embedded intangible must be accounted for 
in evaluating the comparability of the controlled transaction and 
uncontrolled comparables. For example, because product comparability has 
the greatest effect on an application of the comparable uncontrolled 
price method, trademarked tangible property may be insufficiently 
comparable to unbranded tangible property to permit a reliable 
application of the comparable uncontrolled price method. The effect of 
embedded intangibles on comparability will be determined under the 
principles of Sec.  1.482-4. If the transfer of tangible property 
conveys to the recipient a right to exploit an embedded intangible 
(other than in connection with the resale of that item of tangible 
property), it may be necessary to determine the arm's length 
consideration for such intangible separately from the tangible property, 
applying methods appropriate to determining the arm's length result for 
a transfer of intangible property under Sec.  1.482-4. For example, if 
the transfer of a machine conveys the right to exploit a manufacturing 
process incorporated in the machine, then the arm's length consideration 
for the transfer of that right must be determined separately under Sec.  
1.482-4.

[T.D. 8552, 59 FR 35011, July 8, 1994; 60 FR 16382, Mar. 30, 1995]



Sec.  1.482-4  Methods to determine taxable income in connection 
with a transfer of intangible property.

    (a) In general. The arm's length amount charged in a controlled 
transfer of intangible property must be determined under one of the four 
methods listed in this paragraph (a). Each of the methods must be 
applied in accordance with all of the provisions of Sec.  1.482-1, 
including the best method rule of Sec.  1.482-1(c), the comparability 
analysis of Sec.  1.482-1(d), and the arm's length range of Sec.  1.482-
1(e). The arm's length consideration for the transfer of an intangible 
determined under this section must be commensurate with the income 
attributable to the intangible. See Sec.  1.482-4(f)(2) (Periodic 
adjustments). The available methods are--
    (1) The comparable uncontrolled transaction method, described in 
paragraph (c) of this section;
    (2) The comparable profits method, described in Sec.  1.482-5;
    (3) The profit split method, described in Sec.  1.482-6; and
    (4) Unspecified methods described in paragraph (d) of this section.
    (b) Definition of intangible. For purposes of section 482, an 
intangible is an asset that comprises any of the following items and has 
substantial value independent of the services of any individual--
    (1) Patents, inventions, formulae, processes, designs, patterns, or 
know-how;
    (2) Copyrights and literary, musical, or artistic compositions;
    (3) Trademarks, trade names, or brand names;
    (4) Franchises, licenses, or contracts;
    (5) Methods, programs, systems, procedures, campaigns, surveys, 
studies, forecasts, estimates, customer lists, or technical data; and
    (6) Other similar items. For purposes of section 482, an item is 
considered similar to those listed in paragraph (b)(1) through (5) of 
this section if it derives its value not from its physical attributes 
but from its intellectual content or other intangible properties.
    (c) Comparable uncontrolled transaction method--(1) In general. The 
comparable uncontrolled transaction method evaluates whether the amount 
charged for a controlled transfer of intangible property was arm's 
length by reference to the amount charged in a comparable uncontrolled 
transaction. The amount determined under this method may be adjusted as 
required by paragraph (f)(2) of this section (Periodic adjustments).

[[Page 709]]

    (2) Comparability and reliability considerations--(i) In general. 
Whether results derived from applications of this method are the most 
reliable measure of an arm's length result is determined using the 
factors described under the best method rule in Sec.  1.482-1(c). The 
application of these factors under the comparable uncontrolled 
transaction method is discussed in paragraphs (c)(2)(ii), (iii), and 
(iv) of this section.
    (ii) Reliability. If an uncontrolled transaction involves the 
transfer of the same intangible under the same, or substantially the 
same, circumstances as the controlled transaction, the results derived 
from applying the comparable uncontrolled transaction method will 
generally be the most direct and reliable measure of the arm's length 
result for the controlled transfer of an intangible. Circumstances 
between the controlled and uncontrolled transactions will be considered 
substantially the same if there are at most only minor differences that 
have a definite and reasonably ascertainable effect on the amount 
charged and for which appropriate adjustments are made. If such 
uncontrolled transactions cannot be identified, uncontrolled 
transactions that involve the transfer of comparable intangibles under 
comparable circumstances may be used to apply this method, but the 
reliability of the analysis will be reduced.
    (iii) Comparability--(A) In general. The degree of comparability 
between controlled and uncontrolled transactions is determined by 
applying the comparability provisions of Sec.  1.482-1(d). Although all 
of the factors described in Sec.  1.482-1(d)(3) must be considered, 
specific factors may be particularly relevant to this method. In 
particular, the application of this method requires that the controlled 
and uncontrolled transactions involve either the same intangible 
property or comparable intangible property, as defined in paragraph 
(c)(2)(iii)(B)(1) of this section. In addition, because differences in 
contractual terms, or the economic conditions in which transactions take 
place, could materially affect the amount charged, comparability under 
this method also depends on similarity with respect to these factors, or 
adjustments to account for material differences in such circumstances.
    (B) Factors to be considered in determining comparability--(1) 
Comparable intangible property. In order for the intangible property 
involved in an uncontrolled transaction to be considered comparable to 
the intangible property involved in the controlled transaction, both 
intangibles must--
    (i) Be used in connection with similar products or processes within 
the same general industry or market; and
    (ii) Have similar profit potential. The profit potential of an 
intangible is most reliably measured by directly calculating the net 
present value of the benefits to be realized (based on prospective 
profits to be realized or costs to be saved) through the use or 
subsequent transfer of the intangible, considering the capital 
investment and start-up expenses required, the risks to be assumed, and 
other relevant considerations. The need to reliably measure profit 
potential increases in relation to both the total amount of potential 
profits and the potential rate of return on investment necessary to 
exploit the intangible. If the information necessary to directly 
calculate net present value of the benefits to be realized is 
unavailable, and the need to reliably measure profit potential is 
reduced because the potential profits are relatively small in terms of 
total amount and rate of return, comparison of profit potential may be 
based upon the factors referred to in paragraph (c)(2)(iii)(B)(2) of 
this section. See Example 3 of Sec.  1.482-4(c)(4). Finally, the 
reliability of a measure of profit potential is affected by the extent 
to which the profit attributable to the intangible can be isolated from 
the profit attributable to other factors, such as functions performed 
and other resources employed.
    (2) Comparable circumstances. In evaluating the comparability of the 
circumstances of the controlled and uncontrolled transactions, although 
all of the factors described in Sec.  1.482-1(d)(3) must be considered, 
specific factors that may be particularly relevant to this method 
include the following--
    (i) The terms of the transfer, including the exploitation rights 
granted in

[[Page 710]]

the intangible, the exclusive or nonexclusive character of any rights 
granted, any restrictions on use, or any limitations on the geographic 
area in which the rights may be exploited;
    (ii) The stage of development of the intangible (including, where 
appropriate, necessary governmental approvals, authorizations, or 
licenses) in the market in which the intangible is to be used;
    (iii) Rights to receive updates, revisions, or modifications of the 
intangible;
    (iv) The uniqueness of the property and the period for which it 
remains unique, including the degree and duration of protection afforded 
to the property under the laws of the relevant countries;
    (v) The duration of the license, contract, or other agreement, and 
any termination or renegotiation rights;
    (vi) Any economic and product liability risks to be assumed by the 
transferee;
    (vii) The existence and extent of any collateral transactions or 
ongoing business relationships between the transferee and transferor; 
and
    (viii) The functions to be performed by the transferor and 
transferee, including any ancillary or subsidiary services.
    (iv) Data and assumptions. The reliability of the results derived 
from the comparable uncontrolled transaction method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec.  1.482-1(c) (Best method 
rule).
    (3) Arm's length range. See Sec.  1.482-1(e)(2) for the 
determination of an arm's length range.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. (i) USpharm, a U.S. pharmaceutical company, develops a 
new drug Z that is a safe and effective treatment for the disease 
zeezee. USpharm has obtained patents covering drug Z in the United 
States and in various foreign countries. USpharm has also obtained the 
regulatory authorizations necessary to market drug Z in the United 
States and in foreign countries.
    (ii) USpharm licenses its subsidiary in country X, Xpharm, to 
produce and sell drug Z in country X. At the same time, it licenses an 
unrelated company, Ydrug, to produce and sell drug Z in country Y, a 
neighboring country. Prior to licensing the drug, USpharm had obtained 
patent protection and regulatory approvals in both countries and both 
countries provide similar protection for intellectual property rights. 
Country X and country Y are similar countries in terms of population, 
per capita income and the incidence of disease zeezee. Consequently, 
drug Z is expected to sell in similar quantities and at similar prices 
in both countries. In addition, costs of producing and marketing drug Z 
in each country are expected to be approximately the same.
    (iii) USpharm and Xpharm establish terms for the license of drug Z 
that are identical in every material respect, including royalty rate, to 
the terms established between USpharm and Ydrug. In this case the 
district director determines that the royalty rate established in the 
Ydrug license agreement is a reliable measure of the arm's length 
royalty rate for the Xpharm license agreement.
    Example 2. The facts are the same as in Example 1, except that the 
incidence of the disease zeezee in Country Y is much higher than in 
Country X. In this case, the profit potential from exploitation of the 
right to make and sell drug Z is likely to be much higher in country Y 
than it is in Country X. Consequently, the Ydrug license agreement is 
unlikely to provide a reliable measure of the arm's length royalty rate 
for the Xpharm license.
    Example 3. (i) FP, is a foreign company that designs, manufactures 
and sells industrial equipment. FP has developed proprietary components 
that are incorporated in its products. These components are important in 
the operation of FP's equipment and some of them have distinctive 
features, but other companies produce similar components and none of 
these components by itself accounts for a substantial part of the value 
of FP's products.
    (ii) FP licenses its U.S. subsidiary, USSub, exclusive North 
American rights to use the patented technology for producing component 
X, a heat exchanger used for cooling operating mechanisms in industrial 
equipment. Component X incorporates proven technology that makes it 
somewhat more efficient than the heat exchangers commonly used in 
industrial equipment. FP also agrees to provide technical support to 
help adapt component X to USSub's products and to assist with initial 
production. Under the terms of the license agreement USSub pays FP a 
royalty equal to 3 percent of sales of USSub equipment incorporating 
component X.
    (iii) FP does not license unrelated parties to use component X, but 
many similar components are transferred between uncontrolled taxpayers. 
Consequently, the district director decides to apply the comparable 
uncontrolled transaction method to evaluate

[[Page 711]]

whether the 3 percent royalty for component X is an arm's length 
royalty.
    (iv) The district director uses a database of company documents 
filed with the Securities and Exchange Commission (SEC) to identify 
potentially comparable license agreements between uncontrolled taxpayers 
that are on file with the SEC. The district director identifies 40 
license agreements that were entered into in the same year as the 
controlled transfer or in the prior or following year, and that relate 
to transfers of technology associated with industrial equipment that has 
similar applications to USSub's products. Further review of these 
uncontrolled agreements indicates that 25 of them involved components 
that have a similar level of technical sophistication as component X and 
could be expected to play a similar role in contributing to the total 
value of the final product.
    (v) The district director makes a detailed review of the terms of 
each of the 25 uncontrolled agreements and finds that 15 of them are 
similar to the controlled agreement in that they all involve--
    (A) The transfer of exclusive rights for the North American market;
    (B) Products for which the market could be expected to be of a 
similar size to the market for the products into which USSub 
incorporates component X;
    (C) The transfer of patented technology;
    (D) Continuing technical support;
    (E) Access to technical improvements;
    (F) Technology of a similar age; and
    (G) A similar duration of the agreement.
    (vi) Based on these factors and the fact that none of the components 
to which these license agreements relate accounts for a substantial part 
of the value of the final products, the district director concludes that 
these fifteen intangibles have similar profit potential to the component 
X technology.
    (vii) The 15 uncontrolled comparables produce the following royalty 
rates:

------------------------------------------------------------------------
                                                                Royalty
                           License                               rate
                                                               (percent)
------------------------------------------------------------------------
1...........................................................        1.0
2...........................................................        1.0
3...........................................................        1.25
4...........................................................        1.25
5...........................................................        1.5
6...........................................................        1.5
7...........................................................        1.75
8...........................................................        2.0
9...........................................................        2.0
10..........................................................        2.0
11..........................................................        2.25
12..........................................................        2.5
13..........................................................        2.5
14..........................................................        2.75
15..........................................................        3.0
------------------------------------------------------------------------

    (viii) Although the uncontrolled comparables are clearly similar to 
the controlled transaction, it is likely that unidentified material 
differences exist between the uncontrolled comparables and the 
controlled transaction. Therefore, an appropriate statistical technique 
must be used to establish the arm's length range. In this case the 
district director uses the interquartile range to determine the arm's 
length range. Therefore, the arm's length range covers royalty rates 
from 1.25 to 2.5 percent, and an adjustment is warranted to the 3 
percent royalty charged in the controlled transfer. The district 
director determines that the appropriate adjustment corresponds to a 
reduction in the royalty rate to 2.0 percent, which is the median of the 
uncontrolled comparables.
    Example 4. (i) USdrug, a U.S. pharmaceutical company, has developed 
a new drug, Nosplit, that is useful in treating migraine headaches and 
produces no significant side effects. Nosplit replaces another drug, 
Lessplit, that USdrug had previously produced and marketed as a 
treatment for migraine headaches. A number of other drugs for treating 
migraine headaches are already on the market, but Nosplit can be 
expected rapidly to dominate the worldwide market for such treatments 
and to command a premium price since all other treatments produce side 
effects. Thus, USdrug projects that extraordinary profits will be 
derived from Nosplit in the U.S. market and other markets.
    (ii) USdrug licenses its newly established European subsidiary, 
Eurodrug, the rights to produce and market Nosplit in the European 
market. In setting the royalty rate for this license, USdrug considers 
the royalty that it established previously when it licensed the right to 
produce and market Lessplit in the European market to an unrelated 
European pharmaceutical company. In many respects the two license 
agreements are closely comparable. The drugs were licensed at the same 
stage in their development and the agreements conveyed identical rights 
to the licensees. Moreover, there appear to have been no significant 
changes in the European market for migraine headache treatments since 
Lessplit was licensed. However, at the time that Lessplit was licensed 
there were several other similar drugs already on the market to which 
Lessplit was not in all cases superior. Consequently, the projected and 
actual Lessplit profits were substantially less than the projected 
Nosplit profits. Thus, USdrug concludes that the profit potential of 
Lessplit is not similar to the profit potential of Nosplit, and the 
Lessplit license agreement consequently is not a comparable uncontrolled 
transaction for purposes of this paragraph (c) in spite of the other 
indicia of comparability between the two intangibles.

    (d) Unspecified methods--(1) In general. Methods not specified in 
paragraphs (a)(1), (2), and (3) of this section may be used to evaluate 
whether the amount

[[Page 712]]

charged in a controlled transaction is arm's length. Any method used 
under this paragraph (d) must be applied in accordance with the 
provisions of Sec.  1.482-1. Consistent with the specified methods, an 
unspecified method should take into account the general principle that 
uncontrolled taxpayers evaluate the terms of a transaction by 
considering the realistic alternatives to that transaction, and only 
enter into a particular transaction if none of the alternatives is 
preferable to it. For example, the comparable uncontrolled transaction 
method compares a controlled transaction to similar uncontrolled 
transactions to provide a direct estimate of the price the parties would 
have agreed to had they resorted directly to a market alternative to the 
controlled transaction. Therefore, in establishing whether a controlled 
transaction achieved an arm's length result, an unspecified method 
should provide information on the prices or profits that the controlled 
taxpayer could have realized by choosing a realistic alternative to the 
controlled transaction. As with any method, an unspecified method will 
not be applied unless it provides the most reliable measure of an arm's 
length result under the principles of the best method rule. See Sec.  
1.482-1(c). Therefore, in accordance with Sec.  1.482-1(d) 
(Comparability), to the extent that a method relies on internal data 
rather than uncontrolled comparables, its reliability will be reduced. 
Similarly, the reliability of a method will be affected by the 
reliability of the data and assumptions used to apply the method, 
including any projections used.
    (2) Example. The following example illustrates an application of the 
principle of this paragraph (d).

    Example. (i) USbond is a U.S. company that licenses to its foreign 
subsidiary, Eurobond, a proprietary process that permits the manufacture 
of Longbond, a long-lasting industrial adhesive, at a substantially 
lower cost than otherwise would be possible. Using the proprietary 
process, Eurobond manufactures Longbond and sells it to related and 
unrelated parties for the market price of $550 per ton. Under the terms 
of the license agreement, Eurobond pays USbond a royalty of $100 per ton 
of Longbond sold. USbond also manufactures and markets Longbond in the 
United States.
    (ii) In evaluating whether the consideration paid for the transfer 
of the proprietary process to Eurobond was arm's length, the district 
director may consider, subject to the best method rule of Sec.  1.482-
1(c), USbond's alternative of producing and selling Longbond itself. 
Reasonably reliable estimates indicate that if USbond directly supplied 
Longbond to the European market, a selling price of $300 per ton would 
cover its costs and provide a reasonable profit for its functions, risks 
and investment of capital associated with the production of Longbond for 
the European market. Given that the market price of Longbond was $550 
per ton, by licensing the proprietary process to Eurobond, USbond 
forgoes $250 per ton of profit over the profit that would be necessary 
to compensate it for the functions, risks and investment involved in 
supplying Longbond to the European market itself. Based on these facts, 
the district director concludes that a royalty of $100 for the 
proprietary process is not arm's length.

    (e) Coordination with tangible property rules. See Sec.  1.482-3(f) 
for the provisions regarding the coordination between the tangible 
property and intangible property rules.
    (f) Special rules for transfers of intangible property--(1) Form of 
consideration. If a transferee of an intangible pays nominal or no 
consideration and the transferor has retained a substantial interest in 
the property, the arm's length consideration shall be in the form of a 
royalty, unless a different form is demonstrably more appropriate.
    (2) Periodic adjustments--(i) General rule. If an intangible is 
transferred under an arrangement that covers more than one year, the 
consideration charged in each taxable year may be adjusted to ensure 
that it is commensurate with the income attributable to the intangible. 
Adjustments made pursuant to this paragraph (f)(2) shall be consistent 
with the arm's length standard and the provisions of Sec.  1.482-1. In 
determining whether to make such adjustments in the taxable year under 
examination, the district director may consider all relevant facts and 
circumstances throughout the period the intangible is used. The 
determination in an earlier year that the amount charged for an 
intangible was an arm's length amount will not preclude the district 
director in a subsequent taxable year from making an adjustment

[[Page 713]]

to the amount charged for the intangible in the subsequent year. A 
periodic adjustment under the commensurate with income requirement of 
section 482 may be made in a subsequent taxable year without regard to 
whether the taxable year of the original transfer remains open for 
statute of limitation purposes. For exceptions to this rule see 
paragraph (f)(2)(ii) of this section.
    (ii) Exceptions--(A) Transactions involving the same intangible. If 
the same intangible was transferred to an uncontrolled taxpayer under 
substantially the same circumstances as those of the controlled 
transaction; this transaction serves as the basis for the application of 
the comparable uncontrolled transaction method in the first taxable year 
in which substantial periodic consideration was required to be paid; and 
the amount paid in that year was an arm's length amount, then no 
allocation in a subsequent year will be made under paragraph (f)(2)(i) 
of this paragraph for a controlled transfer of intangible property.
    (B) Transactions involving comparable intangible. If the arm's 
length result is derived from the application of the comparable 
uncontrolled transaction method based on the transfer of a comparable 
intangible under comparable circumstances to those of the controlled 
transaction, no allocation will be made under paragraph (f)(2)(i) of 
this section if each of the following facts is established--
    (1) The controlled taxpayers entered into a written agreement 
(controlled agreement) that provided for an amount of consideration with 
respect to each taxable year subject to such agreement, such 
consideration was an arm's length amount for the first taxable year in 
which substantial periodic consideration was required to be paid under 
the agreement, and such agreement remained in effect for the taxable 
year under review;
    (2) There is a written agreement setting forth the terms of the 
comparable uncontrolled transaction relied upon to establish the arm's 
length consideration (uncontrolled agreement), which contains no 
provisions that would permit any change to the amount of consideration, 
a renegotiation, or a termination of the agreement, in circumstances 
comparable to those of the controlled transaction in the taxable year 
under review (or that contains provisions permitting only specified, 
non-contingent, periodic changes to the amount of consideration);
    (3) The controlled agreement is substantially similar to the 
uncontrolled agreement, with respect to the time period for which it is 
effective and the provisions described in paragraph (f)(2)(ii)(B)(2) of 
this section;
    (4) The controlled agreement limits use of the intangible to a 
specified field or purpose in a manner that is consistent with industry 
practice and any such limitation in the uncontrolled agreement;
    (5) There were no substantial changes in the functions performed by 
the controlled transferee after the controlled agreement was executed, 
except changes required by events that were not foreseeable; and
    (6) The aggregate profits actually earned or the aggregate cost 
savings actually realized by the controlled taxpayer from the 
exploitation of the intangible in the year under examination, and all 
past years, are not less than 80% nor more than 120% of the prospective 
profits or cost savings that were foreseeable when the comparability of 
the uncontrolled agreement was established under paragraph (c)(2) of 
this section.
    (C) Methods other than comparable uncontrolled transaction. If the 
arm's length amount was determined under any method other than the 
comparable uncontrolled transaction method, no allocation will be made 
under paragraph (f)(2)(i) of this section if each of the following facts 
is established--
    (1) The controlled taxpayers entered into a written agreement 
(controlled agreement) that provided for an amount of consideration with 
respect to each taxable year subject to such agreement, and such 
agreement remained in effect for the taxable year under review;
    (2) The consideration called for in the controlled agreement was an 
arm's length amount for the first taxable year in which substantial 
periodic consideration was required to be paid, and relevant supporting 
documentation was prepared contemporaneously with

[[Page 714]]

the execution of the controlled agreement;
    (3) There have been no substantial changes in the functions 
performed by the transferee since the controlled agreement was executed, 
except changes required by events that were not foreseeable; and
    (4) The total profits actually earned or the total cost savings 
realized by the controlled transferee from the exploitation of the 
intangible in the year under examination, and all past years, are not 
less than 80% nor more than 120% of the prospective profits or cost 
savings that were foreseeable when the controlled agreement was entered 
into.
    (D) Extraordinary events. No allocation will be made under paragraph 
(f)(2)(i) of this section if the following requirements are met--
    (1) Due to extraordinary events that were beyond the control of the 
controlled taxpayers and that could not reasonably have been anticipated 
at the time the controlled agreement was entered into, the aggregate 
actual profits or aggregate cost savings realized by the taxpayer are 
less than 80% or more than 120% of the prospective profits or cost 
savings; and
    (2) All of the requirements of paragraph (f)(2)(ii) (B) or (C) of 
this section are otherwise satisfied.
    (E) Five-year period. If the requirements of Sec.  1.482-4 
(f)(2)(ii)(B) or (f)(2)(ii)(C) are met for each year of the five-year 
period beginning with the first year in which substantial periodic 
consideration was required to be paid, then no periodic adjustment will 
be made under paragraph (f)(2)(i) of this section in any subsequent 
year.
    (iii) Examples. The following examples illustrate this paragraph 
(f)(2).

    Example 1. (i) USdrug, a U.S. pharmaceutical company, has developed 
a new drug, Nosplit, that is useful in treating migraine headaches and 
produces no significant side effects. A number of other drugs for 
treating migraine headaches are already on the market, but Nosplit can 
be expected rapidly to dominate the worldwide market for such treatments 
and to command a premium price since all other treatments produce side 
effects. Thus, USdrug projects that extraordinary profits will be 
derived from Nosplit in the U.S. and European markets.
    (ii) USdrug licenses its newly established European subsidiary, 
Eurodrug, the rights to produce and market Nosplit for the European 
market for 5 years. In setting the royalty rate for this license, USdrug 
makes projections of the annual sales revenue and the annual profits to 
be derived from the exploitation of Nosplit by Eurodrug. Based on the 
projections, a royalty rate of 3.9% is established for the term of the 
license.
    (iii) In Year 1, USdrug evaluates the royalty rate it received from 
Eurodrug. Given the high profit potential of Nosplit, USdrug is unable 
to locate any uncontrolled transactions dealing with licenses of 
comparable intangible property. USdrug therefore determines that the 
comparable uncontrolled transaction method will not provide a reliable 
measure of an arm's length royalty. However, applying the comparable 
profits method to Eurodrug, USdrug determines that a royalty rate of 
3.9% will result in Eurodrug earning an arm's length return for its 
manufacturing and marketing functions.
    (iv) In Year 5, the U.S. income tax return for USdrug is examined, 
and the district director must determine whether the royalty rate 
between USdrug and Eurodrug is commensurate with the income attributable 
to Nosplit. In making this determination, the district director 
considers whether any of the exceptions in Sec.  1.482-4(f)(2)(ii) are 
applicable. In particular, the district director compares the profit 
projections attributable to Nosplit made by USdrug against the actual 
profits realized by Eurodrug. The projected and actual profits are as 
follows:

------------------------------------------------------------------------
                                              Profit
                                            projections   Actual profits
------------------------------------------------------------------------
Year 1..................................             200             250
Year 2..................................             250             300
Year 3..................................             500             600
Year 4..................................             350             200
Year 5..................................             100             100
                                         -------------------------------
    Total...............................            1400            1450
------------------------------------------------------------------------

    (v) The total profits earned through Year 5 were not less than 80% 
nor more than 120% of the profits that were projected when the license 
was entered into. If the district director determines that the other 
requirements of Sec.  1.482-4(f)(2)(ii)(C) were met, no adjustment will 
be made to the royalty rate between USdrug and Eurodrug for the license 
of Nosplit.
    Example 2. (i) The facts are the same as in Example 1, except that 
Eurodrug's actual profits earned were much higher than the projected 
profits, as follows:

------------------------------------------------------------------------
                                              Profit
                                            projections   Actual profits
------------------------------------------------------------------------
Year 1..................................             200             250
Year 2..................................             250             500
Year 3..................................             500             800
Year 4..................................             350             700
Year 5..................................             100             600
                                         -------------------------------

[[Page 715]]

 
    Total...............................            1400            2850
------------------------------------------------------------------------

    (ii) In examining USdrug's tax return for Year 5, the district 
director considers the actual profits realized by Eurodrug in Year 5, 
and all past years. Accordingly, although Years 1 through 4 may be 
closed under the statute of limitations, for purposes of determining 
whether an adjustment should be made with respect to the royalty rate in 
Year 5 with respect to Nosplit, the district director aggregates the 
actual profits from those years with the profits of Year 5. However, the 
district director will make an adjustment, if any, only with respect to 
Year 5.
    Example 3. (i) FP, a foreign corporation, licenses to USS, its U.S. 
subsidiary, a new air-filtering process that permits manufacturing 
plants to meet new environmental standards. The license runs for a 10-
year period, and the profit derived from the new process is projected to 
be $15 million per year, for an aggregate profit of $150 million.
    (ii) The royalty rate for the license is based on a comparable 
uncontrolled transaction involving a comparable intangible under 
comparable circumstances. The requirements of paragraphs 
(f)(2)(ii)(B)(1) through (5) of this section have been met. 
Specifically, FP and USS have entered into a written agreement that 
provides for a royalty in each year of the license, the royalty rate is 
considered arm's length for the first taxable year in which a 
substantial royalty was required to be paid, the license limited the use 
of the process to a specified field, consistent with industry practice, 
and there are no substantial changes in the functions performed by USS 
after the license was entered into.
    (iii) In examining Year 4 of the license, the district director 
determines that the aggregate actual profits earned by USS through Year 
4 are $30 million, less than 80% of the projected profits of $60 
million. However, USS establishes to the satisfaction of the district 
director that the aggregate actual profits from the process are less 
than 80% of the projected profits in Year 3 because an earthquake 
severely damaged USS's manufacturing plant. Because the difference 
between the projected profits and actual profits was due to an 
extraordinary event that was beyond the control of USS, and could not 
reasonably have been anticipated at the time the license was entered 
into, the requirement under Sec.  1.482-4(f)(2)(ii)(D) has been met, and 
no adjustment under this section is made.

    (3) Ownership of intangible property--(i) Identification of owner--
(A) In general. The legal owner of intangible property pursuant to the 
intellectual property law of the relevant jurisdiction, or the holder of 
rights constituting an intangible property pursuant to contractual terms 
(such as the terms of a license) or other legal provision, will be 
considered the sole owner of the respective intangible property for 
purposes of this section unless such ownership is inconsistent with the 
economic substance of the underlying transactions. See Sec.  1.482-
1(d)(3)(ii)(B) (identifying contractual terms). If no owner of the 
respective intangible property is identified under the intellectual 
property law of the relevant jurisdiction, or pursuant to contractual 
terms (including terms imputed pursuant to Sec.  1.482-1(d)(3)(ii)(B)) 
or other legal provision, then the controlled taxpayer who has control 
of the intangible property, based on all the facts and circumstances, 
will be considered the sole owner of the intangible property for 
purposes of this section.
    (B) Cost sharing arrangements. The rules in this paragraph (f)(3) 
regarding ownership with respect to cost shared intangibles and cost 
sharing arrangements will apply only as provided in Sec.  1.482-7.
    (ii) Examples. The principles of this paragraph (f)(3) are 
illustrated by the following examples:

    Example 1. FP, a foreign corporation, is the registered holder of 
the AA trademark in the United States. FP licenses to its U.S. 
subsidiary, USSub, the exclusive rights to manufacture and market 
products in the United States under the AA trademark. FP is the owner of 
the trademark pursuant to intellectual property law. USSub is the owner 
of the license pursuant to the terms of the license, but is not the 
owner of the trademark. See paragraphs (b)(3) and (4) of this section 
(defining an intangible as, among other things, a trademark or a 
license).
    Example 2. The facts are the same as in Example 1. As a result of 
its sales and marketing activities, USSub develops a list of several 
hundred creditworthy customers that regularly purchase AA trademarked 
products. Neither the terms of the contract between FP and USSub nor the 
relevant intellectual property law specify which party owns the customer 
list. Because USSub has knowledge of the contents of the list, and has 
practical control over its use and dissemination, USSub is considered 
the sole owner of the customer list for purposes of this paragraph 
(f)(3).


[[Page 716]]


    (4) Contribution to the value of intangible property owned by 
another--(i) In general. The arm's length consideration for a 
contribution by one controlled taxpayer that develops or enhances the 
value, or may be reasonably anticipated to develop or enhance the value, 
of intangible property owned by another controlled taxpayer will be 
determined in accordance with the applicable rules under section 482. If 
the consideration for such a contribution is embedded within the 
contractual terms for a controlled transaction that involves such 
intangible property, then ordinarily no separate allocation will be made 
with respect to such contribution. In such cases, pursuant to Sec.  
1.482-1(d)(3), the contribution must be accounted for in evaluating the 
comparability of the controlled transaction to uncontrolled comparables, 
and accordingly in determining the arm's length consideration in the 
controlled transaction.
    (ii) Examples. The principles of this paragraph (f)(4) are 
illustrated by the following examples:

    Example 1. A, a member of a controlled group, allows B, another 
member of the controlled group, to use tangible property, such as 
laboratory equipment, in connection with B's development of an 
intangible that B owns. By furnishing tangible property, A makes a 
contribution to the development of intangible property owned by another 
controlled taxpayer, B. Pursuant to paragraph (f)(4)(i) of this section, 
the arm's length charge for A's furnishing of tangible property will be 
determined under the rules for use of tangible property in Sec.  1.482-
2(c).
    Example 2. (i) Facts. FP, a foreign producer of wristwatches, is the 
registered holder of the YY trademark in the United States and in other 
countries worldwide. FP enters into an exclusive, five-year, renewable 
agreement with its newly organized U.S. subsidiary, USSub. The 
contractual terms of the agreement grant USSub the exclusive right to 
re-sell YY trademark wristwatches in the United States, obligate USSub 
to pay a fixed price per wristwatch throughout the entire term of the 
contract, and obligate both FP and USSub to undertake without separate 
compensation specified types and levels of marketing activities.
    (ii) The consideration for FP's and USSub's marketing activities, as 
well as the consideration for the exclusive right to re-sell YY 
trademarked merchandise in the United States, are embedded in the 
transfer price paid for the wristwatches. Accordingly, pursuant to 
paragraph (f)(4)(i) of this section, ordinarily no separate allocation 
would be appropriate with respect to these embedded contributions.
    (iii) Whether an allocation is warranted with respect to the 
transfer price for the wristwatches is determined under Sec. Sec.  
1.482-1, 1.482-3, and this section through Sec.  1.482-6. The 
comparability analysis would include consideration of all relevant 
factors, including the nature of the intangible property embedded in the 
wristwatches and the nature of the marketing activities required under 
the agreement. This analysis would also take into account that the 
compensation for the activities performed by USSub and FP, as well as 
the consideration for USSub's use of the YY trademark, is embedded in 
the transfer price for the wristwatches, rather than provided for in 
separate agreements. See Sec. Sec.  1.482-3(f) and 1.482-9(m)(4).
    Example 3. (i) Facts. FP, a foreign producer of athletic gear, is 
the registered holder of the AA trademark in the United States and in 
other countries. In year 1, FP licenses to a newly organized U.S. 
subsidiary, USSub, the exclusive rights to use certain manufacturing and 
marketing intangible property to manufacture and market athletic gear in 
the United States under the AA trademark. The license agreement 
obligates USSub to pay a royalty based on sales of trademarked 
merchandise. The license agreement also obligates FP and USSub to 
perform without separate compensation specified types and levels of 
marketing activities. In year 1, USSub manufactures and sells athletic 
gear under the AA trademark in the United States.
    (ii) The consideration for FP's and USSub's respective marketing 
activities is embedded in the contractual terms of the license for the 
AA trademark. Accordingly, pursuant to paragraph (f)(4)(i) of this 
section, ordinarily no separate allocation would be appropriate with 
respect to the embedded contributions in year 1. See Sec.  1.482-
9(m)(4).
    (iii) Whether an allocation is warranted with respect to the royalty 
under the license agreement would be analyzed under Sec.  1.482-1, and 
this section through Sec.  1.482-6. The comparability analysis would 
include consideration of all relevant factors, such as the term and 
geographical exclusivity of the license, the nature of the intangible 
property subject to the license, and the nature of the marketing 
activities required to be undertaken pursuant to the license. Pursuant 
to paragraph (f)(4)(i) of this section, the analysis would also take 
into account the fact that the compensation for the marketing services 
is embedded in the royalty paid for use of the AA trademark, rather than 
provided for in a separate services agreement. For illustrations of 
application of the best method rule, see Sec.  1.482-8 Examples 10, 11, 
and 12.
    Example 4. (i) Facts. The year 1 facts are the same as in Example 3, 
with the following

[[Page 717]]

exceptions. In year 2, USSub undertakes certain incremental marketing 
activities in addition to those required by the contractual terms of the 
license for the AA trademark executed in year 1. The parties do not 
execute a separate agreement with respect to these incremental marketing 
activities performed by USSub. The license agreement executed in year 1 
is of sufficient duration that it is reasonable to anticipate that USSub 
will obtain the benefit of its incremental activities, in the form of 
increased sales or revenues of trademarked products in the U.S. market.
    (ii) To the extent that it was reasonable to anticipate that USSub's 
incremental marketing activities would increase the value only of 
USSub's intangible property (that is, USSub's license to use the AA 
trademark for a specified term), and not the value of the AA trademark 
owned by FP, USSub's incremental activities do not constitute a 
contribution for which an allocation is warranted under paragraph 
(f)(4)(i) of this section.
    Example 5. (i) Facts. The year 1 facts are the same as in Example 3. 
In year 2, FP and USSub enter into a separate services agreement that 
obligates USSub to perform certain incremental marketing activities to 
promote AA trademark athletic gear in the United States, above and 
beyond the activities specified in the license agreement executed in 
year 1. In year 2, USSub begins to perform these incremental activities, 
pursuant to the separate services agreement with FP.
    (ii) Whether an allocation is warranted with respect to USSub's 
incremental marketing activities covered by the separate services 
agreement would be evaluated under Sec. Sec.  1.482-1 and 1.482-9, 
including a comparison of the compensation provided for the services 
with the results obtained under a method pursuant to Sec.  1.482-9, 
selected and applied in accordance with the best method rule of Sec.  
1.482-1(c).
    (iii) Whether an allocation is warranted with respect to the royalty 
under the license agreement is determined under Sec.  1.482-1, and this 
section through Sec.  1.482-6. The comparability analysis would include 
consideration of all relevant factors, such as the term and geographical 
exclusivity of the license, the nature of the intangible property 
subject to the license, and the nature of the marketing activities 
required to be undertaken pursuant to the license. The comparability 
analysis would take into account that the compensation for the 
incremental activities by USSub is provided for in the separate services 
agreement, rather than embedded in the royalty paid for use of the AA 
trademark. For illustrations of application of the best method rule, see 
Sec.  1.482-8 Examples 10, 11, and 12.
    Example 6. (i) Facts. The year 1 facts are the same as in Example 3. 
In year 2, FP and USSub enter into a separate services agreement that 
obligates FP to perform incremental marketing activities, not specified 
in the year 1 license, by advertising AA trademarked athletic gear in 
selected international sporting events, such as the Olympics and the 
soccer World Cup. FP's corporate advertising department develops and 
coordinates these special promotions. The separate services agreement 
obligates USSub to pay an amount to FP for the benefit to USSub that may 
reasonably be anticipated as the result of FP's incremental activities. 
The separate services agreement is not a qualified cost sharing 
arrangement under Sec.  1.482-7T. FP begins to perform the incremental 
activities in year 2 pursuant to the separate services agreement.
    (ii) Whether an allocation is warranted with respect to the 
incremental marketing activities performed by FP under the separate 
services agreement would be evaluated under Sec.  1.482-9. Under the 
circumstances, it is reasonable to anticipate that FP's activities would 
increase the value of USSub's license as well as the value of FP's 
trademark. Accordingly, the incremental activities by FP may constitute 
in part a controlled services transaction for which USSub must 
compensate FP. The analysis of whether an allocation is warranted would 
include a comparison of the compensation provided for the services with 
the results obtained under a method pursuant to Sec.  1.482-9, selected 
and applied in accordance with the best method rule of Sec.  1.482-1(c).
    (iii) Whether an allocation is appropriate with respect to the 
royalty under the license agreement would be evaluated under Sec. Sec.  
1.482-1 through 1.482-3, this section, and Sec. Sec.  1.482-5 and 1.482-
6. The comparability analysis would include consideration of all 
relevant factors, such as the term and geographical exclusivity of 
USSub's license, the nature of the intangible property subject to the 
license, and the marketing activities required to be undertaken by both 
FP and USSub pursuant to the license. This comparability analysis would 
take into account that the compensation for the incremental activities 
performed by FP was provided for in the separate services agreement, 
rather than embedded in the royalty paid for use of the AA trademark. 
For illustrations of application of the best method rule, see Sec.  
1.482-8, Example 10, Example 11, and Example 12.
    (5) Consideration not artificially limited. The arm's length 
consideration for the controlled transfer of an intangible is not 
limited by the consideration paid in any uncontrolled transactions that 
do not meet the requirements of the comparable uncontrolled transaction 
method described in paragraph (c) of

[[Page 718]]

this section. Similarly, the arm's length consideration for an 
intangible is not limited by the prevailing rates of consideration paid 
for the use or transfer of intangibles within the same or similar 
industry.
    (6) Lump sum payments--(i) In general. If an intangible is 
transferred in a controlled transaction for a lump sum, that amount must 
be commensurate with the income attributable to the intangible. A lump 
sum is commensurate with income in a taxable year if the equivalent 
royalty amount for that taxable year is equal to an arm's length 
royalty. The equivalent royalty amount for a taxable year is the amount 
determined by treating the lump sum as an advance payment of a stream of 
royalties over the useful life of the intangible (or the period covered 
by an agreement, if shorter), taking into account the projected sales of 
the licensee as of the date of the transfer. Thus, determining the 
equivalent royalty amount requires a present value calculation based on 
the lump sum, an appropriate discount rate, and the projected sales over 
the relevant period. The equivalent royalty amount is subject to 
periodic adjustments under Sec.  1.482-4(f)(2)(i) to the same extent as 
an actual royalty payment pursuant to a license agreement.
    (ii) Exceptions. No periodic adjustment will be made under paragraph 
(f)(2)(i) of this section if any of the exceptions to periodic 
adjustments provided in paragraph (f)(2)(ii) of this section apply.
    (iii) Example. The following example illustrates the principle of 
this paragraph (f)(5).

    Example. Calculation of the equivalent royalty amount. (i) FSub is 
the foreign subsidiary of USP, a U.S. company. USP licenses FSub the 
right to produce and sell the whopperchopper, a patented new kitchen 
appliance, for the foreign market. The license is for a period of five 
years, and payment takes the form of a single lump-sum charge of 
$500,000 that is paid at the beginning of the period.
    (ii) The equivalent royalty amount for this license is determined by 
deriving an equivalent royalty rate equal to the lump-sum payment 
divided by the present discounted value of FSub's projected sales of 
whopperchoppers over the life of the license. Based on the riskiness of 
the whopperchopper business, an appropriate discount rate is determined 
to be 10 percent. Projected sales of whopperchoppers for each year of 
the license are as follows:

------------------------------------------------------------------------
                                                             Projected
                          Year                                 sales
------------------------------------------------------------------------
1.......................................................      $2,500,000
2.......................................................       2,600,000
3.......................................................       2,700,000
4.......................................................       2,700,000
5.......................................................       2,750,000
------------------------------------------------------------------------

    (iii) Based on this information, the present discounted value of the 
projected whopperchopper sales is approximately $10 million, yielding an 
equivalent royalty rate of approximately 5%. Thus, the equivalent 
royalty amounts for each year are as follows:

------------------------------------------------------------------------
                                             Projected      Equivalent
                  Year                         sales      royalty amount
------------------------------------------------------------------------
1.......................................      $2,500,000        $125,000
2.......................................       2,600,000         130,000
3.......................................       2,700,000         135,000
4.......................................       2,700,000         135,000
5.......................................       2,750,000         137,500
------------------------------------------------------------------------

    (iv) If in any of the five taxable years the equivalent royalty 
amount is determined not to be an arm's length amount, a periodic 
adjustment may be made pursuant to Sec.  1.482-4(f)(2)(i). The 
adjustment in such case would be equal to the difference between the 
equivalent royalty amount and the arm's length royalty in that taxable 
year.
    (g) Coordination with rules governing cost sharing arrangements. 
Section 1.482-7 provides the specific methods to be used to determine 
arm's length results of controlled transactions in connection with a 
cost sharing arrangement. This section provides the specific methods to 
be used to determine arm's length results of a transfer of intangible 
property, including in an arrangement for sharing the costs and risks of 
developing intangibles other than a cost sharing arrangement covered by 
Sec.  1.482-7. In the case of such an arrangement, consideration of the 
principles, methods, comparability, and reliability considerations set 
forth in Sec.  1.482-7 is relevant in determining the best method, 
including an unspecified method, under this section, as appropriately 
adjusted in light of the differences in the facts and circumstances 
between such arrangement and a cost sharing arrangement.
    (h) Effective/applicability date--(1) In general. Except as provided 
in the succeeding sentence, the provisions of paragraphs (f)(3) and (4) 
of this section are generally applicable for taxable

[[Page 719]]

years beginning after December 31, 2006. The provisions of paragraphs 
(f)(3)(i)(B) and (g) of this section are generally applicable on January 
5, 2009.
    (2) Election to apply regulation to earlier taxable years. A person 
may elect to apply the provisions of paragraphs (f)(3) and (4) of this 
section to earlier taxable years in accordance with the rules set forth 
in Sec.  1.482-9(n)(2).

[T.D. 8552, 59 FR 35016, July 8, 1994; T.D. 9278, 71 FR 44484, Aug. 4, 
2006; T.D. 9456, 74 FR 38842, Aug. 4, 2009; T.D. 9568, 76 FR 80090, Dec. 
22, 2011]



Sec.  1.482-5  Comparable profits method.

    (a) In general. The comparable profits method evaluates whether the 
amount charged in a controlled transaction is arm's length based on 
objective measures of profitability (profit level indicators) derived 
from uncontrolled taxpayers that engage in similar business activities 
under similar circumstances.
    (b) Determination of arm's length result--(1) In general. Under the 
comparable profits method, the determination of an arm's length result 
is based on the amount of operating profit that the tested party would 
have earned on related party transactions if its profit level indicator 
were equal to that of an uncontrolled comparable (comparable operating 
profit). Comparable operating profit is calculated by determining a 
profit level indicator for an uncontrolled comparable, and applying the 
profit level indicator to the financial data related to the tested 
party's most narrowly identifiable business activity for which data 
incorporating the controlled transaction is available (relevant business 
activity). To the extent possible, profit level indicators should be 
applied solely to the tested party's financial data that is related to 
controlled transactions. The tested party's reported operating profit is 
compared to the comparable operating profits derived from the profit 
level indicators of uncontrolled comparables to determine whether the 
reported operating profit represents an arm's length result.
    (2) Tested party--(i) In general. For purposes of this section, the 
tested party will be the participant in the controlled transaction whose 
operating profit attributable to the controlled transactions can be 
verified using the most reliable data and requiring the fewest and most 
reliable adjustments, and for which reliable data regarding uncontrolled 
comparables can be located. Consequently, in most cases the tested party 
will be the least complex of the controlled taxpayers and will not own 
valuable intangible property or unique assets that distinguish it from 
potential uncontrolled comparables.
    (ii) Adjustments for tested party. The tested party's operating 
profit must first be adjusted to reflect all other allocations under 
section 482, other than adjustments pursuant to this section.
    (3) Arm's length range. See Sec.  1.482-1(e)(2) for the 
determination of the arm's length range. For purposes of the comparable 
profits method, the arm's length range will be established using 
comparable operating profits derived from a single profit level 
indicator.
    (4) Profit level indicators. Profit level indicators are ratios that 
measure relationships between profits and costs incurred or resources 
employed. A variety of profit level indicators can be calculated in any 
given case. Whether use of a particular profit level indicator is 
appropriate depends upon a number of factors, including the nature of 
the activities of the tested party, the reliability of the available 
data with respect to uncontrolled comparables, and the extent to which 
the profit level indicator is likely to produce a reliable measure of 
the income that the tested party would have earned had it dealt with 
controlled taxpayers at arm's length, taking into account all of the 
facts and circumstances. The profit level indicators should be derived 
from a sufficient number of years of data to reasonably measure returns 
that accrue to uncontrolled comparables. Generally, such a period should 
encompass at least the taxable year under review and the preceding two 
taxable years. This analysis must be applied in accordance with Sec.  
1.482-1(f)(2)(iii)(D). Profit level indicators that may provide a 
reliable basis for comparing operating profits of the tested party and 
uncontrolled comparables include the following--
    (i) Rate of return on capital employed. The rate of return on 
capital employed

[[Page 720]]

is the ratio of operating profit to operating assets. The reliability of 
this profit level indicator increases as operating assets play a greater 
role in generating operating profits for both the tested party and the 
uncontrolled comparable. In addition, reliability under this profit 
level indicator depends on the extent to which the composition of the 
tested party's assets is similar to that of the uncontrolled comparable. 
Finally, difficulties in properly valuing operating assets will diminish 
the reliability of this profit level indicator.
    (ii) Financial ratios. Financial ratios measure relationships 
between profit and costs or sales revenue. Since functional differences 
generally have a greater effect on the relationship between profit and 
costs or sales revenue than the relationship between profit and 
operating assets, financial ratios are more sensitive to functional 
differences than the rate of return on capital employed. Therefore, 
closer functional comparability normally is required under a financial 
ratio than under the rate of return on capital employed to achieve a 
similarly reliable measure of an arm's length result. Financial ratios 
that may be appropriate include the following--
    (A) Ratio of operating profit to sales; and
    (B) Ratio of gross profit to operating expenses. Reliability under 
this profit level indicator also depends on the extent to which the 
composition of the tested party's operating expenses is similar to that 
of the uncontrolled comparables.
    (iii) Other profit level indicators. Other profit level indicators 
not described in this paragraph (b)(4) may be used if they provide 
reliable measures of the income that the tested party would have earned 
had it dealt with controlled taxpayers at arm's length. However, profit 
level indicators based solely on internal data may not be used under 
this paragraph (b)(4) because they are not objective measures of 
profitability derived from operations of uncontrolled taxpayers engaged 
in similar business activities under similar circumstances.
    (c) Comparability and reliability considerations--(1) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec.  1.482-1(c).
    (2) Comparability--(i) In general. The degree of comparability 
between an uncontrolled taxpayer and the tested party is determined by 
applying the provisions of Sec.  1.482-1(d)(2). The comparable profits 
method compares the profitability of the tested party, measured by a 
profit level indicator (generally based on operating profit), to the 
profitability of uncontrolled taxpayers in similar circumstances. As 
with all methods that rely on external market benchmarks, the greater 
the degree of comparability between the tested party and the 
uncontrolled taxpayer, the more reliable will be the results derived 
from the application of this method. The determination of the degree of 
comparability between the tested party and the uncontrolled taxpayer 
depends upon all the relevant facts and circumstances, including the 
relevant lines of business, the product or service markets involved, the 
asset composition employed (including the nature and quantity of 
tangible assets, intangible assets and working capital), the size and 
scope of operations, and the stage in a business or product cycle.
    (ii) Functional, risk and resource comparability. An operating 
profit represents a return for the investment of resources and 
assumption of risks. Therefore, although all of the factors described in 
Sec.  1.482-1(d)(3) must be considered, comparability under this method 
is particularly dependent on resources employed and risks assumed. 
Moreover, because resources and risks usually are directly related to 
functions performed, it is also important to consider functions 
performed in determining the degree of comparability between the tested 
party and an uncontrolled taxpayer. The degree of functional 
comparability required to obtain a reliable result under the comparable 
profits method, however, is generally less than that required under the 
resale price or cost plus methods. For example, because differences in 
functions performed often are reflected in operating expenses, taxpayers 
performing

[[Page 721]]

different functions may have very different gross profit margins but 
earn similar levels of operating profit.
    (iii) Other comparability factors. Other factors listed in Sec.  
1.482-1(d)(3) also may be particularly relevant under the comparable 
profits method. Because operating profit usually is less sensitive than 
gross profit to product differences, reliability under the comparable 
profits method is not as dependent on product similarity as the resale 
price or cost plus method. However, the reliability of profitability 
measures based on operating profit may be adversely affected by factors 
that have less effect on results under the comparable uncontrolled 
price, resale price, and cost plus methods. For example, operating 
profit may be affected by varying cost structures (as reflected, for 
example, in the age of plant and equipment), differences in business 
experience (such as whether the business is in a start-up phase or is 
mature), or differences in management efficiency (as indicated, for 
example, by objective evidence such as expanding or contracting sales or 
executive compensation over time). Accordingly, if material differences 
in these factors are identified based on objective evidence, the 
reliability of the analysis may be affected.
    (iv) Adjustments for the differences between the tested party and 
the uncontrolled taxpayers. If there are differences between the tested 
party and an uncontrolled comparable that would materially affect the 
profits determined under the relevant profit level indicator, 
adjustments should be made according to the comparability provisions of 
Sec.  1.482-1(d)(2). In some cases, the assets of an uncontrolled 
comparable may need to be adjusted to achieve greater comparability 
between the tested party and the uncontrolled comparable. In such cases, 
the uncontrolled comparable's operating income attributable to those 
assets must also be adjusted before computing a profit level indicator 
in order to reflect the income and expense attributable to the adjusted 
assets. In certain cases it may also be appropriate to adjust the 
operating profit of the tested party and comparable parties. For 
example, where there are material differences in accounts payable among 
the comparable parties and the tested party, it will generally be 
appropriate to adjust the operating profit of each party by increasing 
it to reflect an imputed interest charge on each party's accounts 
payable. As another example, it may be appropriate to adjust the 
operating profit of a party to account for material differences in the 
utilization of or accounting for stock-based compensation (as defined by 
Sec.  1.482-7(d)(3)(i)) among the tested party and comparable parties.
    (3) Data and assumptions--(i) In general. The reliability of the 
results derived from the comparable profits method is affected by the 
quality of the data and assumptions used to apply this method.
    (ii) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect operating profit affects 
the reliability of the result. Thus, for example, if differences in 
inventory and other cost accounting practices would materially affect 
operating profit, the ability to make reliable adjustments for such 
differences would affect the reliability of the results.
    (iii) Allocations between the relevant business activity and other 
activities. The reliability of the allocation of costs, income, and 
assets between the relevant business activity and other activities of 
the tested party or an uncontrolled comparable will affect the 
reliability of the determination of operating profit and profit level 
indicators. If it is not possible to allocate costs, income, and assets 
directly based on factual relationships, a reasonable allocation formula 
may be used. To the extent direct allocations are not made, the 
reliability of the results derived from the application of this method 
is reduced relative to the results of a method that requires fewer 
allocations of costs, income, and assets. Similarly, the reliability of 
the results derived from the application of this method is affected by 
the extent to which it is possible to apply the profit level indicator 
to the tested party's financial data that is related solely to the 
controlled transactions. For example, if

[[Page 722]]

the relevant business activity is the assembly of components purchased 
from both controlled and uncontrolled suppliers, it may not be possible 
to apply the profit level indicator solely to financial data related to 
the controlled transactions. In such a case, the reliability of the 
results derived from the application of this method will be reduced.
    (d) Definitions. The definitions set forth in paragraphs (d)(1) 
through (6) of this section apply for purposes of this section.
    (1) Sales revenue means the amount of the total receipts from sale 
of goods and provision of services, less returns and allowances. 
Accounting principles and conventions that are generally accepted in the 
trade or industry of the controlled taxpayer under review must be used.
    (2) Gross profit means sales revenue less cost of goods sold.
    (3) Operating expenses includes all expenses not included in cost of 
goods sold except for interest expense, foreign income taxes (as defined 
in Sec.  1.901-2(a)), domestic income taxes, and any other expenses not 
related to the operation of the relevant business activity. Operating 
expenses ordinarily include expenses associated with advertising, 
promotion, sales, marketing, warehousing and distribution, 
administration, and a reasonable allowance for depreciation and 
amortization.
    (4) Operating profit means gross profit less operating expenses. 
Operating profit includes all income derived from the business activity 
being evaluated by the comparable profits method, but does not include 
interest and dividends, income derived from activities not being tested 
by this method, or extraordinary gains and losses that do not relate to 
the continuing operations of the tested party.
    (5) Reported operating profit means the operating profit of the 
tested party reflected on a timely filed U.S. income tax return. If the 
tested party files a U.S. income tax return, its operating profit is 
considered reflected on a U.S. income tax return if the calculation of 
taxable income on its return for the taxable year takes into account the 
income attributable to the controlled transaction under review. If the 
tested party does not file a U.S. income tax return, its operating 
profit is considered reflected on a U.S. income tax return in any 
taxable year for which income attributable to the controlled transaction 
under review affects the calculation of the U.S. taxable income of any 
other member of the same controlled group. If the comparable operating 
profit of the tested party is determined from profit level indicators 
derived from financial statements or other accounting records and 
reports of comparable parties, adjustments may be made to the reported 
operating profit of the tested party in order to account for material 
differences between the tested party's operating profit reported for U.S 
income tax purposes and the tested party's operating profit for 
financial statement purposes. In addition, in accordance with Sec.  
1.482-1(f)(2)(iii)(D), adjustments under section 482 that are finally 
determined may be taken into account in determining reported operating 
profit.
    (6) Operating assets. The term operating assets means the value of 
all assets used in the relevant business activity of the tested party, 
including fixed assets and current assets (such as cash, cash 
equivalents, accounts receivable, and inventories).
    The term does not include investments in subsidiaries, excess cash, 
and portfolio investments. Operating assets may be measured by their net 
book value or by their fair market value, provided that the same method 
is consistently applied to the tested party and the comparable parties, 
and consistently applied from year to year. In addition, it may be 
necessary to take into account recent acquisitions, leased assets, 
intangibles, currency fluctuations, and other items that may not be 
explicitly recorded in the financial statements of the tested party or 
uncontrolled comparable. Finally, operating assets must be measured by 
the average of the values for the beginning of the year and the end of 
the year, unless substantial fluctuations in the value of operating 
assets during the year make this an inaccurate measure of the average 
value over the year. In such a case, a more accurate measure of the 
average value of operating assets must be applied.

[[Page 723]]

    (e) Examples. The following examples illustrate the application of 
this section.

    Example 1. Transfer of tangible property resulting in no adjustment. 
(i) FP is a publicly traded foreign corporation with a U.S. subsidiary, 
USSub, that is under audit for its 1996 taxable year. FP manufactures a 
consumer product for worldwide distribution. USSub imports the assembled 
product and distributes it within the United States at the wholesale 
level under the FP name.
    (ii) FP does not allow uncontrolled taxpayers to distribute the 
product. Similar products are produced by other companies but none of 
them is sold to uncontrolled taxpayers or to uncontrolled distributors.
    (iii) Based on all the facts and circumstances, the district 
director determines that the comparable profits method will provide the 
most reliable measure of an arm's length result. USSub is selected as 
the tested party because it engages in activities that are less complex 
than those undertaken by FP.
    There is data from a number of independent operators of wholesale 
distribution businesses. These potential comparables are further 
narrowed to select companies in the same industry segment that perform 
similar functions and bear similar risks to USSub. An analysis of the 
information available on these taxpayers shows that the ratio of 
operating profit to sales is the most appropriate profit level 
indicator, and this ratio is relatively stable where at least three 
years are included in the average. For the taxable years 1994 through 
1996, USSub shows the following results:

----------------------------------------------------------------------------------------------------------------
                                                                 1994         1995         1996        Average
----------------------------------------------------------------------------------------------------------------
Sales......................................................     $500,000     $560,000     $500,000      $520,000
Cost of Goods Sold.........................................      393,000      412,400      400,000       401,800
Operating Expenses.........................................       80,000      110,000      104,600        98,200
Operating Profit...........................................       27,000       37,600       (4,600)       20,000
----------------------------------------------------------------------------------------------------------------

    (iv) After adjustments have been made to account for identified 
material differences between USSub and the uncontrolled distributors, 
the average ratio of operating profit to sales is calculated for each of 
the uncontrolled distributors. Applying each ratio to USSub would lead 
to the following comparable operating profit (COP) for USSub:

------------------------------------------------------------------------
                                                       OP/S
             Uncontrolled distributor               (percent)  USSub COP
------------------------------------------------------------------------
A.................................................       1.7      $8,840
B.................................................       3.1      16,120
C.................................................       3.8      19,760
D.................................................       4.5      23,400
E.................................................       4.7      24,440
F.................................................       4.8      24,960
G.................................................       4.9      25,480
H.................................................       6.7      34,840
I.................................................       9.9      51,480
J.................................................      10.5      54,600
------------------------------------------------------------------------

    (v) The data is not sufficiently complete to conclude that it is 
likely that all material differences between USSub and the uncontrolled 
distributors have been identified. Therefore, an arm's length range can 
be established only pursuant to Sec.  1.482- 1(e)(2)(iii)(B). The 
district director measures the arm's length range by the interquartile 
range of results, which consists of the results ranging from $19,760 to 
$34,840. Although USSub's operating income for 1996 shows a loss of 
$4,600, the district director determines that no allocation should be 
made, because USSub's average reported operating profit of $20,000 is 
within this range.
    Example 2. Transfer of tangible property resulting in adjustment. 
(i) The facts are the same as in Example 1 except that USSub reported 
the following income and expenses:

----------------------------------------------------------------------------------------------------------------
                                                                1994         1995          1996        Average
----------------------------------------------------------------------------------------------------------------
Sales.....................................................     $500,000     $560,000      $500,000      $520,000
Cost of Good Sold.........................................      370,000      460,000       400,000       410,000
Operating Expenses........................................      110,000      110,000       110,000       110,000
Operating Profit..........................................       20,000      (10,000)      (10,000)            0
----------------------------------------------------------------------------------------------------------------

    (ii) The interquartile range of comparable operating profits remains 
the same as derived in Example 1: $19,760 to $34,840. USSub's average 
operating profit for the years 1994 through 1996 ($0) falls outside this 
range. Therefore, the district director determines that an allocation 
may be appropriate.
    (iii) To determine the amount, if any, of the allocation, the 
district director compares USSub's reported operating profit for 1996 to 
comparable operating profits derived

[[Page 724]]

from the uncontrolled distributors' results for 1996. The ratio of 
operating profit to sales in 1996 is calculated for each of the 
uncontrolled comparables and applied to USSub's 1996 sales to derive the 
following results:

------------------------------------------------------------------------
                                                         OP/S     USSub
              Uncontrolled distributor                (percent)    COP
------------------------------------------------------------------------
C...................................................       0.5    $2,500
D...................................................       1.5     7,500
E...................................................       2.0    10,000
A...................................................       1.6    13,000
F...................................................       2.8    14,000
B...................................................       2.9    14,500
J...................................................       3.0    15,000
I...................................................       4.4    22,000
H...................................................       6.9    34,500
G...................................................       7.4    37,000
------------------------------------------------------------------------

    (iv) Based on these results, the median of the comparable operating 
profits for 1996 is $14,250. Therefore, USSub's income for 1996 is 
increased by $24,250, the difference between USSub's reported operating 
profit for 1996 and the median of the comparable operating profits for 
1996.
    Example 3. Multiple year analysis. (i) The facts are the same as in 
Example 2. In addition, the district director examines the taxpayer's 
results for the 1997 taxable year. As in Example 2, the district 
director increases USSub's income for the 1996 taxable year by $24,250. 
The results for the 1997 taxable year, together with the 1995 and 1996 
taxable years, are as follows:

----------------------------------------------------------------------------------------------------------------
                                                              1995          1996          1997         Average
----------------------------------------------------------------------------------------------------------------
Sales...................................................     $560,000      $500,000      $530,000      $530,000
Cost of Good Sold.......................................      460,000       400,000       430,000       430,000
Operating Expenses......................................      110,000       110,000       110,000       110,000
Operating Profit........................................      (10,000)      (10,000)      (10,000)      (10,000)
----------------------------------------------------------------------------------------------------------------

    (ii) The interquartile range of comparable operating profits, based 
on average results from the uncontrolled comparables and average sales 
for USSub for the years 1995 through 1997, ranges from $15,500 to 
$30,000. In determining whether an allocation for the 1997 taxable year 
may be made, the district director compares USSub's average reported 
operating profit for the years 1995 through 1997 to the interquartile 
range of average comparable operating profits over this period. USSub's 
average reported operating profit is determined without regard to the 
adjustment made with respect to the 1996 taxable year. See Sec.  1.482-
1(f)(2)(iii)(D). Therefore, USSub's average reported operating profit 
for the years 1995 through 1997 is ($10,000). Because this amount of 
income falls outside the interquartile range, the district director 
determines that an allocation may be appropriate.
    (iii) To determine the amount, if any, of the allocation for the 
1997 taxable year, the district director compares USSub's reported 
operating profit for 1997 to the median of the comparable operating 
profits derived from the uncontrolled distributors' results for 1997. 
The median of the comparable operating profits derived from the 
uncontrolled comparables results for the 1997 taxable year is $12,000. 
Based on this comparison, the district director increases USSub's 1997 
taxable income by $22,000, the difference between the median of the 
comparable operating profits for the 1997 taxable year and USSub's 
reported operating profit of ($10,000) for the 1997 taxable year.
    Example 4. Transfer of intangible to offshore manufacturer. (i) 
DevCo is a U.S. developer, producer and marketer of widgets. DevCo 
develops a new ``high tech widget'' (htw) that is manufactured by its 
foreign subsidiary ManuCo located in Country H. ManuCo sells the htw to 
MarkCo (a U.S. subsidiary of DevCo) for distribution and marketing in 
the United States. The taxable year 1996 is under audit, and the 
district director examines whether the royalty rate of 5 percent paid by 
ManuCo to DevCo is an arm's length consideration for the htw technology.
    (ii) Based on all the facts and circumstances, the district director 
determines that the comparable profits method will provide the most 
reliable measure of an arm's length result. ManuCo is selected as the 
tested party because it engages in relatively routine manufacturing 
activities, while DevCo engages in a variety of complex activities using 
unique and valuable intangibles. Finally, because ManuCo engages in 
manufacturing activities, it is determined that the ratio of operating 
profit to operating assets is an appropriate profit level indicator.
    (iii) Uncontrolled taxpayers performing similar functions cannot be 
found in country H. It is determined that data available in countries M 
and N provides the best match of companies in a similar market 
performing similar functions and bearing similar risks. Such data is 
sufficiently complete to identify many of the material differences 
between ManuCo and the uncontrolled comparables, and to make adjustments 
to account for such differences. However, data is not sufficiently 
complete so that it is likely that no material differences remain. In 
particular, the differences in geographic markets might have materially 
affected the results of the various companies.

[[Page 725]]

    (iv) In a separate analysis, it is determined that the price that 
ManuCo charged to MarkCo for the htw's is an arm's length price under 
Sec.  1.482-3(b). Therefore, ManuCo's financial data derived from its 
sales to MarkCo are reliable. ManuCo's financial data from 1994-1996 is 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                                 1994         1995         1996        Average
----------------------------------------------------------------------------------------------------------------
Assets.....................................................      $24,000      $25,000      $26,000       $25,000
Sales to MarkCo............................................       25,000       30,000       35,000        30,000
Cost of Goods Sold.........................................        6,250        7,500        8,750         7,500
  Royalty to DevCo (5%)....................................        1,250        1,500        1,750         1,500
  Other....................................................        5,000        6,000        7,000         6,000
Operating Expenses.........................................        1,000        1,000        1,000         1,000
Operating Profit...........................................       17,750       21,500       25,250        21,500
----------------------------------------------------------------------------------------------------------------

    (v) Applying the ratios of average operating profit to operating 
assets for the 1994 through 1996 taxable years derived from a group of 
similar uncontrolled comparables located in country M and N to ManuCo's 
average operating assets for the same period provides a set of 
comparable operating profits. The interquartile range for these average 
comparable operating profits is $3,000 to $4,500. ManuCo's average 
reported operating profit for the years 1994 through 1996 ($21,500) 
falls outside this range. Therefore, the district director determines 
that an allocation may be appropriate for the 1996 taxable year.
    (vi) To determine the amount, if any, of the allocation for the 1996 
taxable year, the district director compares ManuCo's reported operating 
profit for 1996 to the median of the comparable operating profits 
derived from the uncontrolled distributors' results for 1996. The median 
result for the uncontrolled comparables for 1996 is $3,750. Based on 
this comparison, the district director increases royalties that ManuCo 
paid by $21,500 (the difference between $25,250 and the median of the 
comparable operating profits, $3,750).
    Example 5. Adjusting operating assets and operating profit for 
differences in accounts receivable. (i) USM is a U.S. company that 
manufactures parts for industrial equipment and sells them to its 
foreign parent corporation. For purposes of applying the comparable 
profits method, 15 uncontrolled manufacturers that are similar to USM 
have been identified.
    (ii) USM has a significantly lower level of accounts receivable than 
the uncontrolled manufacturers. Since the rate of return on capital 
employed is to be used as the profit level indicator, both operating 
assets and operating profits must be adjusted to account for this 
difference. Each uncontrolled comparable's operating assets is reduced 
by the amount (relative to sales) by which they exceed USM's accounts 
receivable. Each uncontrolled comparable's operating profit is adjusted 
by deducting imputed interest income on the excess accounts receivable. 
This imputed interest income is calculated by multiplying the 
uncontrolled comparable's excess accounts receivable by an interest rate 
appropriate for short-term debt.
    Example 6. Adjusting operating profit for differences in accounts 
payable. (i) USD is the U.S. subsidiary of a foreign corporation. USD 
purchases goods from its foreign parent and sells them in the U.S. 
market. For purposes of applying the comparable profits method, 10 
uncontrolled distributors that are similar to USD have been identified.
    (ii) There are significant differences in the level of accounts 
payable among the uncontrolled distributors and USD. To adjust for these 
differences, the district director increases the operating profit of the 
uncontrolled distributors and USD to reflect interest expense imputed to 
the accounts payable. The imputed interest expense for each company is 
calculated by multiplying the company's accounts payable by an interest 
rate appropriate for its short-term debt.

[T.D. 8552, 59 FR 35021, July 8, 1994; 60 FR 16703, Mar. 31, 1995; T.D. 
9088, 68 FR 51177, Aug. 26, 2003; T.D. 9441, 74 FR 352, Jan. 5, 
2009;T.D. 9568, 76 FR 80090, Dec. 22, 2011]



Sec.  1.482-6  Profit split method.

    (a) In general. The profit split method evaluates whether the 
allocation of the combined operating profit or loss attributable to one 
or more controlled transactions is arm's length by reference to the 
relative value of each controlled taxpayer's contribution to that 
combined operating profit or loss. The combined operating profit or loss 
must be derived from the most narrowly identifiable business activity of 
the controlled taxpayers for which data is available that includes the 
controlled transactions (relevant business activity).
    (b) Appropriate share of profits and losses. The relative value of 
each controlled taxpayer's contribution to the success of the relevant 
business activity must be determined in a manner that reflects the 
functions performed,

[[Page 726]]

risks assumed, and resources employed by each participant in the 
relevant business activity, consistent with the comparability provisions 
of Sec.  1.482-1(d)(3). Such an allocation is intended to correspond to 
the division of profit or loss that would result from an arrangement 
between uncontrolled taxpayers, each performing functions similar to 
those of the various controlled taxpayers engaged in the relevant 
business activity. The profit allocated to any particular member of a 
controlled group is not necessarily limited to the total operating 
profit of the group from the relevant business activity. For example, in 
a given year, one member of the group may earn a profit while another 
member incurs a loss. In addition, it may not be assumed that the 
combined operating profit or loss from the relevant business activity 
should be shared equally, or in any other arbitrary proportion. The 
specific method of allocation must be determined under paragraph (c) of 
this section.
    (c) Application--(1) In general. The allocation of profit or loss 
under the profit split method must be made in accordance with one of the 
following allocation methods--(i) The comparable profit split, described 
in paragraph (c)(2) of this section; or
    (ii) The residual profit split, described in paragraph (c)(3) of 
this section.
    (2) Comparable profit split--(i) In general. A comparable profit 
split is derived from the combined operating profit of uncontrolled 
taxpayers whose transactions and activities are similar to those of the 
controlled taxpayers in the relevant business activity. Under this 
method, each uncontrolled taxpayer's percentage of the combined 
operating profit or loss is used to allocate the combined operating 
profit or loss of the relevant business activity.
    (ii) Comparability and reliability considerations--(A) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result is determined using the 
factors described under the best method rule in Sec.  1.482-1(c).
    (B) Comparability--(1) In general. The degree of comparability 
between the controlled and uncontrolled taxpayers is determined by 
applying the comparability provisions of Sec.  1.482-1(d). The 
comparable profit split compares the division of operating profits among 
the controlled taxpayers to the division of operating profits among 
uncontrolled taxpayers engaged in similar activities under similar 
circumstances. Although all of the factors described in Sec.  1.482-
1(d)(3) must be considered, comparability under this method is 
particularly dependent on the considerations described under the 
comparable profits method in Sec.  1.482-5(c)(2) or Sec.  1.482-
9(f)(2)(iii) because this method is based on a comparison of the 
operating profit of the controlled and uncontrolled taxpayers. In 
addition, because the contractual terms of the relationship among the 
participants in the relevant business activity will be a principal 
determinant of the allocation of functions and risks among them, 
comparability under this method also depends particularly on the degree 
of similarity of the contractual terms of the controlled and 
uncontrolled taxpayers. Finally, the comparable profit split may not be 
used if the combined operating profit (as a percentage of the combined 
assets) of the uncontrolled comparables varies significantly from that 
earned by the controlled taxpayers.
    (2) Adjustments for differences between the controlled and 
uncontrolled taxpayers. If there are differences between the controlled 
and uncontrolled taxpayers that would materially affect the division of 
operating profit, adjustments must be made according to the provisions 
of Sec.  1.482-1(d)(2).
    (C) Data and assumptions. The reliability of the results derived 
from the comparable profit split is affected by the quality of the data 
and assumptions used to apply this method. In particular, the following 
factors must be considered--
    (1) The reliability of the allocation of costs, income, and assets 
between the relevant business activity and the participants' other 
activities will affect the accuracy of the determination of combined 
operating profit and its allocation among the participants. If it is not 
possible to allocate costs, income,

[[Page 727]]

and assets directly based on factual relationships, a reasonable 
allocation formula may be used. To the extent direct allocations are not 
made, the reliability of the results derived from the application of 
this method is reduced relative to the results of a method that requires 
fewer allocations of costs, income, and assets. Similarly, the 
reliability of the results derived from the application of this method 
is affected by the extent to which it is possible to apply the method to 
the parties' financial data that is related solely to the controlled 
transactions. For example, if the relevant business activity is the 
assembly of components purchased from both controlled and uncontrolled 
suppliers, it may not be possible to apply the method solely to 
financial data related to the controlled transactions. In such a case, 
the reliability of the results derived from the application of this 
method will be reduced.
    (2) The degree of consistency between the controlled and 
uncontrolled taxpayers in accounting practices that materially affect 
the items that determine the amount and allocation of operating profit 
affects the reliability of the result. Thus, for example, if differences 
in inventory and other cost accounting practices would materially affect 
operating profit, the ability to make reliable adjustments for such 
differences would affect the reliability of the results. Further, 
accounting consistency among the participants in the controlled 
transaction is required to ensure that the items determining the amount 
and allocation of operating profit are measured on a consistent basis.
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec.  1.482-3, 1.482-4, 1.482-5, and 1.482-9, the comparable 
profit split relies exclusively on external market benchmarks. As 
indicated in Sec.  1.482-1(c)(2)(i), as the degree of comparability 
between the controlled and uncontrolled transactions increases, the 
relative weight accorded the analysis under this method will increase. 
In addition, the reliability of the analysis under this method may be 
enhanced by the fact that all parties to the controlled transaction are 
evaluated under the comparable profit split. However, the reliability of 
the results of an analysis based on information from all parties to a 
transaction is affected by the reliability of the data and the 
assumptions pertaining to each party to the controlled transaction. 
Thus, if the data and assumptions are significantly more reliable with 
respect to one of the parties than with respect to the others, a 
different method, focusing solely on the results of that party, may 
yield more reliable results.
    (3) Residual profit split--(i) In general. Under this method, the 
combined operating profit or loss from the relevant business activity is 
allocated between the controlled taxpayers following the two-step 
process set forth in paragraphs (c)(3)(i)(A) and (B) of this section.
    (A) Allocate income to routine contributions. The first step 
allocates operating income to each party to the controlled transactions 
to provide a market return for its routine contributions to the relevant 
business activity. Routine contributions are contributions of the same 
or a similar kind to those made by uncontrolled taxpayers involved in 
similar business activities for which it is possible to identify market 
returns. Routine contributions ordinarily include contributions of 
tangible property, services and intangible property that are generally 
owned by uncontrolled taxpayers engaged in similar activities. A 
functional analysis is required to identify these contributions 
according to the functions performed, risks assumed, and resources 
employed by each of the controlled taxpayers. Market returns for the 
routine contributions should be determined by reference to the returns 
achieved by uncontrolled taxpayers engaged in similar activities, 
consistent with the methods described in Sec. Sec.  1.482-3, 1.482-4, 
1.482-5 and 1.482-9.
    (B) Allocate residual profit--(1) Nonroutine contributions 
generally. The allocation of income to the controlled taxpayer's routine 
contributions will not reflect profits attributable to each controlled 
taxpayer's contributions to the relevant business activity that are not 
routine (nonroutine contributions). A nonroutine contribution is a 
contribution that is not accounted for as a routine contribution. Thus, 
in cases where

[[Page 728]]

such nonroutine contributions are present, there normally will be an 
unallocated residual profit after the allocation of income described in 
paragraph (c)(3)(i)(A) of this section. Under this second step, the 
residual profit generally should be divided among the controlled 
taxpayers based upon the relative value of their nonroutine 
contributions to the relevant business activity. The relative value of 
the nonroutine contributions of each taxpayer should be measured in a 
manner that most reliably reflects each nonroutine contribution made to 
the controlled transaction and each controlled taxpayer's role in the 
nonroutine contributions. If the nonroutine contribution by one of the 
controlled taxpayers is also used in other business activities (such as 
transactions with other controlled taxpayers), an appropriate allocation 
of the value of the nonroutine contribution must be made among all the 
business activities in which it is used.
    (2) Nonroutine contributions of intangible property. In many cases, 
nonroutine contributions of a taxpayer to the relevant business activity 
may be contributions of intangible property. For purposes of paragraph 
(c)(3)(i)(B)(1) of this section, the relative value of nonroutine 
intangible property contributed by taxpayers may be measured by external 
market benchmarks that reflect the fair market value of such intangible 
property. Alternatively, the relative value of nonroutine intangible 
property contributions may be estimated by the capitalized cost of 
developing the intangible property and all related improvements and 
updates, less an appropriate amount of amortization based on the useful 
life of each intangible property. Finally, if the intangible property 
development expenditures of the parties are relatively constant over 
time and the useful life of the intangible property contributed by all 
parties is approximately the same, the amount of actual expenditures in 
recent years may be used to estimate the relative value of nonroutine 
intangible property contributions.
    (ii) Comparability and reliability considerations--(A) In general. 
Whether results derived from this method are the most reliable measure 
of the arm's length result is determined using the factors described 
under the best method rule in Sec.  1.482-1(c). Thus, comparability and 
the quality of data and assumptions must be considered in determining 
whether this method provides the most reliable measure of an arm's 
length result. The application of these factors to the residual profit 
split is discussed in paragraph (c)(3)(ii)(B), (C), and (D) of this 
section.
    (B) Comparability. The first step of the residual profit split 
relies on market benchmarks of profitability. Thus, the comparability 
considerations that are relevant for the first step of the residual 
profit split are those that are relevant for the methods that are used 
to determine market returns for the routine contributions. The second 
step of the residual profit split, however, may not rely so directly on 
market benchmarks. Thus, the reliability of the results under this 
method is reduced to the extent that the allocation of profits in the 
second step does not rely on market benchmarks.
    (C) Data and assumptions. The reliability of the results derived 
from the residual profit split is affected by the quality of the data 
and assumptions used to apply this method. In particular, the following 
factors must be considered--
    (1) The reliability of the allocation of costs, income, and assets 
as described in paragraph (c)(2)(ii)(C)(1) of this section;
    (2) Accounting consistency as described in paragraph 
(c)(2)(ii)(C)(2) of this section;
    (3) The reliability of the data used and the assumptions made in 
valuing the intangible property contributed by the participants. In 
particular, if capitalized costs of development are used to estimate the 
value of intangible property, the reliability of the results is reduced 
relative to the reliability of other methods that do not require such an 
estimate, for the following reasons. First, in any given case, the costs 
of developing the intangible may not be related to its market value. 
Second, the calculation of the capitalized costs of development may 
require the allocation of indirect costs between the relevant business 
activity and the controlled taxpayer's other activities,

[[Page 729]]

which may affect the reliability of the analysis. Finally, the 
calculation of costs may require assumptions regarding the useful life 
of the intangible property.
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec.  1.482-3, 1.482-4, 1.482-5, and 1.482-9, the first step of 
the residual profit split relies exclusively on external market 
benchmarks. As indicated in Sec.  1.482-1(c)(2)(i), as the degree of 
comparability between the controlled and uncontrolled transactions 
increases, the relative weight accorded the analysis under this method 
will increase. In addition, to the extent the allocation of profits in 
the second step is not based on external market benchmarks, the 
reliability of the analysis will be decreased in relation to an analysis 
under a method that relies on market benchmarks. Finally, the 
reliability of the analysis under this method may be enhanced by the 
fact that all parties to the controlled transaction are evaluated under 
the residual profit split. However, the reliability of the results of an 
analysis based on information from all parties to a transaction is 
affected by the reliability of the data and the assumptions pertaining 
to each party to the controlled transaction. Thus, if the data and 
assumptions are significantly more reliable with respect to one of the 
parties than with respect to the others, a different method, focusing 
solely on the results of that party, may yield more reliable results.
    (iii) Example. The provisions of this paragraph (c)(3) are 
illustrated by the following example.

    Example--Application of Residual Profit Split. (i) XYZ is a U.S. 
corporation that develops, manufactures and markets a line of products 
for police use in the United States. XYZ's research unit developed a 
bulletproof material for use in protective clothing and headgear 
(Nulon). XYZ obtains patent protection for the chemical formula for 
Nulon. Since its introduction in the U.S., Nulon has captured a 
substantial share of the U.S. market for bulletproof material.
    (ii) XYZ licensed its European subsidiary, XYZ-Europe, to 
manufacture and market Nulon in Europe. XYZ-Europe is a well- 
established company that manufactures and markets XYZ products in 
Europe. XYZ-Europe has a research unit that adapts XYZ products for the 
defense market, as well as a well-developed marketing network that 
employs brand names that it developed.
    (iii) XYZ-Europe's research unit alters Nulon to adapt it to 
military specifications and develops a high-intensity marketing campaign 
directed at the defense industry in several European countries. 
Beginning with the 1995 taxable year, XYZ-Europe manufactures and sells 
Nulon in Europe through its marketing network under one of its brand 
names.
    (iv) For the 1995 taxable year, XYZ has no direct expenses 
associated with the license of Nulon to XYZ-Europe and incurs no 
expenses related to the marketing of Nulon in Europe. For the 1995 
taxable year, XYZ-Europe's Nulon sales and pre-royalty expenses are $500 
million and $300 million, respectively, resulting in net pre-royalty 
profit of $200 million related to the Nulon business. The operating 
assets employed in XYZ-Europe's Nulon business are $200 million. Given 
the facts and circumstances, the district director determines under the 
best method rule that a residual profit split will provide the most 
reliable measure of an arm's length result. Based on an examination of a 
sample of European companies performing functions similar to those of 
XYZ-Europe, the district director determines that an average market 
return on XYZ-Europe's operating assets in the Nulon business is 10 
percent, resulting in a market return of $20 million (10% x $200 
million) for XYZ- Europe's Nulon business, and a residual profit of $180 
million.
    (v) Since the first stage of the residual profit split allocated 
profits to XYZ-Europe's contributions other than those attributable to 
highly valuable intangible property, it is assumed that the residual 
profit of $180 million is attributable to the valuable intangibles 
related to Nulon, i.e., the European brand name for Nulon and the Nulon 
formula (including XYZ-Europe's modifications). To estimate the relative 
values of these intangibles, the district director compares the ratios 
of the capitalized value of expenditures as of 1995 on Nulon-related 
research and development and marketing over the 1995 sales related to 
such expenditures.
    (vi) Because XYZ's protective product research and development 
expenses support the worldwide protective product sales of the XYZ 
group, it is necessary to allocate such expenses among the worldwide 
business activities to which they relate. The district director 
determines that it is reasonable to allocate the value of these expenses 
based on worldwide protective product sales. Using information on the 
average useful life of its investments in protective product research 
and development, the district director capitalizes and amortizes XYZ's 
protective product research and development expenses. This analysis 
indicates that the capitalized research and development expenditures 
have a value

[[Page 730]]

of $0.20 per dollar of global protective product sales in 1995.
    (vii) XYZ-Europe's expenditures on Nulon research and development 
and marketing support only its sales in Europe. Using information on the 
average useful life of XYZ-Europe's investments in marketing and 
research and development, the district director capitalizes and 
amortizes XYZ-Europe's expenditures and determines that they have a 
value in 1995 of $0.40 per dollar of XYZ-Europe's Nulon sales.
    (viii) Thus, XYZ and XYZ-Europe together contributed $0.60 in 
capitalized intangible development expenses for each dollar of XYZ-
Europe's protective product sales for 1995, of which XYZ contributed 
one-third (or $0.20 per dollar of sales). Accordingly, the district 
director determines that an arm's length royalty for the Nulon license 
for the 1995 taxable year is $60 million, i.e., one-third of XYZ-
Europe's $180 million in residual Nulon profit.
    (d) Effective/applicability date--(1) In general. The provisions of 
paragraphs (c)(2)(ii)(B)(1) and (D), (c)(3)(i)(A) and (B), and 
(c)(3)(ii)(D) of this section are generally applicable for taxable years 
beginning after July 31, 2009.
    (2) Election to apply regulation to earlier taxable years. A person 
may elect to apply the provisions of paragraphs (c)(2)(ii)(B)(1) and 
(D), (c)(3)(i)(A) and (B), and (c)(3)(ii)(D) of this section to earlier 
taxable years in accordance with the rules set forth in Sec.  1.482-
9(n)(2).

[T.D. 8552, 59 FR 35025, July 8, 1994; 60 FR 16382, Mar. 30, 1995, as 
amended by T.D. 9278, 71 FR 44486, Aug. 4, 2006; T.D. 9456, 74 FR 38844, 
Aug. 4, 2009; 74 FR 46345, Sept. 9, 2009]



Sec.  1.482-7  Methods to determine taxable income in connection 
with a cost sharing arrangement.

    (a) In general. The arm's length amount charged in a controlled 
transaction reasonably anticipated to contribute to developing 
intangibles pursuant to a cost sharing arrangement (CSA), as described 
in paragraph (b) of this section, must be determined under a method 
described in this section. Each method must be applied in accordance 
with the provisions of Sec.  1.482-1, except as those provisions are 
modified in this section.
    (1) RAB share method for cost sharing transactions (CSTs). See 
paragraph (b)(1)(i) of this section regarding the requirement that 
controlled participants, as defined in section (j)(1)(i) of this 
section, share intangible development costs (IDCs) in proportion to 
their shares of reasonably anticipated benefits (RAB shares) by entering 
into cost sharing transactions (CSTs).
    (2) Methods for platform contribution transactions (PCTs). The arm's 
length amount charged in a platform contribution transaction (PCT) 
described in paragraph (b)(1)(ii) of this section must be determined 
under the method or methods applicable under the other section or 
sections of the section 482 regulations, as supplemented by paragraph 
(g) of this section. See Sec.  1.482-1(b)(2)(ii) (Selection of category 
of method applicable to transaction), Sec.  1.482-1(b)(2)(iii) 
(Coordination of methods applicable to certain intangible development 
arrangements), and paragraph (g) of this section (Supplemental guidance 
on methods applicable to PCTs).
    (3) Methods for other controlled transactions--(i) Contribution to a 
CSA by a controlled taxpayer that is not a controlled participant. If a 
controlled taxpayer that is not a controlled participant contributes to 
developing a cost shared intangible, as defined in section (j)(1)(i) of 
this section, it must receive consideration from the controlled 
participants under the rules of Sec.  1.482-4(f)(4) (Contribution to the 
value of an intangible owned by another). Such consideration will be 
treated as an intangible development cost for purposes of paragraph (d) 
of this section.
    (ii) Transfer of interest in a cost shared intangible. If at any 
time (during the term, or upon or after the termination, of a CSA) a 
controlled participant transfers an interest in a cost shared intangible 
to another controlled taxpayer, the controlled participant must receive 
an arm's length amount of consideration from the transferee under the 
rules of Sec. Sec.  1.482-4 through 1.482-6 as supplemented by paragraph 
(f)(4) of this section regarding arm's length consideration for a change 
in participation. For this purpose, a capability variation described in 
paragraph (f)(3) of this section is considered to be a controlled 
transfer of interests in cost shared intangibles.
    (iii) Other controlled transactions in connection with a CSA. 
Controlled

[[Page 731]]

transactions between controlled participants that are not PCTs or CSTs 
and are not described in paragraph (a)(3)(ii) of this section (for 
example, provision of a cross operating contribution, as defined in 
paragraph (j)(1)(i) of this section, or make-or-sell rights, as defined 
in paragraph (c)(4) of this section) require arm's length consideration 
under the rules of Sec. Sec.  1.482-1 through 1.482-6, and 1.482-9 as 
supplemented by paragraph (g)(2)(iv) of this section.
    (iv) Controlled transactions in the absence of a CSA. If a 
controlled transaction is reasonably anticipated to contribute to 
developing intangibles pursuant to an arrangement that is not a CSA 
described in paragraph (b)(1) or (5) of this section, whether the 
results of any such controlled transaction are consistent with an arm's 
length result must be determined under the applicable rules of the other 
sections of the regulations under section 482. For example, an 
arrangement for developing intangibles in which one controlled 
taxpayer's costs of developing the intangibles significantly exceeds its 
share of reasonably anticipated benefits from exploiting the developed 
intangibles would not in substance be a CSA, as described in paragraphs 
(b)(1)(i) through (iii) of this section or paragraph (b)(5)(i) of this 
section. In such a case, unless the rules of this section are applicable 
by reason of paragraph (b)(5) of this section, the arrangement must be 
analyzed under other applicable sections of regulations under section 
482 to determine whether it achieves arm's length results, and if not, 
to determine any allocations by the Commissioner that are consistent 
with such other regulations under section 482. See Sec.  1.482-
1(b)(2)(ii) (Selection of category of method applicable to transaction) 
and (iii) (Coordination of methods applicable to certain intangible 
development arrangements).
    (4) Coordination with the arm's length standard. A CSA produces 
results that are consistent with an arm's length result within the 
meaning of Sec.  1.482-1(b)(1) if, and only if, each controlled 
participant's IDC share (as determined under paragraph (d)(4) of this 
section) equals its RAB share, each controlled participant compensates 
its RAB share of the value of all platform contributions by other 
controlled participants, and all other requirements of this section are 
satisfied.
    (b) Cost sharing arrangement. A cost sharing arrangement is an 
arrangement by which controlled participants share the costs and risks 
of developing cost shared intangibles in proportion to their RAB shares. 
An arrangement is a CSA if and only if the requirements of paragraphs 
(b)(1) through (4) of this section are met.
    (1) Substantive requirements--(i) CSTs. All controlled participants 
must commit to, and in fact, engage in cost sharing transactions. In 
CSTs, the controlled participants make payments to each other (CST 
Payments) as appropriate, so that in each taxable year each controlled 
participant's IDC share is in proportion to its respective RAB share.
    (ii) PCTs. All controlled participants must commit to, and in fact, 
engage in platform contributions transactions to the extent that there 
are platform contributions pursuant to paragraph (c) of this section. In 
a PCT, each other controlled participant (PCT Payor) is obligated to, 
and must in fact, make arm's length payments (PCT Payments) to each 
controlled participant (PCT Payee) that provides a platform 
contribution. For guidance on determining such arm's length obligation, 
see paragraph (g) of this section.
    (iii) Divisional interests. Each controlled participant must receive 
a non-overlapping interest in the cost shared intangibles without 
further obligation to compensate another controlled participant for such 
interest.
    (iv) Examples. The following examples illustrate the principles of 
this paragraph (b)(1):

    Example 1. Company A and Company B, who are members of the same 
controlled group, execute an agreement to jointly develop vaccine X and 
own the exclusive rights to commercially exploit vaccine X in their 
respective territories, which together comprise the whole world. The 
agreement provides that they will share some, but not all, of the costs 
for developing Vaccine X in proportion to RAB share. Such agreement is 
not a CSA because Company A and Company B have not agreed to share all 
of the IDCs in proportion to their respective RAB shares.

[[Page 732]]

    Example 2. Company A and Company B agree to share all the costs of 
developing Vaccine X. The agreement also provides for employing certain 
resources and capabilities of Company A in this program including a 
skilled research team and certain research facilities, and provides for 
Company B to make payments to Company A in this respect. However, the 
agreement expressly provides that the program will not employ, and so 
Company B is expressly relieved of the payments in regard to, certain 
software developed by Company A as a medical research tool to model 
certain cellular processes expected to be implicated in the operation of 
Vaccine X even though such software would reasonably be anticipated to 
be relevant to developing Vaccine X and, thus, would be a platform 
contribution. See paragraph (c) of this section. Such agreement is not a 
CSA because Company A and Company B have not engaged in a necessary PCT 
for purposes of developing Vaccine X.
    Example 3. Companies C and D, who are members of the same controlled 
group, enter into a CSA. In the first year of the CSA, C and D conduct 
the intangible development activity, as described in paragraph (d)(1) of 
this section. The total IDCs in regard to such activity are $3,000,000 
of which C and D pay $2,000,000 and $1,000,000, respectively, directly 
to third parties. As between C and D, however, their CSA specifies that 
they will share all IDCs in accordance with their RAB shares (as 
described in paragraph (e)(1) of this section), which are 60% for C and 
40% for D. It follows that C should bear $1,800,000 of the total IDCs 
(60% of total IDCs of $3,000,000) and D should bear $1,200,000 of the 
total IDCs (40% of total IDCs of $3,000,000). D makes a CST payment to C 
of $200,000, that is, the amount by which D's share of IDCs in 
accordance with its RAB share exceeds the amount of IDCs initially borne 
by D ($1,200,000-$1,000,000), and which also equals the amount by which 
the total IDCs initially borne by C exceeds its share of IDCS in 
accordance with its RAB share ($2,000,000--$1,800,000). As a result of 
D's CST payment to C, the IDC shares of C and D are in proportion to 
their respective RAB shares.

    (2) Administrative requirements. The CSA must meet the requirements 
of paragraph (k) of this section.
    (3) Date of a PCT. The controlled participants must enter into a PCT 
as of the earliest date on or after the CSA is entered into on which a 
platform contribution is reasonably anticipated to contribute to 
developing cost shared intangibles.
    (4) Divisional interests--(i) In general. Pursuant to paragraph 
(b)(1)(iii) of this section, each controlled participant must receive a 
non-overlapping interest in the cost shared intangibles without further 
obligation to compensate another controlled participant for such 
interest. Each controlled participant must be entitled to the perpetual 
and exclusive right to the profits from transactions of any member of 
the controlled group that includes the controlled participant with 
uncontrolled taxpayers to the extent that such profits are attributable 
to such interest in the cost shared intangibles.
    (ii) Territorial based divisional interests. The CSA may divide all 
interests in cost shared intangibles on a territorial basis as follows. 
The entire world must be divided into two or more non-overlapping 
geographic territories. Each controlled participant must receive at 
least one such territory, and in the aggregate all the participants must 
receive all such territories. Each controlled participant will be 
assigned the perpetual and exclusive right to exploit the cost shared 
intangibles through the use, consumption, or disposition of property or 
services in its territories. Thus, compensation will be required if 
other members of the controlled group exploit the cost shared 
intangibles in such territory.
    (iii) Field of use based divisional interests. The CSA may divide 
all interests in cost shared intangibles on the basis of all uses 
(whether or not known at the time of the division) to which cost shared 
intangibles are to be put as follows. All anticipated uses of cost 
shared intangibles must be identified. Each controlled participant must 
be assigned at least one such anticipated use, and in the aggregate all 
the participants must be assigned all such anticipated uses. Each 
controlled participant will be assigned the perpetual and exclusive 
right to exploit the cost shared intangibles through the use or uses 
assigned to it and one controlled participant must be assigned the 
exclusive and perpetual right to exploit cost shared intangibles through 
any unanticipated uses.
    (iv) Other divisional bases. (A) In the event that the CSA does not 
divide interests in the cost shared intangibles on the basis of 
exclusive territories or fields of use as described in paragraphs 
(b)(4)(ii) and (iii) of this section, the

[[Page 733]]

CSA may adopt some other basis on which to divide all interests in the 
cost shared intangibles among the controlled participants, provided that 
each of the following criteria is met:
    (1) The basis clearly and unambiguously divides all interests in 
cost shared intangibles among the controlled participants.
    (2) The consistent use of such basis for the division of all 
interests in the cost shared intangibles can be dependably verified from 
the records maintained by the controlled participants.
    (3) The rights of the controlled participants to exploit cost shared 
intangibles are non-overlapping, exclusive, and perpetual.
    (4) The resulting benefits associated with each controlled 
participant's interest in cost shared intangibles are predictable with 
reasonable reliability.
    (B) See paragraph (f)(3) of this section for rules regarding the 
requirement of arm's length consideration for changes in participation 
in CSAs involving divisions of interest described in this paragraph 
(b)(4)(iv).
    (v) Examples. The following examples illustrate the principles of 
this paragraph (b)(4):

    Example 1. Companies P and S, both members of the same controlled 
group, enter into a CSA to develop product Z. Under the CSA, P receives 
the interest in product Z in the United States and S receives the 
interest in product Z in the rest of the world, as described in 
paragraph (b)(4)(ii) of this section. Both P and S have plants for 
manufacturing product Z located in their respective geographic 
territories. However, for commercial reasons, product Z is nevertheless 
manufactured by P in the United States for sale to customers in certain 
locations just outside the United States in close proximity to P's U.S. 
manufacturing plant. Because S owns the territorial rights outside the 
United States, P must compensate S to ensure that S realizes all the 
cost shared intangible profits from P's sales of product Z in S's 
territory. The pricing of such compensation must also ensure that P 
realizes an appropriate return for its manufacturing efforts. Benefits 
projected with respect to such sales will be included for purposes of 
estimating S's, but not P's, RAB share.
    Example 2. The facts are the same as in Example 1 except that P and 
S agree to divide their interest in product Z based on site of 
manufacturing. P will have exclusive and perpetual rights in product Z 
manufactured in facilities owned by P. S will have exclusive and 
perpetual rights to product Z manufactured in facilities owned by S. P 
and S agree that neither will license manufacturing rights in product Z 
to any related or unrelated party. Both P and S maintain books and 
records that allow production at all sites to be verified. Both own 
facilities that will manufacture product Z and the relative capacities 
of these sites are known. All facilities are currently operating at near 
capacity and are expected to continue to operate at near capacity when 
product Z enters production so that it will not be feasible to shift 
production between P's and S's facilities. P and S have no plans to 
build new facilities and the lead time required to plan and build a 
manufacturing facility precludes the possibility that P or S will build 
a new facility during the period for which sales of Product Z are 
expected. Based on these facts, this basis for the division of interests 
in Product Z is a division described in paragraph (b)(4)(iv) of this 
section. The basis for the division of interest is unambiguous and 
clearly defined and its use can be dependably verified. P and S both 
have non-overlapping, exclusive and perpetual rights in Product Z. The 
division of interest results in the participant's relative benefits 
being predictable with reasonable reliability.
    Example 3. The facts are the same as in Example 2 except that P's 
and S's manufacturing facilities are not expected to operate at full 
capacity when product Z enters production. Production of Product Z can 
be shifted at any time between sites owned by P and sites owned by S, 
although neither P nor S intends to shift production as a result of the 
agreement. The division of interests in Product Z between P and S based 
on manufacturing site is not a division described in paragraph 
(b)(4)(iv) of this section because their relative shares of benefits are 
not predictable with reasonable reliability. The fact that neither P nor 
S intends to shift production is irrelevant.

    (5) Treatment of certain arrangements as CSAs--(i) Situation in 
which Commissioner must treat arrangement as a CSA. The Commissioner 
must apply the rules of this section to an arrangement among controlled 
taxpayers if the administrative requirements of paragraph (b)(2) of this 
section are met with respect to such arrangement and the controlled 
taxpayers reasonably concluded that such arrangement was a CSA meeting 
the requirements of paragraphs (b)(1), (3), and (4) of this section.
    (ii) Situation in which Commissioner may treat arrangement as a CSA. 
For arrangements among controlled taxpayers not described in paragraph

[[Page 734]]

(b)(5)(i) of this section, the Commissioner may apply the provisions of 
this section if the Commissioner concludes that the administrative 
requirements of paragraph (b)(2) of this section are met, and, 
notwithstanding technical failure to meet the substantive requirements 
of paragraph (b)(1), (3), or (4) of this section, the rules of this 
section will provide the most reliable measure of an arm's length 
result. See Sec.  1.482-1(c)(1) (the best method rule). For purposes of 
applying this paragraph (b)(5)(ii), any such arrangement shall be 
interpreted by reference to paragraph (k)(1)(iv) of this section.
    (iii) Examples. The following examples illustrate the principles of 
this paragraph (b)(5). In the examples, assume that Companies P and S 
are both members of the same controlled group.

    Example 1. (i) P owns the patent on a formula for a capsulated pain 
reliever, P-Cap. P reasonably anticipates, pending further research and 
experimentation, that the P-Cap formula could form the platform for a 
formula for P-Ves, an effervescent version of P-Cap. P also owns 
proprietary software that it reasonably anticipates to be critical to 
the research efforts. P and S execute a contract that purports to be a 
CSA by which they agree to proportionally share the costs and risks of 
developing a formula for P-Ves. The agreement reflects the various 
contractual requirements described in paragraph (k)(1) of this section 
and P and S comply with the documentation, accounting, and reporting 
requirements of paragraphs (k)(2) through (4) of this section. Both the 
patent rights for P-Cap and the software are reasonably anticipated to 
contribute to the development of P-Ves and therefore are platform 
contributions for which compensation is due from S as part of PCTs. 
Though P and S enter into and implement a PCT for the P-Cap patent 
rights that satisfies the arm's length standard, they fail to enter into 
a PCT for the software.
    (ii) In this case, P and S have substantially complied with the 
contractual requirements of paragraph (k)(1) of this section and the 
documentation, accounting, and reporting requirements of paragraphs 
(k)(2) through (4) of this section and therefore have met the 
administrative requirements of paragraph (b)(2) of this section. 
However, because they did not enter into a PCT, as required under 
paragraphs (b)(1)(ii) and (b)(3) of this section, for the software that 
was reasonably anticipated to contribute to the development of P-Ves 
(see paragraph (c) of this section), they cannot reasonably conclude 
that their arrangement was a CSA. Accordingly, the Commissioner is not 
required under paragraph (b)(5)(i) of this section to apply the rules of 
this section to their arrangement.
    (iii) Nevertheless, the arrangement between P and S closely 
resembles a CSA. If the Commissioner concludes that the rules of this 
section provide the most reliable measure of an arm's length result for 
such arrangement, then pursuant to paragraph (b)(5)(ii) of this section, 
the Commissioner may apply the rules of this section and treat P and S 
as entering into a PCT for the software in accordance with the 
requirements of paragraph (b)(1)(ii) of this section, and make any 
appropriate allocations under paragraph (i) of this section. 
Alternatively, the Commissioner may conclude that the rules of this 
section do not provide the most reliable measure of an arm's length 
result. In such case, the arrangement would be analyzed under the 
methods under other sections of the 482 regulations to determine whether 
the arrangement reaches an arm's length result.
    Example 2. The facts are the same as in Example 1 except that P and 
S do enter into and implement a PCT for the software as required under 
this paragraph (b). The Commissioner determines that the PCT Payments 
for the software were not arm's length; nevertheless, under the facts 
and circumstances at the time they entered into the CSA and PCTs, P and 
S reasonably concluded their arrangement to be a CSA. Because P and S 
have met the requirements of paragraph (b)(2) of this section and 
reasonably concluded their arrangement is a CSA, pursuant to paragraph 
(b)(5)(i) of this section, the Commissioner must apply the rules of this 
section to their arrangement. Accordingly, the Commissioner treats the 
arrangement as a CSA and makes adjustments to the PCT Payments as 
appropriate under this section to achieve an arm's length result for the 
PCT for the software.
    Example 3. (i) The facts are the same as in Example 1 except that P 
and S do enter into a PCT for the software as required under this 
paragraph (b). The agreement entered into by P and S provides for a 
fixed consideration of $50 million per year for four years, payable at 
the end of each year. This agreement satisfies the arm's length 
standard. However, S actually pays P consideration at the end of each 
year in the form of four annual royalties equal to two percent of sales. 
While such royalties at the time of the PCT were expected to be $50 
million per year, actual sales during the first year were less than 
anticipated and the first royalty payment was only $25 million.
    (ii) In this case, P and S failed to implement the terms of their 
agreement. Under these circumstances, P and S could not reasonably 
conclude that their arrangement was a CSA, as described in paragraph 
(b)(1) of this section. Accordingly, the Commissioner is not required 
under paragraph (b)(5)(i) of

[[Page 735]]

this section to apply the rules of this section to their arrangement.
    (iii) Nevertheless, the arrangement between P and S closely 
resembles a CSA. If the Commissioner concludes that the rules of this 
section provide the most reliable measure of an arm's length result for 
such arrangement, then pursuant to paragraph (b)(5)(ii) of this section, 
the Commissioner may apply the rules of this section and make any 
appropriate allocations under paragraph (i) of this section. 
Alternatively, the Commissioner may conclude that the rules of this 
section do not provide the most reliable measure of an arm's length 
result. In such case, the arrangement would be analyzed under the 
methods under other sections of the 482 regulations to determine whether 
the arrangement reaches an arm's length result.
    Example 4. (i) The facts are the same as in Example 1 except that P 
does not own proprietary software and P and S use a method for 
determining the arm's length amount of the PCT Payment for the P-Cap 
patent rights different from the method used in Example 1.
    (ii) P and S determine that the arm's length amount of the PCT 
Payments for the P-Cap patent is $10 million. However, the Commissioner 
determines the best method for determining the arm's length amount of 
the PCT Payments for the P-Cap patent rights and under such method the 
arm's length amount is $100 million. To determine this $10 million 
present value, P and S assumed a useful life of eight years for the 
platform contribution, because the P-Cap patent rights will expire after 
eight years. However, the P-Cap patent rights are expected to lead to 
benefits attributable to exploitation of the cost shared intangibles 
extending many years beyond the expiration of the P-Cap patent, because 
use of the P-Cap patent rights will let P and S bring P-Ves to market 
before the competition, and because P and S expect to apply for 
additional patents covering P-Ves, which would bar competitors from 
selling that product for many future years. The assumption by P and S of 
a useful life for the platform contribution that is less than the 
anticipated period of exploitation of the cost shared intangibles is 
contrary to paragraph (g)(2)(ii) of this section, and reduces the 
reliability of the method used by P and S.
    (iii) The method used by P and S employs a declining royalty. The 
royalty starts at 8% of sales, based on an application of the CUT method 
in which the purported CUTs all involve licenses to manufacture and sell 
the current generation of P-Cap, and declines to 0% over eight years, 
declining by 1% each year. Such make-or-sell rights are fundamentally 
different from use of the P-Cap patent rights to generate a new product. 
This difference raises the issue of whether the make-or-sell rights are 
sufficiently comparable to the rights that are the subject of the PCT 
Payment. See Sec.  1.482-4(c). While a royalty rate for make-or-sell 
rights can form the basis for a reliable determination of an arm's 
length PCT Payment in the CUT-based implementation of the income method 
described in paragraph (g)(4) of this section, under that method such 
royalty rate does not decline to zero. Therefore, the use of a declining 
royalty rate based on an initial rate for make-or-sell rights further 
reduces the reliability of the method used by P and S.
    (iv) Sales of the next-generation product are not anticipated until 
after seven years, at which point the royalty rate will have declined to 
1%. The temporal mismatch between the period of the royalty rate decline 
and the period of exploitation raises further concerns about the 
method's reliability.
    (v) For the reasons given in paragraphs (ii) through (iv) of this 
Example 4, the method used by P and S is so unreliable and so contrary 
to provisions of this section that P and S could not reasonably conclude 
that they had contracted to make arm's length PCT Payments as required 
by paragraphs (b)(1)(ii) and (b)(3) of this section, and thus could not 
reasonably conclude that their arrangement was a CSA. Accordingly, the 
Commissioner is not required under paragraph (b)(5)(i) of this section 
to apply the rules of this section to their arrangement.
    (vi) Nevertheless, the arrangement between P and S closely resembles 
a CSA. If the Commissioner concludes that the rules of this section 
provide the most reliable measure of an arm's length result for such 
arrangement, then pursuant to paragraph (b)(5)(ii) of this section, the 
Commissioner may apply the rules of this section and make any 
appropriate allocations under paragraph (i) of this section. 
Alternatively, the Commissioner may conclude that the rules of this 
section do not provide the most reliable measure of an arm's length 
result. In such case, the arrangement would be analyzed under the 
methods under other section 482 regulations to determine whether the 
arrangement reaches an arm's length result.

    (6) Entity classification of CSAs. See Sec.  301.7701-1(c) of this 
chapter for the classification of CSAs for purposes of the Internal 
Revenue Code.
    (c) Platform contributions--(1) In general. A platform contribution 
is any resource, capability, or right that a controlled participant has 
developed, maintained, or acquired externally to the intangible 
development activity (whether prior to or during the course of the CSA) 
that is reasonably anticipated to contribute to developing cost shared 
intangibles. The determination whether a resource, capability, or right

[[Page 736]]

is reasonably anticipated to contribute to developing cost shared 
intangibles is ongoing and based on the best available information. 
Therefore, a resource, capability, or right reasonably determined not to 
be a platform contribution as of an earlier point in time, may be 
reasonably determined to be a platform contribution at a later point in 
time. The PCT obligation regarding a resource or capability or right 
once determined to be a platform contribution does not terminate merely 
because it may later be determined that such resource or capability or 
right has not contributed, and no longer is reasonably anticipated to 
contribute, to developing cost shared intangibles. Notwithstanding the 
other provisions of this paragraph (c), platform contributions do not 
include rights in land or depreciable tangible property, and do not 
include rights in other resources acquired by IDCs. See paragraph (d)(1) 
of this section.
    (2) Terms of platform contributions--(i) Presumed to be exclusive. 
For purposes of a PCT, the PCT Payee's provision of a platform 
contribution is presumed to be exclusive. Thus, it is presumed that the 
platform resource, capability, or right is not reasonably anticipated to 
be committed to any business activities other than the CSA Activity, as 
defined in paragraph (j)(1)(i) of this section, whether carried out by 
the controlled participants, other controlled taxpayers, or uncontrolled 
taxpayers.
    (ii) Rebuttal of exclusivity. The controlled participants may rebut 
the presumption set forth in paragraph (c)(2)(i) of this section to the 
satisfaction of the Commissioner. For example, if the platform resource 
is a research tool, then the controlled participants could rebut the 
presumption by establishing to the satisfaction of the Commissioner 
that, as of the date of the PCT, the tool is reasonably anticipated not 
only to contribute to the CSA Activity but also to be licensed to an 
uncontrolled taxpayer. In such case, the PCT Payments may need to be 
prorated as described in paragraph (c)(2)(iii) of this section.
    (iii) Proration of PCT Payments to the extent allocable to other 
business activities--(A) In general. Some transfer pricing methods 
employed to determine the arm's length amount of the PCT Payments do so 
by considering the overall value of the platform contributions as 
opposed to, for example, the value of the anticipated use of the 
platform contributions in the CSA Activity. Such a transfer pricing 
method is consistent with the presumption that the platform contribution 
is exclusive (that is, that the resources, capabilities or rights that 
are the subject of a platform contribution are reasonably anticipated to 
contribute only to the CSA Activity). See paragraph (c)(2)(i) (Terms of 
platform contributions--Presumed to be exclusive) of this section. The 
PCT Payments determined under such transfer pricing method may have to 
be prorated if the controlled participants can rebut the presumption 
that the platform contribution is exclusive to the satisfaction of the 
Commissioner as provided in paragraph (c)(2)(ii) of this section. In the 
case of a platform contribution that also contributes to lines of 
business of a PCT Payor that are not reasonably anticipated to involve 
exploitation of the cost shared intangibles, the need for explicit 
proration may in some cases be avoided through aggregation of 
transactions. See paragraph (g)(2)(iv) of this section (Aggregation of 
transactions).
    (B) Determining the proration of PCT Payments. Proration will be 
done on a reasonable basis in proportion to the relative economic value, 
as of the date of the PCT, reasonably anticipated to be derived from the 
platform contribution by the CSA Activity as compared to the value 
reasonably anticipated to be derived from the platform contribution by 
other business activities. In the case of an aggregate valuation done 
under the principles of paragraph (g)(2)(iv) of this section that 
addresses payment for resources, capabilities, or rights used for 
business activities other than the CSA Activity (for example, the right 
to exploit an existing intangible without further development), the 
proration of the aggregate payments may have to reflect the economic 
value attributable to such resources, capabilities, or rights as well. 
For purposes of the best method rule under Sec.  1.482-1(c), the 
reliability of the analysis under a method that requires proration 
pursuant to this paragraph is

[[Page 737]]

reduced relative to the reliability of an analysis under a method that 
does not require proration.
    (3) Categorization of the PCT. For purposes of Sec.  1.482-
1(b)(2)(ii) and paragraph (a)(2) of this section, a PCT must be 
identified by the controlled participants as a particular type of 
transaction (for example, a license for royalty payments). See paragraph 
(k)(2)(ii)(H) of this section. Such designation must be consistent with 
the actual conduct of the controlled participants. If the conduct is 
consistent with different, economically equivalent types of transactions 
then the controlled participants may designate the PCT as being any of 
such types of transactions. If the controlled participants fail to make 
such designation in their documentation, the Commissioner may make a 
designation consistent with the principles of paragraph (k)(1)(iv) of 
this section.
    (4) Certain make-or-sell rights excluded--(i) In general. Any right 
to exploit an existing resource, capability, or right without further 
development of such item, such as the right to make, replicate, license, 
or sell existing products, does not constitute a platform contribution 
to a CSA (and the arm's length compensation for such rights (make-or-
sell rights) does not satisfy the compensation obligation under a PCT) 
unless exploitation without further development of such item is 
reasonably anticipated to contribute to developing or further developing 
a cost shared intangible.
    (ii) Examples. The following examples illustrate the principles of 
this paragraph (c)(4):

    Example 1. P and S, which are members of the same controlled group, 
execute a CSA. Under the CSA, P and S will bear their RAB shares of IDCs 
for developing the second generation of ABC, a computer software 
program. Prior to that arrangement, P had incurred substantial costs and 
risks to develop ABC. Concurrent with entering into the arrangement, P 
(as the licensor) executes a license with S (as the licensee) by which S 
may make and sell copies of the existing ABC. Such make-or-sell rights 
do not constitute a platform contribution to the CSA. The rules of 
Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6 must be applied to 
determine the arm's length consideration in connection with the make-or-
sell licensing arrangement. In certain circumstances, this determination 
of the arm's length consideration may be done on an aggregate basis with 
the evaluation of compensation obligations pursuant to the PCTs entered 
into by P and S in connection with the CSA. See paragraph (g)(2)(iv) of 
this section.
    Example 2. (i) P, a software company, has developed and currently 
exploits software program ABC. P and S enter into a CSA to develop 
future generations of ABC. The ABC source code is the platform on which 
future generations of ABC will be built and is therefore a platform 
contribution of P for which compensation is due from S pursuant to a 
PCT. Concurrent with entering into the CSA, P licenses to S the make-or-
sell rights for the current version of ABC. P has entered into similar 
licenses with uncontrolled parties calling for sales-based royalty 
payments at a rate of 20%. The current version of ABC has an expected 
product life of three years. P and S enter into a contingent payment 
agreement to cover both the PCT Payments due from S for P's platform 
contribution and payments due from S for the make-or-sell license. Based 
on the uncontrolled make-or-sell licenses, P and S agree on a sales-
based royalty rate of 20% in Year 1 that declines on a straight line 
basis to 0% over the 3 year product life of ABC.
    (ii) The make-or-sell rights for the current version of ABC are not 
platform contributions, though paragraph (g)(2)(iv) of this section 
provides for the possibility that the most reliable determination of an 
arm's length charge for the platform contribution and the make-or-sell 
license may be one that values the two transactions in the aggregate. A 
contingent payment schedule based on the uncontrolled make-or-sell 
licenses may provide an arm's length charge for the separate make-or-
sell license between P and S, provided the royalty rates in the 
uncontrolled licenses similarly decline, but as a measure of the 
aggregate PCT and licensing payments it does not account for the arm's 
length value of P's platform contributions which include the rights in 
the source code and future development rights in ABC.
    Example 3. S is a controlled participant that owns Patent Q, which 
protects S's use of a research tool that is helpful in developing and 
testing new pharmaceutical compounds. The research tool, which is not 
itself such a compound, is used in the CSA Activity to develop such 
compounds. However, the CSA Activity is not anticipated to result in the 
further development of the research tool or in patents based on Patent 
Q. Although the right to use Patent Q is not anticipated to result in 
the further development of Patent Q or the technology that it protects, 
that right constitutes a platform contribution (as opposed to make-or-
sell rights) because it is

[[Page 738]]

anticipated to contribute to the research activity to develop cost 
shared intangibles relating to pharmaceutical compounds covered by the 
CSA.

    (5) Examples. The following examples illustrate the principles of 
this paragraph (c). In each example, Companies P and S are members of 
the same controlled group, and execute a CSA providing that each will 
have the exclusive right to exploit cost shared intangibles in its own 
territory. See paragraph (b)(4)(ii) of this section (Territorial based 
divisional interests).

    Example 1. Company P has developed and currently markets version 1.0 
of a new software application XYZ. Company P and Company S execute a CSA 
under which they will share the IDCs for developing future versions of 
XYZ. Version 1.0 is reasonably anticipated to contribute to the 
development of future versions of XYZ and therefore Company P's rights 
in version 1.0 constitute a platform contribution from Company P that 
must be compensated by Company S pursuant to a PCT. Pursuant to 
paragraph (c)(3) of this section, the controlled participants designate 
the platform contribution as a transfer of intangibles that would 
otherwise be governed by Sec.  1.482-4, if entered into by controlled 
parties. Accordingly, pursuant to paragraph (a)(2) of this section, the 
applicable method for determining the arm's length value of the 
compensation obligation under the PCT between Company P and Company S 
will be governed by Sec.  1.482-4 as supplemented by paragraph (g) of 
this section. Absent a showing to the contrary by P and S, the platform 
contribution in this case is presumed to be the exclusive provision of 
the benefit of all rights in version 1.0, other than the rights 
described in paragraph (c)(4) of this section (Certain make-or-sell 
rights excluded). This includes the right to use version 1.0 for 
purposes of research and the exclusive right in S's territory to exploit 
any future products that incorporated the technology of version 1.0, and 
would cover a term extending as long as the controlled participants were 
to exploit future versions of XYZ or any other product based on the 
version 1.0 platform. The compensation obligation of Company S pursuant 
to the PCT will reflect the full value of the platform contribution, as 
limited by Company S's RAB share.

    Example 2. Company P and Company S execute a CSA under which they 
will share the IDCs for developing Vaccine Z. Company P will commit to 
the project its research team that has successfully developed a number 
of other vaccines. The expertise and existing integration of the 
research team is a unique resource or capability of Company P which is 
reasonably anticipated to contribute to the development of Vaccine Z. 
Therefore, P's provision of the capabilities of the research team 
constitute a platform contribution for which compensation is due from 
Company S as part of a PCT. Pursuant to paragraph (c)(3) of this 
section, the controlled parties designate the platform contribution as a 
provision of services that would otherwise be governed by Sec.  1.482-
9(a) if entered into by controlled parties. Accordingly, pursuant to 
paragraph (a)(2) of this section, the applicable method for determining 
the arm's length value of the compensation obligation under the PCT 
between Company P and Company S will be governed by Sec.  1.482-9(a) as 
supplemented by paragraph (g) of this section. Absent a showing to the 
contrary by P and S, the platform contribution in this case is presumed 
to be the exclusive provision of the benefits by Company P of its 
research team to the development of Vaccine Z. Because the IDCs include 
the ongoing compensation of the researchers, the compensation obligation 
under the PCT is only for the value of the commitment of the research 
team by Company P to the CSA's development efforts net of such 
researcher compensation. The value of the compensation obligation of 
Company S for the PCT will reflect the full value of the provision of 
services, as limited by Company S's RAB share.
    (d) Intangible development costs--(1) Determining whether costs are 
IDCs. Costs included in IDCs are determined by reference to the scope of 
the intangible development activity (IDA).
    (i) Definition and scope of the IDA. For purposes of this section, 
the IDA means the activity under the CSA of developing or attempting to 
develop reasonably anticipated cost shared intangibles. The scope of the 
IDA includes all of the controlled participants' activities that could 
reasonably be anticipated to contribute to developing the reasonably 
anticipated cost shared intangibles. The IDA cannot be described merely 
by a list of particular resources, capabilities, or rights that will be 
used in the CSA, because such a list would not identify reasonably 
anticipated cost shared intangibles. Also, the scope of the IDA may 
change as the nature or identity of the reasonably anticipated cost 
shared intangibles changes or the nature of the activities necessary for 
their development become clearer. For example, the relevance of certain 
ongoing work to developing reasonably anticipated cost shared 
intangibles or the need for additional work may only become clear over 
time.

[[Page 739]]

    (ii) Reasonably anticipated cost shared intangible. For purposes of 
this section, reasonably anticipated cost shared intangible means any 
intangible, within the meaning of Sec.  1.482-4(b), that, at the 
applicable point in time, the controlled participants intend to develop 
under the CSA. Reasonably anticipated cost shared intangibles may change 
over the course of the CSA. The controlled participants may at any time 
change the reasonably anticipated cost shared intangibles but must 
document any such change pursuant to paragraph (k)(2)(ii)(A)(1) of this 
section. Removal of reasonably anticipated cost shared intangibles does 
not affect the controlled participants' interests in cost shared 
intangibles already developed under the CSA. In addition, the reasonably 
anticipated cost shared intangibles automatically expand to include the 
intended result of any further development of a cost shared intangible 
already developed under the CSA, or applications of such an intangible. 
However, the controlled participants may override this automatic 
expansion in a particular case if they separately remove specified 
further development of such intangible (or specified applications of 
such intangible) from the IDA, and document such separate removal 
pursuant to paragraph (k)(2)(ii)(A)(3) of this section.
    (iii) Costs included in IDCs. For purposes of this section, IDCs 
mean all costs, in cash or in kind (including stock-based compensation, 
as described in paragraph (d)(3) of this section), but excluding 
acquisition costs for land or depreciable property, in the ordinary 
course of business after the formation of a CSA that, based on analysis 
of the facts and circumstances, are directly identified with, or are 
reasonably allocable to, the IDA. Thus, IDCs include costs incurred in 
attempting to develop reasonably anticipated cost shared intangibles 
regardless of whether such costs ultimately lead to development of those 
intangibles, other intangibles developed unexpectedly, or no 
intangibles. IDCs shall also include the arm's length rental charge for 
the use of any land or depreciable tangible property (as determined 
under Sec.  1.482-2(c) (Use of tangible property)) directly identified 
with, or reasonably allocable to, the IDA. Reference to generally 
accepted accounting principles or Federal income tax accounting rules 
may provide a useful starting point but will not be conclusive regarding 
inclusion of costs in IDCs. IDCs do not include interest expense, 
foreign income taxes (as defined in Sec.  1.901-2(a)), or domestic 
income taxes.
    (iv) Examples. The following examples illustrate the principles of 
this paragraph (d)(1):

    Example 1. A contract that purports to be a CSA provides that the 
IDA to which the agreement applies consists of all research and 
development activity conducted at laboratories A, B, and C but not at 
other facilities maintained by the controlled participants. The contract 
does not describe the reasonably anticipated cost shared intangibles 
with respect to which research and development is to be undertaken. The 
contract fails to meet the requirements set forth in paragraph 
(k)(1)(ii)(B) of this section because it fails to adequately describe 
the scope of the IDA to be undertaken.
    Example 2. A contract that purports to be a CSA provides that the 
IDA to which the agreement applies consists of all research and 
development activity conducted by any of the controlled participants 
with the goal of developing a cure for a particular disease. Such a cure 
is thus a reasonably anticipated cost shared intangible. The contract 
also contains a provision that the IDA will exclude any activity that 
builds on the results of the controlled participants' prior research 
concerning Enzyme X even though such activity could reasonably be 
anticipated to contribute to developing such cure. The contract fails to 
meet the requirement set forth in paragraph (d)(1)(i) of this section 
that the scope of the IDA include all of the controlled participants' 
activities that could reasonably be anticipated to contribute to 
developing reasonably anticipated cost shared intangibles.

    (2) Allocation of costs. If a particular cost is directly identified 
with, or reasonably allocable to, a function the results of which will 
benefit both the IDA and other business activities, the cost must be 
allocated on a reasonable basis between the IDA and such other business 
activities in proportion to the relative economic value that the IDA and 
such other business activities are anticipated to derive from such 
results.
    (3) Stock-based compensation--(i) In general. As used in this 
section, the term stock-based compensation means

[[Page 740]]

any compensation provided by a controlled participant to an employee or 
independent contractor in the form of equity instruments, options to 
acquire stock (stock options), or rights with respect to (or determined 
by reference to) equity instruments or stock options, including but not 
limited to property to which section 83 applies and stock options to 
which section 421 applies, regardless of whether ultimately settled in 
the form of cash, stock, or other property.
    (ii) Identification of stock-based compensation with the IDA. The 
determination of whether stock-based compensation is directly identified 
with, or reasonably allocable to, the IDA is made as of the date that 
the stock-based compensation is granted. Accordingly, all stock-based 
compensation that is granted during the term of the CSA and, at date of 
grant, is directly identified with, or reasonably allocable to, the IDA 
is included as an IDC under paragraph (d)(1) of this section. In the 
case of a repricing or other modification of a stock option, the 
determination of whether the repricing or other modification constitutes 
the grant of a new stock option for purposes of this paragraph 
(d)(3)(ii) will be made in accordance with the rules of section 424(h) 
and related regulations.
    (iii) Measurement and timing of stock-based compensation IDC--(A) In 
general. Except as otherwise provided in this paragraph (d)(3)(iii), the 
cost attributable to stock-based compensation is equal to the amount 
allowable to the controlled participant as a deduction for federal 
income tax purposes with respect to that stock-based compensation (for 
example, under section 83(h)) and is taken into account as an IDC under 
this section for the taxable year for which the deduction is allowable.
    (1) Transfers to which section 421 applies. Solely for purposes of 
this paragraph (d)(3)(iii)(A), section 421 does not apply to the 
transfer of stock pursuant to the exercise of an option that meets the 
requirements of section 422(a) or 423(a).
    (2) Deductions of foreign controlled participants. Solely for 
purposes of this paragraph (d)(3)(iii)(A), an amount is treated as an 
allowable deduction of a foreign controlled participant to the extent 
that a deduction would be allowable to a United States taxpayer.
    (3) Modification of stock option. Solely for purposes of this 
paragraph (d)(3)(iii)(A), if the repricing or other modification of a 
stock option is determined, under paragraph (d)(3)(ii) of this section, 
to constitute the grant of a new stock option not identified with, or 
reasonably allocable to, the IDA, the stock option that is repriced or 
otherwise modified will be treated as being exercised immediately before 
the modification, provided that the stock option is then exercisable and 
the fair market value of the underlying stock then exceeds the price at 
which the stock option is exercisable. Accordingly, the amount of the 
deduction that would be allowable (or treated as allowable under this 
paragraph (d)(3)(iii)(A)) to the controlled participant upon exercise of 
the stock option immediately before the modification must be taken into 
account as an IDC as of the date of the modification.
    (4) Expiration or termination of CSA. Solely for purposes of this 
paragraph (d)(3)(iii)(A), if an item of stock-based compensation 
identified with, or reasonably allocable to, the IDA is not exercised 
during the term of a CSA, that item of stock-based compensation will be 
treated as being exercised immediately before the expiration or 
termination of the CSA, provided that the stock-based compensation is 
then exercisable and the fair market value of the underlying stock then 
exceeds the price at which the stock-based compensation is exercisable. 
Accordingly, the amount of the deduction that would be allowable (or 
treated as allowable under this paragraph (d)(3)(iii)(A)) to the 
controlled participant upon exercise of the stock-based compensation 
must be taken into account as an IDC as of the date of the expiration or 
termination of the CSA.
    (B) Election with respect to options on publicly traded stock--(1) 
In general. With respect to stock-based compensation in the form of 
options on publicly traded stock, the controlled participants in a CSA 
may elect to take into account all IDCs attributable to those stock 
options in the same amount, and as of the same time, as the fair value 
of the stock options reflected as a charge

[[Page 741]]

against income in audited financial statements or disclosed in footnotes 
to such financial statements, provided that such statements are prepared 
in accordance with United States generally accepted accounting 
principles by or on behalf of the company issuing the publicly traded 
stock.
    (2) Publicly traded stock. As used in this paragraph (d)(3)(iii)(B), 
the term publicly traded stock means stock that is regularly traded on 
an established United States securities market and is issued by a 
company whose financial statements are prepared in accordance with 
United States generally accepted accounting principles for the taxable 
year.
    (3) Generally accepted accounting principles. For purposes of this 
paragraph (d)(3)(iii)(B), a financial statement prepared in accordance 
with a comprehensive body of generally accepted accounting principles 
other than United States generally accepted accounting principles is 
considered to be prepared in accordance with United States generally 
accepted accounting principles provided that either--
    (i) The fair value of the stock options under consideration is 
reflected in the reconciliation between such other accounting principles 
and United States generally accepted accounting principles required to 
be incorporated into the financial statement by the securities laws 
governing companies whose stock is regularly traded on United States 
securities markets; or
    (ii) In the absence of a reconciliation between such other 
accounting principles and United States generally accepted accounting 
principles that reflects the fair value of the stock options under 
consideration, such other accounting principles require that the fair 
value of the stock options under consideration be reflected as a charge 
against income in audited financial statements or disclosed in footnotes 
to such statements.
    (4) Time and manner of making the election. The election described 
in this paragraph (d)(3)(iii)(B) is made by an explicit reference to the 
election in the written contract required by paragraph (k)(1) of this 
section or in a written amendment to the CSA entered into with the 
consent of the Commissioner pursuant to paragraph (d)(3)(iii)(C) of this 
section. In the case of a CSA in existence on August 26, 2003, the 
election by written amendment to the CSA may be made without the consent 
of the Commissioner if such amendment is entered into not later than the 
latest due date (with regard to extensions) of a federal income tax 
return of any controlled participant for the first taxable year 
beginning after August 26, 2003.
    (C) Consistency. Generally, all controlled participants in a CSA 
taking options on publicly traded stock into account under paragraph 
(d)(3)(ii), (d)(3)(iii)(A), or (d)(3)(iii)(B) of this section must use 
that same method of identification, measurement and timing for all 
options on publicly traded stock with respect to that CSA. Controlled 
participants may change their method only with the consent of the 
Commissioner and only with respect to stock options granted during 
taxable years subsequent to the taxable year in which the Commissioner's 
consent is obtained. All controlled participants in the CSA must join in 
requests for the Commissioner's consent under this paragraph 
(d)(3)(iii)(C). Thus, for example, if the controlled participants make 
the election described in paragraph (d)(3)(iii)(B) of this section upon 
the formation of the CSA, the election may be revoked only with the 
consent of the Commissioner, and the consent will apply only to stock 
options granted in taxable years subsequent to the taxable year in which 
consent is obtained. Similarly, if controlled participants already have 
granted stock options that have been or will be taken into account under 
the general rule of paragraph (d)(3)(iii)(A) of this section, then 
except in cases specified in the last sentence of paragraph 
(d)(3)(iii)(B)(4) of this section, the controlled participants may make 
the election described in paragraph (d)(3)(iii)(B) of this section only 
with the consent of the Commissioner, and the consent will apply only to 
stock options granted in taxable years subsequent to the taxable year in 
which consent is obtained.
    (4) IDC share. A controlled participant's IDC share for a taxable 
year is equal to the controlled participant's cost contribution for the 
taxable year, divided by the sum of all IDCs for the

[[Page 742]]

taxable year. A controlled participant's cost contribution for a taxable 
year means all of the IDCs initially borne by the controlled 
participant, plus all of the CST Payments that the participant makes to 
other controlled participants, minus all of the CST Payments that the 
participant receives from other controlled participants.
    (5) Examples. The following examples illustrate this paragraph (d):

    Example 1. Foreign parent (FP) and its U.S. subsidiary (USS) enter 
into a CSA to develop a better mousetrap. USS and FP share the costs of 
FP's R&D facility that will be exclusively dedicated to this research, 
the salaries of the researchers at the facility, and overhead costs 
attributable to the project. They also share the cost of a conference 
facility that is at the disposal of the senior executive management of 
each company. Based on the facts and circumstances, the cost of the 
conference facility cannot be directly identified with, and is not 
reasonably allocable to, the IDA. In this case, the cost of the 
conference facility must be excluded from the amount of IDCs.
    Example 2. U.S. parent (USP) and its foreign subsidiary (FS) enter 
into a CSA to develop intangibles for producing a new device. USP and FS 
share the costs of an R&D facility, the salaries of the facility's 
researchers, and overhead costs attributable to the project. Although 
USP also incurs costs related to field testing of the device, USP does 
not include those costs in the IDCs that USP and FS will share under the 
CSA. The Commissioner may determine, based on the facts and 
circumstances, that the costs of field testing are IDCs that the 
controlled participants must share.
    Example 3. U.S. parent (USP) and its foreign subsidiary (FS) enter 
into a CSA to develop a new process patent. USP assigns certain 
employees to perform solely R&D to develop a new mathematical algorithm 
to perform certain calculations. That algorithm will be used both to 
develop the new process patent and to develop a new design patent the 
development of which is outside the scope of the CSA. During years 
covered by the CSA, USP compensates such employees with cash salaries, 
stock-based compensation, or a combination of both. USP and FS 
anticipate that the economic value attributable to the R&D will be 
derived from the process patent and the design patent in a relative 
proportion of 75% and 25%, respectively. Applying the principles of 
paragraph (d)(2) of this section, 75% of the compensation of such 
employees must be allocated to the development of the new process patent 
and, thus, treated as IDCs. With respect to the cash salary 
compensation, the IDC is 75% of the face value of the cash. With respect 
to the stock-based compensation, the IDC is 75% of the value of the 
stock-based compensation as determined under paragraph (d)(3)(iii) of 
this section.
    Example 4. Foreign parent (FP) and its U.S. subsidiary (USS) enter 
into a CSA to develop a new computer source code. FP has an executive 
officer who oversees a research facility and employees dedicated solely 
to the IDA. The executive officer also oversees other research 
facilities and employees unrelated to the IDA, and performs certain 
corporate overhead functions. The full amount of the costs of the 
research facility and employees dedicated solely to the IDA can be 
directly identified with the IDA and, therefore, are IDCs. In addition, 
based on the executive officer's records of time worked on various 
matters, the controlled participants reasonably allocate 20% of the 
executive officer's compensation to supervision of the facility and 
employees dedicated to the IDA, 50% of the executive officer's 
compensation to supervision of the facilities and employees unrelated to 
the IDA, and 30% of the executive officer's compensation to corporate 
overhead functions. The controlled participants also reasonably 
determine that the results of the executive officer's corporate overhead 
functions yield equal economic benefit to the IDA and the other business 
activities of FP. Applying the principles of paragraph (d)(1) of this 
section, the executive officer's compensation allocated to supervising 
the facility and employees dedicated to the IDA (amounting to 20% of the 
executive officer's total compensation) must be treated as IDCs. 
Applying the principles of paragraph (d)(2) of this section, half of the 
executive officer's compensation allocated to corporate overhead 
functions (that is, half of 30% of the executive officer's total 
compensation), must be treated as IDCs. Therefore, a total of 35% (20% 
plus 15%) of the executive officer's total compensation must be treated 
as IDCs.

    (e) Reasonably anticipated benefits share--(1) Definition--(i) In 
general. A controlled participant's share of reasonably anticipated 
benefits is equal to its reasonably anticipated benefits divided by the 
sum of the reasonably anticipated benefits, as defined in paragraph 
(j)(1)(i) of this section, of all the controlled participants. RAB 
shares must be updated to account for changes in economic conditions, 
the business operations and practices of the participants, and the 
ongoing development of intangibles under the CSA. For purposes of 
determining RAB shares at any given time, reasonably anticipated 
benefits must be estimated over the entire period, past and future,

[[Page 743]]

of exploitation of the cost shared intangibles, and must reflect 
appropriate updates to take into account the most reliable data 
regarding past and projected future results available at such time. RAB 
shares determined for a particular purpose shall not be further updated 
for that purpose based on information not available at the time that 
determination needed to be made. For example, RAB shares determined in 
order to determine IDC shares for a particular taxable year (as set 
forth in paragraphs (b)(1)(i) and (d)(4) of this section) shall not be 
recomputed based on information not available at that time. Similarly, 
RAB shares determined for the purpose of using a particular method such 
as the acquisition price method (as set forth in paragraph (g)(5)(ii) of 
this section) to evaluate the arm's length amount charged in a PCT shall 
not be recomputed based on information not available at the date of that 
PCT. However, nothing in this paragraph (e)(1)(i) shall limit the 
Commissioner's use of subsequently available information for purposes of 
its allocation determinations in accordance with the provisions of 
paragraph (i) (Allocations by the Commissioner in connection with a CSA) 
of this section.
    (ii) Reliability. A controlled participant's RAB share must be 
determined by using the most reliable estimate. In determining which of 
two or more available estimates is most reliable, the quality of the 
data and assumptions used in the analysis must be taken into account, 
consistent with Sec.  1.482-1(c)(2)(ii) (Data and assumptions). Thus, 
the reliability of an estimate will depend largely on the completeness 
and accuracy of the data, the soundness of the assumptions, and the 
relative effects of particular deficiencies in data or assumptions on 
different estimates. If two estimates are equally reliable, no 
adjustment should be made based on differences between the estimates. 
The following factors will be particularly relevant in determining the 
reliability of an estimate of RAB shares:
    (A) The basis used for measuring benefits, as described in paragraph 
(e)(2)(ii) of this section.
    (B) The projections used to estimate benefits, as described in 
paragraph (e)(2)(iii) of this section.
    (iii) Examples. The following examples illustrate the principles of 
this paragraph (e)(1):

    Example 1. (i) USP and FS plan to conduct research to develop 
Product Lines A and B. USP and FS reasonably anticipate respective 
benefits from Product Line A of 100X and 200X and respective benefits 
from Product Line B, respectively, of 300X and 400X. USP and FS thus 
reasonably anticipate combined benefits from Product Lines A and B of 
400X and 600X, respectively.
    (ii) USP and FS could enter into a separate CSA to develop Product 
Line A with respective RAB shares of 33\1/3\ percent and 66\2/3\ percent 
(reflecting a ratio of 100X to 200X), and into a separate CSA to develop 
Product Line B with respective RAB shares of 42\6/7\ percent and 57\1/7\ 
percent (reflecting a ratio of 300X to 400X). Alternatively, USP and FS 
could enter into a single CSA to develop both Product Lines A and B with 
respective RAB shares of 40 percent and 60 percent (in the ratio of 400X 
to 600X). If the separate CSAs are chosen, then any costs for activities 
that contribute to developing both Product Line A and Product Line B 
will constitute IDCs of the respective CSAs as required by paragraphs 
(d)(1) and (2) of this section.
    Example 2. (i) USP, a US company, wholly owns foreign subsidiary, 
FS. USP and FS enter into a CSA at the start of Year 1. The CSA's total 
IDCs are $100,000 in each year for Years 1 through 4. In Year 1, USP 
correctly estimates its RAB share as 50%, based on information available 
at the time, and therefore correctly computes $50,000 as its cost 
contribution for Year 1.
    (ii) In Year 4, USP correctly estimates its RAB share to be 70%, 
based on information available at the time and, therefore, correctly 
computes $70,000 as its cost contribution for Year 4.
    (iii) In Year 4, USP also files an amended return for Year 1 in 
which USP deducts a cost contribution of $70,000, asserting that, for 
this purpose, it should revise its Year 1 estimated RAB share to 70% 
based on the information that is now available to it in Year 4. The 
Commissioner determines that USP is incorrect for two reasons. First, a 
RAB share determined for a particular purpose (here, to determine USP's 
IDC shares and thus USP's cost contributions in Year 1) should not be 
revised based on information not available to USP until Year 4. See 
paragraph (e)(1)(i) of this section. Second, more generally, USP is not 
permitted to file an amended return for this purpose under Sec.  1.482-
1(a)(3). Therefore, for both of these reasons, Commissioner adjusts 
USP's amended return for Year 1 by disallowing $20,000 of the $70,000 
deduction.


[[Page 744]]


    (2) Measure of benefits--(i) In general. In order to estimate a 
controlled participant's RAB share, the amount of each controlled 
participant's reasonably anticipated benefits must be measured on a 
basis that is consistent for all such participants. See paragraph 
(e)(2)(ii)(E) Example 9 of this section. If a controlled participant 
transfers a cost shared intangible to another controlled taxpayer, other 
than by way of a transfer described in paragraph (f) of this section, 
that controlled participant's benefits from the transferred intangible 
must be measured by reference to the transferee's benefits, disregarding 
any consideration paid by the transferee to the controlled participant 
(such as a royalty pursuant to a license agreement). Reasonably 
anticipated benefits are measured either on a direct basis, by reference 
to estimated benefits to be generated by the use of cost shared 
intangibles (generally based on additional revenues plus cost savings 
less any additional costs incurred), or on an indirect basis, by 
reference to certain measurements that reasonably can be assumed to 
relate to benefits to be generated. Such indirect bases of measurement 
of anticipated benefits are described in paragraph (e)(2)(ii) of this 
section. A controlled participant's reasonably anticipated benefits must 
be measured on the basis, whether direct or indirect, that most reliably 
determines RAB shares. In determining which of two bases of measurement 
is most reliable, the factors set forth in Sec.  1.482-1(c)(2)(ii) (Data 
and assumptions) must be taken into account. It normally will be 
expected that the basis that provided the most reliable estimate for a 
particular year will continue to provide the most reliable estimate in 
subsequent years, absent a material change in the factors that affect 
the reliability of the estimate. Regardless of whether a direct or 
indirect basis of measurement is used, adjustments may be required to 
account for material differences in the activities that controlled 
participants undertake to exploit their interests in cost shared 
intangibles. See Examples 4 and 7 of paragraph (e)(2)(ii)(E) of this 
section.
    (ii) Indirect bases for measuring anticipated benefits. Indirect 
bases for measuring anticipated benefits from participation in a CSA 
include the following:
    (A) Units used, produced, or sold. Units of items used, produced, or 
sold by each controlled participant in the business activities in which 
cost shared intangibles are exploited may be used as an indirect basis 
for measuring its anticipated benefits. This basis of measurement will 
more reliably determine RAB shares to the extent that each controlled 
participant is expected to have a similar increase in net profit or 
decrease in net loss attributable to the cost shared intangibles per 
unit of the item or items used, produced, or sold. This circumstance is 
most likely to arise when the cost shared intangibles are exploited by 
the controlled participants in the use, production, or sale of 
substantially uniform items under similar economic conditions.
    (B) Sales. Sales by each controlled participant in the business 
activities in which cost shared intangibles are exploited may be used as 
an indirect basis for measuring its anticipated benefits. This basis of 
measurement will more reliably determine RAB shares to the extent that 
each controlled participant is expected to have a similar increase in 
net profit or decrease in net loss attributable to cost shared 
intangibles per dollar of sales. This circumstance is most likely to 
arise if the costs of exploiting cost shared intangibles are not 
substantial relative to the revenues generated, or if the principal 
effect of using cost shared intangibles is to increase the controlled 
participants' revenues (for example, through a price premium on the 
products they sell) without affecting their costs substantially. Sales 
by each controlled participant are unlikely to provide a reliable basis 
for measuring RAB shares unless each controlled participant operates at 
the same market level (for example, manufacturing, distribution, etc.).
    (C) Operating profit. Operating profit of each controlled 
participant from the activities in which cost shared intangibles are 
exploited, as determined before any expense (including amortization) on 
account of IDCs, may be used as an indirect basis for measuring 
anticipated benefits. This basis of measurement will more reliably 
determine

[[Page 745]]

RAB shares to the extent that such profit is largely attributable to the 
use of cost shared intangibles, or if the share of profits attributable 
to the use of cost shared intangibles is expected to be similar for each 
controlled participant. This circumstance is most likely to arise when 
cost shared intangibles are closely associated with the activity that 
generates the profit and the activity could not be carried on or would 
generate little profit without use of those intangibles.
    (D) Other bases for measuring anticipated benefits. Other bases for 
measuring anticipated benefits may in some circumstances be appropriate, 
but only to the extent that there is expected to be a reasonably 
identifiable relationship between the basis of measurement used and 
additional revenue generated or net costs saved by the use of cost 
shared intangibles. For example, a division of costs based on employee 
compensation would be considered unreliable unless there were a 
relationship between the amount of compensation and the expected 
additional revenue generated or net costs saved by the controlled 
participants from using the cost shared intangibles.
    (E) Examples. The following examples illustrates this paragraph 
(e)(2)(ii):

    Example 1. Controlled parties A and B enter into a CSA to develop 
product and process intangibles for already existing Product P. Without 
such intangibles, A and B would each reasonably anticipate revenue, in 
present value terms, of $100M from sales of Product P until it becomes 
obsolete. With the intangibles, A and B each reasonably anticipate 
selling the same number of units each year, but reasonably anticipate 
that the price will be higher. Because the particular product intangible 
is more highly regarded in A's market, A reasonably anticipates an 
increase of $20M in present value revenue from the product intangible, 
while B reasonably anticipates an increase of only $10M in present value 
from the product intangible. Further, A and B each reasonably anticipate 
spending an additional amount equal to $5M in present value in 
production costs to include the feature embodying the product 
intangible. Finally, A and B each reasonably anticipate saving an amount 
equal to $2M in present value in production costs by using the process 
intangible. A and B reasonably anticipate no other economic effects from 
exploiting the cost shared intangibles. A's reasonably anticipated 
benefits from exploiting the cost shared intangibles equal its 
reasonably anticipated increase in revenue ($20M) plus its reasonably 
anticipated cost savings ($2M) less its reasonably anticipated increased 
costs ($5M), which equals $17M. Similarly, B's reasonably anticipated 
benefits from exploiting the cost shared intangibles equal its 
reasonably anticipated increase in revenue ($10M) plus its reasonably 
anticipated cost savings ($2M) less its reasonably anticipated increased 
costs ($5M), which equals $7M. Thus A's reasonably anticipated benefits 
are $17M and B's reasonably anticipated benefits are $7M.
    Example 2. Foreign Parent (FP) and U.S. Subsidiary (USS) both 
produce a feedstock for the manufacture of various high-performance 
plastic products. Producing the feedstock requires large amounts of 
electricity, which accounts for a significant portion of its production 
cost. FP and USS enter into a CSA to develop a new process that will 
reduce the amount of electricity required to produce a unit of the 
feedstock. FP and USS currently both incur an electricity cost of $2 per 
unit of feedstock produced and rates for each are expected to remain 
similar in the future. The new process, if it is successful, will reduce 
the amount of electricity required by each company to produce a unit of 
the feedstock by 50%. Switching to the new process would not require FP 
or USS to incur significant investment or other costs. Therefore, the 
cost savings each company is expected to achieve after implementing the 
new process are $1 per unit of feedstock produced. Under the CSA, FP and 
USS divide the costs of developing the new process based on the units of 
the feedstock each is anticipated to produce in the future. In this 
case, units produced is the most reliable basis for measuring RAB shares 
and dividing the IDCs because each controlled participant is expected to 
have a similar $1 (50% of current charge of $2) decrease in costs per 
unit of the feedstock produced.
    Example 3. The facts are the same as in Example 2, except that 
currently USS pays $3 per unit of feedstock produced for electricity 
while FP pays $6 per unit of feedstock produced. In this case, units 
produced is not the most reliable basis for measuring RAB shares and 
dividing the IDCs because the participants do not expect to have a 
similar decrease in costs per unit of the feedstock produced. The 
Commissioner determines that the most reliable measure of RAB shares may 
be based on units of the feedstock produced if FP's units are weighted 
relative to USS's units by a factor of 2. This reflects the fact that FP 
pays twice as much as USS for electricity and, therefore, FP's savings 
of $3 per unit of the feedstock (50% reduction of current charge of $6) 
would be twice USS's savings of $1.50 per unit of feedstock (50% 
reduction of current charge of $3) from any new process eventually 
developed.

[[Page 746]]

    Example 4. The facts are the same as in Example 3, except that to 
supply the particular needs of the U.S. market USS manufactures the 
feedstock with somewhat different properties than FP's feedstock. This 
requires USS to employ a somewhat different production process than does 
FP. Because of this difference, USS would incur significant construction 
costs in order to adopt any new process that may be developed under the 
cost sharing agreement. In this case, units produced is not the most 
reliable basis for measuring RAB shares. In order to reliably determine 
RAB shares, the Commissioner measures the reasonably anticipated 
benefits of USS and FP on a direct basis. USS's reasonably anticipated 
benefits are its reasonably anticipated total savings in electricity 
costs, less its reasonably anticipated costs of adopting the new 
process. FS's reasonably anticipated benefits are its reasonably 
anticipated total savings in electricity costs.
    Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a CSA to develop new anesthetic drugs. USP obtains the right to market 
any resulting drugs in the United States and FS obtains the right to 
market any resulting drugs in the rest of the world. USP and FS 
determine RAB shares on the basis of their respective total anticipated 
operating profit from all drugs under development. USP anticipates that 
it will receive a much higher profit than FS per unit sold because the 
price of the drugs is not regulated in the United States, whereas the 
price of the drugs is regulated in many non-U.S. jurisdictions. In both 
controlled participants' territories, the anticipated operating profits 
are almost entirely attributable to the use of the cost shared 
intangibles. In this case, the controlled participants' basis for 
measuring RAB shares is the most reliable.
    Example 6. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) 
manufacture and sell fertilizers. They enter into a CSA to develop a new 
pellet form of a common agricultural fertilizer that is currently 
available only in powder form. Under the CSA, USS obtains the rights to 
produce and sell the new form of fertilizer for the U.S. market while FP 
obtains the rights to produce and sell the new form of fertilizer in the 
rest of the world. The costs of developing the new form of fertilizer 
are divided on the basis of the anticipated sales of fertilizer in the 
controlled participants' respective markets.
    (ii) If the research and development is successful, the pellet form 
will deliver the fertilizer more efficiently to crops and less 
fertilizer will be required to achieve the same effect on crop growth. 
The pellet form of fertilizer can be expected to sell at a price premium 
over the powder form of fertilizer based on the savings in the amount of 
fertilizer that needs to be used. This price premium will be a similar 
premium per dollar of sales in each territory. If the research and 
development is successful, the costs of producing pellet fertilizer are 
expected to be approximately the same as the costs of producing powder 
fertilizer and the same for both FP and USS. Both FP and USS operate at 
approximately the same market levels, selling their fertilizers largely 
to independent distributors.
    (iii) In this case, the controlled participants' basis for measuring 
RAB shares is the most reliable.
    Example 7. The facts are the same as in Example 6, except that FP 
distributes its fertilizers directly while USS sells to independent 
distributors. In this case, sales of USS and FP are not the most 
reliable basis for measuring RAB shares unless adjustments are made to 
account for the difference in market levels at which the sales occur.
    Example 8. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a CSA to develop materials that will be used to train all new entry-
level employees. FP and USS determine that the new materials will save 
approximately ten hours of training time per employee. Because their 
entry-level employees are paid on differing wage scales, FP and USS 
decide that they should not measure benefits based on the number of 
entry-level employees hired by each. Rather, they measure benefits based 
on compensation paid to the entry-level employees hired by each. In this 
case, the basis used for measuring RAB shares is the most reliable 
because there is a direct relationship between compensation paid to new 
entry-level employees and costs saved by FP and USS from the use of the 
new training materials.
    Example 9. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and 
Foreign Subsidiary 2 (FS2) enter into a CSA to develop computer software 
that each will market and install on customers' computer systems. The 
controlled participants measure benefits on the basis of projected sales 
by USP, FS1, and FS2 of the software in their respective geographic 
areas. However, FS1 plans not only to sell but also to license the 
software to unrelated customers, and FS1's licensing income (which is a 
percentage of the licensees' sales) is not counted in the projected 
benefits. In this case, the basis used for measuring the benefits of 
each controlled participant is not the most reliable because all of the 
benefits received by controlled participants are not taken into account. 
In order to reliably determine RAB shares, FS1's projected benefits from 
licensing must be included in the measurement on a basis that is the 
same as that used to measure its own and the other controlled 
participants' projected benefits from sales (for example, all controlled 
participants might measure their benefits on the basis of operating 
profit).

    (iii) Projections used to estimate benefits--(A) In general. The 
reliability of an

[[Page 747]]

estimate of RAB shares also depends upon the reliability of projections 
used in making the estimate. Projections required for this purpose 
generally include a determination of the time period between the 
inception of the research and development activities under the CSA and 
the receipt of benefits, a projection of the time over which benefits 
will be received, and a projection of the benefits anticipated for each 
year in which it is anticipated that the cost shared intangible will 
generate benefits. A projection of the relevant basis for measuring 
anticipated benefits may require a projection of the factors that 
underlie it. For example, a projection of operating profits may require 
a projection of sales, cost of sales, operating expenses, and other 
factors that affect operating profits. If it is anticipated that there 
will be significant variation among controlled participants in the 
timing of their receipt of benefits, and consequently benefit shares are 
expected to vary significantly over the years in which benefits will be 
received, it normally will be necessary to use the present value of the 
projected benefits to reliably determine RAB shares. See paragraph 
(g)(2)(v) of this section for best method considerations regarding 
discount rates used for this purpose. If it is not anticipated that 
benefit shares will significantly change over time, current annual 
benefit shares may provide a reliable projection of RAB shares. This 
circumstance is most likely to occur when the CSA is a long-term 
arrangement, the arrangement covers a wide variety of intangibles, the 
composition of the cost shared intangibles is unlikely to change, the 
cost shared intangibles are unlikely to generate unusual profits, and 
each controlled participant's share of the market is stable.
    (B) Examples. The following examples illustrate the principles of 
this paragraph (e)(2)(iii):

    Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) enter 
into a CSA to develop a new car model. The controlled participants plan 
to spend four years developing the new model and four years producing 
and selling the new model. USS and FP project total sales of $4 billion 
and $2 billion, respectively, over the planned four years of 
exploitation of the new model. The controlled participants determine RAB 
shares for each year of 66\2/3\% for USS and 33\1/3\% for FP, based on 
projected total sales.
    (ii) USS typically begins producing and selling new car models a 
year after FP begins producing and selling new car models. In order to 
reflect USS's one-year lag in introducing new car models, a more 
reliable projection of each participant's RAB share would be based on a 
projection of all four years of sales for each participant, discounted 
to present value.
    Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a CSA to develop new and improved household cleaning products. Both 
controlled participants have sold household cleaning products for many 
years and have stable worldwide market shares. The products under 
development are unlikely to produce unusual profits for either 
controlled participant. The controlled participants determine RAB shares 
on the basis of each controlled participant's current sales of household 
cleaning products. In this case, the controlled participants' RAB shares 
are reliably projected by current sales of cleaning products.
    Example 3. The facts are the same as in Example 2, except that FS's 
market share is rapidly expanding because of the business failure of a 
competitor in its geographic area. The controlled participants' RAB 
shares are not reliably projected by current sales of cleaning products. 
FS's benefit projections should take into account its growth in market 
share.
    Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a CSA to develop synthetic fertilizers and insecticides. FP and USS 
share costs on the basis of each controlled participant's current sales 
of fertilizers and insecticides. The market shares of the controlled 
participants have been stable for fertilizers, but FP's market share for 
insecticides has been expanding. The controlled participants' 
projections of RAB shares are reliable with regard to fertilizers, but 
not reliable with regard to insecticides; a more reliable projection of 
RAB shares would take into account the expanding market share for 
insecticides.

    (f) Changes in participation under a CSA--(1) In general. A change 
in participation under a CSA occurs when there is either a controlled 
transfer of interests or a capability variation. A change in 
participation requires arm's length consideration under paragraph 
(a)(3)(ii) of this section, and as more fully described in this 
paragraph (f).
    (2) Controlled transfer of interests. A controlled transfer of 
interests occurs when a participant in a CSA transfers all or part of 
its interests in cost shared intangibles under the CSA in a

[[Page 748]]

controlled transaction, and the transferee assumes the associated 
obligations under the CSA. For example, a change in the territorial 
based divisional interests or field of use based divisional interests, 
as described in paragraph (b)(4), is a controlled transfer of interests. 
After the controlled transfer of interests occurs, the CSA will still 
exist if at least two controlled participants still have interests in 
the cost shared intangibles. In such a case, the transferee will be 
treated as succeeding to the transferor's prior history under the CSA as 
pertains to the transferred interests, including the transferor's cost 
contributions, benefits derived, and PCT Payments attributable to such 
rights or obligations. A transfer that would otherwise constitute a 
controlled transfer of interests for purposes of this paragraph (f)(2) 
shall not constitute a controlled transfer of interests if it also 
constitutes a capability variation for purposes of paragraph (f)(3) of 
this section.
    (3) Capability variation. A capability variation occurs when, in a 
CSA in which interests in cost shared intangibles are divided as 
described in paragraph (b)(4)(iv) of this section, the controlled 
participants' division of interests or their relative capabilities or 
capacities to benefit from the cost shared intangibles are materially 
altered. For purposes of paragraph (a)(3)(ii) of this section, a 
capability variation is considered to be a controlled transfer of 
interests in cost shared intangibles, in which any controlled 
participant whose RAB share decreases as a result of the capability 
variation is a transferor, and any controlled participant whose RAB 
share thus increases is the transferee of the interests in cost shared 
intangibles.
    (4) Arm's length consideration for a change in participation. In the 
event of a change in participation, the arm's length amount of 
consideration from the transferee, under the rules of Sec. Sec.  1.482-1 
and 1.482-4 through 1.482-6 and paragraph (a)(3)(ii) of this section, 
will be determined consistent with the reasonably anticipated 
incremental change in the returns to the transferee and transferor 
resulting from such change in participation. Such changes in returns 
will themselves depend on the reasonably anticipated incremental changes 
in the benefits from exploiting the cost shared intangibles, IDCs borne, 
and PCT Payments (if any). However, any arm's length consideration 
required under this paragraph (f)(4) with respect to a capability 
variation shall be reduced as necessary to prevent duplication of an 
adjustment already performed under paragraph (i)(2)(ii)(A) of this 
section that resulted from the same capability variation. If an 
adjustment has been performed already under this paragraph (f)(4) with 
respect to a capability variation, then for purposes of any adjustment 
to be performed under paragraph (i)(2)(ii)(A) of this section, the 
controlled participants' projected benefit shares referred to in 
paragraph (i)(2)(ii)(A) of this section shall be considered to be the 
controlled participants' respective RAB shares after the capability 
variation occurred.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (f):

    Example 1. X, Y, and Z are the only controlled participants in a 
CSA. The CSA divides interests in cost shared intangibles on a 
territorial basis as described in paragraph (b)(4)(ii) of this section. 
X is assigned the territories of the Americas, Y is assigned the 
territory of the UK and Australia, and Z is assigned the rest of the 
world. When the CSA is formed, X has a platform contribution T. Under 
the PCTs for T, Y and Z are each obligated to pay X royalties equal to 
five percent of their respective sales. Aside from T, there are no 
platform contributions. Two years after the formation of the CSA, Y 
transfers to Z its interest in cost shared intangibles relating to the 
UK territory, and the associated obligations, in a controlled transfer 
of interests described in paragraph (f)(2) of this section. At that time 
the reasonably anticipated benefits from exploiting cost shared 
intangibles in the UK have a present value of $11M, the reasonably 
anticipated IDCs to be borne relating to the UK territory have a present 
value of $3M, and the reasonably anticipated PCT Payments to be made to 
X relating to sales in the UK territory have a present value of $2M. As 
arm's length consideration for the change in participation due to the 
controlled transfer of interests, Z must pay Y compensation with an 
anticipated present value of $11M, less $3M, less $2M, which equals $6M.
    Example 2. As in Example 2 of paragraph (b)(4)(v) of this section, 
companies P and S, both members of the same controlled group, enter into 
a CSA to develop product Z. P and

[[Page 749]]

S agree to divide their interest in product Z based on site of 
manufacturing. P will have exclusive and perpetual rights in product Z 
manufactured in facilities owned by P. S will have exclusive and 
perpetual rights to product Z manufactured in facilities owned by S. P 
and S agree that neither will license manufacturing rights in product Z 
to any related or unrelated party. Both P and S maintain books and 
records that allow production at all sites to be verified. Both own 
facilities that will manufacture product Z and the relative capacities 
of these sites are known. All facilities are currently operating at near 
capacity and are expected to continue to operate at near capacity when 
product Z enters production so that it will not be feasible to shift 
production between P's and S's facilities. P and S have no plans to 
build new facilities and the lead time required to plan and build a 
manufacturing facility precludes the possibility that P or S will build 
a new facility during the period for which sales of Product Z are 
expected. When the CSA is formed, P has a platform contribution T. Under 
the PCT for T, S is obligated to pay P sales-based royalties according 
to a certain formula. Aside from T, there are no other platform 
contributions. Two years after the formation of the CSA, owing to a 
change in plans not reasonably foreseeable at the time the CSA was 
entered into, S acquires additional facilities F for the manufacture of 
Product Z. Such acquisition constitutes a capability variation described 
in paragraph (f)(3) of this section. Under this capability variation, 
S's RAB share increases from 50% to 60%. Accordingly, there is a 
compensable change in participation under paragraph (f)(3) of this 
section.

    (g) Supplemental guidance on methods applicable to PCTs--(1) In 
general. This paragraph (g) provides supplemental guidance on applying 
the methods listed in this paragraph (g)(1) for purposes of evaluating 
the arm's length amount charged in a PCT. Each method will yield a value 
for the compensation obligation of each PCT Payor consistent with the 
product of the combined pre-tax value to all controlled participants of 
the platform contribution that is the subject of the PCT and the PCT 
Payor's RAB share. Each method must yield results consistent with 
measuring the value of a platform contribution by reference to the 
future income anticipated to be generated by the resulting cost shared 
intangibles. The methods are--
    (i) The comparable uncontrolled transaction method described in 
Sec.  1.482-4(c), or the comparable uncontrolled services price method 
described in Sec.  1.482-9(c), as further described in paragraph (g)(3) 
of this section;
    (ii) The income method, described in paragraph (g)(4) of this 
section;
    (iii) The acquisition price method, described in paragraph (g)(5) of 
this section;
    (iv) The market capitalization method, described in paragraph (g)(6) 
of this section;
    (v) The residual profit split method, described in paragraph (g)(7) 
of this section; and
    (vi) Unspecified methods, described in paragraph (g)(8) of this 
section.
    (2) Best method analysis applicable for evaluation of a PCT pursuant 
to a CSA--(i) In general. Each method must be applied in accordance with 
the provisions of Sec.  1.482-1, including the best method rule of Sec.  
1.482-1(c), the comparability analysis of Sec.  1.482-1(d), and the 
arm's length range of Sec.  1.482-1(e), except as those provisions are 
modified in this paragraph (g).
    (ii) Consistency with upfront contractual terms and risk 
allocation--the investor model--(A) In general. Although all of the 
factors entering into a best method analysis described in Sec.  1.482-
1(c) and (d) must be considered, specific factors may be particularly 
relevant in the context of a CSA. In particular, the relative 
reliability of an application of any method depends on the degree of 
consistency of the analysis with the applicable contractual terms and 
allocation of risk under the CSA and this section among the controlled 
participants as of the date of the PCT, unless a change in such terms or 
allocation has been made in return for arm's length consideration. In 
this regard, a CSA involves an upfront division of the risks as to both 
reasonably anticipated obligations and reasonably anticipated benefits 
over the reasonably anticipated term of the CSA Activity. Accordingly, 
the relative reliability of an application of a method also depends on 
the degree of consistency of the analysis with the assumption that, as 
of the date of the PCT, each controlled participant's aggregate net 
investment in the CSA Activity (including platform contributions, 
operating contributions, as such term is defined in

[[Page 750]]

paragraph (j)(1)(i) of this section, operating cost contributions, as 
such term is defined in paragraph (j)(1)(i) of this section, and cost 
contributions) is reasonably anticipated to earn a rate of return (which 
might be reflected in a discount rate used in applying a method) 
appropriate to the riskiness of the controlled participant's CSA 
Activity over the entire period of such CSA Activity. If the cost shared 
intangibles themselves are reasonably anticipated to contribute to 
developing other intangibles, then the period described in the preceding 
sentence includes the period, reasonably anticipated as of the date of 
the PCT, of developing and exploiting such indirectly benefited 
intangibles.
    (B) Example. The following example illustrates the principles of 
this paragraph (g)(2)(ii):

    Example. (i) P, a U.S. corporation, has developed a software 
program, DEF, which applies certain algorithms to reconstruct complete 
DNA sequences from partially-observed DNA sequences. S is a wholly-owned 
foreign subsidiary of P. On the first day of Year 1, P and S enter into 
a CSA to develop a new generation of genetic tests, GHI, based in part 
on the use of DEF. DEF is therefore a platform contribution of P for 
which compensation is due from S pursuant to a PCT. S makes no platform 
contributions to the CSA. Sales of GHI are projected to commence two 
years after the inception of the CSA and then to continue for eight more 
years. Based on industry experience, P and S are confident that GHI will 
be replaced by a new type of genetic testing based on technology 
unrelated to DEF or GHI and that, at that point, GHI will have no 
further value. P and S project that that replacement will occur at the 
end of Year 10.
    (ii) For purposes of valuing the PCT for P's platform contribution 
of DEF to the CSA, P and S apply a type of residual profit split method 
that is not described in paragraph (g)(7) of this section and which, 
accordingly, constitutes an unspecified method. See paragraph (g)(7)(i) 
(last sentence) of this section. The principles of this paragraph (g)(2) 
apply to any method for valuing a PCT, including the unspecified method 
used by P and S.
    (iii) Under the method employed by P and S, in each year, a portion 
of the income from sales of GHI in S's territory is allocated to certain 
routine contributions made by S. The residual of the profit or loss from 
GHI sales in S's territory after the routine allocation step is divided 
between P and S pro rata to their capital stocks allocable to S's 
territory. Each controlled participant's capital stock is computed by 
capitalizing, applying a capital growth factor to, and amortizing its 
historical expenditures regarding DEF allocable to S's territory (in the 
case of P), or its ongoing cost contributions towards developing GHI (in 
the case of S). The amortization of the capital stocks is effected on a 
straight-line basis over an assumed four-year life for the relevant 
expenditures. The capital stocks are grown using an assumed growth 
factor that P and S consider to be appropriate.
    (iv) The assumption that all expenditures amortize on a straight-
line basis over four years does not appropriately reflect the principle 
that as of the date of the PCT regarding DEF, every contribution to the 
development of GHI, including DEF, is reasonably anticipated to have 
value throughout the entire period of exploitation of GHI which is 
projected to continue through Year 10. Under this method as applied by P 
and S, the share of the residual profit in S's territory that is 
allocated to P as a PCT Payment from S will decrease every year. After 
Year 4, P's capital stock in DEF will necessarily be $0, so that P will 
receive none of the residual profit or loss from GHI sales in S's 
territory after Year 4 as a PCT Payment.
    (v) As a result of this limitation of the PCT Payments to be made by 
S, the anticipated return to S's aggregate investment in the CSA, over 
the whole period of S's CSA Activity, is at a rate that is significantly 
higher than the appropriate rate of return for S's CSA Activity (as 
determined by a reliable method). This discrepancy is not consistent 
with the investor model principle that S should anticipate a rate of 
return to its aggregate investment in the CSA, over the whole period of 
its CSA Activity, appropriate for the riskiness of its CSA Activity. The 
inconsistency of the method with the investor model materially lessens 
its reliability for purposes of a best method analysis. See Sec.  1.482-
1(c)(2)(ii)(B).

    (iii) Consistency of evaluation with realistic alternatives--(A) In 
general. The relative reliability of an application of a method also 
depends on the degree of consistency of the analysis with the assumption 
that uncontrolled taxpayers dealing at arm's length would have evaluated 
the terms of the transaction, and only entered into such transaction, if 
no alternative is preferable. This condition is not met, therefore, 
where for any controlled participant the total anticipated present value 
of its income attributable to its entering into the CSA, as of the date 
of the PCT, is less than the total anticipated present value of its 
income that could be achieved through an alternative arrangement 
realistically available to

[[Page 751]]

that controlled participant. In principle, this comparison is made on a 
post-tax basis but, in many cases, a comparison made on a pre-tax basis 
will yield equivalent results. See also paragraph (g)(2)(v)(B)(1) of 
this section (Discount rate variation between realistic alternatives).
    (B) Examples. The following examples illustrate the principles of 
this paragraph (g)(2)(iii):

    Example 1. (i) P, a corporation, and S, a wholly-owned subsidiary of 
P, enter into a CSA to develop a personal transportation device (the 
product). Under the arrangement, P will undertake all of the R&D, and 
manufacture and market the product in Country X. S will make CST 
Payments to P for its appropriate share of P's R&D costs, and 
manufacture and market the product in the rest of the world. P owns 
existing patents and trade secrets that are reasonably anticipated to 
contribute to the development of the product. Therefore the rights in 
the patents and trade secrets are platform contributions for which 
compensation is due from S as part of a PCT.
    (ii) S's manufacturing and distribution activities under the CSA 
will be routine in nature, and identical to the activities it would 
undertake if it alternatively licensed the product from P.
    (iii) Reasonably reliable estimates indicate that P could develop 
the product without assistance from S and license the product outside of 
Country X for a royalty of 20% of sales. Based on reliable financial 
projections that include all future development costs and licensing 
revenue that are allocable to the non-Country X market, and using a 
discount rate appropriate for the riskiness of P's role as a licensor 
(see paragraph (g)(2)(v) of this section), the post-tax present value of 
this licensing alternative to P for the non-Country X market (measured 
as of the date of the PCT) would be $500 million. Thus, based on this 
realistic alternative, the anticipated post-tax present value under the 
CSA to P in the non-Country X market (measured as of the date of the 
PCT), taking into account anticipated development costs allocable to the 
non-Country X market, and anticipated CST Payments and PCT Payments from 
S, and using a discount rate appropriate for the riskiness of P's role 
as a participant in the CSA, should not be less than $500 million.
    Example 2. (i) The facts are the same as in Example 1, except that 
there are no reliable estimates of the value to P from the licensing 
alternative to the CSA. Further, reasonably reliable estimates indicate 
that an arm's length return for S's routine manufacturing and 
distribution activities is a 10% mark-up on total costs of goods sold 
plus operating expenses related to those activities. Finally, the 
Commissioner determines that the respective activities undertaken by P 
and S (other than licensing payments, cost contributions, and PCT 
Payments) would be identical regardless of whether the arrangement was 
undertaken as a CSA (cost sharing alternative) or as a long-term 
licensing arrangement (licensing alternative). In particular, in both 
alternatives, P would perform all research activities and S would 
undertake routine manufacturing and distribution activities associated 
with its territory.
    (ii) P undertakes an economic analysis that derives S's cost 
contributions under the CSA, based on reliable financial projections. 
Based on this and further economic analysis, P determines S's PCT 
Payment as a certain lump sum amount to be paid as of the date of the 
PCT (Date D).
    (iii) Based on reliable financial projections that include S's cost 
contributions and that incorporate S's PCT Payment, as computed by P, 
and using a discount rate appropriate for the riskiness of S's role as a 
CSA participant (see paragraphs (g)(2)(v) and (4)(vi)(F) of this 
section), the anticipated post-tax net present value to S in the cost 
sharing alternative (measured as of Date D) is $800 million. Further, 
based on these same reliable projections (but incorporating S's 
licensing payments instead of S's cost contributions and PCT Payment), 
and using a discount rate appropriate for the riskiness of S's role as a 
long-term licensee, the anticipated post-tax net present value to S in 
the licensing alternative (measured as of Date D) is $100 million. Thus, 
S's anticipated post-tax net present value is $700 million greater in 
the cost sharing alternative than in the licensing alternative. This 
result suggests that P's anticipated post-tax present value must be 
significantly less under the cost sharing alternative than under the 
licensing alternative. This means that the reliability of P's analysis 
as described in paragraph (ii) of this Example 2 is reduced, because P 
would not be expected to enter into a CSA if its alternative of being a 
long-term licensor is preferable.
    Example 3. (i) The facts are the same as in paragraphs (i) and (ii) 
of Example 2. In addition, based on reliable financial projections that 
include S's cost contributions and S's PCT Payment, and using a discount 
rate appropriate for the riskiness of S's role as a CSA participant, the 
anticipated post-tax net present value to S under the CSA (measured as 
of the date of the PCT) is $50 million. Also, instead of entering the 
CSA, S has the realistic alternative of manufacturing and distributing 
product Z unrelated to the personal transportation device, with the same 
anticipated 10% mark-up on total costs that it would anticipate for its 
routine activities in Example 2. Under its realistic alternative,

[[Page 752]]

at a discount rate appropriate for the riskiness of S's role with 
respect to product Z, S anticipates a present value of $100 million.
    (ii) Because the lump sum PCT Payment made by S results in S having 
a considerably lower anticipated net present value than S could achieve 
through an alternative arrangement realistically available to it, the 
reliability of P's calculation of the lump sum PCT Payment is reduced.

    (iv) Aggregation of transactions. The combined effect of multiple 
contemporaneous transactions, consisting either of multiple PCTs, or of 
one or more PCT and one or more other transactions in connection with a 
CSA that are not governed by this section (such as transactions 
involving cross operating contributions or make-or-sell rights), may 
require evaluation in accordance with the principles of aggregation 
described in Sec.  1.482-1(f)(2)(i). In such cases, it may be that the 
multiple transactions are reasonably anticipated, as of the date of the 
PCT(s), to be so interrelated that the method that provides the most 
reliable measure of an arm's length charge is a method under this 
section applied on an aggregate basis for the PCT(s) and other 
transactions. A section 482 adjustment may be made by comparing the 
aggregate arm's length charge so determined to the aggregate payments 
actually made for the multiple transactions. In such a case, it 
generally will not be necessary to allocate separately the aggregate 
arm's length charge as between various PCTs or as between PCTs and such 
other transactions. However, such an allocation may be necessary for 
other purposes, such as applying paragraph (i)(6) (Periodic adjustments) 
of this section. An aggregate determination of the arm's length charge 
for multiple transactions will often yield a payment for a controlled 
participant that is equal to the aggregate value of the platform 
contributions and other resources, capabilities, and rights covered by 
the multiple transactions multiplied by that controlled participant's 
RAB share. Because RAB shares only include benefits from cost shared 
intangibles, the reliability of an aggregate determination of payments 
for multiple transactions may be reduced to the extent that it includes 
transactions covering resources, capabilities, and rights for which the 
controlled participants' expected benefit shares differ substantially 
from their RAB shares.
    (v) Discount rate--(A) In general. The best method analysis in 
connection with certain methods or forms of payment may depend on a rate 
or rates of return used to convert projected results of transactions to 
present value, or to otherwise convert monetary amounts at one or more 
points in time to equivalent amounts at a different point or points in 
time. For this purpose, a discount rate or rates should be used that 
most reliably reflect the market-correlated risks of activities or 
transactions and should be applied to the best estimates of the relevant 
projected results, based on all the information potentially available at 
the time for which the present value calculation is to be performed. 
Depending on the particular facts and circumstances, the market-
correlated risk involved and thus, the discount rate, may differ among a 
company's various activities or transactions. Normally, discount rates 
are most reliably determined by reference to market information.
    (B) Considerations in best method analysis of discount rate--(1) 
Discount rate variation between realistic alternatives. Realistic 
alternatives may involve varying risk exposure and, thus, may be more 
reliably evaluated using different discount rates. See paragraphs 
(g)(4)(i)(F) and (vi)(F) of this section. In some circumstances, a party 
may have less risk as a licensee of intangibles needed in its 
operations, and so require a lower discount rate, than it would have by 
entering into a CSA to develop such intangibles, which may involve the 
party's assumption of additional risk in funding its cost contributions 
to the IDA. Similarly, self-development of intangibles and licensing out 
may be riskier for the licensor, and so require a higher discount rate, 
than entering into a CSA to develop such intangibles, which would 
relieve the licensor of the obligation to fund a portion of the IDCs of 
the IDA.
    (2) Implied discount rates. In some circumstances, the particular 
discount rate or rates used for certain activities or transactions 
logically imply that

[[Page 753]]

certain other activities will have a particular discount rate or set of 
rates (implied discount rates). To the extent that an implied discount 
rate is inappropriate in light of the facts and circumstances, which may 
include reliable direct evidence of the appropriate discount rate 
applicable for such other activities, the reliability of any method is 
reduced where such method is based on the discount rates from which such 
an inappropriate implied discount rate is derived. See paragraphs 
(g)(4)(vi)(F)(2) and (g)(4)(viii), Example 8 of this section.
    (3) Discount rate variation between forms of payment. Certain forms 
of payment may involve different risks than others. For example, 
ordinarily a royalty computed on a profits base would be more volatile, 
and so require a higher discount rate to discount projected payments to 
present value, than a royalty computed on a sales base.
    (4) Post-tax rate. In general, discount rate estimates that may be 
inferred from the operations of the capital markets are post-tax 
discount rates. Therefore, an analysis would in principle apply post-tax 
discount rates to income net of expense items including taxes (post-tax 
income). However, in certain circumstances the result of applying a 
post-tax discount rate to post-tax income is equivalent to the product 
of the result of applying a post-tax discount rate to income net of 
expense items other than taxes (pre-tax income), and the difference of 
one minus the tax rate (as defined in paragraph (j)(1)(i) of this 
section). Therefore, in such circumstances, calculation of pre-tax 
income, rather than post-tax income, may be sufficient. See, for 
example, paragraph (g)(4)(i)(G) of this section.
    (C) Example. The following example illustrates the principles of 
this paragraph (g)(2)(v):

    Example. (i) P and S form a CSA to develop intangible X, which will 
be used in product Y. P will develop X, and S will make CST Payments as 
its cost contributions. At the start of the CSA, P has a platform 
contribution, for which S commits to make a PCT Payment of 5% of its 
sales of product Y. As part of the evaluation of whether that PCT 
Payment is arm's length, the Commissioner considers whether P had a more 
favorable realistic alternative (see paragraph (g)(2)(iii) of this 
section). Specifically, the Commissioner compares P's anticipated post-
tax discounted present value of the financial projections under the CSA 
(taking into account S's PCT payment of 5% of its sale of product Y) 
with P's anticipated post-tax discounted present value of the financial 
projections under a reasonably available licensing alternative that 
consists of developing intangible X on its own and then licensing X to S 
or to an uncontrolled party similar to S. In undertaking the analysis, 
the Commissioner determines that, because it would be funding the entire 
development of the intangible, P undertakes greater risks in the 
licensing alternative than in the cost sharing alternative (in the cost 
sharing alternative P would be funding only part of the development of 
the intangible).
    (ii) The Commissioner determines that, as between the two scenarios, 
all of the components of P's anticipated financial flows are identical, 
except for the CST and PCT Payments under the CSA, compared to the 
licensing payments under the licensing alternative. Accordingly, the 
Commissioner concludes that the differences in market-correlated risks 
between the two scenarios, and therefore the differences in discount 
rates between the two scenarios, relate to the differences in these 
components of the financial projections.

    (vi) Financial projections. The reliability of an estimate of the 
value of a platform or operating contribution in connection with a PCT 
will often depend upon the reliability of projections used in making the 
estimate. Such projections should reflect the best estimates of the 
items projected (normally reflecting a probability weighted average of 
possible outcomes and thus also reflecting non-market-correlated risk). 
Projections necessary for this purpose may include a projection of 
sales, IDCs, costs of developing operating contributions, routine 
operating expenses, and costs of sales. Some method applications 
directly estimate projections of items attributable to separate 
development and exploitation by the controlled participants within their 
respective divisions. Other method applications indirectly estimate 
projections of items from the perspective of the controlled group as a 
whole, rather than from the perspective of a particular participant, and 
then apportion

[[Page 754]]

the items so estimated on some assumed basis. For example, in some 
applications, sales might be directly projected by division, but 
worldwide projections of other items such as operating expenses might be 
apportioned among divisions in the same ratio as the divisions' 
respective sales. Which approach is more reliable depends on which 
provides the most reliable measure of an arm's length result, 
considering the competing perspectives under the facts and circumstances 
in light of the completeness and accuracy of the underlying data, the 
reliability of the assumptions, and the sensitivity of the results to 
possible deficiencies in the data and assumptions. For these purposes, 
projections that have been prepared for non-tax purposes are generally 
more reliable than projections that have been prepared solely for 
purposes of meeting the requirements in this paragraph (g).
    (vii) Accounting principles--(A) In general. Allocations or other 
valuations done for accounting purposes may provide a useful starting 
point but will not be conclusive for purposes of the best method 
analysis in evaluating the arm's length charge in a PCT, particularly 
where the accounting treatment of an asset is inconsistent with its 
economic value.
    (B) Examples. The following examples illustrate the principles of 
this paragraph (g)(2)(vii):

    Example 1. (i) USP, a U.S. corporation and FSub, a wholly-owned 
foreign subsidiary of USP, enter into a CSA in Year 1 to develop 
software programs with application in the medical field. Company X is an 
uncontrolled software company located in the United States that is 
engaged in developing software programs that could significantly enhance 
the programs being developed by USP and FSub. Company X is still in a 
startup phase, so it has no currently exploitable products or marketing 
intangibles and its workforce consists of a team of software developers. 
Company X has negligible liabilities and tangible property. In Year 2, 
USP purchases Company X as part of an uncontrolled transaction in order 
to acquire its in-process technology and workforce for purposes of the 
development activities of the CSA. USP files a consolidated return that 
includes Company X. For accounting purposes, $50 million of the $100 
million acquisition price is allocated to the in-process technology and 
workforce, and the residual $50 million is allocated to goodwill.
    (ii) The in-process technology and workforce of Company X acquired 
by USP are reasonably anticipated to contribute to developing cost 
shared intangibles and therefore the rights in the in-process technology 
and workforce of Company X are platform contributions for which FSub 
must compensate USP as part of a PCT. In determining whether to apply 
the acquisition price or another method for purposes of evaluating the 
arm's length charge in the PCT, relevant best method analysis 
considerations must be weighed in light of the general principles of 
paragraph (g)(2) of this section. The allocation for accounting purposes 
raises an issue as to the reliability of using the acquisition price 
method in this case because it suggests that a significant portion of 
the value of Company X's nonroutine contributions to USP's business 
activities is allocable to goodwill, which is often difficult to value 
reliably and which, depending on the facts and circumstances, might not 
be attributable to platform contributions that are to be compensated by 
PCTs. See paragraph (g)(5)(iv)(A) of this section.
    (iii) Paragraph (g)(2)(vii)(A) of this section provides that 
accounting treatment may be a starting point, but is not determinative 
for purposes of assessing or applying methods to evaluate the arm's 
length charge in a PCT. The facts here reveal that Company X has nothing 
of economic value aside from its in-process technology and assembled 
workforce. The $50 million of the acquisition price allocated to 
goodwill for accounting purposes, therefore, is economically 
attributable to either of, or both, the in-process technology and the 
workforce. That moots the potential issue under the acquisition price 
method of the reliability of valuation of assets not to be compensated 
by PCTs, since there are no such assets. Assuming the acquisition price 
method is otherwise the most reliable method, the aggregate value of 
Company X's in-process technology and workforce is the full acquisition 
price of $100 million. Accordingly, the aggregate value of the arm's 
length PCT Payments due from FSub to USP for the platform contributions 
consisting of the rights in Company X's in-process technology and 
workforce will equal $100 million multiplied by FSub's RAB share.
    Example 2. (i) The facts are the same as in Example 1, except that 
Company X is a mature software business in the United States with a 
successful current generation of software that it markets under a 
recognized trademark, in addition to having the research team and new 
generation software in process that could significantly enhance the 
programs being developed under USP's and FSub's CSA. USP continues 
Company X's existing business and integrates the research team and the 
in-process technology into the

[[Page 755]]

efforts under its CSA with FSub. For accounting purposes, the $100 
million price for acquiring Company X is allocated $50 million to 
existing software and trademark, $25 million to in-process technology 
and research workforce, and the residual $25 million to goodwill and 
going concern value.
    (ii) In this case an analysis of the facts indicates a likelihood 
that, consistent with the allocation under the accounting treatment 
(although not necessarily in the same amount), a significant amount of 
the nonroutine contributions to the USP's business activities consist of 
goodwill and going concern value economically attributable to the 
existing U.S. software business rather than to the platform 
contributions consisting of the rights in the in-process technology and 
research workforce. In addition, an analysis of the facts indicates that 
a significant amount of the nonroutine contributions to USP's business 
activities consist of the make-or-sell rights under the existing 
software and trademark, which are not platform contributions and might 
be difficult to value. Accordingly, further consideration must be given 
to the extent to which these circumstances reduce the relative 
reliability of the acquisition price method in comparison to other 
potentially applicable methods for evaluating the PCT Payment.
    Example 3. (i) USP, a U.S. corporation, and FSub, a wholly-owned 
foreign subsidiary of USP, enter into a CSA in Year 1 to develop Product 
A. Company Y is an uncontrolled corporation that owns Technology X, 
which is critical to the development of Product A. Company Y currently 
markets Product B, which is dependent on Technology X. USP is solely 
interested in acquiring Technology X, but is only able to do so through 
the acquisition of Company Y in its entirety for $200 million in an 
uncontrolled transaction in Year 2. For accounting purposes, the 
acquisition price is allocated as follows: $120 million to Product B and 
the underlying Technology X, $30 million to trademark and other 
marketing intangibles, and the residual $50 million to goodwill and 
going concern value. After the acquisition of Company Y, Technology X is 
used to develop Product A. No other part of Company Y is used in any 
manner. Immediately after the acquisition, product B is discontinued, 
and, therefore, the accompanying marketing intangibles become worthless. 
None of the previous employees of Company Y is retained.
    (ii) The Technology X of Company Y acquired by USP is reasonably 
anticipated to contribute to developing cost shared intangibles and is 
therefore a platform contribution for which FSub must compensate USP as 
part of a PCT. Although for accounting purposes a significant portion of 
the acquisition price of Company Y was allocated to items other than 
Technology X, the facts demonstrate that USP had no intention of using 
and therefore placed no economic value on any part of Company Y other 
than Technology X. If USP was willing to pay $200 million for Company Y 
solely for purposes of acquiring Technology X, then assuming the 
acquisition price method is otherwise the most reliable method, the 
value of Technology X is the full $200 million acquisition price. 
Accordingly, the value of the arm's length PCT Payment due from FSub to 
USP for the platform contribution consisting of the rights in Technology 
X will equal the product of $200 million and FSub's RAB share.

    (viii) Valuations of subsequent PCTs--(A) Date of subsequent PCT. 
The date of a PCT may occur subsequent to the inception of the CSA. For 
example, an intangible initially developed outside the IDA may only 
subsequently become a platform contribution because that later time is 
the earliest date on which it is reasonably anticipated to contribute to 
developing cost shared intangibles within the IDA. In such case, the 
date of the PCT, and the analysis of the arm's length amount charged in 
the subsequent PCT, is as of such later time.
    (B) Best method analysis for subsequent PCT. In cases where PCTs 
occur on different dates, the determination of the arm's length amount 
charged, respectively, in the prior and subsequent PCTs must be 
coordinated in a manner that provides the most reliable measure of an 
arm's length result. In some circumstances, a subsequent PCT may be 
reliably evaluated independently of other PCTs, as may be possible for 
example, under the acquisition price method. In other circumstances, the 
results of prior and subsequent PCTs may be interrelated and so a 
subsequent PCT may be most reliably evaluated under the residual profit 
split method of paragraph (g)(7) of this section. In those cases, for 
purposes of allocating the present value of nonroutine residual 
divisional profit or loss, and so determining the present value of the 
subsequent PCT Payments, in accordance with paragraph (g)(7)(iii)(C) of 
this section, the PCT Payor's interest in cost shared intangibles, both 
already developed and in process, are treated as additional PCT Payor 
operating contributions as of the date of the subsequent PCT.
    (ix) Arm's length range--(A) In general. The guidance in Sec.  
1.482-1(e) regarding

[[Page 756]]

determination of an arm's length range, as modified by this section, 
applies in evaluating the arm's length amount charged in a PCT under a 
transfer pricing method provided in this section (applicable method). 
Section 1.482-1(e)(2)(i) provides that the arm's length range is 
ordinarily determined by applying a single pricing method selected under 
the best method rule to two or more uncontrolled transactions of similar 
comparability and reliability although use of more than one method may 
be appropriate for the purposes described in Sec.  1.482-1(c)(2)(iii). 
The rules provided in Sec.  1.482-1(e) and this section for determining 
an arm's length range shall not override the rules provided in paragraph 
(i)(6) of this section for periodic adjustments by the Commissioner. The 
provisions in paragraphs (g)(2)(ix)(C) and (D) of this section apply 
only to applicable methods that are based on two or more input 
parameters as described in paragraph (g)(2)(ix)(B) of this section. For 
an example of how the rules of this section for determining an arm's 
length range of PCT Payments are applied, see paragraph (g)(4)(viii) of 
this section.
    (B) Methods based on two or more input parameters. An applicable 
method may determine PCT Payments based on calculations involving two or 
more parameters whose values depend on the facts and circumstances of 
the case (input parameters). For some input parameters (market-based 
input parameters), the value is most reliably determined by reference to 
data that derives from uncontrolled transactions (market data). For 
example, the value of the return to a controlled participant's routine 
contributions, as such term is defined in paragraph (j)(1)(i) of this 
section, to the CSA Activity (which value is used as an input parameter 
in the income method described in paragraph (g)(4) of this section) may 
in some cases be most reliably determined by reference to the profit 
level of a company with rights, resources, and capabilities comparable 
to those routine contributions. See Sec.  1.482-5. As another example, 
the value for the discount rate that reflects the riskiness of a 
controlled participant's role in the CSA (which value is used as an 
input parameter in the income method described in paragraph (g)(4) of 
this section) may in some cases be most reliably determined by reference 
to the stock beta of a company whose overall risk is comparable to the 
riskiness of the controlled participant's role in the CSA.
    (C) Variable input parameters. For some market-based input 
parameters (variable input parameters), the parameter's value is most 
reliably determined by considering two or more observations of market 
data that have, or with adjustment can be brought to, a similar 
reliability and comparability, as described in Sec.  1.482-1(e)(2)(ii) 
(for example, profit levels or stock betas of two or more companies). 
See paragraph (g)(2)(ix)(B) of this section.
    (D) Determination of arm's length PCT Payment. For purposes of 
applying this paragraph (g)(2)(ix), each input parameter is assigned a 
single most reliable value, unless it is a variable input parameter as 
described in paragraph (g)(2)(ix)(C) of this section. The determination 
of the arm's length payment depends on the number of variable input 
parameters.
    (1) No variable input parameters. If there are no variable input 
parameters, the arm's length PCT Payment is a single value determined by 
using the single most reliable value determined for each input 
parameter.
    (2) One variable input parameter. If there is exactly one variable 
input parameter, then under the applicable method, the arm's length 
range of PCT Payments is the interquartile range, as described in Sec.  
1.482-1(e)(2)(iii)(C), of the set of PCT Payment values calculated by 
selecting--
    (i) Iteratively, the value of the variable input parameter that is 
based on each observation as described in paragraph (g)(2)(ix)(C) of 
this section; and
    (ii) The single most reliable values for each other input parameter.
    (3) More than one variable input parameter. If there are two or more 
variable input parameters, then under the applicable method, the arm's 
length range of PCT Payments is the interquartile range, as described in 
Sec.  1.482-1(e)(2)(iii)(C), of the set of PCT Payment values calculated 
iteratively using every possible combination of permitted choices of 
values for the

[[Page 757]]

input parameters. For input parameters other than a variable input 
parameter, the only such permitted choice is the single most reliable 
value. For variable input parameters, such permitted choices include any 
value that is--
    (i) Based on one of the observations described in paragraph 
(g)(2)(ix)(C) of this section; and
    (ii) Within the interquartile range (as described in Sec.  1.482-
1(e)(2)(iii)(C)) of the set of all values so based.
    (E) Adjustments. Section 1.482-1(e)(3), applied as modified by this 
paragraph (g)(2)(ix), determines when the Commissioner may make an 
adjustment to a PCT Payment due to the taxpayer's results being outside 
the arm's length range. Adjustment will be to the median, as defined in 
Sec.  1.482-1(e)(3). Thus, the Commissioner is not required to establish 
an arm's length range prior to making an allocation under section 482.
    (x) Valuation undertaken on a pre-tax basis. PCT Payments in general 
may increase the PCT Payee's tax liability and decrease the PCT Payor's 
tax liability. The arm's length amount of a PCT Payment determined under 
the methods in this paragraph (g) is the value of the PCT Payment 
itself, without regard to such tax effects. Therefore, the methods under 
this section must be applied, with suitable adjustments if needed, to 
determine the PCT Payments on a pre-tax basis. See paragraphs 
(g)(2)(v)(B) and (4)(i)(G) of this section.
    (3) Comparable uncontrolled transaction method. The comparable 
uncontrolled transaction (CUT) method described in Sec.  1.482-4(c), and 
the comparable uncontrolled services price (CUSP) method described in 
Sec.  1.482-9(c), may be applied to evaluate whether the amount charged 
in a PCT is arm's length by reference to the amount charged in a 
comparable uncontrolled transaction. Although all of the factors 
entering into a best method analysis described in Sec.  1.482-1(c) and 
(d) must be considered, comparability and reliability under this method 
are particularly dependent on similarity of contractual terms, degree to 
which allocation of risks is proportional to reasonably anticipated 
benefits from exploiting the results of intangible development, similar 
period of commitment as to the sharing of intangible development risks, 
and similar scope, uncertainty, and profit potential of the subject 
intangible development, including a similar allocation of the risks of 
any existing resources, capabilities, or rights, as well as of the risks 
of developing other resources, capabilities, or rights that would be 
reasonably anticipated to contribute to exploitation within the parties' 
divisions, that is consistent with the actual allocation of risks 
between the controlled participants as provided in the CSA in accordance 
with this section. When applied in the manner described in Sec.  1.482-
4(c) or 1.482-9(c), the CUT or CUSP method will typically yield an arm's 
length total value for the platform contribution that is the subject of 
the PCT. That value must then be multiplied by each PCT Payor's 
respective RAB share in order to determine the arm's length PCT Payment 
due from each PCT Payor. The reliability of a CUT or CUSP that yields a 
value for the platform contribution only in the PCT Payor's division 
will be reduced to the extent that value is not consistent with the 
total worldwide value of the platform contribution multiplied by the PCT 
Payor's RAB share.
    (4) Income method--(i) In general--(A) Equating cost sharing and 
licensing alternatives. The income method evaluates whether the amount 
charged in a PCT is arm's length by reference to a controlled 
participant's best realistic alternative to entering into a CSA. Under 
this method, the arm's length charge for a PCT Payment will be an amount 
such that a controlled participant's present value, as of the date of 
the PCT, of its cost sharing alternative of entering into a CSA equals 
the present value of its best realistic alternative. In general, the 
best realistic alternative of the PCT Payor to entering into the CSA 
would be to license intangibles to be developed by an uncontrolled 
licensor that undertakes the commitment to bear the entire risk of 
intangible development that would otherwise have been shared under the 
CSA. Similarly, the best realistic alternative of the PCT Payee to 
entering into the CSA would be to undertake the commitment to bear the 
entire risk

[[Page 758]]

of intangible development that would otherwise have been shared under 
the CSA and license the resulting intangibles to an uncontrolled 
licensee. Paragraphs (g)(4)(i)(B) through (vi) of this section describe 
specific applications of the income method, but do not exclude other 
possible applications of this method.
    (B) Cost sharing alternative. The PCT Payor's cost sharing 
alternative corresponds to the actual CSA in accordance with this 
section, with the PCT Payor's obligation to make the PCT Payments to be 
determined and its commitment for the duration of the IDA to bear cost 
contributions.
    (C) Licensing alternative. The licensing alternative is derived on 
the basis of a functional and risk analysis of the cost sharing 
alternative, but with a shift of the risk of cost contributions to the 
licensor. Accordingly, the PCT Payor's licensing alternative consists of 
entering into a license with an uncontrolled party, for a term extending 
for what would be the duration of the CSA Activity, to license the make-
or-sell rights in to-be-developed resources, capabilities, or rights of 
the licensor. Under such license, the licensor would undertake the 
commitment to bear the entire risk of intangible development that would 
otherwise have been shared under the CSA. Apart from any difference in 
the allocation of the risks of the IDA, the licensing alternative should 
assume contractual provisions with regard to non-overlapping divisional 
intangible interests, and with regard to allocations of other risks, 
that are consistent with the actual CSA in accordance with this section. 
For example, the analysis under the licensing alternative should assume 
a similar allocation of the risks of any existing resources, 
capabilities, or rights, as well as of the risks of developing other 
resources, capabilities, or rights that would be reasonably anticipated 
to contribute to exploitation within the parties' divisions, that is 
consistent with the actual allocation of risks between the controlled 
participants as provided in the CSA in accordance with this section. 
Accordingly, the financial projections associated with the licensing and 
cost sharing alternatives are necessarily the same except for the 
licensing payments to be made under the licensing alternative and the 
cost contributions and PCT Payments to be made under the CSA.
    (D) Only one controlled participant with nonroutine platform 
contributions. This method involves only one of the controlled 
participants providing nonroutine platform contributions as the PCT 
Payee. For a method under which more than one controlled participant may 
be a PCT Payee, see the application of the residual profit method 
pursuant to paragraph (g)(7) of this section.
    (E) Income method payment forms. The income method may be applied to 
determine PCT Payments in any form of payment (for example, lump sum, 
royalty on sales, or royalty on divisional profit). For converting to 
another form of payment, see generally paragraph (h) (Form of payment 
rules) of this section.
    (F) Discount rates appropriate to cost sharing and licensing 
alternatives. The present value of the cost sharing and licensing 
alternatives, respectively, should be determined using the appropriate 
discount rates in accordance with paragraphs (g)(2)(v) and (g)(4)(vi)(F) 
of this section. See, for example, Sec.  1.482-7(g)(2)(v)(B)(1) 
(Discount rate variation between realistic alternatives). In 
circumstances where the market-correlated risks as between the cost 
sharing and licensing alternatives are not materially different, a 
reliable analysis may be possible by using the same discount rate with 
respect to both alternatives.
    (G) The effect of taxation on determining the arm's length amount. 
(1) In principle, the present values of the cost sharing and licensing 
alternatives should be determined by applying post-tax discount rates to 
post-tax income (including the post-tax value to the controlled 
participant of the PCT Payments). If such approach is adopted, then the 
post-tax value of the PCT Payments must be appropriately adjusted in 
order to determine the arm's length amount of the PCT Payments on a pre-
tax basis. See paragraph (g)(2)(x) of this section.
    (2) In certain circumstances, post-tax income may be derived as the 
product

[[Page 759]]

of the result of applying a post-tax discount rate to pre-tax income, 
and a factor equal to one minus the tax rate (as defined in (j)(1)(i)). 
See paragraph (g)(2)(v)(B) of this section.
    (3) To the extent that a controlled participant's tax rate is not 
materially affected by whether it enters into the cost sharing or 
licensing alternative (or reliable adjustments may be made for varying 
tax rates), the factor (that is, one minus the tax rate) may be 
cancelled from both sides of the equation of the cost sharing and 
licensing alternative present values. Accordingly, in such circumstance 
it is sufficient to apply post-tax discount rates to projections of pre-
tax income for the purpose of equating the cost sharing and licensing 
alternatives. The specific applications of the income method described 
in paragraphs (g)(4)(ii) through (iv) of this section and the examples 
set forth in paragraph (g)(4)(viii) of this section assume that a 
controlled participant's tax rate is not materially affected by whether 
it enters into the cost sharing or licensing alternative.
    (ii) Evaluation of PCT Payor's cost sharing alternative. The present 
value of the PCT Payor's cost sharing alternative is the present value 
of the stream of the reasonably anticipated residuals over the duration 
of the CSA Activity of divisional profits or losses, minus operating 
cost contributions, minus cost contributions, minus PCT Payments.
    (iii) Evaluation of PCT Payor's licensing alternative--(A) 
Evaluation based on CUT. The present value of the PCT Payor's licensing 
alternative may be determined using the comparable uncontrolled 
transaction method, as described in Sec.  1.482-4(c)(1) and (2). In this 
case, the present value of the PCT Payor's licensing alternative is the 
present value of the stream, over what would be the duration of the CSA 
Activity under the cost sharing alternative, of the reasonably 
anticipated residuals of the divisional profits or losses that would be 
achieved under the cost sharing alternative, minus operating cost 
contributions that would be made under the cost sharing alternative, 
minus the licensing payments as determined under the comparable 
uncontrolled transaction method.
    (B) Evaluation based on CPM. The present value of the PCT Payor's 
licensing alternative may be determined using the comparable profits 
method, as described in Sec.  1.482-5. In this case, the present value 
of the licensing alternative is determined as in paragraph 
(g)(4)(iii)(A) of this section, except that the PCT Payor's licensing 
payments, as defined in paragraph (j)(1)(i) of this section, are 
determined in each period to equal the reasonably anticipated residuals 
of the divisional profits or losses that would be achieved under the 
cost sharing alternative, minus operating cost contributions that would 
be made under the cost sharing alternative, minus market returns for 
routine contributions, as defined in paragraph (j)(1)(i) of this 
section. However, treatment of net operating contributions as operating 
cost contributions shall be coordinated with the treatment of other 
routine contributions pursuant to this paragraph so as to avoid 
duplicative market returns to such contributions.
    (iv) Lump sum payment form. Where the form of PCT Payment is a lump 
sum as of the date of the PCT, then, based on paragraphs (g)(4)(i) 
through (iii) of this section, the PCT Payment equals the difference 
between--
    (A) The present value, using the discount rate appropriate for the 
cost sharing alternative, of the stream of the reasonably anticipated 
residuals over the duration of the CSA Activity of divisional profits or 
losses, minus cost contributions and operating cost contributions; and
    (B) The present value of the licensing alternative.
    (v) Application of income method using differential income stream. 
In some cases, the present value of an arm's length PCT Payment may be 
determined as the present value, discounted at the appropriate rate, of 
the PCT Payor's reasonably anticipated stream of additional positive or 
negative income over the duration of the CSA Activity that would result 
(before PCT Payments) from undertaking the cost sharing alternative 
rather than the licensing alternative (differential income stream). See 
Example 9 of paragraph (g)(4)(viii) of this section.

[[Page 760]]

    (vi) Best method analysis considerations. (A) Coordination with 
Sec.  1.482-1(c). Whether results derived from this method are the most 
reliable measure of an arm's length result is determined using the 
factors described under the best method rule in Sec.  1.482-1(c). Thus, 
comparability and the quality of data, the reliability of the 
assumptions, and the sensitivity of the results to possible deficiencies 
in the data and assumptions, must be considered in determining whether 
this method provides the most reliable measure of an arm's length 
result.
    (B) Assumptions Concerning Tax Rates. This method will be more 
reliable to the extent that the controlled participants' respective tax 
rates are not materially affected by whether they enter into the cost 
sharing or licensing alternative. Even if this assumption of invariant 
tax rates across alternatives does not hold, this method may still be 
reliable to the extent that reliable adjustments can be made to reflect 
the variation in tax rates.
    (C) Coordination with Sec.  1.482-4(c)(2). If the licensing 
alternative is evaluated using the comparable uncontrolled transactions 
method, as described in paragraph (g)(4)(iii)(A) of this section, any 
additional comparability and reliability considerations stated in Sec.  
1.482-4(c)(2) may apply.
    (D) Coordination with Sec.  1.482-5(c). If the licensing alternative 
is evaluated using the comparable profits method, as described in 
paragraph (g)(4)(iii)(B) of this section, any additional comparability 
and reliability considerations stated in Sec.  1.482-5(c) may apply.
    (E) Certain Circumstances Concerning PCT Payor. This method may be 
used even if the PCT Payor furnishes significant operating 
contributions, or commits to assume the risk of significant operating 
cost contributions, to the PCT Payor's division. However, in such a 
case, any comparable uncontrolled transactions described in paragraph 
(g)(4)(iii)(A) of this section, and any comparable transactions used 
under Sec.  1.482-5(c) as described in paragraphs (g)(4)(iii)(B) of this 
section, should be consistent with such contributions (or reliable 
adjustments must be made for material differences).
    (F) Discount rates--(1) Reflection of similar risk profiles of cost 
sharing alternative and licensing alternative. Because the financial 
projections associated with the licensing and cost sharing alternatives 
are the same, except for the licensing payments to be made under the 
licensing alternative and the cost contributions and PCT Payments to be 
made under the cost sharing alternative, the analysis of the risk 
profile and financial projections for a realistic alternative to the 
cost sharing alternative must be closely associated with the risk 
profile and financial projections associated with the cost sharing 
alternative, differing only in the treatment of licensing payments, cost 
contributions, and PCT Payments. When using discount rates in applying 
the income method, this means that even if different discount rates are 
warranted for the two alternatives, the risk profiles for the two 
discount rates are closely related to each other because the discount 
rate for the licensing alternative and the discount rate for the cost 
sharing alternative are both derived from the single probability-
weighted financial projections associated with the CSA Activity. The 
difference, if any, in market-correlated risks between the licensing and 
cost sharing alternatives is due solely to the different effects on 
risks of the PCT Payor making licensing payments under the licensing 
alternative, on the one hand, and the PCT Payor making cost 
contributions and PCT Payments under the cost sharing alternative, on 
the other hand. That is, the difference in the risk profile between the 
two scenarios solely reflects the incremental risk, if any, associated 
with the cost contributions taken on by the PCT Payor in developing the 
cost shared intangible under the cost sharing alternative, and the 
difference, if any, in risk associated with the particular payment forms 
of the licensing payments and the PCT Payments, in light of the fact 
that the licensing payments in the licensing alternative are partially 
replaced by cost contributions and partially replaced by PCT Payments in 
the cost sharing alternative, each with its own payment form. An 
analysis under the income method that uses a different discount rate for 
the

[[Page 761]]

cost sharing alternative than for the licensing alternative will be more 
reliable the greater the extent to which the difference, if any, between 
the two discount rates reflects solely these differences in the risk 
profiles of these two alternatives. See, for example, paragraph 
(g)(2)(iii), Example 2 of this section.
    (2) Use of differential income stream as a consideration in 
assessing the best method. An analysis under the income method that uses 
a different discount rate for the cost sharing alternative than for the 
licensing alternative will be more reliable the greater the extent to 
which the implied discount rate for the projected present value of the 
differential income stream is consistent with reliable direct evidence 
of the appropriate discount rate applicable for activities reasonably 
anticipated to generate an income stream with a similar risk profile to 
the differential income stream. Such differential income stream is 
defined as the stream of the reasonably anticipated residuals of the PCT 
Payor's licensing payments to be made under the licensing alternative, 
minus the PCT Payor's cost contributions to be made under the cost 
sharing alternative. See Example 8 of paragraph (g)(4)(viii) of this 
section.
    (vii) Routine platform and operating contributions. For purposes of 
this paragraph (g)(4), any routine contributions that are platform or 
operating contributions, the valuation and PCT Payments for which are 
determined and made independently of the income method, are treated 
similarly to cost contributions and operating cost contributions, 
respectively. Accordingly, wherever used in this paragraph (g)(4), the 
term ``routine contributions'' shall not include routine platform or 
operating contributions, and wherever the terms ``cost contributions'' 
and ``operating cost contributions'' appear in this paragraph, they 
shall include net routine platform contributions and net routine 
operating contributions, respectively. Net routine platform 
contributions are the value of a controlled participant's total 
reasonably anticipated routine platform contributions, plus its 
reasonably anticipated PCT Payments to other controlled participants in 
respect of their routine platform contributions, minus the reasonably 
anticipated PCT Payments it is to receive from other controlled 
participants in respect of its routine platform contributions. Net 
routine operating contributions are the value of a controlled 
participant's total reasonably anticipated routine operating 
contributions, plus its reasonably anticipated arm's length compensation 
to other controlled participants in respect of their routine operating 
contributions, minus the reasonably anticipated arm's length 
compensation it is to receive from other controlled participants in 
respect of its routine operating contributions.
    (viii) Examples. The following examples illustrate the principles of 
this paragraph (g)(4):

    Example 1. (i) For simplicity of calculation in this Example 1, all 
financial flows are assumed to occur at the beginning of each period. 
USP, a software company, has developed version 1.0 of a new software 
application that it is currently marketing. In Year 1 USP enters into a 
CSA with its wholly-owned foreign subsidiary, FS, to develop future 
versions of the software application. Under the CSA, USP will have the 
rights to exploit the future versions in the United States, and FS will 
have the rights to exploit them in the rest of the world. The future 
rights in version 1.0, and USP's development team, are reasonably 
anticipated to contribute to the development of future versions and 
therefore the rights in version 1.0 and the research and development 
team are platform contributions for which compensation is due from FS as 
part of a PCT. USP does not transfer the current exploitation rights in 
version 1.0 to FS. FS will not perform any research or development 
activities and does not furnish any platform contributions nor does it 
control any operating intangibles at the inception of the CSA that would 
be relevant to the exploitation of version 1.0 or future versions of the 
software.
    (ii) FS undertakes financial projections in its territory of the 
CSA:

[[Page 762]]



----------------------------------------------------------------------------------------------------------------
                                                                                                 (5) Operating
                                                                                               income under cost
                   (1) Year                       (2) Sales     (3) Operating     (4) Cost          sharing
                                                                    costs       contributions     alternative
                                                                                                (excluding PCT)
----------------------------------------------------------------------------------------------------------------
1............................................               0               0              50                -50
2............................................               0               0              50                -50
3............................................             200             100              50                 50
4............................................             400             200              50                150
5............................................             600             300              60                240
6............................................             650             325              65                260
7............................................             700             350              70                280
8............................................             750             375              75                300
9............................................             750             375              75                300
10...........................................             675             338              68                269
11...........................................             608             304              61                243
12...........................................             547             273              55                219
13...........................................             410             205              41                164
14...........................................             308             154              31                123
15...........................................             231             115              23                 93
----------------------------------------------------------------------------------------------------------------


FS anticipates that activity on this application will cease after Year 
15. The application was derived from software developed by Company Q, an 
uncontrolled party. FS has a license under Company Q's copyright, but 
that license expires after Year 15 and will not be renewed.
    (iii) In evaluating the cost sharing alternative, FS concludes that 
the cost sharing alternative represents a riskier alternative for FS 
than the licensing alternative because, in cost sharing, FS will take on 
the additional risks associated with cost contributions. Taking this 
difference into account, FS concludes that the appropriate discount rate 
to apply in assessing the licensing alternative, based on discount rates 
of comparable uncontrolled companies undertaking comparable licensing 
transactions, would be 13% per year, whereas the appropriate discount 
rate to apply in assessing the cost sharing alternative would be 15% per 
year. FS determines that the arm's length rate USP would have charged an 
uncontrolled licensee for a license of future versions of the software 
(if USP had further developed version 1.0 on its own) is 35% of the 
sales price, as determined under the CUT method in Sec.  1.482-4(c). FS 
also determines that the tax rate applicable to it will be the same in 
the licensing alternative as in the CSA. Accordingly, the financial 
projections associated with the licensing alternative are:

----------------------------------------------------------------------------------------------------------------
                                                                                                 (11) Operating
                                                                                               income under cost
                                                                               (10) Operating       sharing
           (6) Year               (7) Sales     (8) Operating   (9) Licensing   income under   alternative minus
                                                    costs         payments        licensing     operating income
                                                                                 alternative    under licensing
                                                                                                  alternative
----------------------------------------------------------------------------------------------------------------
1............................               0               0               0               0                -50
2............................               0               0               0               0                -50
3............................             200             100              70              30                 20
4............................             400             200             140              60                 90
5............................             600             300             210              90                150
6............................             650             325             228              97                163
7............................             700             350             245             105                175
8............................             750             375             263             112                188
9............................             750             375             263             112                188
10...........................             675             338             236             101                168
11...........................             608             304             213              91                152
12...........................             547             273             191              83                136
13...........................             410             205             144              61                103
14...........................             308             154             108              46                 77
15...........................             231             115              81              35                 58
----------------------------------------------------------------------------------------------------------------


[[Page 763]]

    (iv) Based on these projections and applying the appropriate 
discount rate, FS determines that under the cost sharing alternative, 
the present value of the stream of residuals of its anticipated 
divisional profits, reduced by the anticipated operating cost 
contributions and cost contributions, but not reduced by any PCT 
Payments (that is, the stream of anticipated operating income as shown 
in column 5) would be $889 million. Under the licensing alternative, the 
present value of the stream of residuals of its anticipated divisional 
profits and losses minus the operating cost contributions (that is, the 
stream of anticipated operating income before licensing payments, which 
is the present value of column 7 reduced by column 8) would be $1.419 
billion, and the present value of the licensing payments would be $994 
million. Therefore, the total value of the licensing alternative would 
be $425 million. In order for the present value of the cost sharing 
alternative to equal the present value of the licensing alternative, the 
present value of the PCT Payments must equal $464 million. Therefore, 
the taxpayer makes and reports PCT Payments with a present value of $464 
million.
    Example 2. Arm's length range. (i) The facts are the same as in 
Example 1. The Commissioner accepts the financial projections undertaken 
by FS. Further, the Commissioner determines that the licensing discount 
rate and the CUT licensing rate are most reliably determined by 
reference to comparable uncontrolled discount rates and license rates, 
respectively. The observations that are in the interquartile range of 
the respective input parameters (see paragraph (g)(2)(ix) of this 
section) are as follows:

------------------------------------------------------------------------
                                                           Comparable
   Observations that are within interquartile range       uncontrolled
                                                          discount rate
------------------------------------------------------------------------
1.....................................................               11%
2.....................................................                12
3 (Median)............................................                13
4.....................................................                15
5.....................................................                17
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                           Comparable
   Observations that are within interquartile range       uncontrolled
                                                         licensing rate
------------------------------------------------------------------------
1.....................................................               30%
2.....................................................                32
3 (Median)............................................                35
4.....................................................                37
5.....................................................                40
------------------------------------------------------------------------

    (ii) Following the principles of paragraph (g)(2)(ix) of this 
section, the Commissioner undertakes 25 different applications of the 
income method, using each combination of the discount rate and licensing 
rate parameters. In undertaking this analysis, the Commissioner assumes 
that the ratio of the median discount rate for the cost sharing 
alternative to the median discount rate for the licensing alternative 
(that is, 15% to 13%) is maintained. The results of the 25 applications 
of the income method, sorted in ascending order of calculated present 
value of the PCT Payment, are as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                 Comparable
                                                uncontrolled       Comparable        Comparable      Calculated lump      Interquartile range of PCT
      INCOME METHOD APPLICATION NUMBER::          licensing     uncontrolled CSA    uncontrolled     sum PCT payment               payments
                                                discount rate     discount rate    licensing rate
--------------------------------------------------------------------------------------------------------------------------------------------------------
1...........................................               17%             19.6%               30%               217
2...........................................                17              19.6                32               263
3...........................................                15              17.3                30               264
4...........................................                15              17.3                32               315
5...........................................                13                15                30               321
6...........................................                17              19.6                35               331
7...........................................                12              13.8                30               354  LQ = 354
8...........................................                17              19.6                37               376
9...........................................                13                15                32               378
10..........................................                11              12.7                30               391  ..................................
11..........................................                15              17.3                35               391
12..........................................                12              13.8                32               415
13..........................................                15              17.3                37               442  Median = 442
14..........................................                17              19.6                40               444
15..........................................                11              12.7                32               455
16..........................................                13                15                35               464
17..........................................                12              13.8                35               505
18..........................................                15              17.3                40               517
19..........................................                13                15                37               520  UQ = 520
20..........................................                11              12.7                35               551
21..........................................                12              13.8                37               566
22..........................................                13                15                40               605
23..........................................                11              12.7                37               615
24..........................................                12              13.8                40               655
25..........................................                11              12.7                40               710
--------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 764]]

    (iii) Accordingly, the Commissioner determines that a taxpayer will 
not be subject to adjustment if its initial (ex ante) determination of 
the present value of PCT Payments is between $354 million and $520 
million (the lower and upper quartile results as shown in the last 
column). Because FS's determination of the present value of the PCT 
Payments, $464 million, is within the interquartile range, no 
adjustments are warranted.
    Example 3. (i) For simplicity of calculation in this Example 3, all 
financial flows are assumed to occur at the beginning of each period. 
USP, a U.S. software company, has developed version 1.0 of a new 
software application, employed to store and retrieve complex data sets 
in certain types of storage media. Version 1.0 is currently being 
marketed. In Year 1, USP enters into a CSA with its wholly-owned foreign 
subsidiary, FS, to develop future versions of the software application. 
Under the CSA, USP will have the exclusive rights to exploit the future 
versions in the U.S., and FS will have the exclusive rights to exploit 
them in the rest of the world. USP's rights in version 1.0, and its 
development team, are reasonably anticipated to contribute to the 
development of future versions of the software application and, 
therefore, the rights in version 1.0 are platform contributions for 
which compensation is due from FS as part of a PCT. USP also transfers 
the current exploitation rights in version 1.0 to FS and the arm's 
length amount of the compensation for such transfer is determined in the 
aggregate with the arm's length PCT Payments in this Example 3. FS does 
not furnish any platform contributions to the CSA nor does it control 
any operating intangibles at the inception of the CSA that would be 
relevant to the exploitation of version 1.0 or future versions of the 
software. It is reasonably anticipated that FS will have gross sales of 
$1000X in its territory for 5 years attributable to its exploitation of 
version 1.0 and the cost shared intangibles, after which time the 
software application will be rendered obsolete and unmarketable by the 
obsolescence of the storage medium technology to which it relates. FS's 
costs reasonably attributable to the CSA, other than cost contributions 
and operating cost contributions, are anticipated to be $250X per year. 
Certain operating cost contributions that will be borne by FS are 
reasonably anticipated to equal $200X per annum for 5 years. In 
addition, FS is reasonably anticipated to pay cost contributions of 
$200X per year as a controlled participant in the CSA.
    (ii) FS concludes that its realistic alternative would be to license 
software from an uncontrolled licensor that would undertake the 
commitment to bear the entire risk of software development. Applying CPM 
using the profit levels experienced by uncontrolled licensees with 
contractual provisions and allocations of risk that are comparable to 
those of FS's licensing alternative, FS determines that it could, as a 
licensee, reasonably expect a (pre-tax) routine return equal to 14% of 
gross sales or $140X per year for 5 years. The remaining net revenue 
would be paid to the uncontrolled licensor as a license fee of $410X per 
year. FS determines that the discount rate that would be applied to 
determine the present value of income and costs attributable to its 
participation in the licensing alternative would be 12.5% as compared to 
the 15% discount rate that would be applicable in determining the 
present value of the net income attributable to its participation in the 
CSA (reflecting the increased risk borne by FS in bearing a share of the 
R & D costs in the cost sharing alternative). FS also determines that 
the tax rate applicable to it will be the same in the licensing 
alternative as in the CSA.
    (iii) On these facts, the present value to FS of entering into the 
cost sharing alternative equals the present value of the annual 
divisional profits ($1,000X minus $250X) minus operating cost 
contributions ($200X) minus cost contributions ($200X) minus PCT 
Payments, determined over 5 years by discounting at a discount rate of 
15%. Thus, the present value of the residuals, prior to subtracting the 
present value of the PCT Payments, is $1349X.
    (iv) On these facts, the present value to FS of entering into the 
licensing alternative would be $561X determined by discounting, over 5 
years, annual divisional profits ($1,000X minus $250X) minus operating 
cost contributions ($200X) and licensing payments ($410X) at a discount 
rate of 12.5% per annum. The present value of the cost sharing 
alternative must also equal $561X but equals $1349X prior to subtracting 
the present value of the PCT Payments. Consequently, the PCT Payments 
must have a present value of $788X.
    Example 4. Pre-tax PCT Payment derived from post-tax information. 
(i) For simplicity of calculation in this Example 4, it is assumed that 
all payments are made at the end of each year. Domestic controlled 
participant USP has developed a technology, Z, that it would like to 
exploit for three years in a CSA. USP enters into a CSA with its wholly-
owned foreign subsidiary, FS, that provides for PCT Payments from FS to 
USP with respect to USP's platform contribution to the CSA of Z in the 
form of three annual installment payments due from FS to USP on the last 
day of each of the first three years of the CSA. FS makes no platform 
contributions to the CSA. Prior to entering into the CSA, FS considers 
that it has the realistic alternative available to it of licensing Z 
from USP rather than entering into a CSA with USP to further develop Z 
for three years.
    (ii) FS undertakes financial projections for both the licensing and 
cost sharing alternatives for exploitation of Z in its territory

[[Page 765]]

of the CSA. These projections are set forth in the following tables. The 
example assumes that there is a reasonably anticipated effective tax 
rate of 25% in each of years 1 through 3 under both the licensing and 
cost sharing alternatives. FS determines that the appropriate post-tax 
discount rate under the licensing alternative is 12.5%, and that the 
appropriate post-tax discount rate under the cost sharing alternative is 
15%.

----------------------------------------------------------------------------------------------------------------
                                            Present value
          Licensing alternative              (12.5% DR)          Year 1            Year 2            Year 3
----------------------------------------------------------------------------------------------------------------
(1) Sales...............................  ................             $1000             $1100             $1210
(2) License Fee.........................  ................               400               440               484
(3) Operating costs.....................  ................               500               550               605
(4) Operating Income....................              $261               100               110               121
(5) Tax (25%)...........................  ................                25                28                30
(6) Post-tax income.....................              $196               $75               $82               $91
----------------------------------------------------------------------------------------------------------------


 
                                            Present value
        Cost sharing alternative              (15% DR)           Year 1            Year 2            Year 3
----------------------------------------------------------------------------------------------------------------
(7) Sales...............................  ................             $1000             $1100             $1210
(8) Cost Contributions..................  ................               200               220               242
(9) PCT Payments........................                 D                 A                 B                 C
(10) Operating costs....................  ................               500               550               605
(11) Operating income excluding PCT.....              $749               300               330               363
(12) Operating income...................                 H                 E                 F                 G
(13) Tax................................  ................  ................  ................
(14) Post-tax income excluding PCT......              $562              $225              $248              $272
(15) Post-tax income....................                 L                 I                 J                 K
----------------------------------------------------------------------------------------------------------------

    (iii) Under paragraph (g)(4) of this section, the arm's length 
charge for a PCT Payment will be an amount such that a controlled 
participant's present value, as of the date of the PCT of its cost 
sharing alternative of entering into a CSA equals the present value of 
its best realistic alternative. This requires that L, the present value 
of the post-tax income under the CSA, equals the present value of the 
post-tax income under the licensing alternative, or $196.
    (iv) FS determines that PCT Payments for Z should be $196 in Year 1 
(A), $215 in Year 2 (B), and $236 in Year 3 (C). By using these amounts 
for A, B, and C in the table above, FS is able to derive the values of 
E, F, G, I, J, and K in the table above. Based on these PCT Payments for 
Z, the post-tax income will be $78 in Year 1 (I), $86 in Year 2 (J), and 
$95 in Year 3 (K). When this post-tax income stream is discounted at the 
appropriate rate for the cost sharing alternative (15%), the net present 
value is $196 (L). The present value of the PCT Payments, when 
discounted at the appropriate post-tax rate, is $488 (D).
    (v) The Commissioner undertakes an audit of the PCT Payments made by 
FS to USP for Z in Years 1 through 3. The Commissioner concludes that 
the PCT Payments for Z are arm's length in accordance with this 
paragraph (g)(4).
    Example 5. Pre-tax PCT Payment derived from post-tax information. 
(i) The facts are the same as in paragraphs (i) and (ii) of Example 4. 
In addition, under this paragraph (g)(4), the arm's length charge for a 
PCT Payment will be an amount such that a controlled participant's 
present value, as of the date of the PCT of its cost sharing alternative 
equals the present value of its best realistic alternative. This 
requires that L, the present value of the post-tax income under the CSA, 
equals the present value of the post-tax income under the licensing 
alternative, or $196.
    (ii) FS determines that the post-tax present value of the cost 
sharing alternative (excluding PCT Payments) is $562. The post-tax 
present value of the licensing alternative is $196. Accordingly, 
payments with a post-tax present value of $366 are required.
    (iii) The Commissioner undertakes an audit of the PCT Payments made 
by FS to USP for Z in Years 1 through 3. In correspondence to the 
Commissioner, USP maintains that the arm's length PCT Payment for Z 
should have a present value of $366 (D).
    (iv) The Commissioner considers that if FS makes PCT Payments for Z 
with a present value of $366, then the post-tax present value under the 
CSA (considering the deductibility of the PCT Payments) will be $287, 
substantially higher than the post-tax present value of the licensing 
arrangement, $196. The Commissioner determines that, under the specific 
facts and assumptions of this example, the present value of the post-tax 
payments may be grossed up by a factor of (one minus the tax rate), 
resulting in a present value of pre-tax payments of $488. Accordingly, 
FS must make yearly PCT Payments (A, B, and C) such that the present 
value of the Payments is $488 (D). (When FS's post-tax income after 
these PCT Payments for Z is discounted at the appropriate rate for the 
cost sharing alternative (15%), the net present value is $196 (L), which 
is equal to the present value of post-tax income under the

[[Page 766]]

licensing alternative.) The Commissioner concludes that the calculations 
that it has made for the PCT Payments for Z are arm's length in 
accordance with this paragraph (g)(4) and, accordingly, makes the 
appropriate adjustments to USP's income tax return to account for the 
gross-up required by paragraph (g)(2)(x) of this section.
    Example 6. Pre-tax PCT Payment derived from pre-tax information. (i) 
The facts are the same as in paragraphs (i) and (ii) of Example 4. In 
addition, under paragraph (g)(4) of this section, the arm's length 
charge for a PCT Payment will be an amount such that a controlled 
participant's present value, as of the date of the PCT of its cost 
sharing alternative of entering into a CSA equals the present value of 
its best realistic alternative. This requires that ``L,'' the present 
value of the post-tax income under the CSA, equals the present value of 
the post-tax income under the licensing alternative, or $196.
    (ii) Under the specific facts and assumptions of this Example 6 (see 
paragraph (g)(4)(i)(G) of this section), and using the same (post-tax) 
discount rates as in Example 4, the present value of pre-tax income 
under the licensing alternative (that is, the operating income) is $261, 
and the present value of pre-tax income under the cost sharing 
alternative (excluding PCT Payments) is $749. Accordingly, FS determines 
that its PCT Payments for Z should have a present value equal to the 
difference between the two, or $488 (D). Such PCT Payments for Z result 
in a present value of post-tax income under the cost sharing alternative 
of $196 (L), which is equal to the present value of post-tax income 
under the licensing alternative.
    (iii) The Commissioner undertakes an audit of the PCT Payments for Z 
made by FS to USP in Years 1 through 3. The Commissioner concludes that 
the PCT Payments for Z are arm's length in accordance with this 
paragraph (g)(4).
    Example 7. Application of income method with a terminal value 
calculation. (i) For simplicity of calculation in this Example 7, all 
financial flows are assumed to occur at the beginning of each period. 
USP's research and development team, Q, has developed a technology, Z, 
for which it has several applications on the market now and several 
planned for release at future dates. In Year 1, USP, enters into a CSA 
with its wholly-owned subsidiary, FS, to develop future applications of 
Z. Under the CSA, USP will have the rights to further develop and 
exploit the future applications of Z in the United States, and FS will 
have the rights to further develop and exploit the future applications 
of Z in the rest of the world. Both Q and the rights to further develop 
and exploit future applications of Z are reasonably anticipated to 
contribute to the development of future applications of Z. Therefore, 
both Q and the rights to further develop and exploit the future 
applications of Z are platform contributions for which compensation is 
due from FS to USP as part of a PCT. USP does not transfer the current 
exploitation rights for current applications of Z to FS. FS will not 
perform any research or development activities on Z and does not furnish 
any platform contributions to the CSA, nor does it control any operating 
intangibles at the inception of the CSA that would be relevant to the 
exploitation of either current or future applications of Z.
    (ii) At the outset of the CSA, FS undertakes an analysis of the PCTs 
involving Q and the rights with respect to Z in order to determine the 
arm's length PCT Payments owing from FS to USP under the CSA. In that 
evaluation, FS concludes that the cost sharing alternative represents a 
riskier alternative for FS than the licensing alternative. FS further 
concludes that the appropriate discount rate to apply in assessing the 
licensing alternative, based on discount rates of comparable 
uncontrolled companies undertaking comparable licensing transactions, 
would be 13% per annum, whereas the appropriate discount rate to apply 
in assessing the cost sharing alternative would be 14% per annum. FS 
undertakes financial projections and anticipates making $100 million in 
sales during the first two years of the CSA in its territory with sales 
in Years 3 through 8 increasing to $200 million, $400 million, $600 
million, $650 million, $700 million, and $750 million, respectively. 
After Year 8, FS expects its sales of all products based upon 
exploitation of Z in the rest of the world to grow at 3% per annum for 
the future. FS and USP do not anticipate cessation of the CSA Activity 
with respect to Z at any determinable date. FS anticipates that its 
manufacturing and distribution costs for exploiting Z (including its 
operating cost contributions), will equal 60% of gross sales of Z from 
Year 1 onwards, and anticipates its cost contributions will equal $25 
million per annum for Years 1 and 2, $50 million per annum for Years 3 
and 4, and 10% of gross sales per annum thereafter.
    (iii) Based on this analysis, FS determines that the arm's length 
royalty rate that USP would have charged an uncontrolled licensee for a 
license of future applications of Z if USP had further developed future 
applications of Z on its own is 30% of the sales price of the Z-based 
product, as determined under the comparable uncontrolled transaction 
method in Sec.  1.482-4(c). In light of the expected sales growth and 
anticipation that the CSA Activity will not cease as of any determinable 
date, FS's determination includes a terminal value calculation. FS 
further determines that under the cost sharing alternative, the present 
value of FS's divisional profits, reduced by the present values of the 
anticipated operating cost contributions and cost contributions, would 
be $1,361 million. Under the licensing alternative, the present

[[Page 767]]

value of the operating divisional profits and losses, reduced by the 
operating cost contributions, would be $2,113 million, and the present 
value of the licensing payments would be $1,585 million. Therefore, the 
total value of the licensing alternative would be $528 million. In order 
for the present value of the cost sharing alternative to equal the 
present value of the licensing alternative, the present value of the PCT 
Payments must equal $833 million. Accordingly, FS pays USP a lump sum 
PCT Payment of $833 million in Year 1 for USP's platform contributions 
of Z and Q.
    (iv) The Commissioner undertakes an audit of the PCTs and concludes, 
based on his own analysis, that this lump sum PCT Payment is within the 
interquartile range of arm's length results for these platform 
contributions. The calculations made by FS in determining the PCT 
Payment in this Example 7 are set forth in the following tables:

                                            Cost Sharing Alternative
----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year, TV =            Y1     Y2     Y3     Y4     Y5     Y6     Y7     Y8  TV
 Terminal Value).
Discount Period...................      0      1      2      3      4      5      6      7  7
Items of Income/Expense at
 Beginning of Year:
    1 Sales.......................    100    100    200    400    600    650    700    750  (3% annual growth in
                                                                                             each year from
                                                                                             previous year).
    2 Routine Cost and Operating       60     60    120    240    360    390    420    450  (60% of annual sales
     Cost Contributions (60% of                                                              in row 1 for each
     sales amount in row 1 of                                                                year).
     relevant year).
    3 Cost Contributions (10% of       25     25     50     50     60     65     70     75  (10% of annual sales
     sales amount in row 1 for                                                               in row 1 for each
     relevant year after Year 5).                                                            year).
    4 Profit = amount in row 1         15     15     30    110    180    195    210    225  (row 1 minus rows 2
     reduced by amounts in rows 2                                                            and 3 for each
     and 3.                                                                                  year).
    5 PV (using 14% discount rate)     15   13.2   23.1   74.2    107    101   95.7   89.9  842.
----------------------------------------------------------------------------------------------------------------
    6 TOTAL PV of Cost Sharing Alternative = Sum of all PV amounts in Row 5 for all Time Periods = $1,361
     million..
----------------------------------------------------------------------------------------------------------------


                                              Licensing Alternative
----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year, TV =            Y1     Y2     Y3     Y4     Y5     Y6     Y7     Y8  TV
 Terminal Value).
Discount Period...................      0      1      2      3      4      5      6      7  7
Items of Income/Expense at
 Beginning of Year:
    7 Sales.......................    100    100    200    400    600    650    700    750  (3% annual growth in
                                                                                             each year from
                                                                                             previous year).
    8 Routine Cost and Operating       60     60    120    240    360    390    420    450  (60% of annual sales
     Cost Contributions (60% of                                                              in row 7 for each
     sales amount in row 7 of                                                                year).
     relevant year).
    9 Operating Profit = amount in     40     40     80    160    240    260    280    300  (Row 7 minus row 8
     Row 7 reduced by amount in                                                              for each year).
     Row 8.
    10 PV of row 9 (using 13%          40   35.4   62.7    111    147    141    135    128  1313.
     discount rate).
----------------------------------------------------------------------------------------------------------------
    11 TOTAL PV FOR ALL AMOUNTS IN ROW 10 = $2,112.7 million....................................................
----------------------------------------------------------------------------------------------------------------
    12 Licensing Payments (30% of      30     30     60    120    180    195    210    225  (30% of amount in
     sales amount in row 7).                                                                 row 7 for each
                                                                                             year).
    13 PV of amount in row 12          30   26.5     47   83.2    110    106    101   95.6  985.
     (using 13% discount rate).
----------------------------------------------------------------------------------------------------------------
14 TOTAL PV FOR ALL AMOUNTS IN ROW 13 = $1,584.5 million.
15 TOTAL PV of Licensing Alternative = Row 11 minus Row 14 = $528 million.
----------------------------------------------------------------------------------------------------------------


[[Page 768]]


                       Calculation of PCT Payment
------------------------------------------------------------------------
 
------------------------------------------------------------------------
16.....................  TOTAL PV OF COST         $1,361 million.
                          SHARING ALTERNATIVE
                          (FROM ROW 6 ABOVE) =.
17.....................  TOTAL PV OF LICENSING    $528 million.
                          ALTERNATIVE (FROM ROW
                          15 ABOVE) =.
18.....................  LUMP SUM PCT PAYMENT =   $833 million.
                          ROW 16 - ROW 17 =.
------------------------------------------------------------------------

    Example 8. (i) The facts are the same as in Example 1, except that 
the taxpayer determines that the appropriate discount rate for the cost 
sharing alternative is 20%. In addition, the taxpayer determines that 
the appropriate discount rate for the licensing alternative is 10%. 
Accordingly, the taxpayer determines that the appropriate present value 
of the PCT Payment is $146 million.
    (ii) Based on the best method analysis described in Example 2, the 
Commissioner determines that the taxpayer's calculation of the present 
value of the PCT Payments is outside of the interquartile range (as 
shown in the sixth column of Example 2), and thus warrants an 
adjustment. Furthermore, in evaluating the taxpayer's analysis, the 
Commissioner undertakes an analysis based on the difference in the 
financial projections between the cost sharing and licensing 
alternatives (as shown in column 11 of Example 1). This column shows the 
anticipated differential income stream of additional positive or 
negative income for FS over the duration of the CSA Activity that would 
result from undertaking the cost sharing alternative (before any PCT 
Payments) rather than the licensing alternative. This anticipated 
differential income stream thus reflects the anticipated incremental 
undiscounted profits to FS from the incremental activity of undertaking 
the risk of developing the cost shared intangibles and enjoying the 
value of its divisional interests. Taxpayer's analysis logically implies 
that the present value of this stream must be $146 million, since only 
then would FS have the same anticipated value in both the cost sharing 
and licensing alternatives. A present value of $146 million implies that 
the discount rate applicable to this stream is 34.4%. Based on a 
reliable calculation of discount rates applicable to the anticipated 
income streams of uncontrolled companies whose resources, capabilities, 
and rights consist primarily of software applications intangibles and 
research and development teams similar to USP's platform contributions 
to the CSA, and which income streams, accordingly, may be reasonably 
anticipated to reflect a similar risk profile to the differential income 
stream, the Commissioner concludes that an appropriate discount rate for 
the anticipated income stream associated with USP's platform 
contributions (that is, the additional positive or negative income over 
the duration of the CSA Activity that would result, before PCT Payments, 
from switching from the licensing alternative to the cost sharing 
alternative) is 16%, which is significantly less than 34.4%. This 
conclusion further suggests that Taxpayer's analysis is unreliable. See 
paragraphs (g)(2)(v)(B)(2) and (g)(4)(vi)(F)(1) and (2) of this section.
    (iii) The Commissioner makes an adjustment of $296 million, so that 
the present value of the PCT Payments is $442 million (the median 
results as shown in column 6 of Example 2).
    Example 9. The facts are the same as in Example 1, except that 
additional data on discount rates are available that were not available 
in Example 1. The Commissioner determines the arm's length charge for 
the PCT Payment by discounting at an appropriate rate the differential 
income stream associated with the rights contributed by USP in the PCT 
(that is, the stream of income in column (11) of Example 1). Based on an 
analysis of a set of public companies whose resources, capabilities, and 
rights consist primarily of resources, capabilities, and rights similar 
to those contributed by USP in the PCT, the Commissioner determines that 
15% to 17% is an appropriate range of discount rates to use to assess 
the value of the differential income stream associated with the rights 
contributed by USP in the PCT. The Commissioner determines that applying 
a discount rate of 17% to the differential income stream associated with 
the rights contributed by USP in the PCT yields a present value of $446 
million, while applying a discount rate of 15% to the differential 
income stream associated with the rights contributed by USP in the PCT 
yields a present value of $510 million. Because the taxpayer's result, 
$464 million, is within the interquartile range determined by the 
Commissioner, no adjustments are warranted. See paragraphs 
(g)(2)(v)(B)(2), (g)(4)(v), and (g)(4)(vi)(F)(1) of this section.

    (5) Acquisition price method--(i) In general. The acquisition price 
method applies the comparable uncontrolled transaction method of Sec.  
1.482-4(c), or the comparable uncontrolled services price method 
described in Sec.  1.482-9(c), to evaluate whether the amount charged in 
a PCT, or group of PCTs, is arm's length by reference to the amount 
charged (the acquisition price) for the stock or asset purchase of an 
entire organization or portion thereof (the target) in an uncontrolled 
transaction.

[[Page 769]]

The acquisition price method is ordinarily used where substantially all 
the target's nonroutine contributions, as such term is defined in 
paragraph (j)(1)(i) of this section, made to the PCT Payee's business 
activities are covered by a PCT or group of PCTs.
    (ii) Determination of arm's length charge. Under this method, the 
arm's length charge for a PCT or group of PCTs covering resources, 
capabilities, and rights of the target is equal to the adjusted 
acquisition price, as divided among the controlled participants 
according to their respective RAB shares.
    (iii) Adjusted acquisition price. The adjusted acquisition price is 
the acquisition price of the target increased by the value of the 
target's liabilities on the date of the acquisition, other than 
liabilities not assumed in the case of an asset purchase, and decreased 
by the value of the target's tangible property on that date and by the 
value on that date of any other resources, capabilities, and rights not 
covered by a PCT or group of PCTs.
    (iv) Best method analysis considerations. The comparability and 
reliability considerations stated in Sec.  1.482-4(c)(2) apply. 
Consistent with those considerations, the reliability of applying the 
acquisition price method as a measure of the arm's length charge for the 
PCT Payment normally is reduced if--
    (A) A substantial portion of the target's nonroutine contributions 
to the PCT Payee's business activities is not required to be covered by 
a PCT or group of PCTs, and that portion of the nonroutine contributions 
cannot reliably be valued;
    (B) A substantial portion of the target's assets consists of 
tangible property that cannot reliably be valued; or
    (C) The date on which the target is acquired and the date of the PCT 
are not contemporaneous.
    (v) Example. The following example illustrates the principles of 
this paragraph (g)(5):

    Example. USP, a U.S. corporation, and its newly incorporated, 
wholly-owned foreign subsidiary (FS) enter into a CSA at the start of 
Year 1 to develop Group Z products. Under the CSA, USP and FS will have 
the exclusive rights to exploit the Group Z products in the U.S. and the 
rest of the world, respectively. At the start of Year 2, USP acquires 
Company X for cash consideration worth $110 million. At this time USP's 
RAB share is 60%, and FS's RAB share is 40% and is not reasonably 
anticipated to change as a result of this acquisition. Company X joins 
in the filing of a U.S. consolidated income tax return with USP. Under 
paragraph (j)(2)(i) of this section, Company X and USP are treated as 
one taxpayer for purposes of this section. Accordingly, the rights in 
any of Company X's resources and capabilities that are reasonably 
anticipated to contribute to the development activities of the CSA will 
be considered platform contributions furnished by USP. Company X's 
resources and capabilities consist of its workforce, certain technology 
intangibles, $15 million of tangible property and other assets and $5 
million in liabilities. The technology intangibles, as well as Company 
X's workforce, are reasonably anticipated to contribute to the 
development of the Group Z products under the CSA and, therefore, the 
rights in the technology intangibles and the workforce are platform 
contributions for which FS must make a PCT Payment to USP. None of 
Company X's existing intangible assets or any of its workforce are 
anticipated to contribute to activities outside the CSA. For purposes of 
this example, it is assumed that no additional adjustment on account of 
tax liabilities is needed. Applying the acquisition price method, the 
value of USP's platform contributions is the adjusted acquisition price 
of $100 million ($110 million acquisition price plus $5 million 
liabilities less $15 million tangible property and other assets). FS 
must make a PCT Payment to USP for these platform contributions with a 
reasonably anticipated present value of $40 million, which is the 
product of $100 million (the value of the platform contributions) and 
40% (FS's RAB share).

    (6) Market capitalization method--(i) In general. The market 
capitalization method applies the comparable uncontrolled transaction 
method of Sec.  1.482-4(c), or the comparable uncontrolled services 
price method described in Sec.  1.482-9(c), to evaluate whether the 
amount charged in a PCT, or group of PCTs, is arm's length by reference 
to the average market capitalization of a controlled participant (PCT 
Payee) whose stock is regularly traded on an established securities 
market. The market capitalization method is ordinarily used where 
substantially all of the PCT Payee's nonroutine contributions to the PCT 
Payee's business are covered by a PCT or group of PCTs.
    (ii) Determination of arm's length charge. Under the market 
capitalization method, the arm's length charge

[[Page 770]]

for a PCT or group of PCTs covering resources, capabilities, and rights 
of the PCT Payee is equal to the adjusted average market capitalization, 
as divided among the controlled participants according to their 
respective RAB shares.
    (iii) Average market capitalization. The average market 
capitalization is the average of the daily market capitalizations of the 
PCT Payee over a period of time beginning 60 days before the date of the 
PCT and ending on the date of the PCT. The daily market capitalization 
of the PCT Payee is calculated on each day its stock is actively traded 
as the total number of shares outstanding multiplied by the adjusted 
closing price of the stock on that day. The adjusted closing price is 
the daily closing price of the stock, after adjustments for stock-based 
transactions (dividends and stock splits) and other pending corporate 
(combination and spin-off) restructuring transactions for which reliable 
arm's length adjustments can be made.
    (iv) Adjusted average market capitalization. The adjusted average 
market capitalization is the average market capitalization of the PCT 
Payee increased by the value of the PCT Payee's liabilities on the date 
of the PCT and decreased by the value on such date of the PCT Payee's 
tangible property and of any other resources, capabilities, or rights of 
the PCT Payee not covered by a PCT or group of PCTs.
    (v) Best method analysis considerations. The comparability and 
reliability considerations stated in Sec.  1.482-4(c)(2) apply. 
Consistent with those considerations, the reliability of applying the 
comparable uncontrolled transaction method using the adjusted market 
capitalization of a company as a measure of the arm's length charge for 
the PCT Payment normally is reduced if--
    (A) A substantial portion of the PCT Payee's nonroutine 
contributions to its business activities is not required to be covered 
by a PCT or group of PCTs, and that portion of the nonroutine 
contributions cannot reliably be valued;
    (B) A substantial portion of the PCT Payee's assets consists of 
tangible property that cannot reliably be valued; or
    (C) Facts and circumstances demonstrate the likelihood of a material 
divergence between the average market capitalization of the PCT Payee 
and the value of its resources, capabilities, and rights for which 
reliable adjustments cannot be made.
    (vi) Examples. The following examples illustrate the principles of 
this paragraph (g)(6):

    Example 1. (i) USP, a publicly traded U.S. company, and its newly 
incorporated wholly-owned foreign subsidiary (FS) enter into a CSA on 
Date 1 to develop software. At that time USP has in-process software but 
has no software ready for the market. Under the CSA, USP and FS will 
have the exclusive rights to exploit the software developed under the 
CSA in the United States and the rest of the world, respectively. On 
Date 1, USP's RAB share is 70% and FS's RAB share is 30%. USP's 
assembled team of researchers and its in-process software are reasonably 
anticipated to contribute to the development of the software under the 
CSA. Therefore, the rights in the research team and in-process software 
are platform contributions for which compensation is due from FS. 
Further, these rights are not reasonably anticipated to contribute to 
any business activity other than the CSA Activity.
    (ii) On Date 1, USP had an average market capitalization of $205 
million, tangible property and other assets that can be reliably valued 
worth $5 million, and no liabilities. Aside from those assets, USP had 
no assets other than its research team and in-process software. Applying 
the market capitalization method, the value of USP's platform 
contributions is $200 million ($205 million average market 
capitalization of USP less $5 million of tangible property and other 
assets). The arm's length value of the PCT Payments FS must make to USP 
for the platform contributions, before any adjustment on account of tax 
liability as described in paragraph (g)(2)(ii) of this section, is $60 
million, which is the product of $200 million (the value of the platform 
contributions) and 30% (FS's RAB share on Date 1).
    Example 2. Aggregation with make-or-sell rights. (i) The facts are 
the same as in Example 1, except that on Date 1 USP also has existing 
software ready for the market. USP separately enters into a license 
agreement with FS for make-or-sell rights for all existing software 
outside the United States. No marketing has occurred, and USP has no 
marketing intangibles. This license of current make-or-sell rights is a 
transaction governed by Sec.  1.482-4. However, after analysis, it is 
determined that the arm's length PCT Payments and the arm's length 
payments for the make-or-sell license may be most reliably determined in 
the aggregate using the market capitalization method, under principles 
described in paragraph (g)(2)(iv) of this

[[Page 771]]

section, and it is further determined that those principles are most 
reliably implemented by computing the aggregate arm's length charge as 
the product of the aggregate value of the existing and in-process 
software and FS's RAB share on Date 1.
    (ii) Applying the market capitalization method, the aggregate value 
of USP's platform contributions and the make-or-sell rights in its 
existing software is $250 million ($255 million average market 
capitalization of USP less $5 million of tangible property and other 
assets). The total arm's length value of the PCT Payments and licensing 
payments FS must make to USP for the platform contributions and current 
make-or-sell rights, before any adjustment on account of tax liability, 
if any, is $75 million, which is the product of $250 million (the value 
of the platform contributions and the make-or-sell rights) and 30% (FS's 
RAB share on Date 1).
    Example 3. Reduced reliability. The facts are the same as in Example 
1 except that USP also has significant nonroutine assets that will be 
used solely in a nascent business division that is unrelated to the 
subject of the CSA and that cannot themselves be reliably valued. Those 
nonroutine contributions are not platform contributions and accordingly 
are not required to be covered by a PCT. The reliability of using the 
market capitalization method to determine the value of USP's platform 
contributions to the CSA is significantly reduced in this case because 
that method would require adjusting USP's average market capitalization 
to account for the significant nonroutine contributions that are not 
required to be covered by a PCT.

    (7) Residual profit split method--(i) In general. The residual 
profit split method evaluates whether the allocation of combined 
operating profit or loss attributable to one or more platform 
contributions subject to a PCT is arm's length by reference to the 
relative value of each controlled participant's contribution to that 
combined operating profit or loss. The combined operating profit or loss 
must be derived from the most narrowly identifiable business activity 
(relevant business activity) of the controlled participants for which 
data are available that include the CSA Activity. The residual profit 
split method may not be used where only one controlled participant makes 
significant nonroutine contributions (including platform or operating 
contributions) to the CSA Activity. The provisions of Sec.  1.482-6 
shall apply to CSAs only to the extent provided and as modified in this 
paragraph (g)(7). Any other application to a CSA of a residual profit 
method not described in paragraphs (g)(7)(ii) and (iii) of this section 
will constitute an unspecified method for purposes of sections 482 and 
6662(e) and the regulations under those sections.
    (ii) Appropriate share of profits and losses. The relative value of 
each controlled participant's contribution to the success of the 
relevant business activity must be determined in a manner that reflects 
the functions performed, risks assumed, and resources employed by each 
participant in the relevant business activity, consistent with the best 
method analysis described in Sec.  1.482-1(c) and (d). Such an 
allocation is intended to correspond to the division of profit or loss 
that would result from an arrangement between uncontrolled taxpayers, 
each performing functions similar to those of the various controlled 
participants engaged in the relevant business activity. The profit 
allocated to any particular controlled participant is not necessarily 
limited to the total operating profit of the group from the relevant 
business activity. For example, in a given year, one controlled 
participant may earn a profit while another controlled participant 
incurs a loss. In addition, it may not be assumed that the combined 
operating profit or loss from the relevant business activity should be 
shared equally, or in any other arbitrary proportion.
    (iii) Profit split--(A) In general. Under the residual profit split 
method, the present value of each controlled participant's residual 
divisional profit or loss attributable to nonroutine contributions 
(nonroutine residual divisional profit or loss) is allocated between the 
controlled participants that each furnish significant nonroutine 
contributions (including platform or operating contributions) to the 
relevant business activity in that division.
    (B) Determine nonroutine residual divisional profit or loss. The 
present value of each controlled participant's nonroutine residual 
divisional profit or loss must be determined to reflect the most 
reliable measure of an arm's length result. The present value of 
nonroutine residual divisional profit or loss equals

[[Page 772]]

the present value of the stream of the reasonably anticipated residuals 
over the duration of the CSA Activity of divisional profit or loss, 
minus market returns for routine contributions, minus operating cost 
contributions, minus cost contributions, using a discount rate 
appropriate to such residuals in accordance with paragraph (g)(2)(v) of 
this section. As used in this paragraph (g)(7), the phrase ``market 
returns for routine contributions'' includes market returns for 
operating cost contributions and excludes market returns for cost 
contributions.
    (C) Allocate nonroutine residual divisional profit or loss--(1) In 
general. The present value of nonroutine residual divisional profit or 
loss in each controlled participant's division must be allocated among 
all of the controlled participants based upon the relative values, 
determined as of the date of the PCTs, of the PCT Payor's as compared to 
the PCT Payee's nonroutine contributions to the PCT Payor's division. 
For this purpose, the PCT Payor's nonroutine contribution consists of 
the sum of the PCT Payor's nonroutine operating contributions and the 
PCT Payor's RAB share of the PCT Payor's nonroutine platform 
contributions. For this purpose, the PCT Payee's nonroutine contribution 
consists of the PCT Payor's RAB share of the PCT Payee's nonroutine 
platform contributions.
    (2) Relative value determination. The relative values of the 
controlled participants' nonroutine contributions must be determined so 
as to reflect the most reliable measure of an arm's length result. 
Relative values may be measured by external market benchmarks that 
reflect the fair market value of such nonroutine contributions. 
Alternatively, the relative value of nonroutine contributions may be 
estimated by the capitalized cost of developing the nonroutine 
contributions and updates, as appropriately grown or discounted so that 
all contributions may be valued on a comparable dollar basis as of the 
same date. If the nonroutine contributions by a controlled participant 
are also used in other business activities (such as the exploitation of 
make-or-sell rights described in paragraph (c)(4) of this section), an 
allocation of the value of the nonroutine contributions must be made on 
a reasonable basis among all the business activities in which they are 
used in proportion to the relative economic value that the relevant 
business activity and such other business activities are anticipated to 
derive over time as the result of such nonroutine contributions.
    (3) Determination of PCT Payments. Any amount of the present value 
of a controlled participant's nonroutine residual divisional profit or 
loss that is allocated to another controlled participant represents the 
present value of the PCT Payments due to that other controlled 
participant for its platform contributions to the relevant business 
activity in the relevant division. For purposes of paragraph (j)(3)(ii) 
of this section, the present value of a PCT Payor's PCT Payments under 
this paragraph shall be deemed reduced to the extent of the present 
value of any PCT Payments owed to it from other controlled participants 
under this paragraph (g)(7). The resulting remainder may be converted to 
a fixed or contingent form of payment in accordance with paragraph (h) 
(Form of payment rules) of this section.
    (4) Routine platform and operating contributions. For purposes of 
this paragraph (g)(7), any routine platform or operating contributions, 
the valuation and PCT Payments for which are determined and made 
independently of the residual profit split method, are treated similarly 
to cost contributions and operating cost contributions, respectively. 
Accordingly, wherever used in this paragraph (g)(7), the term ``routine 
contributions'' shall not include routine platform or operating 
contributions, and wherever the terms ``cost contributions'' and 
``operating cost contributions'' appear in this paragraph (g)(7), they 
shall include net routine platform contributions and net routine 
operating contributions, respectively, as defined in paragraph 
(g)(4)(vii) of this section. However, treatment of net operating 
contributions as operating cost contributions shall be coordinated with 
the treatment of other routine contributions pursuant to paragraphs 
(g)(4)(iii)(B) and (7)(iii)(B) of this section so as to avoid 
duplicative market returns to such contributions.

[[Page 773]]

    (iv) Best method analysis considerations--(A) In general. Whether 
results derived from this method are the most reliable measure of the 
arm's length result is determined using the factors described under the 
best method rule in Sec.  1.482-1(c). Thus, comparability and quality of 
data, reliability of assumptions, and sensitivity of results to possible 
deficiencies in the data and assumptions, must be considered in 
determining whether this method provides the most reliable measure of an 
arm's length result. The application of these factors to the residual 
profit split in the context of the relevant business activity of 
developing and exploiting cost shared intangibles is discussed in 
paragraphs (g)(7)(iv)(B) through (D) of this section.
    (B) Comparability. The derivation of the present value of nonroutine 
residual divisional profit or loss includes a carveout on account of 
market returns for routine contributions. Thus, the comparability 
considerations that are relevant for that purpose include those that are 
relevant for the methods that are used to determine market returns for 
the routine contributions.
    (C) Data and assumptions. The reliability of the results derived 
from the residual profit split is affected by the quality of the data 
and assumptions used to apply this method. In particular, the following 
factors must be considered:
    (1) The reliability of the allocation of costs, income, and assets 
between the relevant business activity and the controlled participants' 
other activities that will affect the reliability of the determination 
of the divisional profit or loss and its allocation among the controlled 
participants. See Sec.  1.482-6(c)(2)(ii)(C)(1).
    (2) The degree of consistency between the controlled participants 
and uncontrolled taxpayers in accounting practices that materially 
affect the items that determine the amount and allocation of operating 
profit or loss affects the reliability of the result. See Sec.  1.482-
6(c)(2)(ii)(C)(2).
    (3) The reliability of the data used and the assumptions made in 
estimating the relative value of the nonroutine contributions by the 
controlled participants. In particular, if capitalized costs of 
development are used to estimate the relative value of nonroutine 
contributions, the reliability of the results is reduced relative to the 
reliability of other methods that do not require such an estimate. This 
is because, in any given case, the costs of developing a nonroutine 
contribution may not be related to its market value and because the 
calculation of the capitalized costs of development may require the 
allocation of indirect costs between the relevant business activity and 
the controlled participant's other activities, which may affect the 
reliability of the analysis.
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec.  1.482-3 through 1.482-5 and Sec.  1.482-9(c), the carveout 
on account of market returns for routine contributions relies 
exclusively on external market benchmarks. As indicated in Sec.  1.482-
1(c)(2)(i), as the degree of comparability between the controlled 
participants and uncontrolled transactions increases, the relative 
weight accorded the analysis under this method will increase. In 
addition, to the extent the allocation of nonroutine residual divisional 
profit or loss is not based on external market benchmarks, the 
reliability of the analysis will be decreased in relation to an analysis 
under a method that relies on market benchmarks. Finally, the 
reliability of the analysis under this method may be enhanced by the 
fact that all the controlled participants are evaluated under the 
residual profit split. However, the reliability of the results of an 
analysis based on information from all the controlled participants is 
affected by the reliability of the data and the assumptions pertaining 
to each controlled participant. Thus, if the data and assumptions are 
significantly more reliable with respect to one of the controlled 
participants than with respect to the others, a different method, 
focusing solely on the results of that party, may yield more reliable 
results.
    (v) Examples. The following examples illustrate the principles of 
this paragraph (g)(7):

    Example 1. (i) For simplicity of calculation in this Example 1, all 
financial flows are assumed to occur at the beginning of each period. 
USP, a U.S. electronic data storage

[[Page 774]]

company, has partially developed technology for a type of extremely 
small compact storage devices (nanodisks) which are expected to provide 
a significant increase in data storage capacity in various types of 
portable devices such as cell phones, MP3 players, laptop computers and 
digital cameras. At the same time, USP's wholly-owned subsidiary, FS, 
has developed significant marketing intangibles outside the United 
States in the form of customer lists, ongoing relations with various 
OEMs, and trademarks that are well recognized by consumers due to a long 
history of marketing successful data storage devices and other hardware 
used in various types of consumer electronics. At the beginning of Year 
1, USP enters into a CSA with FS to develop nanodisk technologies for 
eventual commercial exploitation. Under the CSA, USP will have the right 
to exploit nanodisks in the United States, while FS will have the right 
to exploit nanodisks in the rest of the world. The partially developed 
nanodisk technologies owned by USP are reasonably anticipated to 
contribute to the development of commercially exploitable nanodisks and 
therefore the rights in the nanodisk technologies constitute platform 
contributions of USP for which compensation is due under PCTs. FS does 
not have any platform contributions for the CSA. Due to the fact that 
nanodisk technologies have yet to be incorporated into any commercially 
available product, neither USP nor FS transfers rights to make or sell 
current products in conjunction with the CSA.
    (ii) Because only in FS's territory do both controlled participants 
make significant nonroutine contributions, USP and FS determine that 
they need to determine the relative value of their respective 
contributions to residual divisional profit or loss attributable to the 
CSA Activity only in FS's territory. FS anticipates making no nanodisk 
sales during the first year of the CSA in its territory with revenues in 
Year 2 reaching $200 million. Revenues through Year 5 are reasonably 
anticipated to increase by 50% per year. The annual growth rate for 
revenues is then expected to decline to 30% per annum in Years 6 and 7, 
20% per annum in Years 8 and 9 and 10% per annum in Year 10. Revenues 
are then expected to decline 10% in Year 11 and 5% per annum, 
thereafter. The routine costs (defined here as costs other than cost 
contributions, routine platform and operating contributions, and 
nonroutine contributions) that are allocable to this revenue in 
calculating FS's divisional profit or loss, are anticipated to equal $40 
million for the first year of the CSA and $130 for the second year and 
$200 and $250 million in Years 3 and 4. Total operating expenses 
attributable to product exploitation (including operating cost 
contributions) equal 52% of sales per year. FS undertakes routine 
distribution activities in its markets that constitute routine 
contributions to the relevant business activity of exploiting nanodisk 
technologies. USP and FS estimate that the total market return on these 
routine contributions will amount to 6% of the routine costs. FS expects 
its cost contributions to be $60 million in Year 1, rise to $100 million 
in Years 2 and 3, and then decline again to $60 million in Year 4. 
Thereafter, FS's cost contributions are expected to equal 10% of 
revenues.
    (iii) USP and FS determine the present value of the stream of the 
reasonably anticipated residuals in FS's territory over the duration of 
the CSA Activity of the divisional profit or loss (revenues minus 
routine costs), minus the market returns for routine contributions, the 
operating cost contributions, and the cost contributions. USP and FS 
determine, based on the considerations discussed in paragraph (g)(2)(v) 
of this section, that the appropriate discount rate is 17.5% per annum. 
Therefore, the present value of the nonroutine residual divisional 
profit is $1,395 million.
    (iv) After analysis, USP and FS determine that the relative value of 
the nanodisk technologies contributed by USP to CSA (giving effect only 
to its value in FS's territory) is roughly 150% of the value of FS's 
marketing intangibles (which only have value in FS's territory). 
Consequently, 60% of the nonroutine residual divisional profit is 
attributable to USP's platform contribution. Therefore, FS's PCT 
Payments should have an expected present value equal to $837 million (.6 
x $1,395 million).
    (v) The calculations for this Example 1 are displayed in the 
following table:

[[Page 775]]



--------------------------------------------------------------------------------------------------------------------------------------------------------
 
--------------------------------------------------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV = Terminal Value)............              Y1     Y2     Y3     Y4     Y5     Y6     Y7     Y8     Y9    Y10      Y11      TV
Discount Period.........................................               0      1      2      3      4      5      6      7      8      9       10      10
[1] Sales...............................................               0    200    300    450    675    878   1141   1369   1643   1807     1626
[2] Growth Rate.........................................  ..............  .....    50%    50%    50%    30%    30%    20%    20%    10%     -10%
[3] Exploitation Costs and Operating Cost Contributions               40    130    200    250    351    456    593    712    854    940      846
 (52% of Sales [1]).....................................
[4] Return on [3] (6% of [3])...........................             2.4      8     12     15     21     27     36     43     51     56       51
[5] Cost Contributions (10% of Sales [1] after Year 5)..              60    100    100     60     68     88    114    137    164    181      163
[6] Residual Profit = [1] minus {[3] + [4] + [5]{time} .            -102    -38    -12    125    235    306    398    477    573    630      567    2395
[7] Residual Profit [6] Discounted at 17.5% discount                -102    -32     -9     77    124    137    151    154    158    148      113     477
 rate...................................................
--------------------------------------------------------------------------------------------------------------------------------------------------------
[8] Sum of all amounts in [7] for all time periods = $1,395 million
--------------------------------------------------------------------------------------------------------------------------------------------------------
[9] Relative value in FS's division of USP's nanotechnology to FS's marketing intangibles = 150%
--------------------------------------------------------------------------------------------------------------------------------------------------------
[10] Profit Split (USP).................................                                         60% = 1.5 x [11]
                                                         -----------------------------------------------------------------------------------------------
[11] Profit Split (FS)..................................                                                40%
                                                         -----------------------------------------------------------------------------------------------
[12] FS's PCT Payments..................................                         [8] x [10] = $1,395 million x 60% = $837 million
--------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 776]]

    Example 2. (i) For simplicity of calculation in this Example 2, all 
financial flows are assumed to occur at the beginning of each period. 
USP is a U.S. automobile manufacturing company that has completed 
significant research on the development of diesel-electric hybrid 
engines that, if they could be successfully manufactured, would result 
in providing a significant increased fuel economy for a wide variety of 
motor vehicles. Successful commercialization of the diesel-electric 
hybrid engine will require the development of a new class of advanced 
battery that will be light, relatively cheap to manufacture and yet 
capable of holding a substantial electric charge. FS, a foreign 
subsidiary of USP, has completed significant research on developing 
lithium-ion batteries that appear likely to have the requisite 
characteristics. At the beginning of Year 1, USP enters into a CSA with 
FS to further develop diesel-electric hybrid engines and lithium-ion 
battery technologies for eventual commercial exploitation. Under the 
CSA, USP will have the right to exploit the diesel-electric hybrid 
engine and lithium-ion battery technologies in the United States, while 
FS will have the right to exploit such technologies in the rest of the 
world. The partially developed diesel-electric hybrid engine and 
lithium-ion battery technologies owned by USP and FS, respectively, are 
reasonably anticipated to contribute to the development of commercially 
exploitable automobile engines and therefore the rights in both these 
technologies constitute platform contributions of USP and of FS for 
which compensation is due under PCTs. At the time of inception of the 
CSA, USP owns operating intangibles in the form of self-developed 
marketing intangibles which have significant value in the United States, 
but not in the rest of the world, and that are relevant to exploiting 
the cost shared intangibles. Similarly, FS owns self-developed marketing 
intangibles which have significant value in the rest of the world, but 
not in the United States, and that are relevant to exploiting the cost 
shared intangibles. Although the new class of diesel-electric hybrid 
engine using lithium-ion batteries is not yet ready for commercial 
exploitation, components based on this technology are beginning to be 
incorporated in current-generation gasoline-electric hybrid engines and 
the rights to make and sell such products are transferred from USP to FS 
and vice-versa in conjunction with the inception of the CSA, following 
the same territorial division as in the CSA.
    (ii) USP's estimated RAB share is 66.7%. During Year 1, it is 
anticipated that sales in USP's territory will be $1000X in Year 1. 
Sales in FS's territory are anticipated to be $500X. Thereafter, as 
revenue from the use of components in gasoline-electric hybrids is 
supplemented by revenues from the production of complete diesel-electric 
hybrid engines using lithium-ion battery technology, anticipated sales 
in both territories will increase rapidly at a rate of 50% per annum 
through Year 4. Anticipated sales are then anticipated to increase at a 
rate of 40% per annum for another 4 years. Sales are then anticipated to 
increase at a rate of 30% per annum through Year 10. Thereafter, sales 
are anticipated to decrease at a rate of 5% per annum for the 
foreseeable future as new automotive drivetrain technologies displace 
diesel-electric hybrid engines and lithium-ion batteries. Total 
operating expenses attributable to product exploitation (including 
operating cost contributions) equal 40% of sales per year for both USP 
and FS. USP and FS estimate that the total market return on these 
routine contributions to the CSA will amount to 6% of these operating 
expenses. USP is expected to bear \2/3\ of the total cost contributions 
for the foreseeable future. Cost contributions are expected to total 
$375X in Year 1 (of which $250X are borne by USP) and increase at a rate 
of 25% per annum through Year 6. In Years 7 through 10, cost 
contributions are expected to increase 10% a year. Thereafter, cost 
contributions are expected to decrease by 5% a year for the foreseeable 
future.
    (iii) USP and FS determine the present value of the stream of FS's 
reasonably anticipated residual divisional profit, which is the stream 
of FS's reasonably anticipated divisional profit or loss, minus the 
market returns for routine contributions, minus operating cost 
contributions, minus cost contributions. USP and FS determine, based on 
the considerations discussed in paragraph (g)(2)(v) of this section, 
that the appropriate discount rate is 12% per year. Therefore, the 
present value of the nonroutine residual divisional profit in USP's 
territory is $41,727X and in CFC's territory is $20,864X.
    (iv) After analysis, USP and FS determine that, in the United States 
the relative value of the technologies contributed by USP and FS to the 
CSA and of the operating intangibles used by USP in the exploitation of 
the cost shared intangibles (reported as equaling 100 in total), equals: 
USP's platform contribution (59.5); FS's platform contribution (25.5); 
and USP's operating intangibles (15). Consequently, the present value of 
the arm's length amount of the PCT Payments that USP should pay to FS 
for FS's platform contribution is $10,640X (.255 x $41,727X). Similarly, 
USP and FS determine that, in the rest of the world, the relative value 
of the technologies contributed by USP and FS to the CSA and of the 
operating intangibles used by FS in the exploitation of the cost shared 
intangibles can be divided as follows: USP's platform contribution (63); 
FS's platform contribution (27); and FS's operating intangibles (10). 
Consequently, the present value of the arm's length amount of the PCT 
Payments that FS should pay to USP for

[[Page 777]]

USP's platform contribution is $13,144X (.63 x $20,864X). Therefore, FS 
is required to make a net payment to USP with a present value of $2,504X 
($13,144X - 10,640X).
    (v) The calculations for this Example 2 are displayed in the 
following tables:

                                     Calculation of USP's PCT Payment to FS
----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV =        Y1     Y2     Y3     Y4     Y5     Y6     Y7      Y8      Y9     Y10      TV
 Terminal Value)...............
Discount Period................      0      1      2      3      4      5      6       7       8       9       9
[1] Sales......................   1000   1500   2250   3375   4725   6615   9261   12965   16855   21912
[2] Growth Rate................  .....    50%    50%    50%    40%    40%    40%     40%     30%     30%
[3] Exploitation Costs and         400    600    900   1350   1890   2646   3704    5186    6742    8765
 Operating Cost Contributions
 (40% of Sales [1])............
[4] Return on [3] = 6% of [3]..     24     36     54     81    113    159    222     311     405     526
[5] Cost Contributions.........    250    313    391    488    610    763    839     923    1015    1117
[6] Residual Profit = [1] minus    326    552    905   1456   2111   3047   4495    6545    8693   11504   64287
 {[3] + [4] + [5]{time} .......
[7] Residual Profit [6]            326    492    722   1036   1342   1729   2277    2961    3511    4148   23183
 Discounted at 12% discount
 rate..........................
----------------------------------------------------------------------------------------------------------------
[8] Sum of all amounts in [7] for all time periods = $41,727X
----------------------------------------------------------------------------------------------------------------
Profit Split for Calculation of USP's PCT Payment to FS: [Total of US contributions = 74.5%]
[9] USP's Platform Contribution = 59.5%
[10] FS's Platform Contribution = 25.5%
[11] USP's Operating Intangibles = 15%
----------------------------------------------------------------------------------------------------------------
[12] USP's PCT Payment to FS = [8] x [10] = $41,727X multiplied by 25.5% = $10,640X
----------------------------------------------------------------------------------------------------------------


                                   Calculation of FS's Net PCT Payment to USF
----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV =          Y1     Y2     Y3     Y4     Y5     Y6     Y7     Y8     Y9     Y10      TV
 Terminal Value).................
Discount Period..................      0      1      2      3      4      5      6      7      8       9       9
[13] Sales.......................    500    750   1125   1688   2363   3308   4631   6483   8428   10956
[14] Growth Rate.................  .....    50%    50%    50%    40%    40%    40%    40%    30%     30%
[15] Exploitation Costs and          200    300    450    675    945   1323   1852   2593   3371    4382
 Operating Cost Contributions
 (40% of Sales [13]).............
[16] Return on [15] = 6% of [15].     12     18     27     41     57     79    111    156    202     263
[17] Cost Contributions..........    125    156    195    244    305    381    420    462    508     559
[18] Residual Profit = [13] minus    163    276    453    728   1056   1524   2248   3272   4347    5752   32144
 {[15] + [16] + [17]{time} ......
[19] Residual Profit [18]            163    246    361    518    671    865   1139   1480   1755    2074   11591
 Discounted at 12% discount rate.
----------------------------------------------------------------------------------------------------------------
[20] Sum of all amounts in [19] for all time periods = $20,864X
----------------------------------------------------------------------------------------------------------------
Profit Split for Calculation of FS's PCT Payment to USP: [Total of FS's contributions = 37%]
[21] USP's Platform Contribution = 63%
[22] FS's Platform Contribution = 27%
[23] FS's Operating Intangibles = 10%
----------------------------------------------------------------------------------------------------------------

[[Page 778]]

 
[24] FS's PCT Payment to USP = [20] x [21] = $20,864X multiplied by 63% = $13,144X
----------------------------------------------------------------------------------------------------------------
[25] FS's Net PCT Payment to USP = [24] minus [12] = $13,144X minus $10,640X = $2,504X..........................
----------------------------------------------------------------------------------------------------------------

    (8) Unspecified methods. Methods not specified in paragraphs (g)(3) 
through (7) of this section may be used to evaluate whether the amount 
charged for a PCT is arm's length. Any method used under this paragraph 
(g)(8) must be applied in accordance with the provisions of Sec.  1.482-
1 and of paragraph (g)(2) of this section. Consistent with the specified 
methods, an unspecified method should take into account the general 
principle that uncontrolled taxpayers evaluate the terms of a 
transaction by considering the realistic alternatives to that 
transaction, and only enter into a particular transaction if none of the 
alternatives is preferable to it. Therefore, in establishing whether a 
PCT achieved an arm's length result, an unspecified method should 
provide information on the prices or profits that the controlled 
participant could have realized by choosing a realistic alternative to 
the CSA. See paragraph (k)(2)(ii)(J) of this section. As with any 
method, an unspecified method will not be applied unless it provides the 
most reliable measure of an arm's length result under the principles of 
the best method rule. See Sec.  1.482-1(c) (Best method rule). In 
accordance with Sec.  1.482-1(d) (Comparability), to the extent that an 
unspecified method relies on internal data rather than uncontrolled 
comparables, its reliability will be reduced. Similarly, the reliability 
of a method will be affected by the reliability of the data and 
assumptions used to apply the method, including any projections used.
    (h) Form of payment rules--(1) CST Payments. CST Payments may not be 
paid in shares of stock in the payor (or stock in any member of the 
controlled group that includes the controlled participants).
    (2) PCT Payments--(i) In general. The consideration under a PCT for 
a platform contribution may take one or a combination of both of the 
following forms:
    (A) Payments of a fixed amount (fixed payments), either paid in a 
lump sum payment or in installment payments spread over a specified 
period, with interest calculated in accordance with Sec.  1.482-2(a) 
(Loans or advances).
    (B) Payments contingent on the exploitation of cost shared 
intangibles by the PCT Payor (contingent payments). Accordingly, 
controlled participants have flexibility to adopt a form and period of 
payment, provided that such form and period of payment are consistent 
with an arm's length charge as of the date of the PCT. See also 
paragraphs (h)(2)(iv) and (3) of this section.
    (ii) No PCT Payor Stock. PCT Payments may not be paid in shares of 
stock in the PCT Payor (or stock in any member of the controlled group 
that includes the controlled participants).
    (iii) Specified form of payment--(A) In general. The form of payment 
selected (subject to the rules of this paragraph (h)) for any PCT, 
including, in the case of contingent payments, the contingent base and 
structure of the payments as set forth in paragraph (h)(2)(iii)(B) of 
this section, must be specified no later than the due date of the 
applicable tax return (including extensions) for the later of the 
taxable year of the PCT Payor or PCT Payee that includes the date of 
that PCT.
    (B) Contingent payments. In accordance with paragraph (k)(1)(iv)(A) 
of this section, a provision of a written contract described in 
paragraph (k)(1) of this section, or of the additional documentation 
described in paragraph (k)(2) of this section, that provides for 
payments for a PCT (or group of PCTs) to be contingent on the 
exploitation of cost shared intangibles will be respected as consistent 
with economic substance only if the allocation between the controlled 
participants of the risks attendant on such form of payment is 
determinable before the outcomes of such allocation that would

[[Page 779]]

have materially affected the PCT pricing are known or reasonably 
knowable. A contingent payment provision must clearly and unambiguously 
specify the basis on which the contingent payment obligations are to be 
determined. In particular, the contingent payment provision must clearly 
and unambiguously specify the events that give rise to an obligation to 
make PCT Payments, the royalty base (such as sales or revenues), and the 
computation used to determine the PCT Payments. The royalty base 
specified must be one that permits verification of its proper use by 
reference to books and records maintained by the controlled participants 
in the normal course of business (for example, books and records 
maintained for financial accounting or business management purposes).
    (C) Examples. The following examples illustrate the principles of 
this paragraph (h)(2).

    Example 1. A CSA provides that PCT Payments with respect to a 
particular platform contribution shall be contingent payments equal to 
15% of the revenues from sales of products that incorporate cost shared 
intangibles. The terms further permit (but do not require) the 
controlled participants to adjust such contingent payments in accordance 
with a formula set forth in the arrangement so that the 15% rate is 
subject to adjustment by the controlled participants at their discretion 
on an after-the-fact, uncompensated basis. The Commissioner may impute 
payment terms that are consistent with economic substance with respect 
to the platform contribution because the contingent payment provision 
does not specify the computation used to determine the PCT Payments.
    Example 2. Taxpayer, an automobile manufacturer, is a controlled 
participant in a CSA that involves research and development to perfect 
certain manufacturing techniques necessary to the actual manufacture of 
a state-of-the-art, hybrid fuel injection system known as DRL337. The 
arrangement involves the platform contribution of a design patent 
covering DRL337. Pursuant to paragraph (h)(2)(iii)(B) of this section, 
the CSA provides for PCT Payments with respect to the platform 
contribution of the patent in the form of royalties contingent on sales 
of automobiles that contain the DRL337 system. However, Taxpayer's 
system of book- and record-keeping does not enable Taxpayer to track 
which automobile sales involve automobiles that contain the DRL337 
system. Because Taxpayer has not complied with paragraph (h)(2)(iii)(B) 
of this section, the Commissioner may impute payment terms that are 
consistent with economic substance and susceptible to verification by 
the Commissioner.
    Example 3. (i) Controlled participants A and B enter into a CSA that 
provides for PCT Payments from A to B with respect to B's platform 
contribution, Z, in the form of three annual installment payments due 
from A to B on the last day of each of the first three years of the CSA.
    (ii) On audit, based on all the facts and circumstances, the 
Commissioner determines that the installment PCT Payments are consistent 
with an arm's length charge as of the date of the PCT. Accordingly, the 
Commissioner does not make an adjustment with respect to the PCT 
Payments in any year.
    Example 4. (i) The facts are the same as in Example 3 except that 
the CSA contains an additional term with respect to the PCT Payments. 
Under this provision, A and B further agreed that, if the present value 
(as of the CSA Start Date) of A's actual divisional operating profit or 
loss during the three-year period is less than the present value (as of 
the CSA Start Date) of the divisional operating profit or loss that the 
parties projected for A upon formation of the CSA for that period, then 
the third installment payment shall be subject to a compensating 
adjustment in the amount necessary to reduce the present value (as of 
the CSA Start Date) of the aggregate PCT Payments for those three years 
to the amount that would have been calculated if the actual results had 
been used for the calculation instead of the projected results.
    (ii) This provision further specifies that A will pay B an 
additional amount, $Q, in the first year of the CSA to compensate B for 
taking on additional downside risk through the contingent payment term 
described in paragraph (i) of this Example 4.
    (iii) During the first two years, A pays B installment payments as 
agreed, as well as the additional amount, $Q. In the third year, A and B 
determine that the present value (as of the CSA Start Date) of A's 
actual divisional operating profit or loss during the three-year period 
is less than the present value (as of the CSA Start Date) of the 
divisional operating profit or loss that the parties projected for A 
upon formation of the CSA for that period. A reduces the PCT Payment to 
B in the third year in the amount necessary to reduce the present value 
(as of the CSA Start Date) of the aggregate PCT Payments for those three 
years to the amount that would have been calculated if the actual 
results had been used for the calculation instead of the projected 
results.
    (iv) On audit, based on all the facts and circumstances, the 
Commissioner determines that the installment PCT Payments agreed to be 
paid by A to B were consistent with an arm's length charge as of the 
date of the

[[Page 780]]

PCT. The Commissioner further determines that the contingency was 
sufficiently specified such that its occurrence or nonoccurrence was 
unambiguous and determinable; that the projections were reliable; and 
that the contingency did, in fact, occur. Finally, the Commissioner 
determines, based on all the facts and circumstances, that $Q was within 
the arm's length range for the additional allocation of risk to B. 
Accordingly, no adjustment is made with respect to the installment PCT 
Payments, or the additional PCT Payment for the contingent payment term, 
in any year.
    Example 5. (i) The facts are the same as in Example 4 except that 
the CSA states the amount that A will pay B for the contingent payment 
term is $X, an amount that is less than $Q, and A pays B $X in the first 
year of the CSA.
    (ii) On audit, based on all the facts and circumstances, the 
Commissioner determines that the installment PCT Payments agreed to be 
paid by A to B were consistent with an arm's length charge as of the 
date of the PCT. The Commissioner further determines that the 
contingency was sufficiently specified such that its occurrence or 
nonoccurrence was unambiguous and determinable; that the projections 
were reliable; and that the contingency did, in fact, occur. However, 
the Commissioner also determines, based on all the facts and 
circumstances, that the additional PCT Payment of $X from A to B for the 
contingent payment term was not an arm's length charge for the 
additional allocation of risk as of the CSA Start Date in connection 
with the contingent payment term. Accordingly, the Commissioner makes an 
adjustment to B's results equal to the difference between $X and the 
median of the arm's length range of charges for the contingent payment 
term.
    Example 6. (i) The facts are the same as in Example 3 except that A 
and B further agreed that, if the present value (as of the CSA Start 
Date) of A's actual divisional operating profit or loss during the 
three-year period is either less or greater than the present value (as 
of the CSA Start Date) of the divisional operating profit or loss that 
the parties projected for A upon formation of the CSA for that period, 
then A may make a compensating adjustment to the third installment 
payment in the amount necessary to reduce (if actual divisional 
operating profit or loss is less than the projections) or increase (if 
actual divisional operating profit or loss exceeds the projections) the 
present value (as of the CSA Start Date) of the aggregate PCT Payments 
for those three years to the amount that would have been calculated if 
the actual results had been used for the calculation instead of the 
projected results.
    (ii) On audit, the Commissioner determines that the contingent 
payment term lacks economic substance under Sec. Sec.  1.482-
1(d)(3)(iii)(B) and 1.482-7(h)(2)(iii)(B). It lacks economic substance 
because the allocation of the risks between A and B was indeterminate as 
of the CSA Start Date due to the elective nature of the potential 
compensating adjustments. Specifically, the parties agreed upfront only 
that A might make compensating adjustments to the installment payments. 
By the terms of the agreement, A could decide whether to make such 
adjustments after the outcome of the risks was known or reasonably 
knowable. Even though the contingency and potential compensating 
adjustments were clearly defined in the CSA, no compensating adjustments 
were required by the CSA regardless of the occurrence or nonoccurrence 
of the contingency. As a result, the contingent payment terms did not 
clearly and unambiguously specify the events that give rise to an 
obligation to make PCT Payments, and, accordingly, the obligation to 
make compensating adjustments pursuant to the contingency was 
indeterminate. The contingent payment term allows the taxpayer to make 
adjustments that are favorable to its overall tax position in those 
years where the agreement allows it to make such adjustments, but 
decline to exercise its right to make any adjustment in those years in 
which such an adjustment would be unfavorable to its overall tax 
position. Such terms do not reflect a substantive upfront allocation of 
risk. In addition, the vagueness of the agreement makes it impossible to 
determine whether such contingent payment term warrants an additional 
arm's length charge and, if so, how much.
    (iii) Accordingly, the Commissioner may disregard the contingent 
payment term under Sec. Sec.  1.482-1(d)(3)(ii)(B)(1) and 1.482-
7(k)(1)(iv) and may impute other contractual terms in its place 
consistent with the economic substance of the CSA.
    Example 7. (i) The facts are the same as in Example 6 except that 
the contingent payment term provides that, if the present value (as of 
the CSA Start Date) of A's actual divisional operating profit or loss 
during the three-year period is either less or greater than the present 
value (as of the CSA Start Date) of the divisional operating profit or 
loss that the parties projected for A upon formation of the CSA for that 
period, then A will make a compensating adjustment to the third 
installment payment. The CSA does not specify the amount of (or a 
formula for) any such compensating adjustments.
    (ii) On audit, the Commissioner determines that the contingent 
payment term lacks economic substance under Sec. Sec.  1.482-
1(d)(3)(iii)(B) and 1.482-7(h)(2)(iii)(B). It lacks economic substance 
because the allocation of the risks between A and B was indeterminate as 
of the CSA Start Date due to the failure to specify the amount of (or a 
formula for) the compensating adjustments that must be made if a

[[Page 781]]

contingency occurs. The basis on which the compensating adjustments were 
to be determined was neither clear nor unambiguous. Even though the 
contingency was clearly defined in the CSA and the requirement of a 
compensating adjustment in the event of a contingency was clearly 
specified in the CSA, the parties had no agreement regarding the amount 
of such compensating adjustments. As a result, the computation used to 
determine the PCT Payments was indeterminate. The parties could choose 
to make a small positive compensating adjustment if the actual results 
turned out to be much greater than the projections, and could choose to 
make a significant negative compensating adjustment if the actual 
results turned out to be less than the projections. Such terms do not 
reflect a substantive upfront allocation of risk. In addition, the 
vagueness of the agreement makes it impossible to determine whether such 
contingent payment term warrants an additional arm's length charge and, 
if so, how much.
    (iii) Accordingly, the Commissioner may disregard the contingent 
price term under Sec. Sec.  1.482-1(d)(3)(ii)(B)(1) and 1.482-
7(k)(1)(iv) and may impute other contractual terms in its place 
consistent with economic substance of the CSA.

    (iv) Conversion from fixed to contingent form of payment. With 
regard to a conversion of a fixed present value to a contingent form of 
payment, see paragraphs (g)(2)(v) (Discount rate) and (vi) (Financial 
projections) of this section.
    (3) Coordination of best method rule and form of payment. A method 
described in paragraph (g)(1) of this section evaluates the arm's length 
amount charged in a PCT in terms of a form of payment (method payment 
form). For example, the method payment form for the acquisition price 
method described in paragraph (g)(5) of this section, and for the market 
capitalization method described in paragraph (g)(6) of this section, is 
fixed payment. Applications of the income method provide different 
method payment forms. See paragraphs (g)(4)(i)(E) and (iv) of this 
section. The method payment form may not necessarily correspond to the 
form of payment specified pursuant to paragraphs (h)(2)(iii) and 
(k)(2)(ii)(l) of this section (specified payment form). The 
determination under Sec.  1.482-1(c) of the method that provides the 
most reliable measure of an arm's length result is to be made without 
regard to whether the respective method payment forms under the 
competing methods correspond to the specified payment form. If the 
method payment form of the method determined under Sec.  1.482-1(c) to 
provide the most reliable measure of an arm's length result differs from 
the specified payment form, then the conversion from such method payment 
form to such specified payment form will be made to the satisfaction of 
the Commissioner.
    (i) Allocations by the Commissioner in connection with a CSA--(1) In 
general. The Commissioner may make allocations to adjust the results of 
a controlled transaction in connection with a CSA so that the results 
are consistent with an arm's length result, in accordance with the 
provisions of this paragraph (i).
    (2) CST allocations--(i) In general. The Commissioner may make 
allocations to adjust the results of a CST so that the results are 
consistent with an arm's length result, including any allocations to 
make each controlled participant's IDC share, as determined under 
paragraph (d)(4) of this section, equal to that participant's RAB share, 
as determined under paragraph (e)(1) of this section. Such allocations 
may result from, for purposes of CST determinations, adjustments to--
    (A) Redetermine IDCs by adding any costs (or cost categories) that 
are directly identified with, or are reasonably allocable to, the IDA, 
or by removing any costs (or cost categories) that are not IDCs;
    (B) Reallocate costs between the IDA and other business activities;
    (C) Improve the reliability of the selection or application of the 
basis used for measuring benefits for purposes of estimating a 
controlled participant's RAB share;
    (D) Improve the reliability of the projections used to estimate RAB 
shares, including adjustments described in paragraph (i)(2)(ii) of this 
section; and
    (E) Allocate among the controlled participants any unallocated 
interests in cost shared intangibles.
    (ii) Adjustments to improve the reliability of projections used to 
estimate RAB shares--(A) Unreliable projections. A significant 
divergence between projected benefit shares and benefit shares

[[Page 782]]

adjusted to take into account any available actual benefits to date 
(adjusted benefit shares) may indicate that the projections were not 
reliable for purposes of estimating RAB shares. In such a case, the 
Commissioner may use adjusted benefit shares as the most reliable 
measure of RAB shares and adjust IDC shares accordingly. The projected 
benefit shares will not be considered unreliable, as applied in a given 
taxable year, based on a divergence from adjusted benefit shares for 
every controlled participant that is less than or equal to 20% of the 
participant's projected benefits share. Further, the Commissioner will 
not make an allocation based on such divergence if the difference is due 
to an extraordinary event, beyond the control of the controlled 
participants, which could not reasonably have been anticipated at the 
time that costs were shared. The Commissioner generally may adjust 
projections of benefits used to calculate benefit shares in accordance 
with the provisions of Sec.  1.482-1. In particular, if benefits are 
projected over a period of years, and the projections for initial years 
of the period prove to be unreliable, this may indicate that the 
projections for the remaining years of the period are also unreliable 
and thus should be adjusted. For purposes of this paragraph 
(i)(2)(ii)(A), all controlled participants that are not U.S. persons are 
treated as a single controlled participant. Therefore, an adjustment 
based on an unreliable projection of RAB shares will be made to the IDC 
shares of foreign controlled participants only if there is a matching 
adjustment to the IDC shares of controlled participants that are U.S. 
persons. Nothing in this paragraph (i)(2)(ii)(A) prevents the 
Commissioner from making an allocation if a taxpayer did not use the 
most reliable basis for measuring anticipated benefits. For example, if 
the taxpayer measures its anticipated benefits based on units sold, and 
the Commissioner determines that another basis is more reliable for 
measuring anticipated benefits, then the fact that actual units sold 
were within 20% of the projected unit sales will not preclude an 
allocation under this section.
    (B) Foreign-to-foreign adjustments. Adjustments to IDC shares based 
on an unreliable projection also may be made among foreign controlled 
participants if the variation between actual and projected benefits has 
the effect of substantially reducing U.S. tax.
    (C) Correlative adjustments to PCTs. Correlative adjustments will be 
made to any PCT Payments of a fixed amount that were determined based on 
RAB shares that are subsequently adjusted on a finding that they were 
based on unreliable projections. No correlative adjustments will be made 
to contingent PCT Payments regardless of whether RAB shares were used as 
a parameter in the valuation of those payments.
    (D) Examples. The following examples illustrate the principles of 
this paragraph (i)(2)(ii):

    Example 1. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a CSA to develop new food products, dividing costs on the basis of 
projected sales two years in the future. In Year 1, USP and FS project 
that their sales in Year 3 will be equal, and they divide costs 
accordingly. In Year 3, the Commissioner examines the controlled 
participants' method for dividing costs. USP and FS actually accounted 
for 42% and 58% of total sales, respectively. The Commissioner agrees 
that sales two years in the future provide a reliable basis for 
estimating benefit shares. Because the differences between USP's and 
FS's adjusted and projected benefit shares are less than 20% of their 
projected benefit shares, the projection of future benefits for Year 3 
is reliable.
    Example 2. The facts are the same as in Example 1, except that in 
Year 3 USP and FS actually accounted for 35% and 65% of total sales, 
respectively. The divergence between USP's projected and adjusted 
benefit shares is greater than 20% of USP's projected benefit share and 
is not due to an extraordinary event beyond the control of the 
controlled participants. The Commissioner concludes that the projected 
benefit shares were unreliable, and uses adjusted benefit shares as the 
basis for an adjustment to the cost shares borne by USP and FS.
    Example 3. U.S. Parent (USP), a U.S. corporation, and its foreign 
subsidiary (FS) enter into a CSA in Year 1. They project that they will 
begin to receive benefits from cost shared intangibles in Years 4 
through 6, and that USP will receive 60% of total benefits and FS 40% of 
total benefits. In Years 4 through 6, USP and FS actually receive 50% 
each of the total benefits. In evaluating the reliability of the 
controlled participants'

[[Page 783]]

projections, the Commissioner compares the adjusted benefit shares to 
the projected benefit shares. Although USP's adjusted benefit share 
(50%) is within 20% of its projected benefit share (60%), FS's adjusted 
benefit share (50%) is not within 20% of its projected benefit share 
(40%). Based on this discrepancy, the Commissioner may conclude that the 
controlled participants' projections were unreliable and may use 
adjusted benefit shares as the basis for an adjustment to the cost 
shares borne by USP and FS.
    Example 4. Three controlled taxpayers, USP, FS1, and FS2 enter into 
a CSA. FS1 and FS2 are foreign. USP is a domestic corporation that 
controls all the stock of FS1 and FS2. The controlled participants 
project that they will share the total benefits of the cost shared 
intangibles in the following percentages: USP 50%; FS1 30%; and FS2 20%. 
Adjusted benefit shares are as follows: USP 45%; FS1 25%; and FS2 30%. 
In evaluating the reliability of the controlled participants' 
projections, the Commissioner compares these adjusted benefit shares to 
the projected benefit shares. For this purpose, FS1 and FS2 are treated 
as a single controlled participant. The adjusted benefit share received 
by USP (45%) is within 20% of its projected benefit share (50%). In 
addition, the non-US controlled participant's adjusted benefit share 
(55%) is also within 20% of their projected benefit share (50%). 
Therefore, the Commissioner concludes that the controlled participant's 
projections of future benefits were reliable, despite the fact that 
FS2's adjusted benefit share (30%) is not within 20% of its projected 
benefit share (20%).
    Example 5. The facts are the same as in Example 4. In addition, the 
Commissioner determines that FS2 has significant operating losses and 
has no earnings and profits, and that FS1 is profitable and has earnings 
and profits. Based on all the evidence, the Commissioner concludes that 
the controlled participants arranged that FS1 would bear a larger cost 
share than appropriate in order to reduce FS1's earnings and profits and 
thereby reduce inclusions USP otherwise would be deemed to have on 
account of FS1 under subpart F. Pursuant to paragraph (i)(2)(ii)(B) of 
this section, the Commissioner may make an adjustment solely to the cost 
shares borne by FS1 and FS2 because FS2's projection of future benefits 
was unreliable and the variation between adjusted and projected benefits 
had the effect of substantially reducing USP's U.S. income tax liability 
(on account of FS1 subpart F income).
    Example 6. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS) 
enter into a CSA in 1996 to develop a new treatment for baldness. USS's 
interest in any treatment developed is the right to produce and sell the 
treatment in the U.S. market while FP retains rights to produce and sell 
the treatment in the rest of the world. USS and FP measure their 
anticipated benefits from the CSA based on their respective projected 
future sales of the baldness treatment. The following sales projections 
are used:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
1.............................................            5           10
2.............................................           20           20
3.............................................           30           30
4.............................................           40           40
5.............................................           40           40
6.............................................           40           40
7.............................................           40           40
8.............................................           20           20
9.............................................           10           10
10............................................            5            5
------------------------------------------------------------------------

    (B) In Year 1, the first year of sales, USS is projected to have 
lower sales than FP due to lags in U.S. regulatory approval for the 
baldness treatment. In each subsequent year, USS and FP are projected to 
have equal sales. Sales are projected to build over the first three 
years of the period, level off for several years, and then decline over 
the final years of the period as new and improved baldness treatments 
reach the market.
    (ii) To account for USS's lag in sales in the Year 1, the present 
discounted value of sales over the period is used as the basis for 
measuring benefits. Based on the risk associated with this venture, a 
discount rate of 10 percent is selected. The present discounted value of 
projected sales is determined to be approximately $154.4 million for USS 
and $158.9 million for FP. On this basis USS and FP are projected to 
obtain approximately 49.3% and 50.7% of the benefit, respectively, and 
the costs of developing the baldness treatment are shared accordingly.
    (iii)(A) In Year 6, the Commissioner examines the CSA. USS and FP 
have obtained the following sales results through Year 5:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
1.............................................            0           17
2.............................................           17           35
3.............................................           25           35
4.............................................           38           41
5.............................................           39           41
------------------------------------------------------------------------

    (B) USS's sales initially grew more slowly than projected while FP's 
sales grew more quickly. In each of the first three years of the period, 
the share of total sales of at least one of the parties diverged by over 
20% from its projected share of sales. However, by Year 5 both parties' 
sales had leveled off at approximately their projected values. Taking 
into account this leveling off of sales and

[[Page 784]]

all the facts and circumstances, the Commissioner determines that it is 
appropriate to use the original projections for the remaining years of 
sales. Combining the actual results through Year 5 with the projections 
for subsequent years, and using a discount rate of 10%, the present 
discounted value of sales is approximately $141.6 million for USS and 
$187.3 million for FP. This result implies that USS and FP obtain 
approximately 43.1% and 56.9%, respectively, of the anticipated benefits 
from the baldness treatment. Because these adjusted benefit shares are 
within 20% of the benefit shares calculated based on the original sales 
projections, the Commissioner determines that, based on the difference 
between adjusted and projected benefit shares, the original projections 
were not unreliable. No adjustment is made based on the difference 
between adjusted and projected benefit shares.
    Example 7. (i) The facts are the same as in Example 6, except that 
the actual sales results through Year 5 are as follows:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
1.............................................            0           17
2.............................................           17           35
3.............................................           25           44
4.............................................           34           54
5.............................................           36           55
------------------------------------------------------------------------

    (ii) Based on the discrepancy between the projections and the actual 
results and on consideration of all the facts, the Commissioner 
determines that for the remaining years the following sales projections 
are more reliable than the original projections:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                     Year                           USS           FP
------------------------------------------------------------------------
6.............................................           36           55
7.............................................           36           55
8.............................................           18           28
9.............................................            9           14
10............................................          4.5            7
------------------------------------------------------------------------

    (iii) Combining the actual results through Year 5 with the 
projections for subsequent years, and using a discount rate of 10%, the 
present discounted value of sales is approximately $131.2 million for 
USS and $229.4 million for FP. This result implies that USS and FP 
obtain approximately 35.4% and 63.6%, respectively, of the anticipated 
benefits from the baldness treatment. These adjusted benefit shares 
diverge by greater than 20% from the benefit shares calculated based on 
the original sales projections, and the Commissioner determines that, 
based on the difference between adjusted and projected benefit shares, 
the original projections were unreliable. The Commissioner adjusts cost 
shares for each of the taxable years under examination to conform them 
to the recalculated shares of anticipated benefits.

    (iii) Timing of CST allocations. If the Commissioner makes an 
allocation to adjust the results of a CST, the allocation must be 
reflected for tax purposes in the year in which the IDCs were incurred. 
When a CST payment is owed by one controlled participant to another 
controlled participant, the Commissioner may make appropriate 
allocations to reflect an arm's length rate of interest for the time 
value of money, consistent with the provisions of Sec.  1.482-2(a) 
(Loans or advances).
    (3) PCT allocations. The Commissioner may make allocations to adjust 
the results of a PCT so that the results are consistent with an arm's 
length result in accordance with the provisions of the applicable 
sections of the regulations under section 482, as determined pursuant to 
paragraph (a)(2) of this section.
    (4) Allocations regarding changes in participation under a CSA. The 
Commissioner may make allocations to adjust the results of any 
controlled transaction described in paragraph (f) of this section if the 
controlled participants do not reflect arm's length results in relation 
to any such transaction.
    (5) Allocations when CSTs are consistently and materially 
disproportionate to RAB shares. If a controlled participant bears IDC 
shares that are consistently and materially greater or lesser than its 
RAB share, then the Commissioner may conclude that the economic 
substance of the arrangement between the controlled participants is 
inconsistent with the terms of the CSA. In such a case, the Commissioner 
may disregard such terms and impute an agreement that is consistent with 
the controlled participants' course of conduct, under which a controlled 
participant that bore a disproportionately greater IDC share received 
additional interests in the cost shared intangibles. See Sec. Sec.  
1.482-1(d)(3)(ii)(B) (Identifying contractual terms) and 1.482-
4(f)(3)(ii) (Identification of owner). Such additional interests will 
consist of partial undivided interests in the other controlled 
participant's interest in the cost shared intangible. Accordingly,

[[Page 785]]

that controlled participant must receive arm's length consideration from 
any controlled participant whose IDC share is less than its RAB share 
over time, under the provisions of Sec. Sec.  1.482-1 and 1.482-4 
through 1.482-6 to provide compensation for the latter controlled 
participants' use of such partial undivided interest.
    (6) Periodic adjustments--(i) In general. Subject to the exceptions 
in paragraph (i)(6)(vi) of this section, the Commissioner may make 
periodic adjustments for an open taxable year (the Adjustment Year) and 
for all subsequent taxable years for the duration of the CSA Activity 
with respect to all PCT Payments, if the Commissioner determines that, 
for a particular PCT (the Trigger PCT), a particular controlled 
participant that owes or owed a PCT Payment relating to that PCT (such 
controlled participant being referred to as the PCT Payor for purposes 
of this paragraph (i)(6)) has realized an Actually Experienced Return 
Ratio (AERR) that is outside the Periodic Return Ratio Range (PRRR). The 
satisfaction of the condition stated in the preceding sentence is 
referred to as a Periodic Trigger. See paragraphs (i)(6)(ii) through 
(vi) of this section regarding the PRRR, the AERR, and periodic 
adjustments. In determining whether to make such adjustments, the 
Commissioner may consider whether the outcome as adjusted more reliably 
reflects an arm's length result under all the relevant facts and 
circumstances, including any information known as of the Determination 
Date. The Determination Date is the date of the relevant determination 
by the Commissioner. The failure of the Commissioner to determine for an 
earlier taxable year that a PCT Payment was not arm's length will not 
preclude the Commissioner from making a periodic adjustment for a 
subsequent year. A periodic adjustment under this paragraph (i)(6) may 
be made without regard to whether the taxable year of the Trigger PCT or 
any other PCT remains open for statute of limitations purposes or 
whether a periodic adjustment has previously been made with respect to 
any PCT Payment.
    (ii) PRRR. Except as provided in the next sentence, the PRRR will 
consist of return ratios that are not less than .667 nor more than 1.5. 
Alternatively, if the controlled participants have not substantially 
complied with the documentation requirements referenced in paragraph (k) 
of this section, as modified, if applicable, by paragraphs (m)(2) and 
(3) of this section, the PRRR will consist of return ratios that are not 
less than .8 nor more than 1.25.
    (iii) AERR--(A) In general. The AERR is the present value of total 
profits (PVTP) divided by the present value of investment (PVI). In 
computing PVTP and PVI, present values are computed using the applicable 
discount rate (ADR), and all information available as of the 
Determination Date is taken into account.
    (B) PVTP. The PVTP is the present value, as of the CSA Start Date, 
as defined in section (j)(1)(i) of this section, of the PCT Payor's 
actually experienced divisional profits or losses from the CSA Start 
Date through the end of the Adjustment Year.
    (C) PVI. The PVI is the present value, as of the CSA Start Date, of 
the PCT Payor's investment associated with the CSA Activity, defined as 
the sum of its cost contributions and its PCT Payments, from the CSA 
Start Date through the end of the Adjustment Year. For purposes of 
computing the PVI, PCT Payments means all PCT Payments due from a PCT 
Payor before netting against PCT Payments due from other controlled 
participants pursuant to paragraph (j)(3)(ii) of this section.
    (iv) ADR--(A) In general. Except as provided in paragraph 
(i)(6)(iv)(B) of this section, the ADR is the discount rate pursuant to 
paragraph (g)(2)(v) of this section, subject to such adjustments as the 
Commissioner determines appropriate.
    (B) Publicly traded companies. If the PCT Payor meets the conditions 
of paragraph (i)(6)(iv)(C) of this section, the ADR is the PCT Payor 
WACC as of the date of the Trigger PCT. However, if the Commissioner 
determines, or the controlled participants establish to the satisfaction 
of the Commissioner, that a discount rate other than the PCT Payor WACC 
better reflects the degree of risk of the CSA Activity as of such

[[Page 786]]

date, the ADR is such other discount rate.
    (C) Publicly traded. A PCT Payor meets the conditions of this 
paragraph (i)(6)(iv)(C) if--
    (1) Stock of the PCT Payor is publicly traded; or
    (2) Stock of the PCT Payor is not publicly traded, provided the PCT 
Payor is included in a group of companies for which consolidated 
financial statements are prepared; and a publicly traded company in such 
group owns, directly or indirectly, stock in PCT Payor. Stock of a 
company is publicly traded within the meaning of this paragraph 
(i)(6)(iv)(C) if such stock is regularly traded on an established United 
States securities market and the company issues financial statements 
prepared in accordance with United States generally accepted accounting 
principles for the taxable year.
    (D) PCT Payor WACC. The PCT Payor WACC is the WACC, as defined in 
paragraph (j)(1)(i) of this section, of the PCT Payor or the publicly 
traded company described in paragraph (i)(6)(iv)(C)(2)(ii) of this 
section, as the case may be.
    (E) Generally accepted accounting principles. For purposes of 
paragraph (i)(6)(iv)(C) of this section, a financial statement prepared 
in accordance with a comprehensive body of generally accepted accounting 
principles other than United States generally accepted accounting 
principles is considered to be prepared in accordance with United States 
generally accepted accounting principles provided that the amounts of 
debt, equity, and interest expense are reflected in any reconciliation 
between such other accounting principles and United States generally 
accepted accounting principles required to be incorporated into the 
financial statement by the securities laws governing companies whose 
stock is regularly traded on United States securities markets.
    (v) Determination of periodic adjustments. In the event of a 
Periodic Trigger, subject to paragraph (i)(6)(vi) of this section, the 
Commissioner may make periodic adjustments with respect to all PCT 
Payments between all PCT Payors and PCT Payees for the Adjustment Year 
and all subsequent years for the duration of the CSA Activity pursuant 
to the residual profit split method as provided in paragraph (g)(7) of 
this section, subject to the further modifications in this paragraph 
(i)(6)(v). A periodic adjustment may be made for a particular taxable 
year without regard to whether the taxable years of the Trigger PCT or 
other PCTs remain open for statute of limitation purposes.
    (A) In general. Periodic adjustments are determined by the following 
steps:
    (1) First, determine the present value, as of the date of the 
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of 
this section pursuant to the Adjusted RPSM as defined in paragraph 
(i)(6)(v)(B) of this section (first step result).
    (2) Second, convert the first step result into a stream of 
contingent payments on a base of reasonably anticipated divisional 
profits or losses over the entire duration of the CSA Activity, using a 
level royalty rate (second step rate). See paragraph (h)(2)(iv) of this 
section (Conversion from fixed to contingent form of payment). This 
conversion is made based on all information known as of the 
Determination Date.
    (3) Third, apply the second step rate to the actual divisional 
profit or loss for taxable years preceding and including the Adjustment 
Year to yield a stream of contingent payments for such years, and 
convert such stream to a present value as of the CSA Start Date under 
the principles of paragraph (g)(2)(v) of this section (third step 
result). For this purpose, the second step rate applied to a loss for a 
particular year will yield a negative contingent payment for that year.
    (4) Fourth, convert any actual PCT Payments up through the 
Adjustment Year to a present value as of the CSA Start Date under the 
principles of paragraph (g)(2)(v) of this section. Then subtract such 
amount from the third step result. Determine the nominal amount in the 
Adjustment Year that would have a present value as of the CSA Start Date 
equal to the present value determined in the previous sentence to 
determine the periodic adjustment in the Adjustment Year.

[[Page 787]]

    (5) Fifth, apply the second step rate to the actual divisional 
profit or loss for each taxable year after the Adjustment Year up to and 
including the taxable year that includes the Determination Date to yield 
a stream of contingent payments for such years. For this purpose, the 
second step rate applied to a loss will yield a negative contingent 
payment for that year. Then subtract from each such payment any actual 
PCT Payment made for the same year to determine the periodic adjustment 
for such taxable year.
    (6) For each taxable year subsequent to the year that includes the 
Determination Date, the periodic adjustment for such taxable year (which 
is in lieu of any PCT Payment that would otherwise be payable for that 
year under the taxpayer's position) equals the second step rate applied 
to the actual divisional profit or loss for that year. For this purpose, 
the second step rate applied to a loss for a particular year will yield 
a negative contingent payment for that year.
    (7) If the periodic adjustment for any taxable year is a positive 
amount, then it is an additional PCT Payment owed from the PCT Payor to 
the PCT Payee for such year. If the periodic adjustment for any taxable 
year is a negative amount, then it is an additional PCT Payment owed by 
the PCT Payee to the PCT Payor for such year.
    (B) Adjusted RPSM as of Determination Date. The Adjusted RPSM is the 
residual profit split method pursuant to paragraph (g)(7) of this 
section applied to determine the present value, as of the date of the 
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of 
this section, with the following modifications.
    (1) Actual results up through the Determination Date shall be 
substituted for what otherwise were the projected results over such 
period, as reasonably anticipated as of the date of the Trigger PCT.
    (2) Projected results for the balance of the CSA Activity after the 
Determination Date, as reasonably anticipated as of the Determination 
Date, shall be substituted for what otherwise were the projected results 
over such period, as reasonably anticipated as of the date of the 
Trigger PCT.
    (3) The requirement in paragraph (g)(7)(i) of this section, that at 
least two controlled participants make significant nonroutine 
contributions, does not apply.
    (vi) Exceptions to periodic adjustments--(A) Controlled participants 
establish periodic adjustment not warranted. No periodic adjustment will 
be made under paragraphs (i)(6)(i) and (v) of this section if the 
controlled participants establish to the satisfaction of the 
Commissioner that all the conditions described in one of paragraphs 
(i)(6)(vi)(A)(1) through (4) of this section apply with respect to the 
Trigger PCT.
    (1) Transactions involving the same platform contribution as in the 
Trigger PCT.
    (i) The same platform contribution is furnished to an uncontrolled 
taxpayer under substantially the same circumstances as those of the 
relevant Trigger PCT and with a similar form of payment as the Trigger 
PCT;
    (ii) This transaction serves as the basis for the application of the 
comparable uncontrolled transaction method described in paragraph (g)(3) 
of this section, in the first year and all subsequent years in which 
substantial PCT Payments relating to the Trigger PCT were required to be 
paid; and
    (iii) The amount of those PCT Payments in that first year was arm's 
length.
    (2) Results not reasonably anticipated. The differential between the 
AERR and the nearest bound of the PRRR is due to extraordinary events 
beyond the control of the controlled participants that could not 
reasonably have been anticipated as of the date of the Trigger PCT.
    (3) Reduced AERR does not cause Periodic Trigger. The Periodic 
Trigger would not have occurred had the PCT Payor's divisional profits 
or losses used to calculate its PVTP both taken into account expenses on 
account of operating cost contributions and routine platform 
contributions, and excluded those profits or losses attributable to the 
PCT Payor's routine contributions to its exploitation of cost shared 
intangibles, nonroutine contributions to the

[[Page 788]]

CSA Activity, operating cost contributions, and routine platform 
contributions.
    (4) Increased AERR does not cause Periodic Trigger--(i) The Periodic 
Trigger would not have occurred had the divisional profits or losses of 
the PCT Payor used to calculate its PVTP included its reasonably 
anticipated divisional profits or losses after the Adjustment Year from 
the CSA Activity, including from its routine contributions, its 
operating cost contributions, and its nonroutine contributions to that 
activity, and had the cost contributions and PCT Payments of the PCT 
Payor used to calculate its PVI included its reasonably anticipated cost 
contributions and PCT Payments after the Adjustment Year. The reasonably 
anticipated amounts in the previous sentence are determined based on all 
information available as of the Determination Date.
    (ii) For purposes of this paragraph (i)(6)(vi)(A)(4), the controlled 
participants may, if they wish, assume that the average yearly 
divisional profits or losses for all taxable years prior to and 
including the Adjustment Year, in which there has been substantial 
exploitation of cost shared intangibles resulting from the CSA 
(exploitation years), will continue to be earned in each year over a 
period of years equal to 15 minus the number of exploitation years prior 
to and including the Determination Date.
    (B) Circumstances in which Periodic Trigger deemed not to occur. No 
Periodic Trigger will be deemed to have occurred at the times and in the 
circumstances described in paragraph (i)(6)(vi)(B)(1) or (2) of this 
section.
    (1) 10-year period. In any year subsequent to the 10-year period 
beginning with the first taxable year in which there is substantial 
exploitation of cost shared intangibles resulting from the CSA, if the 
AERR determined is within the PRRR for each year of such 10-year period.
    (2) 5-year period. In any year of the 5-year period beginning with 
the first taxable year in which there is substantial exploitation of 
cost shared intangibles resulting from the CSA, if the AERR falls below 
the lower bound of the PRRR.
    (vii) Examples. The following examples illustrate the rules of this 
paragraph (i)(6):

    Example 1. (i) For simplicity of calculation in this Example 1, all 
financial flows are assumed to occur at the beginning of the year. At 
the beginning of Year 1, USP, a publicly traded U.S. company, and FS, 
its wholly-owned foreign subsidiary, enter into a CSA to develop new 
technology for cell phones. USP has a platform contribution, the rights 
for an in-process technology that when developed will improve the 
clarity of calls, for which compensation is due from FS. FS has no 
platform contributions to the CSA, no operating contributions, and no 
operating cost contributions. USP and FS agree to fixed PCT payments of 
$40 million in Year 1 and $10 million per year for Years 2 through 10. 
At the beginning of Year 1, the weighted average cost of capital of the 
controlled group that includes USP and FS is 15%. In Year 9, the 
Commissioner audits Years 5 through 7 of the CSA and considers whether 
any periodic adjustments should be made. USP and FS have substantially 
complied with the documentation requirements of paragraph (k) of this 
section.
    (ii) FS experiences the results reported in the following table from 
its participation in the CSA through Year 7. In the table, all present 
values (PV) are reported as of the CSA Start Date, which is the same as 
the date of the PCT (and reflect a 15% discount rate as discussed in 
paragraph (iii) of this Example 1). Thus, in any year the present value 
of the cumulative investment is PVI and of the cumulative divisional 
profit or loss is PVTP. All amounts in this table and the tables that 
follow are reported in millions of dollars and cost contributions are 
referred to as ``CCs'' (for simplicity of calculation in this Example 1, 
all financial flows are assumed to occur at the beginning of the year).

----------------------------------------------------------------------------------------------------------------
              a                    b           c           d           e           f           g           h
----------------------------------------------------------------------------------------------------------------
                                                                                          Divisional
            Year                 Sales      Non CC        CCs         PCT     Investment   profit or  AERR (PVTP/
                                             costs                 payments     (d + e)   loss (b-c)  PVI) (g/f)
----------------------------------------------------------------------------------------------------------------
1...........................           0           0          15          40          55           0
2...........................           0           0          17          10          27           0
3...........................           0           0          18          10          28           0
4...........................         705         662          20          10          30          46
5...........................         886         718          22          10          32         168

[[Page 789]]

 
6...........................       1,113         680          24          10          34         433
7...........................       1,179         747          27          10          37         432
PV through Year 5...........         970         846          69          69         138         124        0.90
PV through Year 6...........       1,523       1,184          81          74         155         340        2.20
PV through Year 7...........       2,033       1,507          93          78         171         526        3.09
----------------------------------------------------------------------------------------------------------------

    (iii) Because USP is publicly traded in the United States and is a 
member of the controlled group to which FS (the PCT Payor) belongs, for 
purposes of calculating the AERR for FS, the present values of its PVTP 
and PVI are determined using an ADR of 15%, the weighted average cost of 
capital of the controlled group. (It is assumed that no other rate was 
determined or established, under paragraph (i)(6)(iv)(B) of this 
section, to better reflect the relevant degree of risk.) At a 15% 
discount rate, the PVTP, calculated as of Year 1, and based on actual 
profits realized by FS through Year 7 from exploiting the new cell phone 
technology developed by the CSA, is $526 million. The PVI, based on FS's 
cost contributions and its PCT Payments, is $171 million. The AERR for 
FS is equal to its PVTP divided by its PVI, $526 million/$171 million, 
or 3.09. There is a Periodic Trigger because FS's AERR of 3.09 falls 
outside the PRRR of .67 to 1.5, the applicable PRRR for controlled 
participants complying with the documentation requirements of this 
section.
    (iv) At the time of the Determination Date, it is determined that 
the first Adjustment Year in which a Periodic Trigger occurred was Year 
6, when the AERR of FS was determined to be 2.20. It is also determined 
that for Year 6 none of the exceptions to periodic adjustments described 
in paragraph (i)(6)(vi) of this section applies. The Commissioner 
exercises its discretion under paragraph (i)(6)(i) of this section to 
make periodic adjustments using Year 6 as the Adjustment Year. 
Therefore, the arm's length PCT Payments from FS to USP shall be 
determined for each taxable year using the adjusted residual profit 
split method described in paragraphs (g)(7) and (i)(6)(v)(B) of this 
section. Periodic adjustments will be made for each year to the extent 
the PCT Payments actually made by FS differ from the PCT Payment 
calculation under the adjusted residual profit split method.
    (v) It is determined, as of the Determination Date, that the cost 
shared intangibles will be exploited through Year 10. FS's return for 
routine contributions (determined by the Commissioner, based on the 
return for comparable functions undertaken by comparable uncontrolled 
companies, to be 8% of non-CC costs), and its actual and projected 
results, are described in the following table.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                            a                                    b               c               d               e               f               g
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                            Divisional
                          Year                                 Sales       Non-CC costs   profit or loss        CCs       Routing return     Residual
                                                                                               (b-c)                                      proift (d-e-f)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1.......................................................               0               0               0              15               0             -15
2.......................................................               0               0               0              17               0             -17
3.......................................................               0               0               0              18               0             -18
4.......................................................             705             662              43              20              53             -30
5.......................................................             886             718             168              22              57              89
6.......................................................           1,113             680             433              24              54             355
7.......................................................           1,179             747             432              27              60             345
8.......................................................           1,238             822             416              29              66             321
9.......................................................           1,300             894             406              32              72             302
10......................................................           1,365             974             391              35              78             278
Cumulative PV through Year 10 as of CSA Start Date......           3,312           2,385             927             124             191             612
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (vi) The periodic adjustments are calculated in a series of steps 
set out in paragraph (i)(6)(v)(A) of this section. First, a lump sum for 
the PCT Payment is determined using the adjusted residual profit split 
method. Under the method, based on the considerations discussed in 
paragraph (g)(2)(v) of this section, the appropriate discount rate is 
15% per year. The nonroutine residual divisional profit or loss 
described in paragraph (g)(7)(iii)(B) of this section is $612 million. 
Further, under paragraph (g)(7)(iii)(C) of this

[[Page 790]]

section, the entire nonroutine residual divisional profit constitutes 
the PCT Payment because only USP has nonroutine contributions.
    (vii) In step two, the first step result ($612 million) is converted 
into a level royalty rate based on the reasonably anticipated divisional 
profit or losses of the CSA Activity, the PV of which is reported in the 
table above (net PV of divisional profit or loss for Years 1 through 10 
is $927 million). Consequently, the step two result is a level royalty 
rate of 66.0% ($612/$927) of the divisional profit in Years 1 through 
10.
    (viii) In step three, the Commissioner calculates the PCT Payments 
due through Year 6 by applying the step two royalty rate to the actual 
divisional profits for each year and then determines the aggregate PV of 
these PCT Payments as of the CSA Start Date ($224 million as reported in 
the following table). In step four, the PCT Payments actually made 
through Year 6 are similarly converted to PV as of the CSA Start Date 
($74 million) and subtracted from the amount determined in step three 
($224 million--$74 million = $150 million). That difference of $150 
million, representing a net PV as of the CSA Start Date, is then 
converted to a nominal amount, as of the Adjustment Year, of equivalent 
present value (again using a discount rate of 15%). That nominal amount 
is $302 million (not shown in the table), and is the periodic adjustment 
in Year 6.

----------------------------------------------------------------------------------------------------------------
                a                          b                   c                   d                   e
----------------------------------------------------------------------------------------------------------------
                                                                            Nominal royalty
              Year                 Divisional profit     Royalty rate     due under adjusted   Nominal payments
                                                                              RPSM (b*c)             made
----------------------------------------------------------------------------------------------------------------
Year 1..........................                   0                66.0                  $0                 $40
Year 2..........................                   0                66.0                   0                  10
Year 3..........................                   0                66.0                   0                  10
Year 4..........................                  43                66.0                  28                  10
Year 5..........................                 168                66.0                 111                  10
Year 6..........................                 433                66.0                 286                  10
Cumulative PV as of Year 1......  ..................  ..................                 224                  74
----------------------------------------------------------------------------------------------------------------

    (ix) Under step five, the royalties due from FS to USP for Year 7 
(the year after the Adjustment Year) through Year 9 (the year including 
the Determination Date) are determined. (These determinations are made 
for Years 8 and 9 after the divisional profit for those years becomes 
available.) For each year, the periodic adjustment is a PCT Payment due 
in addition to the $10 million PCT Payment that must otherwise be paid 
under the CSA as described in paragraph (i) of this Example 1. That 
periodic adjustment is calculated as the product of the step two royalty 
rate and the divisional profit, minus the $10 million that was otherwise 
paid for that year. The calculations are shown in the following table:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                               a                                        b                 c                 d                 e                 f
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   Divisional                          Royalty due      PCT Payments        Periodic
                             Year                                    profit         Royalty rate          (b*c)        otherwise paid    adjustment d-e)
--------------------------------------------------------------------------------------------------------------------------------------------------------
7.............................................................               432             66.0%              $285               $10              $275
8.............................................................               416              66.0               275                10               265
9.............................................................               406              66.0               268                10               258
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (x) Under step six, the periodic adjustment for Year 10 (the only 
exploitation year after the year containing the Determination Date) will 
be determined by applying the step two royalty rate to the divisional 
profit. This periodic adjustment is a PCT Payment payable from FS to 
USP, and is in lieu of the $10 payment otherwise due. The calculations 
are shown in the following table, based on a divisional profit of $391 
million. USP and FS experienced the following results in Year 10.


--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                         PCT payment
                                                                                                                      called for under
                             Year                                  Divisional       Royalty rate       Royalty due        original          Periodic
                                                                     profit                                             agreement but      adjustment
                                                                                                                          not made
--------------------------------------------------------------------------------------------------------------------------------------------------------
10............................................................               391             66.0%              $258    $10 (not paid)              $258
--------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 791]]

    Example 2. The facts are the same as in paragraphs (i) through (iii) 
of Example 1. At the time of the Determination Date, it is determined 
that the first Adjustment Year in which a Periodic Trigger occurred was 
Year 6, when the AERR of FS was determined to be 2.73. Upon further 
investigation as to what may have caused the high return in FS's market, 
the Commissioner learns that, in Years 4 through 6, USP's leading 
competitors experienced severe, unforeseen disruptions in their supply 
chains resulting in a significant increase in USP's and FS's market 
share for cell phones. Further analysis determines that without this 
unforeseen occurrence the Periodic Trigger would not have occurred. 
Based on paragraph (i)(6)(vi)(A)(2) of this section, the Commissioner 
determines to his satisfaction that no adjustments are warranted.
    Example 3. (i) USP, a U.S. corporation, and its wholly-owned foreign 
subsidiaries FS1, FS2, and FS3 enter into a CSA at the start of Year 1 
to develop version 2.0 of a computer program. USP makes a platform 
contribution, version 1.0 of the program (upon which version 2.0 will be 
based), for which compensation is due from FS1, FS2, and FS3. None of 
the foreign subsidiaries makes any platform contributions.
    (ii) In Year 6, the Commissioner audits Years 3 through 5 of the CSA 
and considers whether any periodic adjustments should be made. At the 
time of the Determination Date, the Commissioner determines that the 
first Adjustment Year in which a Periodic Trigger occurred was Year 3, 
and further determines that none of the exceptions to periodic 
adjustments described in paragraph (i)(6)(vi) of this section applies. 
The Commissioner exercises his discretion under paragraph (i)(6)(i) of 
this section to make periodic adjustments using Year 3 as the Adjustment 
Year. Therefore, the arm's length PCT Payments from FS1, FS2, and FS3 to 
USP shall be determined using the adjusted residual profit split method 
described in paragraphs (g)(7)(v)(B) and (i)(6)(v)(B) of this section. 
Periodic adjustments will be made for each year to the extent the PCT 
Payments actually made by FS1, FS2, and FS3 differ from the PCT Payment 
calculation under the adjusted residual profit split method.
    (iii) The periodic adjustments are calculated in a series of steps 
set out in paragraph (i)(6)(v)(A) of this section. First, a lump sum for 
the PCT Payments is determined using the adjusted residual profit split 
method. The following results are calculated (based on actual results 
for years for which actual results are available and projected results 
for all years thereafter) in order to apply the adjusted residual profit 
split method (it is determined that the cost shared intangibles will be 
exploited through Year 7, so the results reported in the following table 
are cumulative values through Year 7):

----------------------------------------------------------------------------------------------------------------
                                                                   Divisional profits        Residual profits
                                                                 (cumulative PV through   (cumulative PV through
                          Participant                             year 7 as of the CSA     year 7 as of the CSA
                                                                      start date)              start date)
----------------------------------------------------------------------------------------------------------------
FS1...........................................................                     $667                     $314
FS2...........................................................                      271                      159
FS3...........................................................                      592                      295
----------------------------------------------------------------------------------------------------------------


Because only USP had nonroutine contributions, under paragraph 
(g)(7)(iii)(C) of this section, the entire nonroutine residual 
divisional profit constitutes the PCT Payment owed to USP. Therefore, 
the present values (as of the CSA Start Date) of the PCT Payments owed 
are as follows:
PCT Payment owed from FS1 to USP: $314 million
PCT Payment owed from FS2 to USP: $159 million
PCT Payment owed from FS3 to USP: $295 million
Pursuant to paragraph (i)(6)(v)(A) of this section, the steps in 
paragraphs (i)(6)(v)(A)(2) through (7) of this section are performed 
separately for the PCT Payments that are owed to USP by each of FS1, 
FS2, and FS3.
    (iv) First, the steps are performed with respect to FS1. In step 
two, the first step result ($314 million) is converted into a level 
royalty rate based on FS1's reasonably anticipated divisional profits or 
losses through Year 7 (the PV of which is $667 million). Consequently, 
the step two result is a level royalty rate of 47.1% ($314/$667) of the 
divisional profits in Years 1 through 7. In step three, the Commissioner 
calculates the PCT Payments due through Year 3 (the Adjustment Year) by 
applying the step two royalty rate (47.1%) to FS1's actual divisional 
profits for each year up to and including Year 3 and then determining 
the aggregate PV of these PCT Payments as of Year 3. In step four, the 
PCT Payments actually made by FS1 to USP through Year 3 are similarly 
converted to a PV as of Year 3 and subtracted from the amount determined 
in step three. That difference is the periodic adjustment in Year 3 with 
respect to the PCT Payments made for Years 1 through 3 from FS1 to USP. 
Under step five, the royalties due from FS1 to USP for Year 4 (the year 
after the Adjustment Year) through Year 6 (the year including the 
Determination Date) are determined. The

[[Page 792]]

periodic adjustment for each of these years is calculated as the product 
of the step two royalty rate and the divisional profit for that year, 
minus any actual PCT Payment made by FS1 to USP in that year. The 
periodic adjustment for each such year is a PCT Payment due in addition 
to the PCT Payment from FS1 to USP that was already made under the CSA. 
Under step six, the periodic adjustment for Year 7 (the only 
exploitation year after the year containing the Determination Date) will 
be determined by applying the step two royalty rate to FS1's divisional 
profit for that year. This periodic adjustment for Year 7 is a PCT 
Payment payable from FS1 to USP and is in lieu of any PCT Payment from 
FS1 to USP otherwise due.
    (v) Next, the steps in paragraphs (i)(6)(v)(A)(2) through (7) of 
this section are performed with respect to FS2. In step two, the first 
step result ($159 million) is converted into a level royalty rate based 
on FS2's reasonably anticipated divisional profits or losses through 
Year 7 (the PV of which is $271 million). Consequently, the step two 
result is a level royalty rate of 58.7% ($159/$271) of the divisional 
profits in Years 1 through 7. In step three, the Commissioner calculates 
the PCT Payments due through Year 3 (the Adjustment Year) by applying 
the step two royalty rate (58.7%) to FS2's actual divisional profits for 
each year up to and including Year 3 and then determining the aggregate 
PV of these PCT Payments as of Year 3. In step four, the PCT Payments 
actually made by FS2 to USP through Year 3 are similarly converted to a 
PV as of Year 3 and subtracted from the amount determined in step three. 
That difference is the periodic adjustment in Year 3 with respect to the 
PCT Payments made for Years 1 through 3 from FS2 to USP. Under step 
five, the royalties due from FS2 to USP for Year 4 (the year after the 
Adjustment Year) through Year 6 (the year including the Determination 
Date) are determined. The periodic adjustment for each of these years is 
calculated as the product of the step two royalty rate and the 
divisional profit for that year, minus any actual PCT Payment made by 
FS2 to USP in that year. The periodic adjustment for each such year is a 
PCT Payment due in addition to the PCT Payment from FS2 to USP that was 
already made under the CSA. Under step six, the periodic adjustment for 
Year 7 (the only exploitation year after the year containing the 
Determination Date) will be determined by applying the step two royalty 
rate to FS2's divisional profit for that year. This periodic adjustment 
for Year 7 is a PCT Payment payable from FS2 to USP and is in lieu of 
any PCT Payment from FS2 to USP otherwise due.
    (vi) Finally, the steps in paragraphs (i)(6)(v)(A)(2) through (7) of 
this section are performed with respect to FS3. In step two, the first 
step result ($295 million) is converted into a level royalty rate based 
on FS3's reasonably anticipated divisional profits or losses through 
Year 7 (the PV of which is $592 million). Consequently, the step two 
result is a level royalty rate of 49.8% ($295/$592) of the divisional 
profits in Years 1 through 7. In step three, the Commissioner calculates 
the PCT Payments due through Year 3 (the Adjustment Year) by applying 
the step two royalty rate (49.8%) to FS3's actual divisional profits for 
each year up to and including Year 3 and then determining the aggregate 
PV of these PCT Payments as of Year 3. In step four, the PCT Payments 
actually made by FS3 to USP through Year 3 are similarly converted to a 
PV as of Year 3 and subtracted from the amount determined in step three. 
That difference is the periodic adjustment in Year 3 with respect to the 
PCT Payments made for Years 1 through 3 from FS3 to USP. Under step 
five, the royalties due from FS3 to USP for Year 4 (the year after the 
Adjustment Year) through Year 6 (the year including the Determination 
Date) are determined. The periodic adjustment for each of these years is 
calculated as the product of the step two royalty rate and the 
divisional profit for that year, minus any actual PCT Payment made by 
FS3 to USP in that year. The periodic adjustment for each such year is a 
PCT Payment due in addition to the PCT Payment from FS3 to USP that was 
already made under the CSA. Under step six, the periodic adjustment for 
Year 7 (the only exploitation year after the year containing the 
Determination Date) will be determined by applying the step two royalty 
rate to FS3's divisional profit for that year. This periodic adjustment 
for Year 7 is a PCT Payment payable from FS3 to USP and is in lieu of 
any PCT Payment from FS3 to USP otherwise due.

    (j) Definitions and special rules--(1) Definitions--(i) In general. 
For purposes of this section--

------------------------------------------------------------------------
                                                         Main cross
            Term                   Definition            references
------------------------------------------------------------------------
Acquisition price...........  ....................  Sec.   1.482-
                                                     7(g)(5)(i).
Adjusted acquisition price..  ....................  Sec.   1.482-
                                                     7(g)(5)(iii).
Adjusted average market       ....................  Sec.   1.482-
 capitalization.                                     7(g)(6)(iv).
Adjusted benefit shares.....  ....................  Sec.   1.482-
                                                     7(i)(2)(ii)(A).
Adjusted RPSM...............  ....................  Sec.   1.482-
                                                     7(i)(6)(v)(B).
Adjustment Year.............  ....................  Sec.   1.482-
                                                     7(i)(6)(i).
ADR.........................  ....................  Sec.   1.482-
                                                     7(i)(6)(iv).
AERR........................  ....................  Sec.   1.482-
                                                     7(i)(6)(iii).

[[Page 793]]

 
Applicable Method...........  ....................  Sec.   1.482-
                                                     7(g)(2)(ix)(A).
Average market                ....................  Sec.   1.482-
 capitalization.                                     7(g)(6)(iii).
Benefits....................  Benefits mean the     Sec.   1.482-
                               sum of additional     7(e)(1)(i).
                               revenue generated,
                               plus cost savings,
                               minus any cost
                               increases from
                               exploiting cost
                               shared intangibles.
Capability variation........  ....................  Sec.   1.482-
                                                     7(f)(3).
Change in participation       ....................  Sec.   1.482-7(f).
 under a CSA.
Consolidated group..........  ....................  Sec.   1.482-
                                                     7(j)(2)(i).
Contingent payments.........  ....................  Sec.   1.482-
                                                     7(h)(2)(i)(B).
Controlled participant......  Controlled            Sec.   1.482-
                               participant means a   7(a)(1).
                               controlled
                               taxpayer, as
                               defined under Sec.
                                1.482-1(i)(5),
                               that is a party to
                               the contractual
                               agreement that
                               underlies the CSA,
                               and that reasonably
                               anticipates that it
                               will derive
                               benefits, as
                               defined in
                               paragraph (e)(1)(i)
                               of this section,
                               from exploiting one
                               or more cost shared
                               intangibles.
Controlled transfer of        ....................  Sec.   1.482-
 interests.                                          7(f)(2).
Cost contribution...........  ....................  Sec.   1.482-
                                                     7(d)(4).
Cost shared intangible......  Cost shared           Sec.   1.482-7(b).
                               intangible means
                               any intangible,
                               within the meaning
                               of Sec.   1.482-
                               4(b), that is
                               developed by the
                               IDA, including any
                               portion of such
                               intangible that
                               reflects a platform
                               contribution.
                               Therefore, an
                               intangible
                               developed by the
                               IDA is a cost
                               shared intangible
                               even though the
                               intangible was not
                               always or was never
                               a reasonably
                               anticipated cost
                               shared intangible.
Cost sharing alternative....  ....................  Sec.   1.482-
                                                     7(g)(4)(i)(B).
Cost sharing arrangement or   ....................  Sec.   1.482-7(a),
 CSA.                                                (b).
Cost sharing transactions or  ....................  Sec.   1.482-
 CSTs.                                               7(a)(1), (b)(1)(i).
Cross operating               A cross operating     Sec.   1.482-
 contributions.                contribution is any   7(a)(3)(iii),
                               resource or           (g)(2)(iv).
                               capability or
                               right, other than a
                               platform
                               contribution, that
                               a controlled
                               participant has
                               developed,
                               maintained, or
                               acquired prior to
                               the CSA Start Date,
                               or subsequent to
                               the CSA start date
                               by means other than
                               operating cost
                               contributions or
                               cost contributions,
                               that is reasonably
                               anticipated to
                               contribute to the
                               CSA Activity within
                               another controlled
                               participant's
                               division.
CSA Activity................  CSA Activity is the   Sec.   1.482-
                               activity of           7(c)(2)(i).
                               developing and
                               exploiting cost
                               shared intangibles.
CSA Start Date..............  The CSA Start Date    Sec.   1.482-
                               is the earlier of     7(i)(6)(iii)(B) and
                               the date of the CSA   (k)(1)(ii) and
                               contract or the       (iii).
                               first occurrence of
                               any IDC to which
                               the CSA applies, in
                               accordance with
                               Sec.   1.482-
                               7(k)(1)(iii).
CST Payments................  ....................  Sec.   1.482-
                                                     7(b)(1).
Date of PCT.................  ....................  Sec.   1.482-
                                                     7(b)(3).
Determination Date..........  ....................  Sec.   1.482-
                                                     7(i)(6)(i).
Differential income stream..  ....................  Sec.   1.482-
                                                     7(g)(4)(vi)(F)(2).
Division....................  Division means the    See definitions of
                               territory or other    divisional profit
                               division that         or loss, operating
                               serves as the basis   contribution, and
                               of the division of    operating cost
                               interests under the   contribution.
                               CSA in the cost
                               shared intangibles
                               pursuant to Sec.
                               1.482-7(b)(4).
Divisional interest.........  ....................  Sec.   1.482-
                                                     7(b)(1)(iii),
                                                     (b)(4).
Divisional profit or loss...  Divisional profit or  Sec.   1.482-
                               loss means the        7(g)(4)(iii).
                               operating profit or
                               loss as separately
                               earned by each
                               controlled
                               participant in its
                               division from the
                               CSA Activity,
                               determined before
                               any expense
                               (including
                               amortization) on
                               account of cost
                               contributions,
                               operating cost
                               contributions,
                               routine platform
                               and operating
                               contributions,
                               nonroutine
                               contributions
                               (including platform
                               and operating
                               contributions), and
                               tax.

[[Page 794]]

 
Fixed payments..............  ....................  Sec.   1.482-
                                                     7(h)(2)(i)(A).
Implied discount rate.......  ....................  Sec.   1.482-
                                                     7(g)(2)(v)(B)(2).
IDC share...................  ....................  Sec.   1.482-
                                                     7(d)(4).
Input parameters............  ....................  Sec.   1.482-
                                                     7(g)(2)(ix)(B).
Intangible development        ....................  Sec.   1.482-
 activity or IDA.                                    7(d)(1).
Intangible development costs  ....................  Sec.   1.482-
 or IDCs.                                            7(a)(1), (d)(1).
Licensing alternative.......  ....................  Sec.   1.482-
                                                     7(g)(4)(i)(C).
Licensing payments..........  Licensing payments    Sec.   1.482-
                               means payments        7(g)(4)(iii).
                               pursuant to the
                               licensing
                               obligations under
                               the licensing
                               alternative.
Make-or-sell rights.........  ....................  Sec.   1.482-
                                                     7(c)(4),
                                                     (g)(2)(iv).
Market-based input parameter  ....................  Sec.   1.482-
                                                     7(g)(2)(ix)(B).
Market returns for routine    Market returns for    Sec.   1.482-
 contributions                 routine               7(g)(4), (g)(7).
                               contributions means
                               returns determined
                               by reference to the
                               returns achieved by
                               uncontrolled
                               taxpayers engaged
                               in activities
                               similar to the
                               relevant business
                               activity in the
                               controlled
                               participant's
                               division,
                               consistent with the
                               methods described
                               in Sec.  Sec.
                               1.482-3, 1.482-4,
                               1.482-5, or Sec.
                               1.482-9(c).
Method payment form.........  ....................  Sec.   1.482-
                                                     7(h)(3).
Nonroutine contributions....  Nonroutine            Sec.   1.482-7(g).
                               contributions means
                               a controlled
                               participant's
                               contributions to
                               the relevant
                               business activities
                               that are not
                               routine
                               contributions.
                               Nonroutine
                               contributions
                               ordinarily include
                               both nonroutine
                               platform
                               contributions and
                               nonroutine
                               operating
                               contributions used
                               by controlled
                               participants in the
                               commercial
                               exploitation of
                               their interests in
                               the cost shared
                               intangibles (for
                               example, marketing
                               intangibles used by
                               a controlled
                               participant in its
                               division to sell
                               products that are
                               based on the cost
                               shared intangible).
Nonroutine residual           ....................  Sec.   1.482-
 divisional profit or loss.                          7(g)(7)(iii).
Operating contributions.....  An operating          Sec.   1.482-
                               contribution is any   7(g)(2)(ii),
                               resource or           (g)(4)(vi)(E),
                               capability or         (g)(7)(iii)(A) and
                               right, other than a   (C).
                               platform
                               contribution, that
                               a controlled
                               participant has
                               developed,
                               maintained, or
                               acquired prior to
                               the CSA Start Date,
                               or subsequent to
                               the CSA Start Date
                               by means other than
                               operating cost
                               contributions or
                               cost contributions,
                               that is reasonably
                               anticipated to
                               contribute to the
                               CSA Activity within
                               the controlled
                               participant's
                               division.
Operating cost contributions  Operating cost        Sec.   1.482-
                               contributions means   7(g)(2)(ii),
                               all costs in the      (g)(4)(iii),
                               ordinary course of    (g)(7)(iii)(B).
                               business on or
                               after the CSA Start
                               Date that, based on
                               analysis of the
                               facts and
                               circumstances, are
                               directly identified
                               with, or are
                               reasonably
                               allocable to,
                               developing
                               resources,
                               capabilities, or
                               rights (other than
                               reasonably
                               anticipated cost
                               shared intangibles)
                               that are reasonably
                               anticipated to
                               contribute to the
                               CSA Activity within
                               the controlled
                               participant's
                               division.
PCT Payee...................  ....................  Sec.   1.482-
                                                     7(b)(1)(ii).
PCT Payment.................  ....................  Sec.   1.482-
                                                     7(b)(1)(ii).
PCT Payor...................  ....................  Sec.   1.482-
                                                     7(b)(1)(ii),
                                                     (i)(6)(i).
PCT Payor WACC..............  ....................  Sec.   1.482-
                                                     7(i)(6)(iv)(D).
Periodic adjustments........  ....................  Sec.   1.482-
                                                     7(i)(6)(i).
Periodic Trigger............  ....................  Sec.   1.482-
                                                     7(i)(6)(i).
Platform contribution         ....................  Sec.   1.482-
 transaction or PCT.                                 7(a)(2),
                                                     (b)(1)(ii).
Platform contributions......  ....................  Sec.   1.482-
                                                     7(c)(1).
Post-tax income.............  ....................  Sec.   1.482-
                                                     7(g)(2)(v)(B)(4),
                                                     (g)(4)(i)(G).
Pre-tax income..............  ....................  Sec.   1.482-
                                                     7(g)(2)(v)(B)(4),
                                                     (g)(4)(i)(G).
Projected benefit shares....  ....................  Sec.   1.482-
                                                     7(i)(2)(ii)(A).
PRRR........................  ....................  Sec.   1.482-
                                                     7(i)(6)(ii).

[[Page 795]]

 
PVI.........................  ....................  Sec.   1.482-
                                                     7(i)(6)(iii)(C).
PVTP........................  ....................  Sec.   1.482-
                                                     7(i)(6)(iii)(B).
Reasonably anticipated        A controlled          Sec.   1.482-
 benefits.                     participant's         7(e)(1).
                               reasonably
                               anticipated
                               benefits mean the
                               benefits that
                               reasonably may be
                               anticipated to be
                               derived from
                               exploiting cost
                               shared intangibles.
                               For purposes of
                               this definition,
                               benefits mean the
                               sum of additional
                               revenue generated,
                               plus cost savings,
                               minus any cost
                               increases from
                               exploiting cost
                               shared intangibles.
Reasonably anticipated        ....................  Sec.   1.482-
 benefits or RAB shares.                             7(a)(1), (e)(1).
Reasonably anticipated cost   ....................  Sec.   1.482-
 shared intangible.                                  7(d)(1)(ii).
Relevant business activity..  ....................  Sec.   1.482-
                                                     7(g)(7)(i).
Routine contributions.......  Routine               Sec.   1.482-
                               contributions means   7(g)(4), (g)(7).
                               a controlled
                               participant's
                               contributions to
                               the relevant
                               business activities
                               that are of the
                               same or similar
                               kind to those made
                               by uncontrolled
                               taxpayers involved
                               in similar business
                               activities for
                               which it is
                               possible to
                               identify market
                               returns. Routine
                               contributions
                               ordinarily include
                               contributions of
                               tangible property,
                               services and
                               intangibles that
                               are generally owned
                               by uncontrolled
                               taxpayers engaged
                               in similar
                               activities. A
                               functional analysis
                               is required to
                               identify these
                               contributions
                               according to the
                               functions
                               performed, risks
                               assumed, and
                               resources employed
                               by each of the
                               controlled
                               participants.
Routine platform and          ....................  Sec.   1.482-
 operating contributions,                            7(g)(4)(vii), 1.482-
 and net routine platform                            7(g)(7)(iii)(C)(4).
 and operating contributions.
Specified payment form......  ....................  Sec.   1.482-
                                                     7(h)(3).
Stock-based compensation....  ....................  Sec.   1.482-
                                                     7(d)(3).
Stock options...............  ....................  Sec.   1.482-
                                                     7(d)(3)(i).
Subsequent PCT..............  ....................  Sec.   1.482-
                                                     7(g)(2)(viii).
Target......................  ....................  Sec.   1.482-
                                                     7(g)(5)(i).
Tax rate....................  Reasonably            Sec.   1.482-
                               anticipated           7(g)(2)(v)(B)(4)(ii
                               effective tax rate    ), (g)(4)(i)(G).
                               with respect to the
                               pre-tax income to
                               which the tax rate
                               is being applied.
                               For example, under
                               the income method,
                               this rate would be
                               the reasonably
                               anticipated
                               effective tax rate
                               of the PCT Payor or
                               PCT Payee under the
                               cost sharing
                               alternative or the
                               licensing
                               alternative, as
                               appropriate.
Trigger PCT.................  ....................  Sec.   1.482-
                                                     7(i)(6)(i).
Variable input parameter....  ....................  Sec.   1.482-
                                                     7(g)(2)(ix)(C).
WACC........................  WACC means weighted   Sec.   1.482-
                               average cost of       7(i)(6)(iv)(D).
                               capital.
------------------------------------------------------------------------


    (ii) Examples. The following examples illustrate certain definitions 
in paragraph (j)(1)(i) of this section:

    Example 1. Controlled participant. Foreign Parent (FP) is a foreign 
corporation engaged in the extraction of a natural resource. FP has a 
U.S. subsidiary (USS) to which FP sells supplies of this resource for 
sale in the United States. FP enters into a CSA with USS to develop a 
new machine to extract the natural resource. The machine uses a new 
extraction process that will be patented in the United States and in 
other countries. The CSA provides that USS will receive the rights to 
exploit the machine in the extraction of the natural resource in the 
United States, and FP will receive the rights in the rest of the world. 
This resource does not, however, exist in the United States. Despite the 
fact that USS has received the right to exploit this process in the 
United States, USS is not a controlled participant because it will not 
derive a benefit from exploiting the intangible developed under the CSA.

[[Page 796]]

    Example 2. Controlled participants. (i) U.S. Parent (USP), one 
foreign subsidiary (FS), and a second foreign subsidiary constituting 
the group's research arm (R + D) enter into a CSA to develop 
manufacturing intangibles for a new product line A. USP and FS are 
assigned the exclusive rights to exploit the intangibles respectively in 
the United States and the rest of the world, where each presently 
manufactures and sells various existing product lines. R + D is not 
assigned any rights to exploit the intangibles. R + D's activity 
consists solely in carrying out research for the group. It is reliably 
projected that the RAB shares of USP and FS will be 66\2/3\% and 33\1/
3\%, respectively, and the parties' agreement provides that USP and FS 
will reimburse 66\2/3\% and 33\1/3\%, respectively, of the IDCs incurred 
by R + D with respect to the new intangible.
    (ii) R + D does not qualify as a controlled participant within the 
meaning of paragraph (j)(1)(i) of this section, because it will not 
derive any benefits from exploiting cost shared intangibles. Therefore, 
R + D is treated as a service provider for purposes of this section and 
must receive arm's length consideration for the assistance it is deemed 
to provide to USP and FS, under the rules of paragraph (a)(3) of this 
section and Sec. Sec.  1.482-4(f)(3)(iii) and (4), and 1.482-9, as 
appropriate. Such consideration must be treated as IDCs incurred by USP 
and FS in proportion to their RAB shares (that is, 66\2/3\% and 33\1/
3\%, respectively). R + D will not be considered to bear any share of 
the IDCs under the arrangement.
    Example 3. Cost shared intangible, reasonably anticipated cost 
shared intangible. U.S. Parent (USP) has developed and currently 
exploits an antihistamine, XY, which is manufactured in tablet form. USP 
enters into a CSA with its wholly-owned foreign subsidiary (FS) to 
develop XYZ, a new improved version of XY that will be manufactured as a 
nasal spray. Work under the CSA is fully devoted to developing XYZ, and 
XYZ is developed. During the development period, XYZ is a reasonably 
anticipated cost shared intangible under the CSA. Once developed, XYZ is 
a cost shared intangible under the CSA.
    Example 4. Cost shared intangible. The facts are the same as in 
Example 3, except that in the course of developing XYZ, the controlled 
participants by accident discover ABC, a cure for disease D. ABC is a 
cost shared intangible under the CSA.
    Example 5. Reasonably anticipated benefits. Controlled parties A and 
B enter into a cost sharing arrangement to develop product and process 
intangibles for an already existing Product P. Without such intangibles, 
A and B would each reasonably anticipate revenue, in present value 
terms, of $100M from sales of Product P until it became obsolete. With 
the intangibles, A and B each reasonably anticipate selling the same 
number of units each year, but reasonably anticipate that the price will 
be higher. Because the particular product intangible is more highly 
regarded in A's market, A reasonably anticipates an increase of $20M in 
present value revenue from the product intangible, while B reasonably 
anticipates only an increase of $10M. Further, A and B each reasonably 
anticipate spending an extra $5M present value in production costs to 
include the feature embodying the product intangible. Finally, A and B 
each reasonably anticipate saving $2M present value in production costs 
by using the process intangible. A and B reasonably anticipate no other 
economic effects from exploiting the cost shared intangibles. A's 
reasonably anticipated benefits from exploiting the cost shared 
intangibles equal its reasonably anticipated increase in revenue ($20M) 
plus its reasonably anticipated cost savings ($2M) minus its reasonably 
anticipated increased costs ($5M), which equals $17M. Similarly, B's 
reasonably anticipated benefits from exploiting the cost shared 
intangibles equal its reasonably anticipated increase in revenue ($10M) 
plus its reasonably anticipated cost savings ($2M) minus its reasonably 
anticipated increased costs ($5M), which equals $7M. Thus A's reasonably 
anticipated benefits are $17M and B's reasonably anticipated benefits 
are $7M.

    (2) Special rules--(i) Consolidated group. For purposes of this 
section, all members of the same consolidated group shall be treated as 
one taxpayer. For these purposes, the term consolidated group means all 
members of a group of controlled entities created or organized within a 
single country and subjected to an income tax by such country on the 
basis of their combined income.
    (ii) Trade or business. A participant that is a foreign corporation 
or nonresident alien individual will not be treated as engaged in a 
trade or business within the United States solely by reason of its 
participation in a CSA. See generally Sec.  1.864-2(a).
    (iii) Partnership. A CSA, or an arrangement to which the 
Commissioner applies the rules of this section, will not be treated as a 
partnership to which the rules of subchapter K of the Internal Revenue 
Code apply. See Sec.  301.7701-1(c) of this chapter.
    (3) Character--(i) CST Payments. CST Payments generally will be 
considered

[[Page 797]]

the payor's costs of developing intangibles at the location where such 
development is conducted. For these purposes, IDCs borne directly by a 
controlled participant that are deductible are deemed to be reduced to 
the extent of any CST Payments owed to it by other controlled 
participants pursuant to the CSA. Each cost sharing payment received by 
a payee will be treated as coming pro rata from payments made by all 
payors and will be applied pro rata against the deductions for the 
taxable year that the payee is allowed in connection with the IDCs. 
Payments received in excess of such deductions will be treated as in 
consideration for use of the land and tangible property furnished for 
purposes of the CSA by the payee. For purposes of the research credit 
determined under section 41, CST Payments among controlled participants 
will be treated as provided for intra-group transactions in Sec.  1.41-
6(i). Any payment made or received by a taxpayer pursuant to an 
arrangement that the Commissioner determines not to be a CSA will be 
subject to the provisions of Sec. Sec.  1.482-1 through 1.482-6 and 
1.482-9. Any payment that in substance constitutes a cost sharing 
payment will be treated as such for purposes of this section, regardless 
of its characterization under foreign law.
    (ii) PCT Payments. A PCT Payor's payment required under paragraph 
(b)(1)(ii) of this section is deemed to be reduced to the extent of any 
payments owed to it under such paragraph from other controlled 
participants. Each PCT Payment received by a PCT Payee will be treated 
as coming pro rata out of payments made by all PCT Payors. PCT Payments 
will be characterized consistently with the designation of the type of 
transaction pursuant to paragraphs (c)(3) and (k)(2)(ii)(H) of this 
section. Depending on such designation, such payments will be treated as 
either consideration for a transfer of an interest in intangible 
property or for services.
    (iii) Examples. The following examples illustrate this paragraph 
(j)(3):

    Example 1. U.S. Parent (USP) and its wholly owned Foreign Subsidiary 
(FS) form a CSA to develop a miniature widget, the Small R. Based on RAB 
shares, USP agrees to bear 40% and FS to bear 60% of the costs incurred 
during the term of the agreement. The principal IDCs are operating costs 
incurred by FS in Country Z of 100X annually, and costs incurred by USP 
in the United States also of 100X annually. Of the total costs of 200X, 
USP's share is 80X and FS's share is 120X so that FS must make a payment 
to USP of 20X. The payment will be treated as a reimbursement of 20X of 
USP's costs in the United States. Accordingly, USP's Form 1120 will 
reflect an 80X deduction on account of activities performed in the 
United States for purposes of allocation and apportionment of the 
deduction to source. The Form 5471 ``Information Return of U.S. Persons 
With Respect to Certain Foreign Corporations'' for FS will reflect a 
100X deduction on account of activities performed in Country Z and a 20X 
deduction on account of activities performed in the United States.
    Example 2. The facts are the same as in Example 1, except that the 
100X of costs borne by USP consist of 5X of costs incurred by USP in the 
United States and 95X of arm's length rental charge, as described in 
paragraph (d)(1)(iii) of this section, for the use of a facility in the 
United States. The depreciation deduction attributable to the U.S. 
facility is 7X. The 20X net payment by FS to USP will first be applied 
in reduction pro rata of the 5X deduction for costs and the 7X 
depreciation deduction attributable to the U.S. facility. The 8X 
remainder will be treated as rent for the U.S. facility.
    Example 3. (i) Four members (A, B, C, and D) of a controlled group 
form a CSA to develop the next generation technology for their business. 
Based on RAB shares, the participants agree to bear shares of the costs 
incurred during the term of the agreement in the following percentages: 
A 40%; B 15%; C 25%; and D 20%. The arm's length values of the platform 
contributions they respectively own are in the following amounts for the 
taxable year: A 80X; B 40X; C 30X; and D 30X. The provisional (before 
offsets) and final PCT Payments among A, B, C, and D are shown in the 
table as follows:
    (All amounts stated in X's)

------------------------------------------------------------------------
                                         A        B        C        D
------------------------------------------------------------------------
Payments............................  <40
Sec.  1.482-8  Examples of the best method rule.

    (a) Introduction. In accordance with the best method rule of Sec.  
1.482-1(c), a method may be applied in a particular case only if the 
comparability, quality of data, and reliability of assumptions under 
that method make it more reliable than any other available measure of 
the arm's length result. The following examples illustrate the 
comparative analysis required to apply this rule. As with all of the 
examples in these regulations, these examples are based on simplified 
facts, are provided solely for purposes of illustrating the type of 
analysis required under the relevant rule, and do not provide rules of 
general application. Thus, conclusions reached in these examples as to 
the relative reliability of methods are based on the assumed facts of 
the examples, and are not general conclusions concerning the relative 
reliability of any method.
    (b) Examples.

    Example 1. Preference for comparable uncontrolled price method. 
Company A is the U.S. distribution subsidiary of Company B, a foreign 
manufacturer of consumer electrical appliances. Company A purchases 
toaster ovens from Company B for resale in the U.S. market. To exploit 
other outlets for its toaster ovens, Company B also sells its toaster 
ovens to Company C, an unrelated U.S. distributor of toaster ovens. The 
products sold to Company A and Company C are identical in every respect 
and there are no material differences between the transactions. In this 
case application of the CUP method, using the sales of toaster ovens to 
Company C, generally will provide a more reliable measure of an arm's 
length result for the controlled sale of toaster ovens to Company A than 
the application of any other method. See Sec. Sec.  1.482-1(c)(2)(i) and 
-3(b)(2)(ii)(A).
    Example 2. Resale price method preferred to comparable uncontrolled 
price method. The facts are the same as in Example 1, except that the 
toaster ovens sold to Company A are of substantially higher quality than 
those sold to Company C and the effect on price of such quality 
differences cannot be accurately determined. In addition, in order to 
round out its line of consumer appliances Company A purchases blenders 
from unrelated parties for resale in the United States. The blenders are 
resold to substantially the same customers as the toaster ovens, have a 
similar resale value to the toaster ovens, and are purchased under 
similar terms and in similar volumes. The distribution functions 
performed by Company A appear to be similar for toaster ovens and 
blenders. Given the product differences between the toaster ovens, 
application of the resale price method using the purchases and resales 
of blenders as the uncontrolled comparables is likely to provide a more 
reliable measure of an arm's length result than application of the 
comparable uncontrolled price method using Company B's sales of toaster 
ovens to Company C.
    Example 3. Resale price method preferred to comparable profits 
method. (i) The facts are the same as in Example 2 except that Company A 
purchases all its products from Company B and Company B makes no 
uncontrolled sales into the United States. However, six uncontrolled 
U.S. distributors are identified that purchase a similar line of 
products from unrelated parties. The uncontrolled distributors purchase 
toaster ovens from unrelated parties, but there are significant 
differences in the characteristics of the toaster ovens, including the 
brandnames under which they are sold.

[[Page 804]]

    (ii) Under the facts of this case, reliable adjustments for the 
effect of the different brandnames cannot be made. Except for some 
differences in payment terms and inventory levels, the purchases and 
resales of toaster ovens by the three uncontrolled distributors are 
closely similar to the controlled purchases in terms of the markets in 
which they occur, the volume of the transactions, the marketing 
activities undertaken by the distributor, inventory levels, warranties, 
allocation of currency risk, and other relevant functions and risks. 
Reliable adjustments can be made for the differences in payment terms 
and inventory levels. In addition, sufficiently detailed accounting 
information is available to permit adjustments to be made for 
differences in accounting methods or in reporting of costs between cost 
of goods sold and operating expenses. There are no other material 
differences between the controlled and uncontrolled transactions.
    (iii) Because reliable adjustments for the differences between the 
toaster ovens, including the trademarks under which they are sold, 
cannot be made, these uncontrolled transactions will not serve as 
reliable measures of an arm's length result under the comparable 
uncontrolled price method. There is, however, close functional 
similarity between the controlled and uncontrolled transactions and 
reliable adjustments have been made for material differences that would 
be likely to affect gross profit. Under these circumstances, the gross 
profit margins derived under the resale price method are less likely to 
be susceptible to any unidentified differences than the operating profit 
measures used under the comparable profits method. Therefore, given the 
close functional comparability between the controlled and uncontrolled 
transactions, and the high quality of the data, the resale price method 
achieves a higher degree of comparability and will provide a more 
reliable measure of an arm's length result. See Sec.  1.482-1(c) (Best 
method rule).
    Example 4. Comparable profits method preferred to resale price 
method. The facts are the same as in Example 3, except that the 
accounting information available for the uncontrolled comparables is not 
sufficiently detailed to ensure consistent reporting between cost of 
goods sold and operating expenses of material items such as discounts, 
insurance, warranty costs, and supervisory, general and administrative 
expenses. These expenses are significant in amount. Therefore, whether 
these expenses are treated as costs of goods sold or operating expenses 
would have a significant effect on gross margins. Because in this case 
reliable adjustments can not be made for such accounting differences, 
the reliability of the resale price method is significantly reduced. 
There is, however, close functional similarity between the controlled 
and uncontrolled transactions and reliable adjustments have been made 
for all material differences other than the potential accounting 
differences. Because the comparable profits method is not adversely 
affected by the potential accounting differences, under these 
circumstances the comparable profits method is likely to produce a more 
reliable measure of an arm's length result than the resale price method. 
See Sec.  1.482-1(c) (Best method rule).
    Example 5. Cost plus method preferred to comparable profits method. 
(i) USS is a U.S. company that manufactures machine tool parts and sells 
them to its foreign parent corporation, FP. Four U.S. companies are 
identified that also manufacture various types of machine tool parts but 
sell them to uncontrolled purchasers.
    (ii) Except for some differences in payment terms, the manufacture 
and sales of machine tool parts by the four uncontrolled companies are 
closely similar to the controlled transactions in terms of the functions 
performed and risks assumed. Reliable adjustments can be made for the 
differences in payment terms. In addition, sufficiently detailed 
accounting information is available to permit adjustments to be made for 
differences between the controlled transaction and the uncontrolled 
comparables in accounting methods and in the reporting of costs between 
cost of goods sold and operating expenses.
    (iii) There is close functional similarity between the controlled 
and uncontrolled transactions and reliable adjustments can be made for 
material differences that would be likely to affect gross profit. Under 
these circumstances, the gross profit markups derived under the cost 
plus method are less likely to be susceptible to any unidentified 
differences than the operating profit measures used under the comparable 
profits method. Therefore, given the close functional comparability 
between the controlled and uncontrolled transactions, and the high 
quality of the data, the cost plus method achieves a higher degree of 
comparability and will provide a more reliable measure of an arm's 
length result. See Sec.  1.482-1(c) (Best method rule).
    Example 6. Comparable profits method preferred to cost plus method. 
The facts are the same as in Example 5, except that there are 
significant differences between the controlled and uncontrolled 
transactions in terms of the types of parts and components manufactured 
and the complexity of the manufacturing process. The resulting 
functional differences are likely to materially affect gross profit 
margins, but it is not possible to identify the specific differences and 
reliably adjust for their effect on gross profit. Because these 
functional differences would be reflected in differences in operating 
expenses, the operating profit measures used

[[Page 805]]

under the comparable profits method implicitly reflect to some extent 
these functional differences. Therefore, because in this case the 
comparable profits method is less sensitive than the cost plus method to 
the potentially significant functional differences between the 
controlled and uncontrolled transactions, the comparable profits method 
is likely to produce a more reliable measure of an arm's length result 
than the cost plus method. See Sec.  1.482-1(c) (Best method rule).
    Example 7. Preference for comparable uncontrolled transaction 
method. (i) USpharm, a U.S. pharmaceutical company, develops a new drug 
Z that is a safe and effective treatment for the disease zeezee. USpharm 
has obtained patents covering drug Z in the United States and in various 
foreign countries. USpharm has also obtained the regulatory 
authorizations necessary to market drug Z in the United States and in 
foreign countries.
    (ii) USpharm licenses its subsidiary in country X, Xpharm, to 
produce and sell drug Z in country X. At the same time, it licenses an 
unrelated company, Ydrug, to produce and sell drug Z in country Y, a 
neighboring country. Prior to licensing the drug, USpharm had obtained 
patent protection and regulatory approvals in both countries and both 
countries provide similar protection for intellectual property rights. 
Country X and country Y are similar countries in terms of population, 
per capita income and the incidence of disease zeezee. Consequently, 
drug Z is expected to sell in similar quantities and at similar prices 
in both countries. In addition, costs of producing drug Z in each 
country are expected to be approximately the same.
    (iii) USpharm and Xpharm establish terms for the license of drug Z 
that are identical in every material respect, including royalty rate, to 
the terms established between USpharm and Ydrug. In this case the 
district director determines that the royalty rate established in the 
Ydrug license agreement is a reliable measure of the arm's length 
royalty rate for the Xpharm license agreement. Given that the same 
property is transferred in the controlled and uncontrolled transactions, 
and that the circumstances under which the transactions occurred are 
substantially the same, in this case the comparable uncontrolled 
transaction method is likely to provide a more reliable measure of an 
arm's length result than any other method. See Sec.  1.482-4(c)(2)(ii).
    Example 8. Residual profit split method preferred to other methods. 
(i) USC is a U.S. company that develops, manufactures and sells 
communications equipment. EC is the European subsidiary of USC. EC is an 
established company that carries out extensive research and development 
activities and develops, manufactures and sells communications equipment 
in Europe. There are extensive transactions between USC and EC. USC 
licenses valuable technology it has developed to EC for use in the 
European market but EC also licenses valuable technology it has 
developed to USC. Each company uses components manufactured by the other 
in some of its products and purchases products from the other for resale 
in its own market.
    (ii) Detailed accounting information is available for both USC and 
EC and adjustments can be made to achieve a high degree of consistency 
in accounting practices between them. Relatively reliable allocations of 
costs, income and assets can be made between the business activities 
that are related to the controlled transactions and those that are not. 
Relevant marketing and research and development expenditures can be 
identified and reasonable estimates of the useful life of the related 
intangibles are available so that the capitalized value of the 
intangible development expenses of USC and EC can be calculated. In this 
case there is no reason to believe that the relative value of these 
capitalized expenses is substantially different from the relative value 
of the intangible property of USC and EC. Furthermore, comparables are 
identified that could be used to estimate a market return for the 
routine contributions of USC and EC. Based on these facts, the residual 
profit split could provide a reliable measure of an arm's length result.
    (iii) There are no uncontrolled transactions involving property that 
is sufficiently comparable to much of the tangible and intangible 
property transferred between USC and EC to permit use of the comparable 
uncontrolled price method or the comparable uncontrolled transaction 
method. Uncontrolled companies are identified in Europe and the United 
States that perform somewhat similar activities to USC and EC; however, 
the activities of none of these companies are as complex as those of USC 
and EC and they do not use similar levels of highly valuable intangible 
property that they have developed themselves. Under these circumstances, 
the uncontrolled companies may be useful in determining a market return 
for the routine contributions of USC and EC, but that return would not 
reflect the value of the intangible property employed by USC and EC. 
Thus, none of the uncontrolled companies is sufficiently similar so that 
reliable results would be obtained using the resale price, cost plus, or 
comparable profits methods. Moreover, no uncontrolled companies can be 
identified that engaged in sufficiently similar activities and 
transactions with each other to employ the comparable profit split 
method.
    (iv) Given the difficulties in applying the other methods, the 
reliability of the internal

[[Page 806]]

data on USC and EC, and the fact that acceptable comparables are 
available for deriving a market return for the routine contributions of 
USC and EC, the residual profit split method is likely to provide the 
most reliable measure of an arm's length result in this case.
    Example 9. Comparable profits method preferred to profit split. (i) 
Company X is a large, complex U.S. company that carries out extensive 
research and development activities and manufactures and markets a 
variety of products. Company X has developed a new process by which 
compact disks can be fabricated at a fraction of the cost previously 
required. The process is expected to prove highly profitable, since 
there is a large market for compact disks. Company X establishes a new 
foreign subsidiary, Company Y, and licenses it the rights to use the 
process to fabricate compact disks for the foreign market as well as 
continuing technical support and improvements to the process. Company Y 
uses the process to fabricate compact disks which it supplies to related 
and unrelated parties.
    (ii) The process licensed to Company Y is unique and highly valuable 
and no uncontrolled transfers of intangible property can be found that 
are sufficiently comparable to permit reliable application of the 
comparable uncontrolled transaction method. Company X is a large, 
complex company engaged in a variety of activities that owns unique and 
highly valuable intangible property. Consequently, no uncontrolled 
companies can be found that are similar to Company X. Furthermore, 
application of the profit split method in this case would involve the 
difficult and problematic tasks of allocating Company X's costs and 
assets between the relevant business activity and other activities and 
assigning a value to Company X's intangible contributions. On the other 
hand, Company Y performs relatively routine manufacturing and marketing 
activities and there are a number of similar uncontrolled companies. 
Thus, application of the comparable profits method using Company Y as 
the tested party is likely to produce a more reliable measure of an 
arm's length result than a profit split in this case.
    Example 10. Cost of services plus method preferred to other methods. 
(i) FP designs and manufactures consumer electronic devices that 
incorporate advanced technology. In year 1, FP introduces Product X, an 
entertainment device targeted primarily at the youth market. FP's 
wholly-owned, exclusive U.S. distributor, USSub, sells Product X in the 
U.S. market. USSub hires an independent marketing firm, Agency A, to 
promote Product X in the U.S. market. Agency A has successfully promoted 
other electronic products on behalf of other uncontrolled parties. USSub 
executes a one-year, renewable contract with Agency A that requires it 
to develop the market for Product X, within an annual budget set by 
USSub. In years 1 through 3, Agency A develops advertising, buys media, 
and sponsors events featuring Product X. Agency A receives a markup of 
25% on all expenses of promoting Product X, with the exception of media 
buys, which are reimbursed at cost. During year 3, sales of Product X 
decrease sharply, as Product X is displaced by competitors' products. At 
the end of year 3, sales of Product X are discontinued.
    (ii) Prior to the start of year 4, FP develops a new entertainment 
device, Product Y. Like Product X, Product Y is intended for sale to the 
youth market, but it is marketed under a new trademark distinct from 
that used for Product X. USSub decides to perform all U.S. market 
promotion for Product Y. USSub hires key Agency A staff members who 
handled the successful Product X campaign. To promote Product Y, USSub 
intends to use methods similar to those used successfully by Agency A to 
promote Product X (print advertising, media, event sponsorship, etc.). 
FP and USSub enter into a one-year, renewable agreement concerning 
promotion of Product Y in the U.S. market. Under the agreement, FP 
compensates USSub for promoting Product Y, based on a cost of services 
plus markup of A%. Third-party media buys by USSub in connection with 
Product Y are reimbursed at cost.
    (iii) Assume that under the contractual arrangements between FP and 
USSub, the arm's length consideration for Product Y and the trademark or 
other intangible property may be determined reliably under one or more 
transfer pricing methods. At issue in this example is the separate 
evaluation of the arm's length compensation for the year 4 promotional 
activities performed by USSub pursuant to its contract with FP.
    (iv) USSub's accounting records contain reliable data that 
separately state the costs incurred to promote Product Y. A functional 
analysis indicates that USSub's activities to promote Product Y in year 
4 are similar to activities performed by Agency A during years 1 through 
3 under the contract with USSub. In other respects, no material 
differences exist in the market conditions or the promotional activities 
performed in year 4, as compared to those in years 1 through 3.
    (v) It is possible to identify uncontrolled distributors or 
licensees of electronic products that perform, as one component of their 
business activities, promotional activities similar to those performed 
by USSub. However, it is unlikely that publicly available accounting 
data from these companies would allow computation of the comparable 
transactional costs or total services costs associated with the 
marketing or promotional activities that these entities perform, as one 
component of business activities. If that

[[Page 807]]

were possible, the comparable profits method for services might provide 
a reliable measure of an arm's length result. The functional analysis of 
the marketing activities performed by USSub in year 4 indicates that 
they are similar to the activities performed by Agency A in years 1 
through 3 for Product X. Because reliable information is available 
concerning the markup on costs charged in a comparable uncontrolled 
transaction, the most reliable measure of an arm's length price is the 
cost of services plus method in Sec.  1.482-9(e).
    Example 11. CPM for services preferred to other methods. (i) FP 
manufactures furniture and accessories for residential use. FP sells its 
products to retailers in Europe under the trademark, ``Moda.'' FP holds 
all worldwide rights to the trademark, including in the United States. 
USSub is FP's wholly-owned subsidiary in the U.S. market and the 
exclusive U.S. distributor of FP's merchandise. Historically, USSub 
dealt only with specialized designers in the U.S. market and advertised 
in trade publications targeted to this market. Although items sold in 
the U.S. and Europe are physically identical, USSub's U.S. customers 
generally resell the merchandise as non-branded merchandise.
    (ii) FP retains an independent firm to evaluate the feasibility of 
selling FP's trademarked merchandise in the general wholesale and retail 
market in the United States. The study concludes that this segment of 
the U.S. market, which is not exploited by USSub, may generate 
substantial profits. Based on this study, FP enters into a separate 
agreement with USSub, which provides that USSub will develop this market 
in the United States for the benefit of FP. USSub separately accounts 
for personnel expenses, overhead, and out-of-pocket costs attributable 
to the initial stage of the marketing campaign (Phase I). USSub receives 
as compensation its costs, plus a markup of X%, for activities in Phase 
I. At the end of Phase I, FP will evaluate the program. If success 
appears likely, USSub will begin full-scale distribution of trademarked 
merchandise in the new market segment, pursuant to agreements negotiated 
with FP at that time.
    (iii) Assume that under the contractual arrangements in effect 
between FP and USSub, the arm's length consideration for the merchandise 
and the trademark or other intangible property may be determined 
reliably under one or more transfer pricing methods. At issue in this 
example is the separate evaluation of the arm's length compensation for 
the marketing activities conducted by USSub in years 1 and following.
    (iv) A functional analysis reveals that USSub's activities consist 
primarily of modifying the promotional materials created by FP, 
negotiating media buys, and arranging promotional events. FP separately 
compensates USSub for all Phase I activities, and detailed accounting 
information is available regarding the costs of these activities. The 
Phase I activities of USSub are similar to those of uncontrolled 
companies that perform, as their primary business activity, a range of 
advertising and media relations activities on a contract basis for 
uncontrolled parties.
    (v) No information is available concerning the comparable 
uncontrolled prices for services in transactions similar to those 
engaged in by FP and USSub. Nor is any information available concerning 
uncontrolled transactions that would allow application of the cost of 
services plus method. It is possible to identify uncontrolled 
distributors or licensees of home furnishings that perform, as one 
component of their business activities, promotional activities similar 
to those performed by USSub. However, it is unlikely that publicly 
available accounting data from these companies would allow computation 
of the comparable transactional costs or total services costs associated 
with the marketing or promotional activities that these entities 
performed, as one component of their business activities. On the other 
hand, it is possible to identify uncontrolled advertising and media 
relations companies, the principal business activities of which are 
similar to the Phase I activities of USSub. Under these circumstances, 
the most reliable measure of an arm's length price is the comparable 
profits method of Sec.  1.482-9(f). The uncontrolled advertising 
comparables' treatment of material items, such as classification of 
items as cost of goods sold or selling, general, and administrative 
expenses, may differ from that of USSub. Such inconsistencies in 
accounting treatment between the uncontrolled comparables and the tested 
party, or among the comparables, are less important when using the ratio 
of operating profit to total services costs under the comparable profits 
method for services in Sec.  1.482-9(f). Under this method, the 
operating profit of USSub from the Phase I activities is compared to the 
operating profit of uncontrolled parties that perform general 
advertising and media relations as their primary business activity.
    Example 12. Residual profit split preferred to other methods. (i) 
USP is a manufacturer of athletic apparel sold under the AA trademark, 
to which FP owns the worldwide rights. USP sells AA trademark apparel in 
countries throughout the world, but prior to year 1, USP did not sell 
its merchandise in Country X. In year 1, USP acquires an uncontrolled 
Country X company which becomes its wholly-owned subsidiary, XSub. USP 
enters into an exclusive distribution arrangement with XSub in Country 
X. Before being acquired by USP in year 1, XSub distributed athletic 
apparel purchased from uncontrolled suppliers and resold that 
merchandise to retailers. After being acquired by

[[Page 808]]

USP in year 1, XSub continues to distribute merchandise from 
uncontrolled suppliers and also begins to distribute AA trademark 
apparel. Under a separate agreement with USP, XSub uses its best efforts 
to promote the AA trademark in Country X, with the goal of maximizing 
sales volume and revenues from AA merchandise.
    (ii) Prior to year 1, USP executed long-term endorsement contracts 
with several prominent professional athletes. These contracts give USP 
the right to use the names and likenesses of the athletes in any country 
in which AA merchandise is sold during the term of the contract. These 
contracts remain in effect for five years, starting in year 1. Before 
being acquired by USP, XSub renewed a long-term agreement with 
SportMart, an uncontrolled company that owns a nationwide chain of 
sporting goods retailers in Country X. XSub has been SportMart's primary 
supplier from the time that SportMart began operations. Under the 
agreement, SportMart will provide AA merchandise preferred shelf-space 
and will feature AA merchandise at no charge in its print ads and 
seasonal promotions. In consideration for these commitments, USP and 
XSub grant SportMart advance access to new products and the right to use 
the professional athletes under contract with USP in SportMart 
advertisements featuring AA merchandise (subject to approval of content 
by USP).
    (iii) Assume that it is possible to segregate all transactions by 
XSub that involve distribution of merchandise acquired from uncontrolled 
distributors (non-controlled transactions). In addition, assume that, 
apart from the activities undertaken by USP and XSub to promote AA 
apparel in Country X, the arm's length compensation for other functions 
performed by USP and XSub in the Country X market in years 1 and 
following can be reliably determined. At issue in this Example 12 is the 
application of the residual profit split analysis to determine the 
appropriate division between USP and XSub of the balance of the 
operating profits from the Country X market, that is the portion 
attributable to nonroutine contributions to the marketing and 
promotional activities.
    (iv) A functional analysis of the marketing and promotional 
activities conducted in the Country X market, as described in this 
example, indicates that both USP and XSub made nonroutine contributions 
to the business activity. USP contributed the long-term endorsement 
contracts with professional athletes. XSub contributed its long-term 
contractual rights with SportMart, which were made more valuable by its 
successful, long-term relationship with SportMart.
    (v) Based on the facts and circumstances, including the fact that 
both USP and XSub made valuable nonroutine contributions to the 
marketing and promotional activities and an analysis of the availability 
(or lack thereof) of comparable and reliable market benchmarks, the 
Commissioner determines that the most reliable measure of an arm's 
length result is the residual profit split method in Sec.  1.482-9(g). 
The residual profit split analysis would take into account both routine 
and nonroutine contributions by USP and XSub, in order to determine an 
appropriate allocation of the combined operating profits in the Country 
X market from the sale of AA merchandise and from related promotional 
and marketing activities.
    Example 13. Preference for acquisition price method. (i) USP 
develops, manufacturers, and distributes pharmaceutical products. USP 
and FS, USP's wholly-owned subsidiary, enter into a CSA to develop a new 
oncological drug, Oncol. Immediately prior to entering into the CSA, USP 
acquires Company X, an unrelated U.S. pharmaceutical company. Company X 
is solely engaged in oncological pharmaceutical research, and its only 
significant resources and capabilities are its workforce and its sole 
patent, which is associated with Compound X, a promising molecular 
compound derived from a rare plant, which USP reasonably anticipates 
will contribute to developing Oncol. All of Company X researchers will 
be engaged solely in research that is reasonably anticipated to 
contribute to developing Oncol as well. The rights in the Compound X and 
the commitment of Company X's researchers to the development of Oncol 
are platform contributions for which compensation is due from FS as part 
of a PCT.
    (ii) In this case, the acquisition price method, based on the lump 
sum price paid by USP for Company X, is likely to provide a more 
reliable measure of an arm's length PCT Payment due to USP than the 
application of any other method. See Sec. Sec.  1.482-4(c)(2) and 1.482-
7(g)(5)(iv)(A).
    Example 14. Preference for market capitalization method. (i) Company 
X is a publicly traded U.S. company solely engaged in oncological 
pharmaceutical research and its only significant resources and 
capabilities are its workforce and its sole patent, which is associated 
with Compound Y, a promising molecular compound derived from a rare 
plant. Company X has no marketable products. Company X enters into a CSA 
with FS, a newly-formed foreign subsidiary, to develop a new oncological 
drug, Oncol, derived from Compound Y. Compound Y is reasonably 
anticipated to contribute to developing Oncol. All of Company X 
researchers will be engaged solely in research that is reasonably 
anticipated to contribute to developing Oncol under the CSA. The rights 
in Compound Y and the commitment of Company X's researchers are platform 
contributions for which compensation is due from FS as part of a PCT.

[[Page 809]]

    (ii) In this case, given that Company X's platform contributions 
covered by PCTs relate to its entire economic value, the application of 
the market capitalization method, based on the market capitalization of 
Company X, provides a reliable measure of an arm's length result for 
Company X's PCTs to the CSA. See Sec. Sec.  1.482-4(c)(2) and 1.482-
7(g)(6)(v)(A).
    Example 15. Preference for market capitalization method. (i) 
MicroDent, Inc. (MDI) is a publicly traded company that developed a new 
dental surgical microscope ScopeX-1, which drastically shortens many 
surgical procedures. On January 1 of Year 1, MDI entered into a CSA with 
a wholly-owned foreign subsidiary (FS) to develop ScopeX-2, the next 
generation of ScopeX-1. In the CSA, divisional interests are divided on 
a territorial basis. The rights associated with ScopeX-1, as well as 
MDI's research capabilities are reasonably anticipated to contribute to 
the development of ScopeX-2 and are therefore platform contributions for 
which compensation is due from FS as part of a PCT. At the time of the 
PCT, MDI's only product was the ScopeX-I microscope, although MDI was in 
the process of developing ScopeX-2. Concurrent with the CSA, MDI 
separately transfers exclusive and perpetual exploitation rights 
associated with ScopeX-1 to FS in the same territory as assigned to FS 
in the CSA.
    (ii) Although the transactions between MDI and FS under the CSA are 
distinct from the transactions between MDI and FS relating to the 
exploitation rights for ScopeX-1, it is likely to be more reliable to 
evaluate the combined effect of the transactions than to evaluate them 
in isolation. This is because the combined transactions between MDI and 
FS relate to all of the economic value of MDI (that is, the exploitation 
rights and research rights associated with ScopeX-1, as well as the 
research capabilities of MDI). In this case, application of the market 
capitalization method, based on the enterprise value of MDI on January 1 
of Year 1, is likely to provide a reliable measure of an arm's length 
payment for the aggregated transactions. See Sec. Sec.  1.482-4(c)(2) 
and 1.482-7(g)(6)(v)(A).
    (iii) Notwithstanding that the market capitalization method provides 
the most reliable measure of the aggregated transactions between MDI and 
FS, see Sec.  1.482-7(g)(2)(iv) for further considerations of when 
further analysis may be required to distinguish between the remuneration 
to MDI associated with PCTs under the CSA (for research rights and 
capabilities associated with ScopeX-1) and the remuneration to MDI for 
the exploitation rights associated with ScopeX-1.
    Example 16. Income method (applied using CPM) preferred to 
acquisition price method. The facts are the same as in Example 13, 
except that the acquisition occurred significantly in advance of 
formation of the CSA, and reliable adjustments cannot be made for this 
time difference. In addition, Company X has other valuable molecular 
patents and associated research capabilities, apart from Compound X, 
that are not reasonably anticipated to contribute to the development of 
Oncol and that cannot be reliably valued. The CSA divides divisional 
interests on a territorial basis. Under the terms of the CSA, USP will 
undertake all R&D (consisting of laboratory research and clinical 
testing) and manufacturing associated with Oncol, as well as the 
distribution activities for its territory (the United States). FS will 
distribute Oncol in its territory (the rest of the world). FS's 
distribution activities are routine in nature, and the profitability 
from its activities may be reliably determined from third-party 
comparables. FS does not furnish any platform contributions. At the time 
of the PCT, reliable (ex ante) financial projections associated with the 
development of Oncol and its separate exploitation in each of USP's and 
FSub's assigned geographical territories are undertaken. In this case, 
application of the income method using CPM is likely to provide a more 
reliable measure of an arm's length result than application of the 
acquisition price method based on the price paid by USP for Company X. 
See Sec.  1.482-7(g)(4)(vi) and (5)(iv)(C).
    Example 17. Evaluation of alternative methods. (i) The facts are the 
same as in Example 13, except that the acquisition occurred sometime 
prior to the CSA, and Company X has some areas of promising research 
that are not reasonably anticipated to contribute to developing Oncol. 
For purposes of this example, the CSA is assumed to divide divisional 
interests on a territorial basis. In general, the Commissioner 
determines that the acquisition price data is useful in informing the 
arm's length price, but not necessarily determinative. Under the terms 
of the CSA, USP will undertake all R&D (consisting of laboratory 
research and clinical testing) and manufacturing associated with Oncol, 
as well as the distribution activities for its territory (the United 
States). FS will distribute Oncol in its territory (the rest of the 
world). FS's distribution activities are routine in nature, and the 
profitability from its activities may be reliably determined from third-
party comparables. At the time of the PCT, financial projections 
associated with the development of Oncol and its separate exploitation 
in each of USP's and FSub's assigned geographical territories are 
undertaken.
    (ii) Under the facts, it is possible that the acquisition price 
method or the income method using CPM might reasonably be applied. 
Whether the acquisition price method or the income method provides the 
most reliable evidence of the arm's length price of USP's contributions 
depends on a number of

[[Page 810]]

factors, including the reliability of the financial projections, the 
reliability of the discount rate chosen, and the extent to which the 
acquisition price of Company X can be reliably adjusted to account for 
changes in value over the time period between the acquisition and the 
formation of the CSA and to account for the value of the in-process 
research done by Company X that does not constitute platform 
contributions to the CSA. See Sec.  1.482-7(g)(4)(vi) and (5)(iv)(A) and 
(C).
    Example 18. Evaluation of alternative methods. (i) The facts are the 
same as in Example 17, except that FS has a patent on Compound Y, which 
the parties reasonably anticipate will be useful in mitigating potential 
side effects associated with Compound X and thereby contribute to the 
development of Oncol. The rights in Compound Y constitute a platform 
contribution for which compensation is due from USP as part of a PCT. 
The value of FS's platform contribution cannot be reliably measured by 
market benchmarks.
    (ii) Under the facts, it is possible that either the acquisition 
price method and the income method together or the residual profit split 
method might reasonably be applied to determine the arm's length PCT 
Payments due between USP and FS. Under the first option the PCT Payment 
for the platform contributions related to Company X's workforce and 
Compound X would be determined using the acquisition price method 
referring to the lump sum price paid by USP for Company X. Because the 
value of these platform contributions can be determined by reference to 
a market benchmark, they are considered routine platform contributions. 
Accordingly, under this option, the platform contribution related to 
Compound Y would be the only nonroutine platform contribution and the 
relevant PCT Payment is determined using the income method. Under the 
second option, rather than looking to the acquisition price for Company 
X, all the platform contributions are considered nonroutine and the RPSM 
is applied to determine the PCT Payments for each platform contribution. 
Under either option, the PCT Payments will be netted against each other.
    (iii) Whether the acquisition price method together with the income 
method or the residual profit split method provides the most reliable 
evidence of the arm's length price of the platform contributions of USP 
and FS depends on a number of factors, including the reliability of the 
determination of the relative values of the platform contributions for 
purposes of the RPSM, and the extent to which the acquisition price of 
Company X can be reliably adjusted to account for changes in value over 
the time period between the acquisition and the formation of the CSA and 
to account for the value of the rights in the in-process research done 
by Company X that does not constitute platform contributions to the CSA. 
In these circumstances, it is also relevant to consider whether the 
results of each method are consistent with each other, or whether one or 
both methods are consistent with other potential methods that could be 
applied. See Sec.  1.482-7(g)(4)(vi), (5)(iv), and (7)(iv).

    (c) Effective/applicability date--(1) In general. Paragraphs (a) and 
(b) Examples 10 through 12 of this section are generally applicable for 
taxable years beginning after December 31, 2006. Paragraph (b) Examples 
13 through 18 of this section are generally applicable on January 5, 
2009.
    (2) Election to apply regulation to earlier taxable years. A person 
may elect to apply the provisions of paragraph (b) Examples 10,11, and 
12 of this section to earlier taxable years in accordance with the rules 
set forth in Sec.  1.482-9(n)(2).

[T.D. 8552, 59 FR 35028, July 8, 1994, as amended by T.D. 9278, 71 FR 
44487, Aug. 4, 2006; T.D. 9441, 74 FR 388, Jan. 5, 2009; T.D. 9456, 74 
FR 38845, Aug. 4, 2009; 74 FR 46346, Sept. 9, 2009; T.D. 9568, 76 FR 
80134, Dec. 22, 2011]



Sec.  1.482-9  Methods to determine taxable income in connection 
with a controlled services transaction.

    (a) In general. The arm's length amount charged in a controlled 
services transaction must be determined under one of the methods 
provided for in this section. Each method must be applied in accordance 
with the provisions of Sec.  1.482-1, including the best method rule of 
Sec.  1.482-1(c), the comparability analysis of Sec.  1.482-1(d), and 
the arm's length range of Sec.  1.482-1(e), except as those provisions 
are modified in this section. The methods are--
    (1) The services cost method, described in paragraph (b) of this 
section;
    (2) The comparable uncontrolled services price method, described in 
paragraph (c) of this section;
    (3) The gross services margin method, described in paragraph (d) of 
this section;
    (4) The cost of services plus method, described in paragraph (e) of 
this section;
    (5) The comparable profits method, described in Sec.  1.482-5 and in 
paragraph (f) of this section;
    (6) The profit split method, described in Sec.  1.482-6 and in 
paragraph (g) of this section; and

[[Page 811]]

    (7) Unspecified methods, described in paragraph (h) of this section.
    (b) Services cost method--(1) In general. The services cost method 
evaluates whether the amount charged for certain services is arm's 
length by reference to the total services costs (as defined in paragraph 
(j) of this section) with no markup. If a taxpayer applies the services 
cost method in accordance with the rules of this paragraph (b), then it 
will be considered the best method for purposes of Sec.  1.482-1(c), and 
the Commissioner's allocations will be limited to adjusting the amount 
charged for such services to the properly determined amount of such 
total services costs.
    (2) Eligibility for the services cost method. To apply the services 
cost method to a service in accordance with the rules of this paragraph 
(b), all of the following requirements must be satisfied with respect to 
the service--
    (i) The service is a covered service as defined in paragraph (b)(3) 
of this section;
    (ii) The service is not an excluded activity as defined in paragraph 
(b)(4) of this section;
    (iii) The service is not precluded from constituting a covered 
service by the business judgment rule described in paragraph (b)(5) of 
this section; and
    (iv) Adequate books and records are maintained as described in 
paragraph (b)(6) of this section.
    (3) Covered services. For purposes of this paragraph (b), covered 
services consist of a controlled service transaction or a group of 
controlled service transactions (see Sec.  1.482-1(f)(2)(i) (aggregation 
of transactions)) that meet the definition of specified covered services 
or low margin covered services.
    (i) Specified covered services. Specified covered services are 
controlled services transactions that the Commissioner specifies by 
revenue procedure. Services will be included in such revenue procedure 
based upon the Commissioner's determination that the specified covered 
services are support services common among taxpayers across industry 
sectors and generally do not involve a significant median comparable 
markup on total services costs. For the definition of the median 
comparable markup on total services costs, see paragraph (b)(3)(ii) of 
this section. The Commissioner may add to, subtract from, or otherwise 
revise the specified covered services described in the revenue procedure 
by subsequent revenue procedure, which amendments will ordinarily be 
prospective only in effect.
    (ii) Low margin covered services. Low margin covered services are 
controlled services transactions for which the median comparable markup 
on total services costs is less than or equal to seven percent. For 
purposes of this paragraph (b), the median comparable markup on total 
services costs means the excess of the arm's length price of the 
controlled services transaction determined under the general section 482 
regulations without regard to this paragraph (b), using the 
interquartile range described in Sec.  1.482-1(e)(2)(iii)(C) and as 
necessary adjusting to the median of such interquartile range, over 
total services costs, expressed as a percentage of total services costs.
    (4) Excluded activity. The following types of activities are 
excluded activities:
    (i) Manufacturing.
    (ii) Production.
    (iii) Extraction, exploration, or processing of natural resources.
    (iv) Construction.
    (v) Reselling, distribution, acting as a sales or purchasing agent, 
or acting under a commission or other similar arrangement.
    (vi) Research, development, or experimentation.
    (vii) Engineering or scientific.
    (viii) Financial transactions, including guarantees.
    (ix) Insurance or reinsurance.
    (5) Not services that contribute significantly to fundamental risks 
of business success or failure. A service cannot constitute a covered 
service unless the taxpayer reasonably concludes in its business 
judgment that the service does not contribute significantly to key 
competitive advantages, core capabilities, or fundamental risks of 
success or failure in one or more trades or businesses of the controlled 
group, as defined in Sec.  1.482-1(i)(6). In evaluating the 
reasonableness of the conclusion

[[Page 812]]

required by this paragraph (b)(5), consideration will be given to all 
the facts and circumstances.
    (6) Adequate books and records. Permanent books of account and 
records are maintained for as long as the costs with respect to the 
covered services are incurred by the renderer. Such books and records 
must include a statement evidencing the taxpayer's intention to apply 
the services cost method to evaluate the arm's length charge for such 
services. Such books and records must be adequate to permit verification 
by the Commissioner of the total services costs incurred by the 
renderer, including a description of the services in question, 
identification of the renderer and the recipient of such services, and 
sufficient documentation to allow verification of the methods used to 
allocate and apportion such costs to the services in question in 
accordance with paragraph (k) of this section.
    (7) Shared services arrangement--(i) In general. If the services 
cost method is used to evaluate the amount charged for covered services, 
and such services are the subject of a shared services arrangement, then 
the arm's length charge to each participant for such services will be 
the portion of the total costs of the services otherwise determined 
under the services cost method of this paragraph (b) that is properly 
allocated to such participant pursuant to the arrangement.
    (ii) Requirements for shared services arrangement. A shared services 
arrangement must meet the requirements described in this paragraph 
(b)(7).
    (A) Eligibility. To be eligible for treatment under this paragraph 
(b)(7), a shared services arrangement must--
    (1) Include two or more participants;
    (2) Include as participants all controlled taxpayers that reasonably 
anticipate a benefit (as defined under paragraph (l)(3)(i) of this 
section) from one or more covered services specified in the shared 
services arrangement; and
    (3) Be structured such that each covered service (or each reasonable 
aggregation of services within the meaning of paragraph (b)(7)(iii)(B) 
of this section) confers a benefit on at least one participant in the 
shared services arrangement.
    (B) Allocation. The costs for covered services must be allocated 
among the participants based on their respective shares of the 
reasonably anticipated benefits from those services, without regard to 
whether the anticipated benefits are in fact realized. Reasonably 
anticipated benefits are benefits as defined in paragraph (l)(3)(i) of 
this section. The allocation of costs must provide the most reliable 
measure of the participants' respective shares of the reasonably 
anticipated benefits under the principles of the best method rule. See 
Sec.  1.482-1(c). The allocation must be applied on a consistent basis 
for all participants and services. The allocation to each participant in 
each taxable year must reasonably reflect that participant's respective 
share of reasonably anticipated benefits for such taxable year. If the 
taxpayer reasonably concluded that the shared services arrangement 
(including any aggregation pursuant to paragraph (b)(7)(iii)(B) of this 
section) allocated costs for covered services on a basis that most 
reliably reflects the participants' respective shares of the reasonably 
anticipated benefits attributable to such services, as provided for in 
this paragraph (b)(7), then the Commissioner may not adjust such 
allocation basis.
    (C) Documentation. The taxpayer must maintain sufficient 
documentation to establish that the requirements of this paragraph 
(b)(7) are satisfied, and include--
    (1) A statement evidencing the taxpayer's intention to apply the 
services cost method to evaluate the arm's length charge for covered 
services pursuant to a shared services arrangement;
    (2) A list of the participants and the renderer or renderers of 
covered services under the shared services arrangement;
    (3) A description of the basis of allocation to all participants, 
consistent with the participants' respective shares of reasonably 
anticipated benefits; and
    (4) A description of any aggregation of covered services for 
purposes of the shared services arrangement, and an indication whether 
this aggregation (if any) differs from the aggregation used

[[Page 813]]

to evaluate the median comparable markup for any low margin covered 
services described in paragraph (b)(3)(ii) of this section.
    (iii) Definitions and special rules--(A) Participant. A participant 
is a controlled taxpayer that reasonably anticipates benefits from 
covered services subject to a shared services arrangement that 
substantially complies with the requirements described in this paragraph 
(b)(7).
    (B) Aggregation. Two or more covered services may be aggregated in a 
reasonable manner taking into account all the facts and circumstances, 
including whether the relative magnitude of reasonably anticipated 
benefits of the participants sharing the costs of such aggregated 
services may be reasonably reflected by the allocation basis employed 
pursuant to paragraph (b)(7)(ii)(B) of this section. The aggregation of 
services under a shared services arrangement may differ from the 
aggregation used to evaluate the median comparable markup for any low 
margin covered services described in paragraph (b)(3)(ii) of this 
section, provided that such alternative aggregation can be implemented 
on a reasonable basis, including appropriately identifying and isolating 
relevant costs, as necessary.
    (C) Coordination with cost sharing arrangements. To the extent that 
an allocation is made to a participant in a shared services arrangement 
that is also a participant in a cost sharing arrangement subject to 
Sec.  1.482-7T, such amount with respect to covered services is first 
allocated pursuant to the shared services arrangement under this 
paragraph (b)(7). Costs allocated pursuant to a shared services 
arrangement may (if applicable) be further allocated between the 
intangible property development activity under Sec.  1.482-7T and other 
activities of the participant.
    (8) Examples. The application of this section is illustrated by the 
following examples. No inference is intended whether the presence or 
absence of one or more facts is determinative of the conclusion in any 
example. For purposes of Examples 1 through 14, assume that Company P 
and its subsidiaries, Company Q and Company R, are corporations and 
members of the same group of controlled entities (PQR Controlled Group). 
For purposes of Example 15, assume that Company P and its subsidiary, 
Company S, are corporations and members of the same group of controlled 
entities (PS Controlled Group). For purposes of Examples 16 through 24, 
assume that Company P and its subsidiaries, Company X, Company Y, and 
Company Z, are corporations and members of the same group of controlled 
entities (PXYZ Group) and that Company P and its subsidiaries satisfy 
all of the requirements for a shared services arrangement specified in 
paragraphs (b)(7)(ii) and (iii) of this section.

    Example 1. Data entry services. (i) Company P, Company Q, and 
Company R own and operate hospitals. Each owns an electronic database of 
medical information gathered by doctors and nurses during interviews and 
treatment of its patients. All three databases are maintained and 
updated by Company P's administrative support employees who perform data 
entry activities by entering medical information from the paper records 
of Company P, Company Q, and Company R into their respective databases.
    (ii) Assume that these services relating to data entry are specified 
covered services within the meaning of paragraph (b)(3)(i) of this 
section. Under the facts and circumstances of the business of the PQR 
Controlled Group, the taxpayer could reasonably conclude that these 
services do not contribute significantly to the controlled group's key 
competitive advantages, core capabilities, or fundamental risks of 
success or failure in the group's business. If these services meet the 
other requirements of this paragraph (b), Company P will be eligible to 
charge these services to Company Q and Company R in accordance with the 
services cost method.
    Example 2. Data entry services. (i) Company P, Company Q, and 
Company R specialize in data entry, data processing, and data 
conversion. Company Q and Company R's data entry activities involve 
converting medical information data contained in paper records to a 
digital format. Company P specializes in data entry activities. This 
specialization reflects, in part, proprietary quality control systems 
and specially trained data entry experts used to ensure the highest 
degree of accuracy of data entry services. Company P is engaged by 
Company Q and Company R to perform these data entry activities for them. 
Company Q and Company R then charge their customers for the data entry 
activities performed by Company P.
    (ii) Assume that these services performed by Company P relating to 
data entry are

[[Page 814]]

specified covered services within the meaning of paragraph (b)(3)(i) of 
this section. Under the facts and circumstances, the taxpayer is unable 
to reasonably conclude that these services do not contribute 
significantly to the controlled group's key competitive advantages, core 
capabilities, or fundamental risks of success or failure in the group's 
business. Company P is not eligible to charge these services to Company 
Q and Company R in accordance with the services cost method.
    Example 3. Recruiting services. (i) Company P, Company Q, and 
Company R are manufacturing companies that sell their products to 
unrelated retail establishments. Company P's human resources department 
recruits mid-level managers and engineers for itself as well as for 
Company Q and Company R by attending job fairs and other recruitment 
events. For recruiting higher-level managers and engineers, each of 
these companies uses recruiters from unrelated executive search firms.
    (ii) Assume that these services relating to recruiting are specified 
covered services within the meaning of paragraph (b)(3)(i) of this 
section. Under the facts and circumstances of the business of the PQR 
Controlled Group, the taxpayer could reasonably conclude that these 
services do not contribute significantly to the controlled group's key 
competitive advantages, core capabilities, or fundamental risks of 
success or failure in the group's business. If these services meet the 
other requirements of this paragraph (b), Company P will be eligible to 
charge these services to Company Q and Company R in accordance with the 
services cost method.
    Example 4. Recruiting services. (i) Company Q and Company R are 
executive recruiting service companies that are hired by other companies 
to recruit professionals. Company P is a recruiting agency that is 
engaged by Company Q and Company R to perform recruiting activities on 
their behalf in certain geographic areas.
    (ii) Assume that the services performed by Company P are specified 
covered services within the meaning of paragraph (b)(3)(i) of this 
section. Under the facts and circumstances, the taxpayer is unable to 
reasonably conclude that these services do not contribute significantly 
to the controlled group's key competitive advantages, core capabilities, 
or fundamental risks of success or failure in the group's business. 
Company P is not eligible to charge these services to Company Q and 
Company R in accordance with the services cost method.
    Example 5. Credit analysis services. (i) Company P is a manufacturer 
and distributor of clothing for retail stores. Company Q and Company R 
are distributors of clothing for retail stores. As part of its 
operations, personnel in Company P perform credit analysis on its 
customers. Most of the customers have a history of purchases from 
Company P, and the credit analysis involves a review of the recent 
payment history of the customer's account. For new customers, the 
personnel in Company P perform a basic credit check of the customer 
using reports from a credit reporting agency. On behalf of Company Q and 
Company R, Company P performs credit analysis on customers who order 
clothing from Company Q and Company R using the same method as Company P 
uses for itself.
    (ii) Assume that these services relating to credit analysis are 
specified covered services within the meaning of paragraph (b)(3)(i) of 
this section. Under the facts and circumstances of the business of the 
PQR Controlled Group, the taxpayer could reasonably conclude that these 
services do not contribute significantly to the controlled group's key 
competitive advantages, core capabilities, or fundamental risks of 
success or failure in the group's business. If these services meet the 
other requirements of this paragraph (b), Company P will be eligible to 
charge these services to Company Q and Company R in accordance with the 
services cost method.
    Example 6. Credit analysis services. (i) Company P, Company Q, and 
Company R lease furniture to retail customers who present a significant 
credit risk and are generally unable to lease furniture from other 
providers. As part of its leasing operations, personnel in Company P 
perform credit analysis on each of the potential lessees. The personnel 
have developed special expertise in determining whether a particular 
customer who presents a significant credit risk (as indicated by credit 
reporting agencies) will be likely to make the requisite lease payments 
on a timely basis. Also, as part of its operations, Company P performs 
similar credit analysis services for Company Q and Company R, which 
charge correspondingly high monthly lease payments.
    (ii) Assume that these services relating to credit analysis are 
specified covered services within the meaning of paragraph (b)(3)(i) of 
this section. Under the facts and circumstances, the taxpayer is unable 
to reasonably conclude that these services do not contribute 
significantly to the controlled group's key competitive advantages, core 
capabilities, or fundamental risks of success or failure in the group's 
business. Company P is not eligible to charge these services to Company 
Q and Company R in accordance with the services cost method.
    Example 7. Credit analysis services. (i) Company P is a large full-
service bank, which provides products and services to corporate and 
consumer markets, including unsecured loans, secured loans, lines of 
credit, letters of credit, conversion of foreign currency, consumer 
loans, trust services, and sales of certificates of deposit. Company Q 
makes

[[Page 815]]

routine consumer loans to individuals, such as auto loans and home 
equity loans. Company R makes only business loans to small businesses.
    (ii) Company P performs credit analysis and prepares credit reports 
for itself, as well as for Company Q and Company R. Company P, Company Q 
and Company R regularly employ these credit reports in the ordinary 
course of business in making decisions regarding extensions of credit to 
potential customers (including whether to lend, rate of interest, and 
loan terms).
    (iii) Assume that these services relating to credit analysis are 
specified covered services within the meaning of paragraph (b)(3)(i) of 
this section. Under the facts and circumstances, the credit analysis 
services constitute part of a ``financial transaction'' described in 
paragraph (b)(4)(viii) of this section. Company P is not eligible to 
charge these services to Company Q and Company R in accordance with the 
services cost method.
    Example 8. Data verification services. (i) Company P, Company Q and 
Company R are manufacturers of industrial supplies. Company P's 
accounting department performs periodic reviews of the accounts payable 
information of Company P, Company Q and Company R, and identifies any 
inaccuracies in the records, such as double-payments and double-charges.
    (ii) Assume that these services relating to verification of data are 
specified covered services within the meaning of paragraph (b)(3)(i) of 
this section. Under the facts and circumstances of the business of the 
PQR Controlled Group, the taxpayer could reasonably conclude that these 
services do not contribute significantly to the controlled group's key 
competitive advantages, core capabilities, or fundamental risks of 
success or failure in the group's business. If these services meet the 
other requirements of this paragraph (b), Company P will be eligible to 
charge these services to Company Q and Company R in accordance with the 
services cost method.
    Example 9. Data verification services. (i) Company P gathers and 
inputs information regarding accounts payable and accounts receivable 
from unrelated parties and utilizes its own computer system to analyze 
that information for purposes of identifying errors in payment and 
receipts (data mining). Company P is compensated for these services 
based on a fee that reflects a percentage of amounts collected by 
customers as a result of the data mining services. These activities 
constitute a significant portion of Company P's business. Company P 
performs similar activities for Company Q and Company R by analyzing 
their accounts payable and accounts receivable records.
    (ii) Assume that these services relating to data mining are 
specified covered services within the meaning of paragraph (b)(3)(i) of 
this section. Under the facts and circumstances, the taxpayer is unable 
to reasonably conclude that these services do not contribute 
significantly to the controlled group's key competitive advantages, core 
capabilities, or fundamental risks of success or failure in the group's 
business. Company P is not eligible to charge these services to Company 
Q and Company R in accordance with the services cost method.
    Example 10. Legal services. (i) Company P is a domestic corporation 
with two wholly-owned foreign subsidiaries, Company Q and Company R. 
Company P and its subsidiaries manufacture and distribute equipment used 
by industrial customers. Company P maintains an in-house legal 
department consisting of attorneys experienced in a wide range of 
business and commercial matters. Company Q and Company R maintain small 
legal departments, consisting of attorneys experienced in matters that 
most frequently arise in the normal course of business of Company Q and 
Company R in their respective jurisdictions.
    (ii) Company P seeks to maintain in-house legal staff with the 
ability to address the majority of legal matters that arise in the 
United States with respect to the operations of Company P, as well as 
any U.S. reporting or compliance obligations of Company Q or Company R. 
These include the preparation and review of corporate contracts relating 
to, for example, product sales, equipment purchases and leases, business 
liability insurance, real estate, employee salaries and benefits. 
Company P relies on outside attorneys for major business transactions 
and highly technical matters such as patent licenses. The in-house legal 
staffs of Company Q and Company R are much more limited. It is necessary 
for Company P to retain several local law firms to handle litigation and 
business disputes arising from the activities of Company Q and Company 
R. Although Company Q and Company R pay the fees of these law firms, the 
hiring authority and general oversight of the firms' representation is 
in the legal department of Company P.
    (iii) In determining what portion of the legal expenses of Company P 
may be allocated to Company Q and Company R, Company P first excludes 
any expenses relating to legal services that constitute shareholder 
activities and other items that are not properly analyzed as controlled 
services. Assume that the remaining services relating to general legal 
functions performed by in-house legal counsel are specified covered 
services within the meaning of paragraph (b)(3)(i) of this section. 
Under the facts and circumstances of the business of the PQR Controlled 
Group, the taxpayer could reasonably conclude that these latter services 
do not contribute significantly to the controlled group's key 
competitive advantages, core capabilities, or fundamental risks of 
success or

[[Page 816]]

failure in the group's business. If these services meet the other 
requirements of this paragraph (b), Company P will be eligible to charge 
these services to Company Q and Company R in accordance with the 
services cost method.
    Example 11. Legal services. (i) Company P is a domestic holding 
company whose operating companies, Company Q and Company R, generate 
electric power for consumers by operating nuclear plants. Assume that, 
although Company P owns 100% of the stock of Companies Q and R, the 
companies do not elect to file a consolidated Federal income tax return 
with Company P.
    (ii) Company P maintains an in-house legal department that includes 
attorneys who are experts in the areas of Federal utilities regulation, 
Federal labor and environmental law, and securities law. Companies Q and 
R maintain their own, smaller in-house legal staffs comprising 
experienced attorneys in the areas of state and local utilities 
regulation, state labor and employment law, and general commercial law. 
The legal department of Company P performs general oversight of the 
legal affairs of the company and determines whether a particular matter 
would be more efficiently handled by the Company P legal department, by 
the legal staffs in the operating companies, or in rare cases, by 
retained outside counsel. In general, Company P has succeeded in 
minimizing duplication and overlap of functions between the legal staffs 
of the various companies or by retained outside counsel.
    (iii) The domestic nuclear power plant operations of Companies Q and 
R are subject to extensive regulation by the U.S. Nuclear Regulatory 
Commission (NRC). Operators are required to obtain pre-construction 
approval, operating licenses, and, at the end of the operational life of 
the nuclear reactor, nuclear decommissioning certificates. Company P 
files consolidated financial statements on behalf of itself, as well as 
Companies Q and R, with the United States Securities and Exchange 
Commission (SEC). In these SEC filings, Company P discloses that failure 
to obtain any of these licenses (and the related periodic renewals) or 
agreeing to licenses on terms less favorable than those granted to 
competitors would have a material adverse impact on the operations of 
Company Q or Company R. Company Q and Company R do not have in-house 
legal staff with experience in the NRC area. Company P maintains a group 
of in-house attorneys with specialized expertise in the NRC area that 
exclusively represents Company Q and Company R before the NRC. Although 
Company P occasionally hires an outside law firm or industry expert to 
assist on particular NRC matters, the majority of the work is performed 
by the specialized legal staff of Company P.
    (iv) Certain of the legal services performed by Company P constitute 
duplicative or shareholder activities that do not confer a benefit on 
the other companies and therefore do not need to be allocated to the 
other companies, while certain other legal services are eligible to be 
charged to Company Q and Company R in accordance with the services cost 
method.
    (v) Assume that the specialized legal services relating to nuclear 
licenses performed by in-house legal counsel of Company P are specified 
covered services within the meaning of paragraph (b)(3)(i) of this 
section. Under the facts and circumstances, the taxpayer is unable to 
reasonably conclude that these services do not contribute significantly 
to the controlled group's key competitive advantages, core capabilities, 
or fundamental risks of success or failure in the group's business. 
Company P is not eligible to charge these services to Company Q and 
Company R in accordance with the services cost method.
    Example 12. Group of services. (i) Company P, Company Q, and Company 
R are manufacturing companies that sell their products to unrelated 
retail establishments. Company P has an enterprise resource planning 
(ERP) system that maintains data relating to accounts payable and 
accounts receivable information for all three companies. Company P's 
personnel perform the daily operations on this ERP system such as 
inputting data relating to accounts payable and accounts receivable into 
the system and extracting data relating to accounts receivable and 
accounts payable in the form of reports or electronic media and 
providing those data to all three companies. Periodically, Company P's 
computer specialists also modify the ERP system to adapt to changing 
business functions in all three companies. Company P's computer 
specialists make these changes by either modifying the underlying 
software program or by purchasing additional software or hardware from 
unrelated third party vendors.
    (ii) Assume that the services relating to accounts payable and 
accounts receivable are specified covered services within the meaning of 
paragraph (b)(3)(i) of this section. Under the facts and circumstances 
of the business of the PQR Controlled Group, the taxpayer could 
reasonably conclude that these services do not contribute significantly 
to the controlled group's key competitive advantages, core capabilities, 
or fundamental risks of success or failure in the group's business. If 
these services meet the other requirements of this paragraph (b), 
Company P will be eligible to charge these services to Company Q and 
Company R in accordance with the services cost method.

[[Page 817]]

    (iii) Assume that the services performed by Company P's computer 
specialists that relate to modifying the ERP system are specifically 
excluded from the services described in a revenue procedure referenced 
in paragraph (b)(3) of this section as developing hardware or software 
solutions (such as systems integration, Web site design, writing 
computer programs, modifying general applications software, or 
recommending the purchase of commercially available hardware or 
software). If these services do not constitute low margin covered 
services within the meaning of paragraph (b)(3)(ii) of this section, 
then Company P is not eligible to charge these services to Company Q and 
Company R in accordance with the services cost method.
    Example 13. Group of services. (i) Company P manufactures and sells 
widgets under an exclusive contract to Customer 1. Company Q and Company 
R sell widgets under exclusive contracts to Customer 2 and Customer 3, 
respectively. At least one year in advance, each of these customers can 
accurately forecast its need for widgets. Using these forecasts, each 
customer over the course of the year places orders for widgets with the 
appropriate company, Company P, Company Q, or Company R. A customer's 
actual need for widgets seldom deviates from that customer's forecasted 
need.
    (ii) It is most efficient for the PQR Controlled Group companies to 
manufacture and store an inventory of widgets in advance of delivery. 
Although all three companies sell widgets, only Company P maintains a 
centralized warehouse for widgets. Pursuant to a contract, Company P 
provides storage of these widgets to Company Q and Company R at an arm's 
length price.
    (iii) Company P's personnel also obtain orders from all three 
companies' customers to draw up purchase orders for widgets as well as 
make payment to suppliers for widget replacement parts. In addition, 
Company P's personnel use data entry to input information regarding 
orders and sales of widgets and replacement parts for all three 
companies into a centralized computer system. Company P's personnel also 
maintain the centralized computer system and extract data for all three 
companies when necessary.
    (iv) Assume that these services relating to tracking purchases and 
sales of inventory are specified covered services within the meaning of 
paragraph (b)(3)(i) of this section. Under the facts and circumstances 
of the business of the PQR Controlled Group, the taxpayer could 
reasonably conclude that these services do not contribute significantly 
to the controlled group's key competitive advantages, core capabilities, 
or fundamental risks of success or failure in the group's business. If 
these services meet the other requirements of this paragraph (b), 
Company P will be eligible to charge these services to Company Q and 
Company R in accordance with the services cost method.
    Example 14. Group of services. (i) Company P, Company Q, and Company 
R assemble and sell gadgets to unrelated customers. Each of these 
companies purchases the components necessary for assembly of the gadgets 
from unrelated suppliers. As a service to its subsidiaries, Company P's 
personnel obtain orders for components from all three companies, prepare 
purchase orders, and make payment to unrelated suppliers for the 
components. In addition, Company P's personnel use data entry to input 
information regarding orders and sales of gadgets for all three 
companies into a centralized computer. Company P's personnel also 
maintain the centralized computer system and extract data for all three 
companies on an as-needed basis. The services provided by Company P 
personnel, in conjunction with the centralized computer system, 
constitute a state-of-the-art inventory management system that allows 
Company P to order components necessary for assembly of the gadgets on a 
``just-in-time'' basis.
    (ii) Unrelated suppliers deliver the components directly to Company 
P, Company Q and Company R. Each company stores the components in its 
own facilities for use in filling specific customer orders. The 
companies do not maintain any inventory that is not identified in 
specific customer orders. Because of the efficiencies associated with 
services provided by personnel of Company P, all three companies are 
able to significantly reduce their inventory-related costs. Company P's 
Chief Executive Officer makes a statement in one of its press 
conferences with industry analysts that its inventory management system 
is critical to the company's success.
    (iii) Assume that these services relating to tracking purchases and 
sales of inventory are specified covered services within the meaning of 
paragraph (b)(3)(i) of this section. Under the facts and circumstances, 
the taxpayer is unable to reasonably conclude that these services do not 
contribute significantly to the controlled group's key competitive 
advantages, core capabilities, or fundamental risks of success or 
failure in the group's business. Company P is not eligible to charge 
these services to Company Q and Company R in accordance with the 
services cost method.
    Example 15. Low margin covered services. Company P renders certain 
accounting services to Company S. Company P uses the services cost 
method for the accounting services, and determines the amount charged as 
its total cost of rendering the services, with no markup. Based on an 
application of the section 482 regulations without regard to this 
paragraph (b), the interquartile range of arm's length markups on total 
services costs for these accounting services is between 3%

[[Page 818]]

and 9%, and the median is 6%. Because the median comparable markup on 
total services costs is 6%, which is less than 7%, the accounting 
services constitute low margin covered services within the meaning of 
paragraph (b)(3)(ii) of this section.
    Example 16. Shared services arrangement and reliable measure of 
reasonably anticipated benefit (allocation key). (i) Company P operates 
a centralized data processing facility that performs automated invoice 
processing and order generation for all of its subsidiaries, Companies 
X, Y, Z, pursuant to a shared services arrangement.
    (ii) In evaluating the shares of reasonably anticipated benefits 
from the centralized data processing services, the total value of the 
merchandise on the invoices and orders may not provide the most reliable 
measure of reasonably anticipated benefits shares, because value of 
merchandise sold does not bear a relationship to the anticipated 
benefits from the underlying covered services.
    (iii) The total volume of orders and invoices processed may provide 
a more reliable basis for evaluating the shares of reasonably 
anticipated benefits from the data processing services. Alternatively, 
depending on the facts and circumstances, total central processing unit 
time attributable to the transactions of each subsidiary may provide a 
more reliable basis on which to evaluate the shares of reasonably 
anticipated benefits.
    Example 17. Shared services arrangement and reliable measure of 
reasonably anticipated benefit (allocation key). (i) Company P operates 
a centralized center that performs human resources functions, such as 
administration of pension, retirement, and health insurance plans that 
are made available to employees of its subsidiaries, Companies X, Y, Z, 
pursuant to a shared services arrangement.
    (ii) In evaluating the shares of reasonably anticipated benefits 
from these centralized services, the total revenues of each subsidiary 
may not provide the most reliable measure of reasonably anticipated 
benefit shares, because total revenues do not bear a relationship to the 
shares of reasonably anticipated benefits from the underlying services.
    (iii) Employee headcount or total compensation paid to employees may 
provide a more reliable basis for evaluating the shares of reasonably 
anticipated benefits from the covered services.
    Example 18. Shared services arrangement and reliable measure of 
reasonably anticipated benefit (allocation key). (i) Company P performs 
human resource services (service A) on behalf of the PXYZ Group that 
qualify for the services cost method. Under that method, Company P 
determines the amount charged for these services pursuant to a shared 
services arrangement based on an application of paragraph (b)(7) of this 
section. Service A constitutes a specified covered service described in 
a revenue procedure pursuant to paragraph (b)(3)(i) of this section. The 
total services costs for service A otherwise determined under the 
services cost method is 300.
    (ii) Companies X, Y and Z reasonably anticipate benefits from 
service A. Company P does not reasonably anticipate benefits from 
service A. Assume that if relative reasonably anticipated benefits were 
precisely known, the appropriate allocation of charges pursuant to 
paragraph (k) of this section to Company X, Y and Z for service A is as 
follows:

                                Service A
                            [Total cost 300]
------------------------------------------------------------------------
                         Company
------------------------------------------------------------------------
X.......................................................             150
Y.......................................................              75
Z.......................................................              75
------------------------------------------------------------------------

    (iii) The total number of employees (employee headcount) in each 
company is as follows:
    Company X--600 employees.
    Company Y--250 employees.
    Company Z--250 employees.
    (iv) Company P allocates the 300 total services costs of service A 
based on employee headcount as follows:

                                Service A
                            [Total cost 300]
------------------------------------------------------------------------
                                                      Company
             Allocation key              -------------------------------
                                             Headcount        Amount
------------------------------------------------------------------------
X.......................................             600             164
Y.......................................             250              68
Z.......................................             250              68
------------------------------------------------------------------------

    (v) Based on these facts, Company P may reasonably conclude that the 
employee headcount allocation basis most reliably reflects the 
participants' respective shares of the reasonably anticipated benefits 
attributable to service A.

    Example 19. Shared services arrangement and reliable measure of 
reasonably anticipated benefit (allocation key). (i) Company P performs 
accounts payable services (service B) on behalf of the PXYZ Group and 
determines the amount charged for the services under such method 
pursuant to a shared services arrangement based on an application of 
paragraph (b)(7) of this section. Service B is a specified covered 
service described in a revenue procedure pursuant to paragraph (b)(3)(i) 
of this section. The total services costs for service B otherwise 
determined under the services cost method is 500.


[[Page 819]]


    (ii) Companies X, Y and Z reasonably anticipate benefits from 
service B. Company P does not reasonably anticipate benefits from 
service B. Assume that if relative reasonably anticipated benefits were 
precisely known, the appropriate allocation of charges pursuant to 
paragraph (k) of this section to Companies X, Y and Z for service B is 
as follows:

                                Service B
                            [Total cost 500]
------------------------------------------------------------------------
                         Company
------------------------------------------------------------------------
X.......................................................             125
Y.......................................................             205
Z.......................................................             170
------------------------------------------------------------------------

    (iii) The total number of employees (employee headcount) in each 
company is as follows:
    Company X--600.
    Company Y--200.
    Company Z--200.
    (iv) The total number of transactions (transaction volume) with 
uncontrolled customers by each company is as follows:
    Company X--2,000.
    Company Y--4,000.
    Company Z--3,500.
    (v) If Company P allocated the 500 total services costs of service B 
based on employee headcount, the resulting allocation would be as 
follows:

                                Service B
                            [Total cost 500]
------------------------------------------------------------------------
                                                      Company
             Allocation key              -------------------------------
                                             Headcount        Amount
------------------------------------------------------------------------
X.......................................             600             300
Y.......................................             200             100
Z.......................................             200             100
------------------------------------------------------------------------

    (vi) In contrast, if Company P used volume of transactions with 
uncontrolled customers as the allocation basis under the shared services 
arrangement, the allocation would be as follows:

                                Service B
                            [Total cost 500]
------------------------------------------------------------------------
                                                      Company
                                         -------------------------------
             Allocation key                 Transaction
                                              Volume          Amount
------------------------------------------------------------------------
X.......................................           2,000             105
Y.......................................           4,000             211
Z.......................................           3,500             184
------------------------------------------------------------------------

    (vii) Based on these facts, Company P may reasonably conclude that 
the transaction volume, but not the employee headcount, allocation basis 
most reliably reflects the participants' respective shares of the 
reasonably anticipated benefits attributable to service B.

    Example 20. Shared services arrangement and aggregation. (i) Company 
P performs human resource services (service A) and accounts payable 
services (service B) on behalf of the PXYZ Group that qualify for the 
services cost method. Company P determines the amount charged for these 
services under such method pursuant to a shared services arrangement 
based on an application of paragraph (b)(7) of this section. Service A 
and service B are specified covered services described in a revenue 
procedure pursuant to paragraph (b)(3)(i) of this section. The total 
services costs otherwise determined under the services cost method for 
service A is 300 and for service B is 500; total services costs for 
services A and B are 800. Company P determines that aggregation of 
services A and B for purposes of the arrangement is appropriate.

    (ii) Companies X, Y and Z reasonably anticipate benefits from 
services A and B. Company P does not reasonably anticipate benefits from 
services A and B. Assume that if relative reasonably anticipated 
benefits were precisely known, the appropriate allocation of total 
charges pursuant to paragraph (k) of this section to Companies X, Y and 
Z for services A and B is as follows:

                            Services A and B
                            [Total cost 800]
------------------------------------------------------------------------
                         Company
------------------------------------------------------------------------
X.......................................................             350
Y.......................................................             100
Z.......................................................             350
------------------------------------------------------------------------

    (iii) The total volume of transactions with uncontrolled customers 
in each company is as follows:
    Company X--2,000.
    Company Y--4,000.
    Company Z--4,000.
    (iv) The total number of employees in each company is as follows:
    Company X--600.

[[Page 820]]

    Company Y--200.
    Company Z--200.
    (v) If Company P allocated the 800 total services costs of services 
A and B based on transaction volume or employee headcount, the resulting 
allocation would be as follows:

                                             Aggregated Services AB
                                                [Total cost 800]
----------------------------------------------------------------------------------------------------------------
                                                          Allocation key                  Allocation key
                                                 ---------------------------------------------------------------
                     Company                        Transaction
                                                      volume          Amount         Headcount        Amount
----------------------------------------------------------------------------------------------------------------
X...............................................           2,000             160             600             480
Y...............................................           4,000             320             200             160
Z...............................................           4,000             320             200             160
----------------------------------------------------------------------------------------------------------------

    (vi) In contrast, if aggregated services AB were allocated by 
reference to the total U.S. dollar value of sales to uncontrolled 
parties (trade sales) by each company, the following results would 
obtain:

                         Aggregated Services AB
                            [Total costs 800]
------------------------------------------------------------------------
                                                  Allocation key
                                         -------------------------------
                 Company                    Trade sales
                                            (millions)        Amount
------------------------------------------------------------------------
X.......................................            $400             314
Y.......................................             120              94
Z.......................................             500             392
------------------------------------------------------------------------

    (vii) Based on these facts, Company P may reasonably conclude that 
the trade sales, but not the transaction volume or the employee 
headcount, allocation basis most reliably reflects the participants' 
respective shares of the reasonably anticipated benefits attributable to 
services AB.
    Example 21. Shared services arrangement and aggregation. (i) Company 
P performs services A through P on behalf of the PXYZ Group that qualify 
for the services cost method. Company P determines the amount charged 
for these services under such method pursuant to a shared services 
arrangement based on an application of paragraph (b)(7) of this section. 
All of these services A through P constitute either specified covered 
services or low margin covered services described in paragraph (b)(3) of 
this section. The total services costs for services A through P 
otherwise determined under the services cost method is 500. Company P 
determines that aggregation of services A through P for purposes of the 
arrangement is appropriate.
    (ii) Companies X and Y reasonably anticipate benefits from services 
A through P and Company Z reasonably anticipates benefits from services 
A through M but not from services N through P (Company Z performs 
services similar to services N through P on its own behalf). Company P 
does not reasonably anticipate benefits from services A through P. 
Assume that if relative reasonably anticipated benefits were precisely 
known, the appropriate allocation of total charges pursuant to paragraph 
(k) of this section to Company X, Y, and Z for services A through P is 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                      Services A-M (cost  Services N-P (cost     Services A-P
                       Company                               490)                 10)          (total cost 500)
----------------------------------------------------------------------------------------------------------------
X...................................................                  90                   5                  95
Y...................................................                 240                   5                 245
Z...................................................                 160                 160
----------------------------------------------------------------------------------------------------------------

    (iii) The total volume of transactions with uncontrolled customers 
in each company is as follows:
    Company X--2,000.
    Company Y--4,500.
    Company Z--3,500.
    (iv) Company P allocates the 500 total services costs of services A 
through P based on transaction volume as follows:

                         Aggregated Services A-Z
                            [Total costs 500]
------------------------------------------------------------------------
                                                  Allocation key
                                         -------------------------------
                 Company                    Transaction
                                              volume          Amount
------------------------------------------------------------------------
X.......................................           2,000             100
Y.......................................           4,500             225
Z.......................................           3,500             175
------------------------------------------------------------------------

    (v) Based on these facts, Company P may reasonably conclude that the 
transaction

[[Page 821]]

volume allocation basis most reliably reflects the participants' 
respective shares of the reasonably anticipated benefits attributable to 
services A through P.
    Example 22. Renderer reasonably anticipates benefits. (i) Company P 
renders services on behalf of the PXYZ Group that qualify for the 
services cost method. Company P determines the amount charged for these 
services under such method. Company P's share of reasonably anticipated 
benefits from services A, B, C, and D is 20% of the total reasonably 
anticipated benefits of all participants. Company P's total services 
cost for services A, B, C, and D charged within the group is 100.
    (ii) Based on an application of paragraph (b)(7) of this section, 
Company P charges 80 which is allocated among Companies X, Y, and Z. No 
charge is made to Company P under the shared services arrangement for 
activities that it performs on its own behalf.
    Example 23. Coordination with cost sharing arrangement. (i) Company 
P performs human resource services (service A) on behalf of the PXYZ 
Group that qualify for the services cost method. Company P determines 
the amount charged for these services under such method pursuant to a 
shared services arrangement based on an application of paragraph (b)(7) 
of this section. Service A constitutes a specified covered service 
described in a revenue procedure pursuant to paragraph (b)(3)(i) of this 
section. The total services costs for service A otherwise determined 
under the services cost method is 300.
    (ii) Company X, Y, Z, and P reasonably anticipate benefits from 
service A. Using a basis of allocation that is consistent with the 
controlled participants' respective shares of the reasonably anticipated 
benefits from the shared services, the total charge of 300 is allocated 
as follows:
    X--100.
    Y--50.
    Z--25.
    P--125.
    (iii) In addition to performing services, P undertakes 500 of R&D 
and incurs manufacturing and other costs of 1,000.
    (iv) Companies P and X enter into a cost sharing arrangement in 
accordance with Sec.  1.482-7T. Under the arrangement, Company P will 
undertake all intangible property development activities. All of Company 
P's research and development (R&D) activity is devoted to the intangible 
property development activity under the cost sharing arrangement. 
Company P will manufacture, market, and otherwise exploit the product in 
its defined territory. Companies P and X will share intangible property 
development costs in accordance with their reasonably anticipated 
benefits from the intangible property, and Company X will make payments 
to Company P as required under Sec.  1.482-7T. Company X will 
manufacture, market, and otherwise exploit the product in the rest of 
the world.
    (v) A portion of the charge under the shared services arrangement is 
in turn allocable to the intangible property development activity 
undertaken by Company P. The most reliable estimate of the proportion 
allocable to the intangible property development activity is determined 
to be 500 (Company P's R&D expenses) divided by 1,500 (Company P's total 
non-covered services costs), or one-third. Accordingly, one-third of 
Company P's charge of 125, or 42, is allocated to the intangible 
property development activity. Companies P and X must share the 
intangible property development costs of the cost shared intangible 
property (including the charge of 42 that is allocated under the shared 
services arrangement) in proportion to their respective shares of 
reasonably anticipated benefits under the cost sharing arrangement. That 
is, the reasonably anticipated benefit shares under the cost sharing 
arrangement are determined separately from reasonably anticipated 
benefit shares under the shared services arrangement.
    Example 24. Coordination with cost sharing arrangement. (i) The 
facts and analysis are the same as in Example 25, except that Company X 
also performs intangible property development activities related to the 
cost sharing arrangement. Using a basis of allocation that is consistent 
with the controlled participants' respective shares of the reasonably 
anticipated benefits from the shared services, the 300 of service costs 
is allocated as follows:
    X--100.
    Y--50.
    Z--25.
    P--125.
    (ii) In addition to performing services, Company P undertakes 500 of 
R&D and incurs manufacturing and other costs of 1,000. Company X 
undertakes 400 of R&D and incurs manufacturing and other costs of 600.
    (iii) Companies P and X enter into a cost sharing arrangement in 
accordance with Sec.  1.482-7T. Under the arrangement, both Companies P 
and X will undertake intangible property development activities. All of 
the research and development activity conducted by Companies P and X is 
devoted to the intangible property development activity under the cost 
sharing arrangement. Both Companies P and X will manufacture, market, 
and otherwise exploit the product in their respective territories and 
will share intangible property development costs in accordance with 
their reasonably anticipated benefits from the intangible property, and 
both will make payments as required under Sec.  1.482-7T.
    (iv) A portion of the charge under the shared services arrangement 
is in turn allocable to the intangible property development

[[Page 822]]

activities undertaken by Companies P and X. The most reliable estimate 
of the portion allocable to Company P's intangible property development 
activity is determined to be 500 (Company P's R&D expenses) divided by 
1,500 (P's total non-covered services costs), or one-third. Accordingly, 
one-third of Company P's allocated services cost method charge of 125, 
or 42, is allocated to its intangible property development activity.
    (v) In addition, it is necessary to determine the portion of the 
charge under the shared services arrangement to Company X that should be 
further allocated to Company X's intangible property development 
activities under the cost sharing arrangement. The most reliable 
estimate of the portion allocable to Company X's intangible property 
development activity is 400 (Company X's R&D expenses) divided by 1,000 
(Company X's costs), or 40%. Accordingly, 40% of the 100 that was 
allocated to Company X, or 40, is allocated in turn to Company X's 
intangible property development activities. Company X makes a payment to 
Company P of 100 under the shared services arrangement and includes 40 
of services cost method charges in the pool of intangible property 
development costs.
    (vi) The parties' respective contributions to intangible property 
development costs under the cost sharing arrangement are as follows:
P: 500 + (0.333 * 125) = 542
X: 400 + (0.40 * 100) = 440

    (c) Comparable uncontrolled services price method--(1) In general. 
The comparable uncontrolled services price method evaluates whether the 
amount charged in a controlled services transaction is arm's length by 
reference to the amount charged in a comparable uncontrolled services 
transaction.
    (2) Comparability and reliability considerations--(i) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec.  1.482-1(c). The 
application of these factors under the comparable uncontrolled services 
price method is discussed in paragraphs (c)(2)(ii) and (iii) of this 
section.
    (ii) Comparability--(A) In general. The degree of comparability 
between controlled and uncontrolled transactions is determined by 
applying the provisions of Sec.  1.482-1(d). Although all of the factors 
described in Sec.  1.482-1(d)(3) must be considered, similarity of the 
services rendered, and of the intangible property (if any) used in 
performing the services, generally will have the greatest effects on 
comparability under this method. In addition, because even minor 
differences in contractual terms or economic conditions could materially 
affect the amount charged in an uncontrolled transaction, comparability 
under this method depends on close similarity with respect to these 
factors, or adjustments to account for any differences. The results 
derived from applying the comparable uncontrolled services price method 
generally will be the most direct and reliable measure of an arm's 
length price for the controlled transaction if an uncontrolled 
transaction has no differences from the controlled transaction that 
would affect the price, or if there are only minor differences that have 
a definite and reasonably ascertainable effect on price and for which 
appropriate adjustments are made. If such adjustments cannot be made, or 
if there are more than minor differences between the controlled and 
uncontrolled transactions, the comparable uncontrolled services price 
method may be used, but the reliability of the results as a measure of 
the arm's length price will be reduced. Further, if there are material 
differences for which reliable adjustments cannot be made, this method 
ordinarily will not provide a reliable measure of an arm's length 
result.
    (B) Adjustments for differences between controlled and uncontrolled 
transactions. If there are differences between the controlled and 
uncontrolled transactions that would affect price, adjustments should be 
made to the price of the uncontrolled transaction according to the 
comparability provisions of Sec.  1.482-1(d)(2). Specific examples of 
factors that may be particularly relevant to application of this method 
include--
    (1) Quality of the services rendered;
    (2) Contractual terms (for example, scope and terms of warranties or 
guarantees regarding the services, volume, credit and payment terms, 
allocation of risks, including any contingent-payment terms and whether 
costs were incurred without a provision for current reimbursement);
    (3) Intangible property (if any) used in rendering the services;

[[Page 823]]

    (4) Geographic market in which the services are rendered or 
received;
    (5) Risks borne (for example, costs incurred to render the services, 
without provision for current reimbursement);
    (6) Duration or quantitative measure of services rendered;
    (7) Collateral transactions or ongoing business relationships 
between the renderer and the recipient, including arrangement for the 
provision of tangible property in connection with the services; and
    (8) Alternatives realistically available to the renderer and the 
recipient.
    (iii) Data and assumptions. The reliability of the results derived 
from the comparable uncontrolled services price method is affected by 
the completeness and accuracy of the data used and the reliability of 
the assumptions made to apply the method. See Sec.  1.482-1(c) (best 
method rule).
    (3) Arm's length range. See Sec.  1.482-1(e)(2) for the 
determination of an arm's length range.
    (4) Examples. The principles of this paragraph (c) are illustrated 
by the following examples:

    Example 1. Internal comparable uncontrolled services price. Company 
A, a United States corporation, performs shipping, stevedoring, and 
related services for controlled and uncontrolled parties on a short-term 
or as-needed basis. Company A charges uncontrolled parties in Country X 
a uniform fee of $60 per container to place loaded cargo containers in 
Country X on oceangoing vessels for marine transportation. Company A 
also performs identical services in Country X for its wholly-owned 
subsidiary, Company B, and there are no substantial differences between 
the controlled and uncontrolled transactions. In evaluating the 
appropriate measure of the arm's length price for the container-loading 
services performed for Company B, because Company A renders 
substantially identical services in Country X to both controlled and 
uncontrolled parties, it is determined that the comparable uncontrolled 
services price constitutes the best method for determining the arm's 
length price for the controlled services transaction. Based on the 
reliable data provided by Company A concerning the price charged for 
services in comparable uncontrolled transactions, a loading charge of 
$60 per cargo container will be considered the most reliable measure of 
the arm's length price for the services rendered to Company B. See 
paragraph (c)(2)(ii)(A) of this section.
    Example 2. External comparable uncontrolled services price. (i) The 
facts are the same as in Example 1, except that Company A performs 
services for Company B, but not for uncontrolled parties. Based on 
information obtained from unrelated parties (which is determined to be 
reliable under the comparability standards set forth in paragraph (c)(2) 
of this section), it is determined that uncontrolled parties in Country 
X perform services comparable to those rendered by Company A to Company 
B, and that such parties charge $60 per cargo container.
    (ii) In evaluating the appropriate measure of an arm's length price 
for the loading services that Company A renders to Company B, the $60 
per cargo container charge is considered evidence of a comparable 
uncontrolled services price. See paragraph (c)(2)(ii)(A) of this 
section.
    Example 3. External comparable uncontrolled services price. The 
facts are the same as in Example 2, except that uncontrolled parties in 
Country X render similar loading and stevedoring services, but only 
under contracts that have a minimum term of one year. If the difference 
in the duration of the services has a material effect on prices, 
adjustments to account for these differences must be made to the results 
of the uncontrolled transactions according to the provisions of Sec.  
1.482-1(d)(2), and such adjusted results may be used as a measure of the 
arm's length result.
    Example 4. Use of valuable intangible property. (i) Company A, a 
United States corporation in the biotechnology sector, renders research 
and development services exclusively to its affiliates. Company B is 
Company A's wholly-owned subsidiary in Country X. Company A renders 
research and development services to Company B.
    (ii) In performing its research and development services function, 
Company A uses proprietary software that it developed internally. 
Company A uses the software to evaluate certain genetically engineered 
compounds developed by Company B. Company A owns the copyright on this 
software and does not license it to uncontrolled parties.
    (iii) No uncontrolled parties can be identified that perform 
services identical or with a high degree of similarity to those 
performed by Company A. Because there are material differences for which 
reliable adjustments cannot be made, the comparable uncontrolled 
services price method is unlikely to provide a reliable measure of the 
arm's length price. See paragraph (c)(2)(ii)(A) of this section.
    Example 5. Internal comparable. (i) Company A, a United States 
corporation, and its subsidiaries render computer consulting services 
relating to systems integration and networking to business clients in 
various countries. Company A and its subsidiaries render only consulting 
services, and do not manufacture computer hardware or software nor 
distribute such products. The controlled

[[Page 824]]

group is organized according to industry specialization, with key 
industry specialists working for Company A. These personnel typically 
form the core consulting group that teams with consultants from the 
local-country subsidiaries to serve clients in the subsidiaries' 
respective countries.
    (ii) Company A and its subsidiaries sometimes undertake engagements 
directly for clients, and sometimes work as subcontractors to unrelated 
parties on more extensive supply-chain consulting engagements for 
clients. In undertaking the latter engagements with third party 
consultants, Company A typically prices its services based on consulting 
hours worked multiplied by a rate determined for each category of 
employee. The company also charges, at no markup, for out-of-pocket 
expenses such as travel, lodging, and data acquisition charges. The 
Company has established the following schedule of hourly rates:

------------------------------------------------------------------------
                Category                               Rate
------------------------------------------------------------------------
Project managers........................  $400 per hour.
Technical staff.........................  $300 per hour.
------------------------------------------------------------------------

    (iii) Thus, for example, a project involving 100 hours of the time 
of project managers and 400 hours of technical staff time would result 
in the following project fees (without regard to any out-of-pocket 
expenses): ([100 hrs. x $400/hr.] + [400 hrs. x $300/hr.]) = $40,000 + 
$120,000 = $160,000.
    (iv) Company B, a Country X subsidiary of Company A, contracts to 
perform consulting services for a Country X client in the banking 
industry. In undertaking this engagement, Company B uses its own 
consultants and also uses Company A project managers and technical staff 
that specialize in the banking industry for 75 hours and 380 hours, 
respectively. In determining an arm's length charge, the price that 
Company A charges for consulting services as a subcontractor in 
comparable uncontrolled transactions will be considered evidence of a 
comparable uncontrolled services price. Thus, in this case, a payment of 
$144,000, (or [75 hrs. x $400/hr.] + [380 hrs. x $300/hr.] = $30,000 + 
$114,000) may be used as a measure of the arm's length price for the 
work performed by Company A project mangers and technical staff. In 
addition, if the comparable uncontrolled services price method is used, 
then, consistent with the practices employed by the comparables with 
respect to similar types of expenses, Company B must reimburse Company A 
for appropriate out-of-pocket expenses. See paragraph (c)(2)(ii)(A) of 
this section.
    Example 6. Adjustments for differences. (i) The facts are the same 
as in Example 5, except that the engagement is undertaken with the 
client on a fixed fee basis. That is, prior to undertaking the 
engagement Company B and Company A estimate the resources required to 
undertake the engagement, and, based on hourly fee rates, charge the 
client a single fee for completion of the project. Company A's portion 
of the engagement results in fees of $144,000.
    (ii) The engagement, once undertaken, requires 20% more hours by 
each of Companies A and B than originally estimated. Nevertheless, the 
unrelated client pays the fixed fee that was agreed upon at the start of 
the engagement. Company B pays Company A $144,000, in accordance with 
the fixed fee arrangement.
    (iii) Company A often enters into similar fixed fee engagements with 
clients. In addition, Company A's records for similar engagements show 
that when it experiences cost overruns, it does not collect additional 
fees from the client for the difference between projected and actual 
hours. Accordingly, in evaluating whether the fees paid by Company B to 
Company A are arm's length, it is determined that no adjustments to the 
intercompany service charge are warranted. See Sec.  1.482-1(d)(3)(ii) 
and paragraph (c)(2)(ii)(A) of this section.

    (5) Indirect evidence of the price of a comparable uncontrolled 
services transaction--(i) In general. The price of a comparable 
uncontrolled services transaction may be derived based on indirect 
measures of the price charged in comparable uncontrolled services 
transactions, but only if--
    (A) The data are widely and routinely used in the ordinary course of 
business in the particular industry or market segment for purposes of 
determining prices actually charged in comparable uncontrolled services 
transactions;
    (B) The data are used to set prices in the controlled services 
transaction in the same way they are used to set prices in uncontrolled 
services transactions of the controlled taxpayer, or in the same way 
they are used by uncontrolled taxpayers to set prices in uncontrolled 
services transactions; and
    (C) The amount charged in the controlled services transaction may be 
reliably adjusted to reflect differences in quality of the services, 
contractual terms, market conditions, risks borne (including contingent-
payment terms), duration or quantitative measure of services rendered, 
and other factors that may affect the price to which uncontrolled 
taxpayers would agree.
    (ii) Example. The following example illustrates this paragraph 
(c)(5):


[[Page 825]]


    Example. Indirect evidence of comparable uncontrolled services 
price. (i) Company A is a United States insurance company. Company A's 
wholly-owned Country X subsidiary, Company B, performs specialized risk 
analysis for Company A as well as for uncontrolled parties. In 
determining the price actually charged to uncontrolled entities for 
performing such risk analysis, Company B uses a proprietary, multi-
factor computer program, which relies on the gross value of the policies 
in the customer's portfolio, the relative composition of those policies, 
their location, and the estimated number of personnel hours necessary to 
complete the project. Uncontrolled companies that perform comparable 
risk analysis in the same industry or market-segment use similar 
proprietary computer programs to price transactions with uncontrolled 
customers (the competitors' programs may incorporate different inputs, 
or may assign different weights or values to individual inputs, in 
arriving at the price).
    (ii) During the taxable year subject to audit, Company B performed 
risk analysis for uncontrolled parties as well as for Company A. Because 
prices charged to uncontrolled customers reflected the composition of 
each customer's portfolio together with other factors, the prices 
charged in Company B's uncontrolled transactions do not provide a 
reliable basis for determining the comparable uncontrolled services 
price for the similar services rendered to Company A. However, in 
evaluating an arm's length price for the studies performed by Company B 
for Company A, Company B's proprietary computer program may be 
considered as indirect evidence of the comparable uncontrolled services 
price that would be charged to perform the services for Company A. The 
reliability of the results obtained by application of this internal 
computer program as a measure of an arm's length price for the services 
will be increased to the extent that Company A used the internal 
computer program to generate actual transaction prices for risk-analysis 
studies performed for uncontrolled parties during the same taxable year 
under audit; Company A used data that are widely and routinely used in 
the ordinary course of business in the insurance industry to determine 
the price charged; and Company A reliably adjusted the price charged in 
the controlled services transaction to reflect differences that may 
affect the price to which uncontrolled taxpayers would agree.

    (d) Gross services margin method--(1) In general. The gross services 
margin method evaluates whether the amount charged in a controlled 
services transaction is arm's length by reference to the gross profit 
margin realized in comparable uncontrolled transactions. This method 
ordinarily is used in cases where a controlled taxpayer performs 
services or functions in connection with an uncontrolled transaction 
between a member of the controlled group and an uncontrolled taxpayer. 
This method may be used where a controlled taxpayer renders services 
(agent services) to another member of the controlled group in connection 
with a transaction between that other member and an uncontrolled 
taxpayer. This method also may be used in cases where a controlled 
taxpayer contracts to provide services to an uncontrolled taxpayer 
(intermediary function) and another member of the controlled group 
actually performs a portion of the services provided.
    (2) Determination of arm's length price--(i) In general. The gross 
services margin method evaluates whether the price charged or amount 
retained by a controlled taxpayer in the controlled services transaction 
in connection with the relevant uncontrolled transaction is arm's length 
by determining the appropriate gross profit of the controlled taxpayer.
    (ii) Relevant uncontrolled transaction. The relevant uncontrolled 
transaction is a transaction between a member of the controlled group 
and an uncontrolled taxpayer as to which the controlled taxpayer 
performs agent services or an intermediary function.
    (iii) Applicable uncontrolled price. The applicable uncontrolled 
price is the price paid or received by the uncontrolled taxpayer in the 
relevant uncontrolled transaction.
    (iv) Appropriate gross services profit. The appropriate gross 
services profit is computed by multiplying the applicable uncontrolled 
price by the gross services profit margin in comparable uncontrolled 
transactions. The determination of the appropriate gross services profit 
will take into account any functions performed by other members of the 
controlled group, as well as any other relevant factors described in 
Sec.  1.482-1(d)(3). The comparable gross services profit margin may be 
determined by reference to the commission in an uncontrolled 
transaction, where that commission is stated as a percentage of the 
price charged in the uncontrolled transaction.

[[Page 826]]

    (v) Arm's length range. See Sec.  1.482-1(e)(2) for determination of 
the arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described under the best method rule in Sec.  1.482-1(c). The 
application of these factors under the gross services margin method is 
discussed in paragraphs (d)(3)(ii) and (iii) of this section.
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between an uncontrolled transaction and a controlled 
transaction is determined by applying the comparability provisions of 
Sec.  1.482-1(d). A gross services profit provides compensation for 
services or functions that bear a relationship to the relevant 
uncontrolled transaction, including an operating profit in return for 
the investment of capital and the assumption of risks by the controlled 
taxpayer performing the services or functions under review. Therefore, 
although all of the factors described in Sec.  1.482-1(d)(3) must be 
considered, comparability under this method is particularly dependent on 
similarity of services or functions performed, risks borne, intangible 
property (if any) used in providing the services or functions, and 
contractual terms, or adjustments to account for the effects of any such 
differences. If possible, the appropriate gross services profit margin 
should be derived from comparable uncontrolled transactions by the 
controlled taxpayer under review, because similar characteristics are 
more likely found among different transactions by the same controlled 
taxpayer than among transactions by other parties. In the absence of 
comparable uncontrolled transactions involving the same controlled 
taxpayer, an appropriate gross services profit margin may be derived 
from transactions of uncontrolled taxpayers involving comparable 
services or functions with respect to similarly related transactions.
    (B) Other comparability factors. Comparability under this method is 
not dependent on close similarity of the relevant uncontrolled 
transaction to the related transactions involved in the uncontrolled 
comparables. However, substantial differences in the nature of the 
relevant uncontrolled transaction and the relevant transactions involved 
in the uncontrolled comparables, such as differences in the type of 
property transferred or service provided in the relevant uncontrolled 
transaction, may indicate significant differences in the services or 
functions performed by the controlled and uncontrolled taxpayers with 
respect to their respective relevant transactions. Thus, it ordinarily 
would be expected that the services or functions performed in the 
controlled and uncontrolled transactions would be with respect to 
relevant transactions involving the transfer of property within the same 
product categories or the provision of services of the same general type 
(for example, information-technology systems design). Furthermore, 
significant differences in the intangible property (if any) used by the 
controlled taxpayer in the controlled services transaction as distinct 
from the uncontrolled comparables may also affect the reliability of the 
comparison. Finally, the reliability of profit measures based on gross 
services profit may be adversely affected by factors that have less 
effect on prices. For example, gross services profit may be affected by 
a variety of other factors, including cost structures or efficiency (for 
example, differences in the level of experience of the employees 
performing the service in the controlled and uncontrolled transactions). 
Accordingly, if material differences in these factors are identified 
based on objective evidence, the reliability of the analysis may be 
affected.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions. If there are material differences between the controlled 
and uncontrolled transactions that would affect the gross services 
profit margin, adjustments should be made to the gross services profit 
margin, according to the comparability provisions of Sec.  1.482-
1(d)(2). For this purpose, consideration of the total services costs 
associated with functions performed and risks assumed may be necessary 
because differences in functions performed are often reflected in these 
costs. If there

[[Page 827]]

are differences in functions performed, however, the effect on gross 
services profit of such differences is not necessarily equal to the 
differences in the amount of related costs. Specific examples of factors 
that may be particularly relevant to this method include--
    (1) Contractual terms (for example, scope and terms of warranties or 
guarantees regarding the services or function, volume, credit and 
payment terms, and allocation of risks, including any contingent-payment 
terms);
    (2) Intangible property (if any) used in performing the services or 
function;
    (3) Geographic market in which the services or function are 
performed or in which the relevant uncontrolled transaction takes place; 
and
    (4) Risks borne, including, if applicable, inventory-type risk.
    (D) Buy-sell distributor. If a controlled taxpayer that performs an 
agent service or intermediary function is comparable to a distributor 
that takes title to goods and resells them, the gross profit margin 
earned by such distributor on uncontrolled sales, stated as a percentage 
of the price for the goods, may be used as the comparable gross services 
profit margin.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the gross services margin method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec.  1.482-1(c) (best method 
rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect the gross services 
profit margin affects the reliability of the results under this method.
    (4) Examples. The principles of this paragraph (d) are illustrated 
by the following examples:

    Example 1. Agent services. Company A and Company B are members of a 
controlled group. Company A is a foreign manufacturer of industrial 
equipment. Company B is a U.S. company that acts as a commission agent 
for Company A by arranging for Company A to make direct sales of the 
equipment it manufactures to unrelated purchasers in the U.S. market. 
Company B does not take title to the equipment but instead receives from 
Company A commissions that are determined as a specified percentage of 
the sales price for the equipment that is charged by Company A to the 
unrelated purchaser. Company B also arranges for direct sales of similar 
equipment by unrelated foreign manufacturers to unrelated purchasers in 
the U.S. market. Company B charges these unrelated foreign manufacturers 
a commission fee of 5% of the sales price charged by the unrelated 
foreign manufacturers to the unrelated U.S. purchasers for the 
equipment. Information regarding the comparable agent services provided 
by Company B to unrelated foreign manufacturers is sufficiently complete 
to conclude that it is likely that all material differences between the 
controlled and uncontrolled transactions have been identified and 
adjustments for such differences have been made. If the comparable gross 
services profit margin is 5% of the price charged in the relevant 
transactions involved in the uncontrolled comparables, then the 
appropriate gross services profit that Company B may earn and the arm's 
length price that it may charge Company A for its agent services is 
equal to 5% of the applicable uncontrolled price charged by Company A in 
sales of equipment in the relevant uncontrolled transactions.
    Example 2. Agent services. The facts are the same as in Example 1, 
except that Company B does not act as a commission agent for unrelated 
parties and it is not possible to obtain reliable information concerning 
commission rates charged by uncontrolled commission agents that engage 
in comparable transactions with respect to relevant sales of property. 
It is possible, however, to obtain reliable information regarding the 
gross profit margins earned by unrelated parties that briefly take title 
to and then resell similar property in uncontrolled transactions, in 
which they purchase the property from foreign manufacturers and resell 
the property to purchasers in the U.S. market. Analysis of the facts and 
circumstances indicates that, aside from certain minor differences for 
which adjustments can be made, the uncontrolled parties that resell 
property perform similar functions and assume similar risks as Company B 
performs and assumes when it acts as a commission agent for Company A's 
sales of property. Under these circumstances, the gross profit margin 
earned by the unrelated distributors on the purchase and resale of 
property may be used, subject to any adjustments for any material 
differences between the controlled and uncontrolled transactions, as a 
comparable gross services profit margin. The appropriate gross services 
profit that Company B may earn and the arm's length price that it may 
charge Company A for its agent services is therefore equal to this 
comparable gross services margin, multiplied by the applicable 
uncontrolled price charged by Company A in

[[Page 828]]

its sales of equipment in the relevant uncontrolled transactions.
    Example 3. Agent services. (i) Company A and Company B are members 
of a controlled group. Company A is a U.S. corporation that renders 
computer consulting services, including systems integration and 
networking, to business clients.
    (ii) In undertaking engagements with clients, Company A in some 
cases pays a commission of 3% of its total fees to unrelated parties 
that assist Company A in obtaining consulting engagements. Typically, 
such fees are paid to non-computer consulting firms that provide 
strategic management services for their clients. When Company A obtains 
a consulting engagement with a client of a non-computer consulting firm, 
Company A does not subcontract with the other consulting firm, nor does 
the other consulting firm play any role in Company A's consulting 
engagement.
    (iii) Company B, a Country X subsidiary of Company A, assists 
Company A in obtaining an engagement to perform computer consulting 
services for a Company B banking industry client in Country X. Although 
Company B has an established relationship with its Country X client and 
was instrumental in arranging for Company A's engagement with the 
client, Company A's particular expertise was the primary consideration 
in motivating the client to engage Company A. Based on the relative 
contributions of Companies A and B in obtaining and undertaking the 
engagement, Company B's role was primarily to facilitate the consulting 
engagement between Company A and the Country X client. Information 
regarding the commissions paid by Company A to unrelated parties for 
providing similar services to facilitate Company A's consulting 
engagements is sufficiently complete to conclude that it is likely that 
all material differences between these uncontrolled transactions and the 
controlled transaction between Company B and Company A have been 
identified and that appropriate adjustments have been made for any such 
differences. If the comparable gross services margin earned by unrelated 
parties in providing such agent services is 3% of total fees charged in 
the relevant transactions involved in the uncontrolled comparables, then 
the appropriate gross services profit that Company B may earn and the 
arm's length price that it may charge Company A for its agent services 
is equal to this comparable gross services margin (3%), multiplied by 
the applicable uncontrolled price charged by Company A in its relevant 
uncontrolled consulting engagement with Company B's client.
    Example 4. Intermediary function. (i) The facts are the same as in 
Example 3, except that Company B contracts directly with its Country X 
client to provide computer consulting services and Company A performs 
the consulting services on behalf of Company B. Company A does not enter 
into a consulting engagement with Company B's Country X client. Instead, 
Company B charges its Country X client an uncontrolled price for the 
consulting services, and Company B pays a portion of the uncontrolled 
price to Company A for performing the consulting services on behalf of 
Company B.
    (ii) Analysis of the relative contributions of Companies A and B in 
obtaining and undertaking the consulting contract indicates that Company 
B functioned primarily as an intermediary contracting party, and the 
gross services margin method is the most reliable method for determining 
the amount that Company B may retain as compensation for its 
intermediary function with respect to Company A's consulting services. 
In this case, therefore, because Company B entered into the relevant 
uncontrolled transaction to provide services, Company B receives the 
applicable uncontrolled price that is paid by the Country X client for 
the consulting services. Company A technically performs services for 
Company B when it performs, on behalf of Company B, the consulting 
services Company B contracted to provide to the Country X client. The 
arm's length amount that Company A may charge Company B for performing 
the consulting services on Company B's behalf is equal to the applicable 
uncontrolled price received by Company B in the relevant uncontrolled 
transaction, less Company B's appropriate gross services profit, which 
is the amount that Company B may retain as compensation for performing 
the intermediary function.
    (iii) Reliable data concerning the commissions that Company A paid 
to uncontrolled parties for assisting it in obtaining engagements to 
provide consulting services similar to those it has provided on behalf 
of Company B provide useful information in applying the gross services 
margin method. However, consideration should be given to whether the 
third party commission data may need to be adjusted to account for any 
additional risk that Company B may have assumed as a result of its 
function as an intermediary contracting party, compared with the risk it 
would have assumed if it had provided agent services to assist Company A 
in entering into an engagement to provide its consulting service 
directly. In this case, the information regarding the commissions paid 
by Company A to unrelated parties for providing agent services to 
facilitate its performance of consulting services for unrelated parties 
is sufficiently complete to conclude that all material differences 
between these uncontrolled transactions and the controlled performance 
of an intermediary function, including possible differences in the 
amount of risk assumed in connection with performing that function, have 
been identified and that appropriate adjustments have been made. If

[[Page 829]]

the comparable gross services margin earned by unrelated parties in 
providing such agent services is 3% of total fees charged in Company B's 
relevant uncontrolled transactions, then the appropriate gross services 
profit that Company B may retain as compensation for performing an 
intermediary function (and the amount, therefore, that is deducted from 
the applicable uncontrolled price to arrive at the arm's length price 
that Company A may charge Company B for performing consulting services 
on Company B's behalf) is equal to this comparable gross services margin 
(3%), multiplied by the applicable uncontrolled price charged by Company 
B in its contract to provide services to the uncontrolled party.
    Example 5. External comparable. (i) The facts are the same as in 
Example 4, except that neither Company A nor Company B engages in 
transactions with third parties that facilitate similar consulting 
engagements.
    (ii) Analysis of the relative contributions of Companies A and B in 
obtaining and undertaking the contract indicates that Company B's role 
was primarily to facilitate the consulting arrangement between Company A 
and the Country X client. Although no reliable internal data are 
available regarding comparable transactions with uncontrolled entities, 
reliable data exist regarding commission rates for similar facilitating 
services between uncontrolled parties. These data indicate that a 3% 
commission (3% of total engagement fee) is charged in such transactions. 
Information regarding the uncontrolled comparables is sufficiently 
complete to conclude that it is likely that all material differences 
between the controlled and uncontrolled transactions have been 
identified and adjusted for. If the appropriate gross services profit 
margin is 3% of total fees, then an arm's length result of the 
controlled services transaction is for Company B to retain an amount 
equal to 3% of total fees paid to it.

    (e) Cost of services plus method--(1) In general. The cost of 
services plus method evaluates whether the amount charged in a 
controlled services transaction is arm's length by reference to the 
gross services profit markup realized in comparable uncontrolled 
transactions. The cost of services plus method is ordinarily used in 
cases where the controlled service renderer provides the same or similar 
services to both controlled and uncontrolled parties. This method is 
ordinarily not used in cases where the controlled services transaction 
involves a contingent-payment arrangement, as described in paragraph 
(i)(2) of this section.
    (2) Determination of arm's length price--(i) In general. The cost of 
services plus method measures an arm's length price by adding the 
appropriate gross services profit to the controlled taxpayer's 
comparable transactional costs.
    (ii) Appropriate gross services profit. The appropriate gross 
services profit is computed by multiplying the controlled taxpayer's 
comparable transactional costs by the gross services profit markup, 
expressed as a percentage of the comparable transactional costs earned 
in comparable uncontrolled transactions.
    (iii) Comparable transactional costs. Comparable transactional costs 
consist of the costs of providing the services under review that are 
taken into account as the basis for determining the gross services 
profit markup in comparable uncontrolled transactions. Depending on the 
facts and circumstances, such costs typically include all compensation 
attributable to employees directly involved in the performance of such 
services, materials and supplies consumed or made available in rendering 
such services, and may include as well other costs of rendering the 
services. Comparable transactional costs must be determined on a basis 
that will facilitate comparison with the comparable uncontrolled 
transactions. For that reason, comparable transactional costs may not 
necessarily equal total services costs, as defined in paragraph (j) of 
this section, and in appropriate cases may be a subset of total services 
costs. Generally accepted accounting principles or Federal income tax 
accounting rules (where Federal income tax data for comparable 
transactions or business activities are available) may provide useful 
guidance but will not conclusively establish the appropriate comparable 
transactional costs for purposes of this method.
    (iv) Arm's length range. See Sec.  1.482-1(e)(2) for determination 
of an arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from the application of this method are the most 
reliable measure of the arm's length result must be determined using the 
factors described

[[Page 830]]

under the best method rule in Sec.  1.482-1(c).
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between controlled and uncontrolled transactions is 
determined by applying the comparability provisions of Sec.  1.482-1(d). 
A service renderer's gross services profit provides compensation for 
performing services related to the controlled services transaction under 
review, including an operating profit for the service renderer's 
investment of capital and assumptions of risks. Therefore, although all 
of the factors described in Sec.  1.482-1(d)(3) must be considered, 
comparability under this method is particularly dependent on similarity 
of services or functions performed, risks borne, intangible property (if 
any) used in providing the services or functions, and contractual terms, 
or adjustments to account for the effects of any such differences. If 
possible, the appropriate gross services profit markup should be derived 
from comparable uncontrolled transactions of the same taxpayer 
participating in the controlled services transaction because similar 
characteristics are more likely to be found among services provided by 
the same service provider than among services provided by other service 
providers. In the absence of such services transactions, an appropriate 
gross services profit markup may be derived from comparable uncontrolled 
services transactions of other service providers. If the appropriate 
gross services profit markup is derived from comparable uncontrolled 
services transactions of other service providers, in evaluating 
comparability the controlled taxpayer must consider the results under 
this method expressed as a markup on total services costs of the 
controlled taxpayer, because differences in functions performed may be 
reflected in differences in service costs other than those included in 
comparable transactional costs.
    (B) Other comparability factors. Comparability under this method is 
less dependent on close similarity between the services provided than 
under the comparable uncontrolled services price method. Substantial 
differences in the services may, however, indicate significant 
functional differences between the controlled and uncontrolled 
taxpayers. Thus, it ordinarily would be expected that the controlled and 
uncontrolled transactions would involve services of the same general 
type (for example, information-technology systems design). Furthermore, 
if a significant amount of the controlled taxpayer's comparable 
transactional costs consists of service costs incurred in a tax 
accounting period other than the tax accounting period under review, the 
reliability of the analysis would be reduced. In addition, significant 
differences in the value of the services rendered, due for example to 
the use of valuable intangible property, may also affect the reliability 
of the comparison. Finally, the reliability of profit measures based on 
gross services profit may be adversely affected by factors that have 
less effect on prices. For example, gross services profit may be 
affected by a variety of other factors, including cost structures or 
efficiency-related factors (for example, differences in the level of 
experience of the employees performing the service in the controlled and 
uncontrolled transactions). Accordingly, if material differences in 
these factors are identified based on objective evidence, the 
reliability of the analysis may be affected.
    (C) Adjustments for differences between the controlled and 
uncontrolled transactions. If there are material differences between the 
controlled and uncontrolled transactions that would affect the gross 
services profit markup, adjustments should be made to the gross services 
profit markup earned in the comparable uncontrolled transaction 
according to the provisions of Sec.  1.482-1(d)(2). For this purpose, 
consideration of the comparable transactional costs associated with the 
functions performed and risks assumed may be necessary, because 
differences in the functions performed are often reflected in these 
costs. If there are differences in functions performed, however, the 
effect on gross services profit of such differences is not necessarily 
equal to the differences in the amount of related comparable 
transactional costs. Specific examples of the factors that may be 
particularly relevant to this method include--

[[Page 831]]

    (1) The complexity of the services;
    (2) The duration or quantitative measure of services;
    (3) Contractual terms (for example, scope and terms of warranties or 
guarantees provided, volume, credit and payment terms, allocation of 
risks, including any contingent-payment terms);
    (4) Economic circumstances; and
    (5) Risks borne.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the cost of services plus method is affected by the 
completeness and accuracy of the data used and the reliability of the 
assumptions made to apply this method. See Sec.  1.482-1(c) (Best method 
rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect the gross services 
profit markup affects the reliability of the results under this method. 
Thus, for example, if differences in cost accounting practices would 
materially affect the gross services profit markup, the ability to make 
reliable adjustments for such differences would affect the reliability 
of the results obtained under this method. Further, reliability under 
this method depends on the extent to which the controlled and 
uncontrolled transactions reflect consistent reporting of comparable 
transactional costs. For purposes of this paragraph (e)(3)(iii)(B), the 
term comparable transactional costs includes the cost of acquiring 
tangible property that is transferred (or used) with the services, to 
the extent that the arm's length price of the tangible property is not 
separately evaluated as a controlled transaction under another 
provision.
    (4) Examples. The principles of this paragraph (e) are illustrated 
by the following examples:

    Example 1. Internal comparable. (i) Company A designs and assembles 
information-technology networks and systems. When Company A renders 
services for uncontrolled parties, it receives compensation based on 
time and materials as well as certain other related costs necessary to 
complete the project. This fee includes the cost of hardware and 
software purchased from uncontrolled vendors and incorporated in the 
final network or system, plus a reasonable allocation of certain 
specified overhead costs incurred by Company A in providing these 
services. Reliable accounting records maintained by Company A indicate 
that Company A earned a gross services profit markup of 10% on its time, 
materials and specified overhead in providing design services during the 
year under examination on information technology projects for 
uncontrolled entities.
    (ii) Company A designed an information-technology network for its 
Country X subsidiary, Company B. The services rendered to Company B are 
similar in scope and complexity to services that Company A rendered to 
uncontrolled parties during the year under examination. Using Company 
A's accounting records (which are determined to be reliable under 
paragraph (e)(3) of this section), it is possible to identify the 
comparable transactional costs involved in the controlled services 
transaction with reference to the costs incurred by Company A in 
rendering similar design services to uncontrolled parties. Company A's 
records indicate that it does not incur any additional types of costs in 
rendering similar services to uncontrolled customers. The data available 
are sufficiently complete to conclude that it is likely that all 
material differences between the controlled and uncontrolled 
transactions have been identified and adjusted for. Based on the gross 
services profit markup data derived from Company A's uncontrolled 
transactions involving similar design services, an arm's length result 
for the controlled services transaction is equal to the price that will 
allow Company A to earn a 10% gross services profit markup on its 
comparable transactional costs.
    Example 2. Inability to adjust for differences in comparable 
transactional costs. The facts are the same as in Example 1, except that 
Company A's staff that rendered the services to Company B consisted 
primarily of engineers in training status or on temporary rotation from 
other Company A subsidiaries. In addition, the Company B network 
incorporated innovative features, including specially designed software 
suited to Company B's requirements. The use of less-experienced 
personnel and staff on temporary rotation, together with the special 
features of the Company B network, significantly increased the time and 
costs associated with the project as compared to time and costs 
associated with similar projects completed for uncontrolled customers. 
These factors constitute material differences between the controlled and 
the uncontrolled transactions that affect the determination of Company 
A's comparable transactional costs associated with the controlled 
services transaction, as well as the gross services profit

[[Page 832]]

markup. Moreover, it is not possible to perform reliable adjustments for 
these differences on the basis of the available accounting data. Under 
these circumstances, the reliability of the cost of services plus method 
as a measure of an arm's length price is substantially reduced.
    Example 3. Operating loss by reference to total services costs. The 
facts and analysis are the same as in Example 1, except that an 
unrelated Company C, instead of Company A, renders similar services to 
uncontrolled parties and publicly available information indicates that 
Company C earned a gross services profit markup of 10% on its time, 
materials and certain specified overhead in providing those services. As 
in Example 1, Company A still provides services for its Country X 
subsidiary, Company B. In accordance with the requirements in paragraph 
(e)(3)(ii) of this section, the taxpayer performs additional analysis 
and restates the results of Company A's controlled services transaction 
with its Country X subsidiary, Company B, in the form of a markup on 
Company A's total services costs. This analysis by reference to total 
services costs shows that Company A generated an operating loss on the 
controlled services transaction, which indicates that functional 
differences likely exist between the controlled services transaction 
performed by Company A and uncontrolled services transactions performed 
by Company C, and that these differences may not be reflected in the 
comparable transactional costs. Upon further scrutiny, the presence of 
such functional differences between the controlled and uncontrolled 
transactions may indicate that the cost of services plus method does not 
provide the most reliable measure of an arm's length result under the 
facts and circumstances.
    Example 4. Internal comparable. (i) Company A, a U.S. corporation, 
and its subsidiaries perform computer consulting services relating to 
systems integration and networking for business clients in various 
countries. Company A and its subsidiaries render only consulting 
services and do not manufacture or distribute computer hardware or 
software to clients. The controlled group is organized according to 
industry specialization, with key industry specialists working for 
Company A. These personnel typically form the core consulting group that 
teams with consultants from the local-country subsidiaries to serve 
clients in the subsidiaries' respective countries.
    (ii) On some occasions, Company A and its subsidiaries undertake 
engagements directly for clients. On other occasions, they work as 
subcontractors for uncontrolled parties on more extensive consulting 
engagements for clients. In undertaking the latter engagements with 
third-party consultants, Company A typically prices its services at four 
times the compensation costs of its consultants, defined as the 
consultants' base salary plus estimated fringe benefits, as defined in 
this table:

------------------------------------------------------------------------
                 Category                               Rate
------------------------------------------------------------------------
Project managers..........................  $100 per hour.
Technical staff...........................  $75 per hour.
------------------------------------------------------------------------

    (iii) In uncontrolled transactions, Company A also charges the 
customer, at no markup, for out-of-pocket expenses such as travel, 
lodging, and data acquisition charges. Thus, for example, a project 
involving 100 hours of time from project managers, and 400 hours of 
technical staff time would result in total compensation costs to Company 
A of (100 hrs. x $100/hr.) + (400 hrs. x $75/hr.) = $10,000 + $30,000 = 
$40,000. Applying the markup of 300%, the total fee charged would thus 
be (4 x $40,000), or $160,000, plus out-of-pocket expenses.
    (iv) Company B, a Country X subsidiary of Company A, contracts to 
render consulting services to a Country X client in the banking 
industry. In undertaking this engagement, Company B uses its own 
consultants and also uses the services of Company A project managers and 
technical staff that specialize in the banking industry for 75 hours and 
380 hours, respectively. The data available are sufficiently complete to 
conclude that it is likely that all material differences between the 
controlled and uncontrolled transactions have been identified and 
adjusted for. Based on reliable data concerning the compensation costs 
to Company A, an arm's length result for the controlled services 
transaction is equal to $144,000. This is calculated as follows: [4 x 
(75 hrs. x $100/hr.)] + [4 x (380 hrs. x $75/hr.)] = $30,000 + $114,000 
= $144,000, reflecting a 300% markup on the total compensation costs for 
Company A project managers and technical staff. In addition, consistent 
with Company A's pricing of uncontrolled transactions, Company B must 
reimburse Company A for appropriate out-of-pocket expenses incurred in 
performing the services.

    (f) Comparable profits method--(1) In general. The comparable 
profits method evaluates whether the amount charged in a controlled 
transaction is arm's length, based on objective measures of 
profitability (profit level indicators) derived from uncontrolled 
taxpayers that engage in similar business activities under similar 
circumstances. The rules in Sec.  1.482-5 relating to the comparable 
profits method apply to controlled services transactions, except as 
modified in this paragraph (f).
    (2) Determination of arm's length result--(i) Tested party. This 
paragraph (f)

[[Page 833]]

applies where the relevant business activity of the tested party as 
determined under Sec.  1.482-5(b)(2) is the rendering of services in a 
controlled services transaction. Where the tested party determined under 
Sec.  1.482-5(b)(2) is instead the recipient of the controlled services, 
the rules under this paragraph (f) are not applicable to determine the 
arm's length result.
    (ii) Profit level indicators. In addition to the profit level 
indicators provided in Sec.  1.482-5(b)(4), a profit level indicator 
that may provide a reliable basis for comparing operating profits of the 
tested party involved in a controlled services transaction and 
uncontrolled comparables is the ratio of operating profit to total 
services costs (as defined in paragraph (j) of this section).
    (iii) Comparability and reliability considerations--Data and 
assumptions--Consistency in accounting. Consistency in accounting 
practices between the relevant business activity of the tested party and 
the uncontrolled service providers is particularly important in 
determining the reliability of the results under this method, but less 
than in applying the cost of services plus method. Adjustments may be 
appropriate if materially different treatment is applied to particular 
cost items related to the relevant business activity of the tested party 
and the uncontrolled service providers. For example, adjustments may be 
appropriate where the tested party and the uncontrolled comparables use 
inconsistent approaches to classify similar expenses as ``cost of goods 
sold'' and ``selling, general, and administrative expenses.'' Although 
distinguishing between these two categories may be difficult, the 
distinction is less important to the extent that the ratio of operating 
profit to total services costs is used as the appropriate profit level 
indicator. Determining whether adjustments are necessary under these or 
similar circumstances requires thorough analysis of the functions 
performed and consideration of the cost accounting practices of the 
tested party and the uncontrolled comparables. Other adjustments as 
provided in Sec.  1.482-5(c)(2)(iv) may also be necessary to increase 
the reliability of the results under this method.
    (3) Examples. The principles of this paragraph (f) are illustrated 
by the following examples:

    Example 1. Ratio of operating profit to total services costs as the 
appropriate profit level indicator. (i) A Country T parent firm, Company 
A, and its Country Y subsidiary, Company B, both engage in manufacturing 
as their principal business activity. Company A also performs certain 
advertising services for itself and its affiliates. In year 1, Company A 
renders advertising services to Company B.
    (ii) Based on the facts and circumstances, it is determined that the 
comparable profits method will provide the most reliable measure of an 
arm's length result. Company A is selected as the tested party. No data 
are available for comparable independent manufacturing firms that render 
advertising services to third parties. Financial data are available, 
however, for ten independent firms that render similar advertising 
services as their principal business activity in Country X. The ten 
firms are determined to be comparable under Sec.  1.482-5(c). Neither 
Company A nor the comparable companies use valuable intangible property 
in rendering the services.
    (iii) Based on the available financial data of the comparable 
companies, it cannot be determined whether these comparable companies 
report costs for financial accounting purposes in the same manner as the 
tested party. The publicly available financial data of the comparable 
companies segregate total services costs into cost of goods sold and 
sales, general and administrative costs, with no further segmentation of 
costs provided. Due to the limited information available regarding the 
cost accounting practices used by the comparable companies, the ratio of 
operating profits to total services costs is determined to be the most 
appropriate profit level indicator. This ratio includes total services 
costs to minimize the effect of any inconsistency in accounting 
practices between Company A and the comparable companies.
    Example 2. Application of the operating profit to total services 
costs profit level indicator. (i) Company A is a foreign subsidiary of 
Company B, a U.S. corporation. Company B is under examination for its 
year 1 taxable year. Company B renders management consulting services to 
Company A. Company B's consulting function includes analyzing Company 
A's operations, benchmarking Company A's financial performance against 
companies in the same industry, and to the extent necessary, developing 
a strategy to improve Company A's operational performance. The 
accounting records of Company B allow reliable identification of the 
total services costs of the consulting staff associated with the 
management consulting services rendered to

[[Page 834]]

Company A. Company A reimburses Company B for its costs associated with 
rendering the consulting services, with no markup.
    (ii) Based on all the facts and circumstances, it is determined that 
the comparable profits method will provide the most reliable measure of 
an arm's length result. Company B is selected as the tested party, and 
its rendering of management consulting services is identified as the 
relevant business activity. Data are available from ten domestic 
companies that operate in the industry segment involving management 
consulting and that perform activities comparable to the relevant 
business activity of Company B. These comparables include entities that 
primarily perform management consulting services for uncontrolled 
parties. The comparables incur similar risks as Company B incurs in 
performing the consulting services and do not make use of valuable 
intangible property or special processes.
    (iii) Based on the available financial data of the comparables, it 
cannot be determined whether the comparables report their costs for 
financial accounting purposes in the same manner as Company B reports 
its costs in the relevant business activity. The available financial 
data for the comparables report only an aggregate figure for costs of 
goods sold and operating expenses, and do not segment the underlying 
services costs. Due to this limitation, the ratio of operating profits 
to total services costs is determined to be the most appropriate profit 
level indicator.
    (iv) For the taxable years 1 through 3, Company B shows the 
following results for the services performed for Company A:

----------------------------------------------------------------------------------------------------------------
                                                      Year 1          Year 2          Year 3          Average
----------------------------------------------------------------------------------------------------------------
Revenues........................................       1,200,000       1,100,000       1,300,000       1,200,000
Cost of Goods Sold..............................         100,000         100,000             N/A          66,667
Operating Expenses..............................       1,100,000       1,000,000       1,300,000       1,133,333
Operating Profit................................               0               0               0               0
----------------------------------------------------------------------------------------------------------------

    (v) After adjustments have been made to account for identified 
material differences between the relevant business activity of Company B 
and the comparables, the average ratio for the taxable years 1 through 3 
of operating profit to total services costs is calculated for each of 
the uncontrolled service providers. Applying each ratio to Company B's 
average total services costs from the relevant business activity for the 
taxable years 1 through 3 would lead to the following comparable 
operating profit (COP) for the services rendered by Company B:

------------------------------------------------------------------------
                                                OP/Total
                                                 service      Company B
        Uncontrolled service provider             costs          COP
                                                (percent)
------------------------------------------------------------------------
Company 1...................................         15.75      $189,000
Company 2...................................         15.00       180,000
Company 3...................................         14.00       168,000
Company 4...................................         13.30       159,600
Company 5...................................         12.00       144,000
Company 6...................................         11.30       135,600
Company 7...................................         11.25       135,000
Company 8...................................         11.18       134,160
Company 9...................................         11.11       133,320
Company 10..................................         10.75       129,000
------------------------------------------------------------------------

    (vi) The available data are not sufficiently complete to conclude 
that it is likely that all material differences between the relevant 
business activity of Company B and the comparables have been identified. 
Therefore, an arm's length range can be established only pursuant to 
Sec.  1.482-1(e)(2)(iii)(B). The arm's length range is established by 
reference to the interquartile range of the results as calculated under 
Sec.  1.482-1(e)(2)(iii)(C), which consists of the results ranging from 
$168,000 to $134,160. Company B's reported average operating profit of 
zero ($0) falls outside this range. Therefore, an allocation may be 
appropriate.
    (vii) Because Company B reported income of zero, to determine the 
amount, if any, of the allocation, Company B's reported operating profit 
for year 3 is compared to the comparable operating profits derived from 
the comparables' results for year 3. The ratio of operating profit to 
total services costs in year 3 is calculated for each of the comparables 
and applied to Company B's year 3 total services costs to derive the 
following results:

------------------------------------------------------------------------
                                                OP/Total
                                                 service
        Uncontrolled service provider          costs (for     Company B
                                                 year 3)         COP
                                                (percent)
------------------------------------------------------------------------
Company 1...................................         15.00      $195,000
Company 2...................................         14.75       191,750
Company 3...................................         14.00       182,000
Company 4...................................         13.50       175,500
Company 5...................................         12.30       159,900
Company 6...................................         11.05       143,650
Company 7...................................         11.03       143,390
Company 8...................................         11.00       143,000
Company 9...................................         10.50       136,500
Company 10..................................         10.25       133,250
------------------------------------------------------------------------

    (viii) Based on these results, the median of the comparable 
operating profits for year 3 is $151,775. Therefore, Company B's income 
for year 3 is increased by $151,775, the difference between Company B's 
reported operating profit for year 3 of zero and the median of the 
comparable operating profits for year 3.

[[Page 835]]

    Example 3. Material difference in accounting for stock-based 
compensation. (i) Taxpayer, a U.S. corporation the stock of which is 
publicly traded, performs controlled services for its wholly-owned 
subsidiaries. The arm's length price of these controlled services is 
evaluated under the comparable profits method for services in paragraph 
(f) of this section by reference to the net cost plus profit level 
indicator (PLI). Taxpayer is the tested party under paragraph (f)(2)(i) 
of this section. The Commissioner identifies the most narrowly 
identifiable business activity of the tested party for which data are 
available that incorporate the controlled transaction (the relevant 
business activity). The Commissioner also identifies four uncontrolled 
domestic service providers, Companies A, B, C, and D, each of which 
performs exclusively activities similar to the relevant business 
activity of Taxpayer that is subject to analysis under paragraph (f) of 
this section. The stock of Companies A, B, C, and D is publicly traded 
on a U.S. stock exchange. Assume that Taxpayer makes an election to 
apply these regulations to earlier taxable years.
    (ii) Stock options are granted to the employees of Taxpayer that 
engage in the relevant business activity. Assume that, as determined 
under a method in accordance with U.S. generally accepted accounting 
principles, the fair value of such stock options attributable to the 
employees' performance of the relevant business activity is 500 for the 
taxable year in question. In evaluating the controlled services, 
Taxpayer includes salaries, fringe benefits, and related compensation of 
these employees in ``total services costs,'' as defined in paragraph (j) 
of this section. Taxpayer does not include any amount attributable to 
stock options in total services costs, nor does it deduct that amount in 
determining ''reported operating profit'' within the meaning of Sec.  
1.482-5(d)(5), for the year under examination.
    (iii) Stock options are granted to the employees of Companies A, B, 
C, and D. Under a fair value method in accordance with U.S. generally 
accepted accounting principles, the comparables include in total 
compensation the value of the stock options attributable to the 
employees' performance of the relevant business activity for the annual 
financial reporting period, and treat this amount as an expense in 
determining operating profit for financial accounting purposes. The 
treatment of employee stock options is summarized in the following 
table:

----------------------------------------------------------------------------------------------------------------
                                                                   Salaries and
                                                                    other non-     Stock options   Stock options
                                                                      option        fair value       expensed
                                                                   compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................           1,000             500               0
Company A.......................................................           7,000           2,000           2,000
Company B.......................................................           4,300             250             250
Company C.......................................................          12,000           4,500           4,500
Company D.......................................................          15,000           2,000           2,000
----------------------------------------------------------------------------------------------------------------

    (iv) A material difference in accounting for stock-based 
compensation (within the meaning of Sec.  1.482-7T(d)(3)(i)) exists. 
Analysis indicates that this difference would materially affect the 
measure of an arm's length result under this paragraph (f). In making an 
adjustment to improve comparability under Sec. Sec.  1.482-1(d)(2) and 
1.482-5(c)(2)(iv), the Commissioner includes in total services costs of 
the tested party the total compensation costs of 1,500 (including stock 
option fair value). In addition, the Commissioner calculates the net 
cost plus PLI by reference to the financial-accounting data of Companies 
A, B, C, and D, which take into account compensatory stock options.
    Example 4. Material difference in utilization of stock-based 
compensation. (i) The facts are the same as in paragraph (i) of Example 
3.
    (ii) No stock options are granted to the employees of Taxpayer that 
engage in the relevant business activity. Thus, no deduction for stock 
options is made in determining ``reported operating profit'' (within the 
meaning of Sec.  1.482-5(d)(5)) for the taxable year under examination.
    (iii) Stock options are granted to the employees of Companies A, B, 
C, and D, but none of these companies expense stock options for 
financial accounting purposes. Under a method in accordance with U.S. 
generally accepted accounting principles, however, Companies A, B, C, 
and D disclose the fair value of the stock options for financial 
accounting purposes. The utilization and treatment of employee stock 
options is summarized in the following table:

----------------------------------------------------------------------------------------------------------------
                                                                   Salaries and
                                                                    other non-     Stock options   Stock options
                                                                      option        fair value       expensed
                                                                   compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................           1,000               0             N/A

[[Page 836]]

 
Company A.......................................................           7,000           2,000               0
Company B.......................................................           4,300             250               0
Company C.......................................................          12,000           4,500               0
Company D.......................................................          15,000           2,000               0
----------------------------------------------------------------------------------------------------------------

    (iv) A material difference in the utilization of stock-based 
compensation (within the meaning of Sec.  1.482-7T(d)(3)(i)) exists. 
Analysis indicates that these differences would materially affect the 
measure of an arm's length result under this paragraph (f). In 
evaluating the comparable operating profits of the tested party, the 
Commissioner uses Taxpayer's total services costs, which include total 
compensation costs of 1,000. In considering whether an adjustment is 
necessary to improve comparability under Sec. Sec.  1.482-1(d)(2) and 
1.482-5(c)(2)(iv), the Commissioner recognizes that the total 
compensation provided to employees of Taxpayer is comparable to the 
total compensation provided to employees of Companies A, B, C, and D. 
Because Companies A, B, C, and D do not expense stock-based compensation 
for financial accounting purposes, their reported operating profits must 
be adjusted in order to improve comparability with the tested party. The 
Commissioner increases each comparable's total services costs, and also 
reduces its reported operating profit, by the fair value of the stock-
based compensation incurred by the comparable company.
    (v) The adjustments to the data of Companies A, B, C, and D 
described in paragraph (iv) of this Example 4 are summarized in the 
following table:

----------------------------------------------------------------------------------------------------------------
                                   Salaries and
                                    other non-     Stock options  Total services     Operating     Net cost plus
                                      option        fair value       costs (A)      profit (B)       PLI (B/A)
                                   compensation                                                      (Percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
    Company A...................           7,000           2,000          25,000           6,000           24.00
    Company B...................           4,300             250          12,500           2,500           20.00
    Company C...................          12,000           4,500          36,000          11,000           30.56
    Company D...................          15,000           2,000          27,000           7,000           25.93
As adjusted:
    Company A...................           7,000           2,000          27,000           4,000           14.81
    Company B...................           4,300             250          12,750           2,250           17.65
    Company C...................          12,000           4,500          40,500           6,500           16.05
    Company D...................          15,000           2,000          29,000           5,000           17.24
----------------------------------------------------------------------------------------------------------------

    Example 5. Non-material difference in utilization of stock-based 
compensation. (i) The facts are the same as in paragraph (i) of Example 
3.
    (ii) Stock options are granted to the employees of Taxpayer that 
engage in the relevant business activity. Assume that, as determined 
under a method in accordance with U.S. generally accepted accounting 
principles, the fair value of such stock options attributable to the 
employees' performance of the relevant business activity is 50 for the 
taxable year. Taxpayer includes salaries, fringe benefits, and all other 
compensation of these employees (including the stock option fair value) 
in ``total services costs,'' as defined in paragraph (j) of this 
section, and deducts these amounts in determining ``reported operating 
profit'' within the meaning of Sec.  1.482-5(d)(5), for the taxable year 
under examination.
    (iii) Stock options are granted to the employees of Companies A, B, 
C, and D, but none of these companies expense stock options for 
financial accounting purposes. Under a method in accordance with U.S. 
generally accepted accounting principles, however, Companies A, B, C, 
and D disclose the fair value of the stock options for financial 
accounting purposes. The utilization and treatment of employee stock 
options is summarized in the following table:

----------------------------------------------------------------------------------------------------------------
                                                                   Salaries and
                                                                    other non-     Stock options   Stock options
                                                                      option        fair value       expensed
                                                                   compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................           1,000              50              50
Company A.......................................................           7,000             100               0
Company B.......................................................           4,300              40               0

[[Page 837]]

 
Company C.......................................................          12,000             130               0
Company D.......................................................          15,000              75               0
----------------------------------------------------------------------------------------------------------------

    (iv) Analysis of the data reported by Companies A, B, C, and D 
indicates that an adjustment for differences in utilization of stock-
based compensation would not have a material effect on the determination 
of an arm's length result.

----------------------------------------------------------------------------------------------------------------
                                   Salaries and
                                    other non-     Stock options  Total services     Operating     Net cost plus
                                      option        fair value       costs (A)      profit (B)       PLI (B/A)
                                   compensation                                                      (percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
    Company A...................           7,000             100          25,000           6,000           24.00
    Company B...................           4,300              40          12,500           2,500           20.00
    Company C...................          12,000             130          36,000          11,000           30.56
    Company D...................          15,000              75          27,000           7,000           25.93
As adjusted:
    Company A...................           7,000             100          25,100           5,900           23.51
    Company B...................           4,300              40          12,540           2,460           19.62
    Company C...................          12,000             130          36,130          10,870           30.09
    Company D...................          15,000              75          27,075           6,925           25.58
----------------------------------------------------------------------------------------------------------------

    (v) Under the circumstances, the difference in utilization of stock-
based compensation would not materially affect the determination of the 
arm's length result under this paragraph (f). Accordingly, in 
calculating the net cost plus PLI, no comparability adjustment is made 
to the data of Companies A, B, C, or D pursuant to Sec. Sec.  1.482-
1(d)(2) and 1.482-5(c)(2)(iv).
    Example 6. Material difference in comparables' accounting for stock-
based compensation. (i) The facts are the same as in paragraph (i) of 
Example 3.
    (ii) Stock options are granted to the employees of Taxpayer that 
engage in the relevant business activity. Assume that, as determined 
under a method in accordance with U.S. generally accepted accounting 
principles, the fair value of such stock options attributable to 
employees' performance of the relevant business activity is 500 for the 
taxable year. Taxpayer includes salaries, fringe benefits, and all other 
compensation of these employees (including the stock option fair value) 
in ``total services costs,'' as defined in paragraph (j) of this 
section, and deducts these amounts in determining ``reported operating 
profit'' (within the meaning of Sec.  1.482-5(d)(5)) for the taxable 
year under examination.
    (iii) Stock options are granted to the employees of Companies A, B, 
C, and D. Companies A and B expense the stock options for financial 
accounting purposes in accordance with U.S. generally accepted 
accounting principles. Companies C and D do not expense the stock 
options for financial accounting purposes. Under a method in accordance 
with U.S. generally accepted accounting principles, however, Companies C 
and D disclose the fair value of these options in their financial 
statements. The utilization and accounting treatment of options are 
depicted in the following table:

----------------------------------------------------------------------------------------------------------------
                                                                    Salary and
                                                                    other non-     Stock options   Stock options
                                                                      option        fair value       expensed
                                                                   compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................           1,000             500             500
Company A.......................................................           7,000           2,000           2,000
Company B.......................................................           4,300             250             250
Company C.......................................................          12,000           4,500               0
Company D.......................................................          15,000           2,000               0
----------------------------------------------------------------------------------------------------------------

    (iv) A material difference in accounting for stock-based 
compensation (within the meaning of Sec.  1.482-7T(d)(3)(i)) exists. 
Analysis indicates that this difference would materially affect the 
measure of the arm's length result under paragraph (f) of this section. 
In evaluating the comparable operating profits of the tested party, the 
Commissioner includes in

[[Page 838]]

total services costs Taxpayer's total compensation costs of 1,500 
(including stock option fair value of 500). In considering whether an 
adjustment is necessary to improve comparability under Sec. Sec.  1.482-
1(d)(2) and 1.482-5(c)(2)(iv), the Commissioner recognizes that the 
total employee compensation (including stock options provided by 
Taxpayer and Companies A, B, C, and D) provides a reliable basis for 
comparison. Because Companies A and B expense stock-based compensation 
for financial accounting purposes, whereas Companies C and D do not, an 
adjustment to the comparables' operating profit is necessary. In 
computing the net cost plus PLI, the Commissioner uses the financial-
accounting data of Companies A and B, as reported. The Commissioner 
increases the total services costs of Companies C and D by amounts equal 
to the fair value of their respective stock options, and reduces the 
operating profits of Companies C and D accordingly.
    (v) The adjustments described in paragraph (iv) of this Example 6 
are depicted in the following table. For purposes of illustration, the 
unadjusted data of Companies A and B are also included.

----------------------------------------------------------------------------------------------------------------
                                   Salaries and
                                    other non-     Stock options  Total services     Operating     Net cost plus
                                      option        fair value       costs (A)      profit (B)       PLI (B/A)
                                   compensation                                                      (percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
    Company A...................           7,000           2,000          27,000           4,000           14.80
    Company B...................           4,300             250          12,750           2,250           17.65
As adjusted:
    Company C...................          12,000           4,500          40,500           6,500           16.05
    Company D...................          15,000           2,000          29,000           5,000           17.24
----------------------------------------------------------------------------------------------------------------


    (g) Profit split method--(1) In general. The profit split method 
evaluates whether the allocation of the combined operating profit or 
loss attributable to one or more controlled transactions is arm's length 
by reference to the relative value of each controlled taxpayer's 
contribution to that combined operating profit or loss. The relative 
value of each controlled taxpayer's contribution is determined in a 
manner that reflects the functions performed, risks assumed and 
resources employed by such controlled taxpayer in the relevant business 
activity. For application of the profit split method (both the 
comparable profit split and the residual profit split), see Sec.  1.482-
6. The residual profit split method may not be used where only one 
controlled taxpayer makes significant nonroutine contributions.
    (2) Examples. The principles of this paragraph (g) are illustrated 
by the following examples:

    Example 1. Residual profit split. (i) Company A, a corporation 
resident in Country X, auctions spare parts by means of an interactive 
database. Company A maintains a database that lists all spare parts 
available for auction. Company A developed the software used to run the 
database. Company A's database is managed by Company A employees in a 
data center located in Country X, where storage and manipulation of data 
also take place. Company A has a wholly-owned subsidiary, Company B, 
located in Country Y. Company B performs marketing and advertising 
activities to promote Company A's interactive database. Company B 
solicits unrelated companies to auction spare parts on Company A's 
database, and solicits customers interested in purchasing spare parts 
online. Company B owns and maintains a computer server in Country Y, 
where it receives information on spare parts available for auction. 
Company B has also designed a specialized communications network that 
connects its data center to Company A's data center in Country X. The 
communications network allows Company B to enter data from uncontrolled 
companies on Company A's database located in Country X. Company B's 
communications network also allows uncontrolled companies to access 
Company A's interactive database and purchase spare parts. Company B 
bore the risks and cost of developing this specialized communications 
network. Company B enters into contracts with uncontrolled companies and 
provides the companies access to Company A's database through the 
Company B network.
    (ii) Analysis of the facts and circumstances indicates that both 
Company A and Company B possess valuable intangible property that they 
use to conduct the spare parts auction business. Company A bore the 
economic risks of developing and maintaining software and the 
interactive database. Company B bore the economic risks of developing 
the necessary technology to transmit information from its server to 
Company A's data center, and to allow uncontrolled companies to access 
Company A's database. Company B helped to enhance the value of Company 
A's

[[Page 839]]

trademark and to establish a network of customers in Country Y. In 
addition, there are no market comparables for the transactions between 
Company A and Company B to reliably evaluate them separately. Given the 
facts and circumstances, the Commissioner determines that a residual 
profit split method will provide the most reliable measure of an arm's 
length result.
    (iii) Under the residual profit split method, profits are first 
allocated based on the routine contributions of each taxpayer. Routine 
contributions include general sales, marketing or administrative 
functions performed by Company B for Company A for which it is possible 
to identify market returns. Any residual profits will be allocated based 
on the nonroutine contributions of each taxpayer. Since both Company A 
and Company B provided nonroutine contributions, the residual profits 
are allocated based on these contributions.
    Example 2. Residual profit split. (i) Company A, a Country 1 
corporation, provides specialized services pertaining to the processing 
and storage of Level 1 hazardous waste (for purposes of this example, 
the most dangerous type of waste). Under long-term contracts with 
private companies and governmental entities in Country 1, Company A 
performs multiple services, including transportation of Level 1 waste, 
development of handling and storage protocols, recordkeeping, and 
supervision of waste-storage facilities owned and maintained by the 
contracting parties. Company A's research and development unit has also 
developed new and unique processes for transport and storage of Level 1 
waste that minimize environmental and occupational effects. In addition 
to this novel technology, Company A has substantial know-how and a long-
term record of safe operations in Country 1.
    (ii) Company A's subsidiary, Company B, has been in operation 
continuously for a number of years in Country 2. Company B has 
successfully completed several projects in Country 2 involving Level 2 
and Level 3 waste, including projects with government-owned entities. 
Company B has a license in Country 2 to handle Level 2 waste (Level 3 
does not require a license). Company B has established a reputation for 
completing these projects in a responsible manner. Company B has 
cultivated contacts with procurement officers, regulatory and licensing 
officials, and other government personnel in Country 2.
    (iii) Country 2 government publishes invitations to bid on a project 
to handle the country's burgeoning volume of Level 1 waste, all of which 
is generated in government-owned facilities. Bidding is limited to 
companies that are domiciled in Country 2 and that possess a license 
from the government to handle Level 1 or Level 2 waste. In an effort to 
submit a winning bid to secure the contract, In an effort to submit a 
winning bid to secure the contract, Company B points to its Level 2 
license and its record of successful completion of projects, and also 
demonstrates to Country 2 government that it has access to substantial 
technical expertise pertaining to processing of Level 1 waste.
    (iv) Company A enters into a long-term technical services agreement 
with Company B. Under this agreement, Company A agrees to supply to 
Company B project managers and other technical staff who have detailed 
knowledge of Company A's proprietary Level 1 remediation techniques. 
Company A commits to perform under any long-term contracts entered into 
by Company B. Company B agrees to compensate Company A based on a markup 
on Company A's marginal costs (pro rata compensation and current 
expenses of Company A personnel). In the bid on the Country 2 contract 
for Level 1 waste remediation, Company B proposes to use a multi-
disciplinary team of specialists from Company A and Company B. Project 
managers from Company A will direct the team, which will also include 
employees of Company B and will make use of physical assets and 
facilities owned by Company B. Only Company A and Company B personnel 
will perform services under the contract. Country 2 grants Company B a 
license to handle Level 1 waste.
    (v) Country 2 grants Company B a five-year, exclusive contract to 
provide processing services for all Level 1 hazardous waste generated in 
County 2. Under the contract, Company B is to be paid a fixed price per 
ton of Level 1 waste that it processes each year. Company B undertakes 
that all services provided will meet international standards applicable 
to processing of Level 1 waste. Company B begins performance under the 
contract.
    (vi) Analysis of the facts and circumstances indicates that both 
Company A and Company B make nonroutine contributions to the Level 1 
waste processing activity in Country 2. In addition, it is determined 
that reliable comparables are not available for the services that 
Company A provides under the long-term contract, in part because those 
services incorporate specialized knowledge and process intangible 
property developed by Company A. It is also determined that reliable 
comparables are not available for the Level 2 license in Country 2, the 
successful track record, the government contacts with Country 2 
officials, and other intangible property that Company B provided. In 
view of these facts, the Commissioner determines that the residual 
profit split method for services in paragraph (g) of this section 
provides the most reliable means of evaluating the arm's length results 
for the transaction. In evaluating the appropriate returns to Company A 
and Company B

[[Page 840]]

for their respective contributions, the Commissioner takes into account 
that the controlled parties incur different risks, because the contract 
between the controlled parties provides that Company A will be 
compensated on the basis of marginal costs incurred, plus a markup, 
whereas the contract between Company B and the government of Country 2 
provides that Company B will be compensated on a fixed-price basis per 
ton of Level 1 waste processed.
    (vii) In the first stage of the residual profit split, an arm's 
length return is determined for routine activities performed by Company 
B in Country 2, such as transportation, recordkeeping, and 
administration. In addition, an arm's length return is determined for 
routine activities performed by Company A (administrative, human 
resources, etc.) in connection with providing personnel to Company B. 
After the arm's length return for these functions is determined, 
residual profits may be present. In the second stage of the residual 
profit split, any residual profit is allocated by reference to the 
relative value of the nonroutine contributions made by each taxpayer. 
Company A's nonroutine contributions include its commitment to perform 
under the contract and the specialized technical knowledge made 
available through the project managers under the services agreement with 
Company B. Company B's nonroutine contributions include its licenses to 
handle Level 1 and Level 2 waste in Country 2, its knowledge of and 
contacts with procurement, regulatory and licensing officials in the 
government of Country 2, and its record in Country 2 of successfully 
handling non-Level 1 waste.

    (h) Unspecified methods. Methods not specified in paragraphs (b) 
through (g) of this section may be used to evaluate whether the amount 
charged in a controlled services transaction is arm's length. Any method 
used under this paragraph (h) must be applied in accordance with the 
provisions of Sec.  1.482-1. Consistent with the specified methods, an 
unspecified method should take into account the general principle that 
uncontrolled taxpayers evaluate the terms of a transaction by 
considering the realistic alternatives to that transaction, including 
economically similar transactions structured as other than services 
transactions, and only enter into a particular transaction if none of 
the alternatives is preferable to it. For example, the comparable 
uncontrolled services price method compares a controlled services 
transaction to similar uncontrolled transactions to provide a direct 
estimate of the price to which the parties would have agreed had they 
resorted directly to a market alternative to the controlled services 
transaction. Therefore, in establishing whether a controlled services 
transaction achieved an arm's length result, an unspecified method 
should provide information on the prices or profits that the controlled 
taxpayer could have realized by choosing a realistic alternative to the 
controlled services transaction (for example, outsourcing a particular 
service function, rather than performing the function itself). As with 
any method, an unspecified method will not be applied unless it provides 
the most reliable measure of an arm's length result under the principles 
of the best method rule. See Sec.  1.482-1(c). Therefore, in accordance 
with Sec.  1.482-1(d) (comparability), to the extent that an unspecified 
method relies on internal data rather than uncontrolled comparables, its 
reliability will be reduced. Similarly, the reliability of a method will 
be affected by the reliability of the data and assumptions used to apply 
the method, including any projections used.

    Example. (i) Company T, a U.S. corporation, develops computer 
software programs including a real estate investment program that 
performs financial analysis of commercial real properties. Companies U, 
V, and W are owned by Company T. The primary business activity of 
Companies U, V, and W is commercial real estate development. For 
business reasons, Company T does not sell the computer program to its 
customers (on a compact disk or via download from Company T's server 
through the Internet). Instead, Company T maintains the software program 
on its own server and allows customers to access the program through the 
Internet by using a password. The transactions between Company T and 
Companies U, V, and W are structured as controlled services transactions 
whereby Companies U, V, and W obtain access via the Internet to Company 
T's software program for financial analysis. Each year, Company T 
provides a revised version of the computer program including the most 
recent data on the commercial real estate market, rendering the old 
version obsolete.
    (ii) In evaluating whether the consideration paid by Companies U, V, 
and W to Company T was arm's length, the Commissioner may consider, 
subject to the best method rule of Sec.  1.482-1(c), Company T's 
alternative of selling the computer program to Companies U, V, and W on 
a compact disk or

[[Page 841]]

via download through the Internet. The Commissioner determines that the 
controlled services transactions between Company T and Companies U, V, 
and W are comparable to the transfer of a similar software program on a 
compact disk or via download through the Internet between uncontrolled 
parties. Subject to adjustments being made for material differences 
between the controlled services transactions and the comparable 
uncontrolled transactions, the uncontrolled transfers of tangible 
property may be used to evaluate the arm's length results for the 
controlled services transactions between Company T and Companies U, V, 
and W.

    (i) Contingent-payment contractual terms for services--(1) 
Contingent-payment contractual terms recognized in general. In the case 
of a contingent-payment arrangement, the arm's length result for the 
controlled services transaction generally would not require payment by 
the recipient to the renderer in the tax accounting period in which the 
service is rendered if the specified contingency does not occur in that 
period. If the specified contingency occurs in a tax accounting period 
subsequent to the period in which the service is rendered, the arm's 
length result for the controlled services transaction generally would 
require payment by the recipient to the renderer on a basis that 
reflects the recipient's benefit from the services rendered and the 
risks borne by the renderer in performing the activities in the absence 
of a provision that unconditionally obligates the recipient to pay for 
the activities performed in the tax accounting period in which the 
service is rendered.
    (2) Contingent-payment arrangement. For purposes of this paragraph 
(i), an arrangement will be treated as a contingent-payment arrangement 
if it meets all of the requirements in paragraph (i)(2)(i) of this 
section and is consistent with the economic substance and conduct 
requirement in paragraph (i)(2)(ii) of this section.
    (i) General requirements--(A) Written contract. The arrangement is 
set forth in a written contract entered into prior to, or 
contemporaneous with, the start of the activity or group of activities 
constituting the controlled services transaction.
    (B) Specified contingency. The contract states that payment for a 
controlled services transaction is contingent (in whole or in part) upon 
the happening of a future benefit (within the meaning of Sec.  1.482-
9(l)(3)) for the recipient directly related to the activity or group of 
activities. For purposes of the preceding sentence, whether the future 
benefit is directly related to the activity or group of activities is 
evaluated based on all the facts and circumstances.
    (C) Basis for payment. The contract provides for payment on a basis 
that reflects the recipient's benefit from the services rendered and the 
risks borne by the renderer.
    (ii) Economic substance and conduct. The arrangement, including the 
contingency and the basis for payment, is consistent with the economic 
substance of the controlled transaction and the conduct of the 
controlled parties. See Sec.  1.482-1(d)(3)(ii)(B).
    (3) Commissioner's authority to impute contingent-payment terms. 
Consistent with the authority in Sec.  1.482-1(d)(3)(ii)(B), the 
Commissioner may impute contingent-payment contractual terms in a 
controlled services transaction if the economic substance of the 
transaction is consistent with the existence of such terms.
    (4) Evaluation of arm's length charge. Whether the amount charged in 
a contingent-payment arrangement is arm's length will be evaluated in 
accordance with this section and other applicable regulations under 
section 482. In evaluating whether the amount charged in a contingent-
payment arrangement for the manufacture, construction, or development of 
tangible or intangible property owned by the recipient is arm's length, 
the charge determined under the rules of Sec. Sec.  1.482-3 and 1.482-4 
for the transfer of similar property may be considered. See Sec.  1.482-
1(f)(2)(ii).
    (5) Examples. The principles of this paragraph (i) are illustrated 
by the following examples:

    Example 1. (i) Company X is a member of a controlled group that has 
operated in the pharmaceutical sector for many years. In year 1, Company 
X enters into a written services agreement with Company Y, another 
member of the controlled group, whereby Company X will perform certain 
research and development activities for Company Y. The parties enter 
into the agreement before Company X undertakes any of

[[Page 842]]

the research and development activities covered by the agreement. At the 
time the agreement is entered into, the possibility that any new 
products will be developed is highly uncertain and the possible market 
or markets for any products that may be developed are not known and 
cannot be estimated with any reliability. Under the agreement, Company Y 
will own any patent or other rights that result from the activities of 
Company X under the agreement and Company Y will make payments to 
Company X only if such activities result in commercial sales of one or 
more derivative products. In that event, Company Y will pay Company X, 
for a specified period, x% of Company Y's gross sales of each of such 
products. Payments are required with respect to each jurisdiction in 
which Company Y has sales of such a derivative product, beginning with 
the first year in which the sale of a product occurs in the jurisdiction 
and continuing for six additional years with respect to sales of that 
product in that jurisdiction.
    (ii) As a result of research and development activities performed by 
Company X for Company Y in years 1 through 4, a compound is developed 
that may be more effective than existing medications in the treatment of 
certain conditions. Company Y registers the patent rights with respect 
to the compound in several jurisdictions in year 4. In year 6, Company Y 
begins commercial sales of the product in Jurisdiction A and, in that 
year, Company Y makes the payment to Company X that is required under 
the agreement. Sales of the product continue in Jurisdiction A in years 
7 through 9 and Company Y makes the payments to Company X in years 7 
through 9 that are required under the agreement.
    (iii) The years under examination are years 6 through 9. In 
evaluating whether the contingent-payment terms will be recognized, the 
Commissioner considers whether the conditions of paragraph (i)(2) of 
this section are met and whether the arrangement, including the 
specified contingency and basis of payment, is consistent with the 
economic substance of the controlled services transaction and with the 
conduct of the controlled parties. The Commissioner determines that the 
contingent-payment arrangement is reflected in the written agreement 
between Company X and Company Y; that commercial sales of products 
developed under the arrangement represent future benefits for Company Y 
directly related to the controlled services transaction; and that the 
basis for the payment provided for in the event such sales occur 
reflects the recipient's benefit and the renderer's risk. Consistent 
with Sec.  1.482-1(d)(3)(ii)(B) and (iii)(B), the Commissioner 
determines that the parties' conduct over the term of the agreement has 
been consistent with their contractual allocation of risk; that Company 
X has the financial capacity to bear the risk that its research and 
development services may be unsuccessful and that it may not receive 
compensation for such services; and that Company X exercises managerial 
and operational control over the research and development, such that it 
is reasonable for Company X to assume the risk of those activities. 
Based on all these facts, the Commissioner determines that the 
contingent-payment arrangement is consistent with economic substance.
    (iv) In determining whether the amount charged under the contingent-
payment arrangement in each of years 6 through 9 is arm's length, the 
Commissioner evaluates under this section and other applicable rules 
under section 482 the compensation paid in each year for the research 
and development services. This analysis takes into account that under 
the contingent-payment terms Company X bears the risk that it might not 
receive payment for its services in the event that those services do not 
result in marketable products and the risk that the magnitude of its 
payment depends on the magnitude of product sales, if any. The 
Commissioner also considers the alternatives reasonably available to the 
parties in connection with the controlled services transaction. One such 
alternative, in view of Company X's willingness and ability to bear the 
risk and expenses of research and development activities, would be for 
Company X to undertake such activities on its own behalf and to license 
the rights to products successfully developed as a result of such 
activities. Accordingly, in evaluating whether the compensation of x% of 
gross sales that is paid to Company X during the first four years of 
commercial sales of derivative products is arm's length, the 
Commissioner may consider the royalties (or other consideration) charged 
for intangible property that are comparable to those incorporated in the 
derivative products and that resulted from Company X's research and 
development activities under the contingent-payment arrangement.
    Example 2. (i) The facts are the same as in Example 1, except that 
no commercial sales ever materialize with regard to the patented 
compound so that, consistent with the agreement, Company Y makes no 
payments to Company X in years 6 through 9.
    (ii) Based on all the facts and circumstances, the Commissioner 
determines that the contingent-payment arrangement is consistent with 
economic substance, and the result (no payments in years 6 through 9) is 
consistent with an arm's length result.
    Example 3. (i) The facts are the same as in Example 1, except that, 
in the event that Company X's activities result in commercial sales of 
one or more derivative products by Company Y, Company Y will pay Company 
X a fee equal to the research and development costs borne by Company X 
plus an amount

[[Page 843]]

equal to x% of such costs, with the payment to be made in the first year 
in which any such sales occur. The x% markup on costs is within the 
range, ascertainable in year 1, of markups on costs of independent 
contract researchers that are compensated under terms that 
unconditionally obligate the recipient to pay for the activities 
performed in the tax accounting period in which the service is rendered. 
In year 6, Company Y makes the single payment to Company X that is 
required under the arrangement.
    (ii) The years under examination are years 6 through 9. In 
evaluating whether the contingent-payment terms will be recognized, the 
Commissioner considers whether the requirements of paragraph (i)(2) of 
this section were met at the time the written agreement was entered into 
and whether the arrangement, including the specified contingency and 
basis for payment, is consistent with the economic substance of the 
controlled services transaction and with the conduct of the controlled 
parties. The Commissioner determines that the contingent-payment terms 
are reflected in the written agreement between Company X and Company Y 
and that commercial sales of products developed under the arrangement 
represent future benefits for Company Y directly related to the 
controlled services transaction. However, in this case, the Commissioner 
determines that the basis for payment provided for in the event such 
sales occur (costs of the services plus x%, representing the markup for 
contract research in the absence of any nonpayment risk) does not 
reflect the recipient's benefit and the renderer's risks in the 
controlled services transaction. Based on all the facts and 
circumstances, the Commissioner determines that the contingent-payment 
arrangement is not consistent with economic substance.
    (iii) Accordingly, the Commissioner determines to exercise its 
authority to impute contingent-payment contractual terms that accord 
with economic substance, pursuant to paragraph (i)(3) of this section 
and Sec.  1.482-1(d)(3)(ii)(B). In this regard, the Commissioner takes 
into account that at the time the arrangement was entered into, the 
possibility that any new products would be developed was highly 
uncertain and the possible market or markets for any products that may 
be developed were not known and could not be estimated with any 
reliability. In such circumstances, it is reasonable to conclude that 
one possible basis of payment, in order to reflect the recipient's 
benefit and the renderer's risks, would be a charge equal to a 
percentage of commercial sales of one or more derivative products that 
result from the research and development activities. The Commissioner in 
this case may impute terms that require Company Y to pay Company X a 
percentage of sales of the products developed under the agreement in 
each of years 6 through 9.
    (iv) In determining an appropriate arm's length charge under such 
imputed contractual terms, the Commissioner conducts an analysis under 
this section and other applicable rules under section 482, and considers 
the alternatives reasonably available to the parties in connection with 
the controlled services transaction. One such alternative, in view of 
Company X's willingness and ability to bear the risks and expenses of 
research and development activities, would be for Company X to undertake 
such activities on its own behalf and to license the rights to products 
successfully developed as a result of such activities. Accordingly, for 
purposes of its determination, the Commissioner may consider the 
royalties (or other consideration) charged for intangible property that 
are comparable to those incorporated in the derivative products that 
resulted from Company X's research and development activities under the 
contingent-payment arrangement.

    (j) Total services costs. For purposes of this section, total 
services costs means all costs of rendering those services for which 
total services costs are being determined. Total services costs include 
all costs in cash or in kind (including stock-based compensation) that, 
based on analysis of the facts and circumstances, are directly 
identified with, or reasonably allocated in accordance with the 
principles of paragraph (k)(2) of this section to, the services. In 
general, costs for this purpose should comprise provision for all 
resources expended, used, or made available to achieve the specific 
objective for which the service is rendered. Reference to generally 
accepted accounting principles or Federal income tax accounting rules 
may provide a useful starting point but will not necessarily be 
conclusive regarding inclusion of costs in total services costs. Total 
services costs do not include interest expense, foreign income taxes (as 
defined in Sec.  1.901-2(a)), or domestic income taxes.
    (k) Allocation of costs--(1) In general. In any case where the 
renderer's activity that results in a benefit (within the meaning of 
paragraph (l)(3) of this section) for one recipient in a controlled 
services transaction also generates a benefit for one or more other 
members of a controlled group (including the benefit, if any, to the 
renderer), and the amount charged under this section

[[Page 844]]

in the controlled services transaction is determined under a method that 
makes reference to costs, costs must be allocated among the portions of 
the activity performed for the benefit of the first mentioned recipient 
and such other members of the controlled group under this paragraph (k). 
The principles of this paragraph (k) must also be used whenever it is 
appropriate to allocate and apportion any class of costs (for example, 
overhead costs) in order to determine the total services costs of 
rendering the services. In no event will an allocation of costs based on 
a generalized or non-specific benefit be appropriate.
    (2) Appropriate method of allocation and apportionment--(i) 
Reasonable method standard. Any reasonable method may be used to 
allocate and apportion costs under this section. In establishing the 
appropriate method of allocation and apportionment, consideration should 
be given to all bases and factors, including, for example, total 
services costs, total costs for a relevant activity, assets, sales, 
compensation, space utilized, and time spent. The costs incurred by 
supporting departments may be apportioned to other departments on the 
basis of reasonable overall estimates, or such costs may be reflected in 
the other departments' costs by applying reasonable departmental 
overhead rates. Allocations and apportionments of costs must be made on 
the basis of the full cost, as opposed to the incremental cost.
    (ii) Use of general practices. The practices used by the taxpayer to 
apportion costs in connection with preparation of statements and 
analyses for the use of management, creditors, minority shareholders, 
joint venturers, clients, customers, potential investors, or other 
parties or agencies in interest will be considered as potential 
indicators of reliable allocation methods, but need not be accorded 
conclusive weight by the Commissioner. In determining the extent to 
which allocations are to be made to or from foreign members of a 
controlled group, practices employed by the domestic members in 
apportioning costs among themselves will also be considered if the 
relationships with the foreign members are comparable to the 
relationships among the domestic members of the controlled group. For 
example, if for purposes of reporting to public stockholders or to a 
governmental agency, a corporation apportions the costs attributable to 
its executive officers among the domestic members of a controlled group 
on a reasonable and consistent basis, and such officers exercise 
comparable control over foreign members of the controlled group, such 
domestic apportionment practice will be considered in determining the 
allocations to be made to the foreign members.
    (3) Examples. The principles of this paragraph (k) are illustrated 
by the following examples:

    Example 1. Company A pays an annual license fee of 500x to an 
uncontrolled taxpayer for unlimited use of a database within the 
corporate group. Under the terms of the license with the uncontrolled 
taxpayer, Company A is permitted to use the database for its own use and 
in rendering research services to its subsidiary, Company B. Company B 
obtains benefits from the database that are similar to those that it 
would obtain if it had independently licensed the database from the 
uncontrolled taxpayer. Evaluation of the arm's length charge (under a 
method in which costs are relevant) to Company B for the controlled 
services that incorporate use of the database must take into account the 
full amount of the license fee of 500x paid by Company A, as reasonably 
allocated and apportioned to the relevant benefits, although the 
incremental use of the database for the benefit of Company B did not 
result in an increase in the license fee paid by Company A.
    Example 2. (i) Company A is a consumer products company located in 
the United States. Companies B and C are wholly-owned subsidiaries of 
Company A and are located in Countries B and C, respectively. Company A 
and its subsidiaries manufacture products for sale in their respective 
markets. Company A hires a consultant who has expertise regarding a 
manufacturing process used by Company A and its subsidiary, Company B. 
Company C, the Country C subsidiary, uses a different manufacturing 
process, and accordingly will not receive any benefit from the outside 
consultant hired by Company A. In allocating and apportioning the cost 
of hiring the outside consultant (100), Company A determines that sales 
constitute the most appropriate allocation key.
    (ii) Company A and its subsidiaries have the following sales:

[[Page 845]]



----------------------------------------------------------------------------------------------------------------
                   Company                           A                B                C              Total
----------------------------------------------------------------------------------------------------------------
Sales.......................................             400              100              200              700
----------------------------------------------------------------------------------------------------------------

    (iii) Because Company C does not obtain any benefit from the 
consultant, none of the costs are allocated to it. Rather, the costs of 
100 are allocated and apportioned ratably to Company A and Company B as 
the entities that obtain a benefit from the campaign, based on the total 
sales of those entities (500). An appropriate allocation of the costs of 
the consultant is as follows:

------------------------------------------------------------------------
             Company                    A            B          Total
------------------------------------------------------------------------
Allocation.......................      400/500      100/500
Amount...........................           80           20          100
------------------------------------------------------------------------

    (l) Controlled services transaction--(1) In general. A controlled 
services transaction includes any activity (as defined in paragraph 
(l)(2) of this section) by one member of a group of controlled taxpayers 
(the renderer) that results in a benefit (as defined in paragraph (l)(3) 
of this section) to one or more other members of the controlled group 
(the recipient(s)).
    (2) Activity. An activity includes the performance of functions, 
assumptions of risks, or use by a renderer of tangible or intangible 
property or other resources, capabilities, or knowledge, such as 
knowledge of and ability to take advantage of particularly advantageous 
situations or circumstances. An activity also includes making available 
to the recipient any property or other resources of the renderer.
    (3) Benefit--(i) In general. An activity is considered to provide a 
benefit to the recipient if the activity directly results in a 
reasonably identifiable increment of economic or commercial value that 
enhances the recipient's commercial position, or that may reasonably be 
anticipated to do so. An activity is generally considered to confer a 
benefit if, taking into account the facts and circumstances, an 
uncontrolled taxpayer in circumstances comparable to those of the 
recipient would be willing to pay an uncontrolled party to perform the 
same or similar activity on either a fixed or contingent-payment basis, 
or if the recipient otherwise would have performed for itself the same 
activity or a similar activity. A benefit may result to the owner of 
intangible property if the renderer engages in an activity that is 
reasonably anticipated to result in an increase in the value of that 
intangible property. Paragraphs (l)(3)(ii) through (v) of this section 
provide guidelines that indicate the presence or absence of a benefit 
for the activities in the controlled services transaction.
    (ii) Indirect or remote benefit. An activity is not considered to 
provide a benefit to the recipient if, at the time the activity is 
performed, the present or reasonably anticipated benefit from that 
activity is so indirect or remote that the recipient would not be 
willing to pay, on either a fixed or contingent-payment basis, an 
uncontrolled party to perform a similar activity, and would not be 
willing to perform such activity for itself for this purpose. The 
determination whether the benefit from an activity is indirect or remote 
is based on the nature of the activity and the situation of the 
recipient, taking into consideration all facts and circumstances.
    (iii) Duplicative activities. If an activity performed by a 
controlled taxpayer duplicates an activity that is performed, or that 
reasonably may be anticipated to be performed, by another controlled 
taxpayer on or for its own account, the activity is generally not 
considered to provide a benefit to the recipient, unless the duplicative 
activity itself provides an additional benefit to the recipient.
    (iv) Shareholder activities. An activity is not considered to 
provide a benefit if the sole effect of that activity is either to 
protect the renderer's capital investment in the recipient or in other 
members of the controlled group, or to facilitate compliance by the 
renderer with reporting, legal, or regulatory requirements applicable 
specifically to the renderer, or both. Activities in the nature of day-
to-day management generally do not relate to protection of the 
renderer's capital investment. Based on analysis of the facts and 
circumstances, activities in connection with a corporate reorganization 
may be

[[Page 846]]

considered to provide a benefit to one or more controlled taxpayers.
    (v) Passive association. A controlled taxpayer generally will not be 
considered to obtain a benefit where that benefit results from the 
controlled taxpayer's status as a member of a controlled group. A 
controlled taxpayer's status as a member of a controlled group may, 
however, be taken into account for purposes of evaluating comparability 
between controlled and uncontrolled transactions.
    (4) Disaggregation of transactions. A controlled services 
transaction may be analyzed as two separate transactions for purposes of 
determining the arm's length consideration, if that analysis is the most 
reliable means of determining the arm's length consideration for the 
controlled services transaction. See the best method rule under Sec.  
1.482-1(c).
    (5) Examples. The principles of this paragraph (l) are illustrated 
by the following examples. In each example, assume that Company X is a 
U.S. corporation and Company Y is a wholly-owned subsidiary of Company X 
in Country B.

    Example 1. In general. In developing a worldwide advertising and 
promotional campaign for a consumer product, Company X pays for and 
obtains designation as an official sponsor of the Olympics. This 
designation allows Company X and all its subsidiaries, including Company 
Y, to identify themselves as sponsors and to use the Olympic logo in 
advertising and promotional campaigns. The Olympic sponsorship campaign 
generates benefits to Company X, Company Y, and other subsidiaries of 
Company X.
    Example 2. Indirect or remote benefit. Based on recommendations 
contained in a study performed by its internal staff, Company X 
implements certain changes in its management structure and the 
compensation of managers of divisions located in the United States. No 
changes were recommended or considered for Company Y in Country B. The 
internal study and the resultant changes in its management may increase 
the competitiveness and overall efficiency of Company X. Any benefits to 
Company Y as a result of the study are, however, indirect or remote. 
Consequently, Company Y is not considered to obtain a benefit from the 
study.
    Example 3. Indirect or remote benefit. Based on recommendations 
contained in a study performed by its internal staff, Company X decides 
to make changes to the management structure and management compensation 
of its subsidiaries, in order to increase their profitability. As a 
result of the recommendations in the study, Company X implements 
substantial changes in the management structure and management 
compensation scheme of Company Y. The study and the changes implemented 
as a result of the recommendations are anticipated to increase the 
profitability of Company X and its subsidiaries. The increased 
management efficiency of Company Y that results from these changes is 
considered to be a specific and identifiable benefit, rather than remote 
or speculative.
    Example 4. Duplicative activities. At its corporate headquarters in 
the United States, Company X performs certain treasury functions for 
Company X and for its subsidiaries, including Company Y. These treasury 
functions include raising capital, arranging medium and long-term 
financing for general corporate needs, including cash management. Under 
these circumstances, the treasury functions performed by Company X do 
not duplicate the functions performed by Company Y's staff. Accordingly, 
Company Y is considered to obtain a benefit from the functions performed 
by Company X.
    Example 5. Duplicative activities. The facts are the same as in 
Example 4, except that Company Y's functions include ensuring that the 
financing requirements of its own operations are met. Analysis of the 
facts and circumstances indicates that Company Y independently 
administers all financing and cash-management functions necessary to 
support its operations, and does not utilize financing obtained by 
Company X. Under the circumstances, the treasury functions performed by 
Company X are duplicative of similar functions performed by Company Y's 
staff, and the duplicative functions do not enhance Company Y's 
position. Accordingly, Company Y is not considered to obtain a benefit 
from the duplicative activities performed by Company X.
    Example 6. Duplicative activities. Company X's in-house legal staff 
has specialized expertise in several areas, including intellectual 
property. The intellectual property legal staff specializes in 
technology licensing, patents, copyrights, and negotiating and drafting 
intellectual property agreements. Company Y is involved in negotiations 
with an unrelated party to enter into a complex joint venture that 
includes multiple licenses and cross-licenses of patents and copyrights. 
Company Y retains outside counsel that specializes in intellectual 
property law to review the transaction documents. Company Y does not 
have in-house counsel of its own to review intellectual property 
transaction documents. Outside counsel advises that the terms for the 
proposed transaction are advantageous to Company Y and that the 
contracts are valid and fully enforceable. Company X's intellectual 
property legal staff possess valuable knowledge of Company Y's

[[Page 847]]

patents and technological achievements. They are capable of identifying 
particular scientific attributes protected under patent that strengthen 
Company Y's negotiating position, and of discovering flaws in the 
patents offered by the unrelated party. To reduce risk associated with 
the transaction, Company X's intellectual property legal staff reviews 
the transaction documents before Company Y executes the contracts. 
Company X's intellectual property legal staff also separately evaluates 
the patents and copyrights with respect to the licensing arrangements 
and concurs in the opinion provided by outside counsel. The activities 
performed by Company X substantially duplicate the legal services 
obtained by Company Y, but they also reduce risk associated with the 
transaction in a way that confers an additional benefit on Company Y.
    Example 7. Shareholder activities. Company X is a publicly held 
corporation. U.S. laws and regulations applicable to publicly held 
corporations such as Company X require the preparation and filing of 
periodic reports that show, among other things, profit and loss 
statements, balance sheets, and other material financial information 
concerning the company's operations. Company X, Company Y and each of 
the other subsidiaries maintain their own separate accounting 
departments that record individual transactions and prepare financial 
statements in accordance with their local accounting practices. Company 
Y, and the other subsidiaries, forward the results of their financial 
performance to Company X, which analyzes and compiles these data into 
periodic reports in accordance with U.S. laws and regulations. Because 
Company X's preparation and filing of the reports relate solely to its 
role as an investor of capital or shareholder in Company Y or to its 
compliance with reporting, legal, or regulatory requirements, or both, 
these activities constitute shareholder activities and therefore Company 
Y is not considered to obtain a benefit from the preparation and filing 
of the reports.
    Example 8. Shareholder activities. The facts are the same as in 
Example 7, except that Company Y's accounting department maintains a 
general ledger recording individual transactions, but does not prepare 
any financial statements (such as profit and loss statements and balance 
sheets). Instead, Company Y forwards the general ledger data to Company 
X, and Company X analyzes and compiles financial statements for Company 
Y, as well as for Company X's overall operations, for purposes of 
complying with U.S. reporting requirements. Company Y is subject to 
reporting requirements in Country B similar to those applicable to 
Company X in the United States. Much of the data that Company X analyzes 
and compiles regarding Company Y's operations for purposes of complying 
with the U.S. reporting requirements are made available to Company Y for 
its use in preparing reports that must be filed in Country B. Company Y 
incorporates these data, after minor adjustments for differences in 
local accounting practices, into the reports that it files in Country B. 
Under these circumstances, because Company X's analysis and compilation 
of Company Y's financial data does not relate solely to its role as an 
investor of capital or shareholder in Company Y, or to its compliance 
with reporting, legal, or regulatory requirements, or both, these 
activities do not constitute shareholder activities.
    Example 9. Shareholder activities. Members of Company X's internal 
audit staff visit Company Y on a semiannual basis in order to review the 
subsidiary's adherence to internal operating procedures issued by 
Company X and its compliance with U.S. anti-bribery laws, which apply to 
Company Y on account of its ownership by a U.S. corporation. Because the 
sole effect of the reviews by Company X's audit staff is to protect 
Company X's investment in Company Y, or to facilitate Company X's 
compliance with U.S. anti-bribery laws, or both, the visits are 
shareholder activities and therefore Company Y is not considered to 
obtain a benefit from the visits.
    Example 10. Shareholder activities. Country B recently enacted 
legislation that changed the foreign currency exchange controls 
applicable to foreign shareholders of Country B corporations. Company X 
concludes that it may benefit from changing the capital structure of 
Company Y, thus taking advantage of the new foreign currency exchange 
control laws in Country B. Company X engages an investment banking firm 
and a law firm to review the Country B legislation and to propose 
possible changes to the capital structure of Company Y. Because Company 
X's retention of the firms facilitates Company Y's ability to pay 
dividends and other amounts and has the sole effect of protecting 
Company X's investment in Company Y, these activities constitute 
shareholder activities and Company Y is not considered to obtain a 
benefit from the activities.
    Example 11. Shareholder activities. The facts are the same as in 
Example 10, except that Company Y bears the full cost of retaining the 
firms to evaluate the new foreign currency control laws in Country B and 
to make appropriate changes to its stock ownership by Company X. Company 
X is considered to obtain a benefit from the rendering by Company Y of 
these activities, which would be shareholder activities if conducted by 
Company X (see Example 10).
    Example 12. Shareholder activities. The facts are the same as in 
Example 10, except that the new laws relate solely to corporate 
governance in Country B, and Company X retains the law firm and 
investment banking

[[Page 848]]

firm in order to evaluate whether restructuring would increase Company 
Y's profitability, reduce the number of legal entities in Country B, and 
increase Company Y's ability to introduce new products more quickly in 
Country B. Because Company X retained the law firm and the investment 
banking firm primarily to enhance Company Y's profitability and the 
efficiency of its operations, and not solely to protect Company X's 
investment in Company Y or to facilitate Company X's compliance with 
Country B's corporate laws, or to both, these activities do not 
constitute shareholder activities.
    Example 13. Shareholder activities. Company X establishes detailed 
personnel policies for its subsidiaries, including Company Y. Company X 
also reviews and approves the performance appraisals of Company Y's 
executives, monitors levels of compensation paid to all Company Y 
personnel, and is involved in hiring and firing decisions regarding the 
senior executives of Company Y. Because this personnel-related activity 
by Company X involves day-to-day management of Company Y, this activity 
does not relate solely to Company X's role as an investor of capital or 
a shareholder of Company Y, and therefore does not constitute a 
shareholder activity.
    Example 14. Shareholder activities. Each year, Company X conducts a 
two-day retreat for its senior executives. The purpose of the retreat is 
to refine the long-term business strategy of Company X and its 
subsidiaries, including Company Y, and to produce a confidential 
strategy statement. The strategy statement identifies several potential 
growth initiatives for Company X and its subsidiaries and lists general 
means of increasing the profitability of the company as a whole. The 
strategy statement is made available without charge to Company Y and the 
other subsidiaries of Company X. Company Y independently evaluates 
whether to implement some, all, or none of the initiatives contained in 
the strategy statement. Because the preparation of the strategy 
statement does not relate solely to Company X's role as an investor of 
capital or a shareholder of Company Y, the expense of preparing the 
document is not a shareholder expense.
    Example 15. Passive association/benefit. Company X is the parent 
corporation of a large controlled group that has been in operation in 
the information-technology sector for ten years. Company Y is a small 
corporation that was recently acquired by the Company X controlled group 
from local Country B owners. Several months after the acquisition of 
Company Y, Company Y obtained a contract to redesign and assemble the 
information-technology networks and systems of a large financial 
institution in Country B. The project was significantly larger and more 
complex than any other project undertaken to date by Company Y. Company 
Y did not use Company X's marketing intangible property to solicit the 
contract, and Company X had no involvement in the solicitation, 
negotiation, or anticipated execution of the contract. For purposes of 
this section, Company Y is not considered to obtain a benefit from 
Company X or any other member of the controlled group because the 
ability of Company Y to obtain the contract, or to obtain the contract 
on more favorable terms than would have been possible prior to its 
acquisition by the Company X controlled group, was due to Company Y's 
status as a member of the Company X controlled group and not to any 
specific activity by Company X or any other member of the controlled 
group.
    Example 16. Passive association/benefit. The facts are the same as 
in Example 15, except that Company X executes a performance guarantee 
with respect to the contract, agreeing to assist in the project if 
Company Y fails to meet certain mileposts. This performance guarantee 
allowed Company Y to obtain the contract on materially more favorable 
terms than otherwise would have been possible. Company Y is considered 
to obtain a benefit from Company X's execution of the performance 
guarantee.
    Example 17. Passive association/benefit. The facts are the same as 
in Example 15, except that Company X began the process of negotiating 
the contract with the financial institution in Country B before 
acquiring Company Y. Once Company Y was acquired by Company X, the 
contract with the financial institution was entered into by Company Y. 
Company Y is considered to obtain a benefit from Company X's negotiation 
of the contract.
    Example 18. Passive association/benefit. The facts are the same as 
in Example 15, except that Company X sent a letter to the financial 
institution in Country B, which represented that Company X had a certain 
percentage ownership in Company Y and that Company X would maintain that 
same percentage ownership interest in Company Y until the contract was 
completed. This letter allowed Company Y to obtain the contract on more 
favorable terms than otherwise would have been possible. Since this 
letter from Company X to the financial institution simply affirmed 
Company Y's status as a member of the controlled group and represented 
that this status would be maintained until the contract was completed, 
Company Y is not considered to obtain a benefit from Company X's 
furnishing of the letter.
    Example 19. Passive association/benefit. (i) S is a company that 
supplies plastic containers to companies in various industries. S 
establishes the prices for its containers through a price list that 
offers customers discounts based solely on the volume of containers 
purchased.

[[Page 849]]

    (ii) Company X is the parent corporation of a large controlled group 
in the information technology sector. Company Y is a wholly-owned 
subsidiary of Company X located in Country B. Company X and Company Y 
both purchase plastic containers from unrelated supplier S. In year 1, 
Company X purchases 1 million units and Company Y purchases 100,000 
units. S, basing its prices on purchases by the entire group, completes 
the order for 1.1 million units at a price of $0.95 per unit, and 
separately bills and ships the orders to each company. Companies X and Y 
undertake no bargaining with supplier S with respect to the price 
charged, and purchase no other products from supplier S.
    (iii) R1 and its wholly-owned subsidiary R2 are a controlled group 
of taxpayers (unrelated to Company X or Company Y) each of which carries 
out functions comparable to those of Companies X and Y and undertakes 
purchases of plastic containers from supplier S, identical to those 
purchased from S by Company X and Company Y, respectively. S, basing its 
prices on purchases by the entire group, charges R1 and R2 $0.95 per 
unit for the 1.1 million units ordered. R1 and R2 undertake no 
bargaining with supplier S with respect to the price charged, and 
purchase no other products from supplier S.
    (iv) U is an uncontrolled taxpayer that carries out comparable 
functions and undertakes purchases of plastic containers from supplier S 
identical to Company Y. U is not a member of a controlled group, 
undertakes no bargaining with supplier S with respect to the price 
charged, and purchases no other products from supplier S. U purchases 
100,000 plastic containers from S at the price of $1.00 per unit.
    (v) Company X charges Company Y a fee of $5,000, or $0.05 per unit 
of plastic containers purchased by Company Y, reflecting the fact that 
Company Y receives the volume discount from supplier S.
    (vi) In evaluating the fee charged by Company X to Company Y, the 
Commissioner considers whether the transactions between R1, R2, and S or 
the transactions between U and S provide a more reliable measure of the 
transactions between Company X, Company Y and S. The Commissioner 
determines that Company Y's status as a member of a controlled group 
should be taken into account for purposes of evaluating comparability of 
the transactions, and concludes that the transactions between R1, R2, 
and S are more reliably comparable to the transactions between Company 
X, Company Y, and S. The comparable charge for the purchase was $0.95 
per unit. Therefore, obtaining the plastic containers at a favorable 
rate (and the resulting $5,000 savings) is entirely due to Company Y's 
status as a member of the Company X controlled group and not to any 
specific activity by Company X or any other member of the controlled 
group. Consequently, Company Y is not considered to obtain a benefit 
from Company X or any other member of the controlled group.
    Example 20. Disaggregation of transactions. (i) X, a domestic 
corporation, is a pharmaceutical company that develops and manufactures 
ethical pharmaceutical products. Y, a Country B corporation, is a 
distribution and marketing company that also performs clinical trials 
for X in Country B. Because Y does not possess the capability to conduct 
the trials, it contracts with a third party to undertake the trials at a 
cost of $100. Y also incurs $25 in expenses related to the third-party 
contract (for example, in hiring and working with the third party).
    (ii) Based on a detailed functional analysis, the Commissioner 
determines that Y performed functions beyond merely facilitating the 
clinical trials for X, such as audit controls of the third party 
performing those trials. In determining the arm's length price, the 
Commissioner may consider a number of alternatives. For example, for 
purposes of determining the arm's length price, the Commissioner may 
determine that the intercompany service is most reliably analyzed on a 
disaggregated basis as two separate transactions: in this case, the 
contract between Y and the third party could constitute an internal CUSP 
with a price of $100. Y would be further entitled to an arm's length 
remuneration for its facilitating services. If the most reliable method 
is one that provides a markup on Y's costs, then ``total services cost'' 
in this context would be $25. Alternatively, the Commissioner may 
determine that the intercompany service is most reliably analyzed as a 
single transaction, based on comparable uncontrolled transactions 
involving the facilitation of similar clinical trial services performed 
by third parties. If the most reliable method is one that provides a 
markup on all of Y's costs, and the base of the markup determined by the 
comparable companies includes the third-party clinical trial costs, then 
such a markup would be applied to Y's total services cost of $125.
    Example 21. Disaggregation of transactions. (i) X performs a number 
of administrative functions for its subsidiaries, including Y, a 
distributor of widgets in Country B. These services include those 
relating to working capital (inventory and accounts receivable/payable) 
management. To facilitate provision of these services, X purchases an 
ERP system specifically dedicated to optimizing working capital 
management. The system, which entails significant third-party costs and 
which includes substantial intellectual property relating to its 
software, costs $1,000.
    (ii) Based on a detailed functional analysis, the Commissioner 
determines that in providing administrative services for Y, X performed 
functions beyond merely operating

[[Page 850]]

the ERP system itself, since X was effectively using the ERP as an input 
to the administrative services it was providing to Y. In determining 
arm's length price for the services, the Commissioner may consider a 
number of alternatives. For example, if the most reliable uncontrolled 
data is derived from companies that use similar ERP systems purchased 
from third parties to perform similar administrative functions for 
uncontrolled parties, the Commissioner may determine that a CPM is the 
best method for measuring the functions performed by X, and, in 
addition, that a markup on total services costs, based on the markup 
from the comparable companies, is the most reliable PLI. In this case, 
total services cost, and the basis for the markup, would include 
appropriate reflection of the ERP costs of $1,000. Alternatively, X's 
functions may be most reliably measured based on comparable uncontrolled 
companies that perform similar administrative functions using their 
customers' own ERP systems. Under these circumstances, the total 
services cost would equal X's costs of providing the administrative 
services excluding the ERP cost of $1,000.

    (m) Coordination with transfer pricing rules for other 
transactions--(1) Services transactions that include other types of 
transactions. A transaction structured as a controlled services 
transaction may include other elements for which a separate category or 
categories of methods are provided, such as a loan or advance, a rental, 
or a transfer of tangible or intangible property. See Sec. Sec.  1.482-
1(b)(2) and 1.482-2(a), (c), and (d). Whether such an integrated 
transaction is evaluated as a controlled services transaction under this 
section or whether one or more elements should be evaluated separately 
under other sections of the section 482 regulations depends on which 
approach will provide the most reliable measure of an arm's length 
result. Ordinarily, an integrated transaction of this type may be 
evaluated under this section and its separate elements need not be 
evaluated separately, provided that each component of the transaction 
may be adequately accounted for in evaluating the comparability of the 
controlled transaction to the uncontrolled comparables and, accordingly, 
in determining the arm's length result in the controlled transaction. 
See Sec.  1.482-1(d)(3).
    (2) Services transactions that effect a transfer of intangible 
property. A transaction structured as a controlled services transaction 
may in certain cases include an element that constitutes the transfer of 
intangible property or may result in a transfer, in whole or in part, of 
intangible property. Notwithstanding paragraph (m)(1) of this section, 
if such element relating to intangible property is material to the 
evaluation, the arm's length result for the element of the transaction 
that involves intangible property must be corroborated or determined by 
an analysis under Sec.  1.482-4.
    (3) Coordination with rules governing cost sharing arrangements. 
Section 1.482-7 provides the specific methods to be used to determine 
arm's length results of controlled transactions in connection with a 
cost sharing arrangement. This section provides the specific methods to 
be used to determine arm's length results of a controlled service 
transaction, including in an arrangement for sharing the costs and risks 
of developing intangibles other than a cost sharing arrangement covered 
by Sec.  1.482-7. In the case of such an arrangement, consideration of 
the principles, methods, comparability, and reliability considerations 
set forth in Sec.  1.482-7 is relevant in determining the best method, 
including an unspecified method, under this section, as appropriately 
adjusted in light of the differences in the facts and circumstances 
between such arrangement and a cost sharing arrangement.
    (4) Other types of transactions that include controlled services 
transactions. A transaction structured other than as a controlled 
services transaction may include one or more elements for which separate 
pricing methods are provided in this section. Whether such an integrated 
transaction is evaluated under another section of the section 482 
regulations or whether one or more elements should be evaluated 
separately under this section depends on which approach will provide the 
most reliable measure of an arm's length result. Ordinarily, a single 
method may be applied to such an integrated transaction, and the 
separate services component of the transaction need not be separately 
analyzed under this section, provided that the controlled services may 
be adequately accounted for in

[[Page 851]]

evaluating the comparability of the controlled transaction to the 
uncontrolled comparables and, accordingly, in determining the arm's 
length results in the controlled transaction. See Sec.  1.482-1(d)(3).
    (5) Examples. The principles of this paragraph (m) are illustrated 
by the following examples:

    Example 1. (i) U.S. parent corporation Company X enters into an 
agreement to maintain equipment of Company Y, a foreign subsidiary. The 
maintenance of the equipment requires the use of spare parts. The cost 
of the spare parts necessary to maintain the equipment amounts to 
approximately 25 percent of the total costs of maintaining the 
equipment. Company Y pays a fee that includes a charge for labor and 
parts.
    (ii) Whether this integrated transaction is evaluated as a 
controlled services transaction or is evaluated as a controlled services 
transaction and the transfer of tangible property depends on which 
approach will provide the most reliable measure of an arm's length 
result. If it is not possible to find comparable uncontrolled services 
transactions that involve similar services and tangible property 
transfers as the controlled transaction between Company X and Company Y, 
it will be necessary to determine the arm's length charge for the 
controlled services, and then to evaluate separately the arm's length 
charge for the tangible property transfers under Sec.  1.482-1 and 
Sec. Sec.  1.482-3 through 1.482-6. Alternatively, it may be possible to 
apply the comparable profits method of Sec.  1.482-5 to evaluate the 
arm's length profit of Company X or Company Y from the integrated 
controlled transaction. The comparable profits method may provide the 
most reliable measure of an arm's length result if uncontrolled parties 
are identified that perform similar, combined functions of maintaining 
and providing spare parts for similar equipment.
    Example 2. (i) U.S. parent corporation Company X sells industrial 
equipment to its foreign subsidiary, Company Y. In connection with this 
sale, Company X renders to Company Y services that consist of 
demonstrating the use of the equipment and assisting in the effective 
start-up of the equipment. Company X structures the integrated 
transaction as a sale of tangible property and determines the transfer 
price under the comparable uncontrolled price method of Sec.  1.482-
3(b).
    (ii) Whether this integrated transaction is evaluated as a transfer 
of tangible property or is evaluated as a controlled services 
transaction and a transfer of tangible property depends on which 
approach will provide the most reliable measure of an arm's length 
result. In this case, the controlled services may be similar to services 
rendered in the transactions used to determine the comparable 
uncontrolled price, or they may appropriately be considered a difference 
between the controlled transaction and comparable transactions with a 
definite and reasonably ascertainable effect on price for which 
appropriate adjustments can be made. See Sec.  1.482-1(d)(3)(ii)(A)(6). 
In either case, application of the comparable uncontrolled price method 
to evaluate the integrated transaction may provide a reliable measure of 
an arm's length result, and application of a separate transfer pricing 
method for the controlled services element of the transaction is not 
necessary.
    Example 3. (i) The facts are the same as in Example 2 except that, 
after assisting Company Y in start-up, Company X also renders ongoing 
services, including instruction and supervision regarding Company Y's 
ongoing use of the equipment. Company X structures the entire 
transaction, including the incremental ongoing services, as a sale of 
tangible property, and determines the transfer price under the 
comparable uncontrolled price method of Sec.  1.482-3(b).
    (ii) Whether this integrated transaction is evaluated as a transfer 
of tangible property or is evaluated as a controlled services 
transaction and a transfer of tangible property depends on which 
approach will provide the most reliable measure of an arm's length 
result. It may not be possible to identify comparable uncontrolled 
transactions in which a seller of merchandise renders services similar 
to the ongoing services rendered by Company X to Company Y. In such a 
case, the incremental services in connection with ongoing use of the 
equipment could not be taken into account as a comparability factor 
because they are not similar to the services rendered in connection with 
sales of similar tangible property. Accordingly, it may be necessary to 
evaluate separately the transfer price for such services under this 
section in order to produce the most reliable measure of an arm's length 
result. Alternatively, it may be possible to apply the comparable 
profits method of Sec.  1.482-5 to evaluate the arm's length profit of 
Company X or Company Y from the integrated controlled transaction. The 
comparable profits method may provide the most reliable measure of an 
arm's length result if uncontrolled parties are identified that perform 
the combined functions of selling equipment and rendering ongoing after-
sale services associated with such equipment. In that case, it would not 
be necessary to separately evaluate the transfer price for the 
controlled services under this section.
    Example 4. (i) Company X, a U.S. corporation, and Company Y, a 
foreign corporation, are members of a controlled group. Both

[[Page 852]]

companies perform research and development activities relating to 
integrated circuits. In addition, Company Y manufactures integrated 
circuits. In years 1 through 3, Company X engages in substantial 
research and development activities, gains significant know-how 
regarding the development of a particular high-temperature resistant 
integrated circuit, and memorializes that research in a written report. 
In years 1 through 3, Company X generates overall net operating losses 
as a result of the expenditures associated with this research and 
development effort. At the beginning of year 4, Company X enters into a 
technical assistance agreement with Company Y. As part of this 
agreement, the researchers from Company X responsible for this project 
meet with the researchers from Company Y and provide them with a copy of 
the written report. Three months later, the researchers from Company Y 
apply for a patent for a high-temperature resistant integrated circuit 
based in large part upon the know-how obtained from the researchers from 
Company X.
    (ii) The controlled services transaction between Company X and 
Company Y includes an element that constitutes the transfer of 
intangible property (such as, know-how). Because the element relating to 
the intangible property is material to the arm's length evaluation, the 
arm's length result for that element must be corroborated or determined 
by an analysis under Sec.  1.482-4.

    (6) Global dealing operations. [Reserved]
    (n) Effective/applicability date--(1) In general. This section is 
generally applicable for taxable years beginning after July 31, 2009. In 
addition, a person may elect to apply the provisions of this section to 
earlier taxable years. See paragraph (n)(2) of this section.
    (2) Election to apply regulations to earlier taxable years--(i) 
Scope of election. A taxpayer may elect to apply Sec.  1.482-1(a)(1), 
(b)(2)(i), (d)(3)(ii)(C) Examples 3 through 6, (d)(3)(v), (f)(2)(ii)(A), 
(f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii) Example 1, (i), (j)(6)(i) and 
(j)(6)(ii), Sec.  1.482-2(b), (f)(1) and (2), Sec.  1.482-4(f)(3)(i)(A), 
(f)(3)(ii) Examples 1 and 2, (f)(4), (h)(1) and (2), Sec.  1.482-
6(c)(2)(ii)(B)(1), (c)(2)(ii)(D), (c)(3)(i)(A), (c)(3)(i)(B), 
(c)(3)(ii)(D), and (d), Sec.  1.482-8(b) Examples 10 through 12, (c)(1) 
and (c)(2), Sec.  1.482-9(a) through (m)(2), and (m)(4) through (n)(2), 
Sec.  1.861-8(a)(5)(ii), (b)(3), (e)(4), (f)(4)(i), (g) Examples 17, 18, 
and 30, Sec.  1.6038A-3(a)(3) Example 4 and (i), Sec.  1.6662-
6(d)(2)(ii)(B), (d)(2)(iii)(B)(4), (d)(2)(iii)(B)(6), and (g), and Sec.  
31.3121(s)-1(c)(2)(iii) and (d) of this chapter to any taxable year 
beginning after September 10, 2003. Such election requires that all of 
the provisions of such sections be applied to such taxable year and all 
subsequent taxable years (earlier taxable years) of the taxpayer making 
the election.
    (ii) Effect of election. An election to apply the regulations to 
earlier taxable years has no effect on the limitations on assessment and 
collection or on the limitations on credit or refund (see Chapter 66 of 
the Internal Revenue Code).
    (iii) Time and manner of making election. An election to apply the 
regulations to earlier taxable years must be made by attaching a 
statement to the taxpayer's timely filed U.S. tax return (including 
extensions) for its first taxable year beginning after July 31, 2009.
    (iv) Revocation of election. An election to apply the regulations to 
earlier taxable years may not be revoked without the consent of the 
Commissioner.

[T.D. 9456, 74 FR 38846, Aug. 4, 2009, as amended by 74 FR 46345, Sept. 
9, 2009; T.D. 9568, 76 FR 80136, Dec. 22, 2011]



Sec.  1.483-1  Interest on certain deferred payments.

    (a) Amount constituting interest in certain deferred payment 
transactions--(1) In general. Except as provided in paragraph (c) of 
this section, section 483 applies to a contract for the sale or exchange 
of property if the contract provides for one or more payments due more 
than 1 year after the date of the sale or exchange, and the contract 
does not provide for adequate stated interest. In general, a contract 
has adequate stated interest if the contract provides for a stated rate 
of interest that is at least equal to the test rate (determined under 
Sec.  1.483-3) and the interest is paid or compounded at least annually. 
Section 483 may apply to a contract whether the contract is express 
(written or oral) or implied. For purposes of section 483, a sale or 
exchange is any transaction treated as a sale or exchange for tax 
purposes. In addition, for purposes of section 483, property includes 
debt instruments and investment units, but does not include money, 
services, or the right to use property. For the treatment of certain 
obligations given in exchange for services or the use of property, see 
sections

[[Page 853]]

404 and 467. For purposes of this paragraph (a), money includes 
functional currency and, in certain circumstances, nonfunctional 
currency. See Sec.  1.988-2(b)(2) for circumstances when nonfunctional 
currency is treated as money rather than as property.
    (2) Treatment of contracts to which section 483 applies--(i) 
Treatment of unstated interest. If section 483 applies to a contract, 
unstated interest under the contract is treated as interest for tax 
purposes. Thus, for example, unstated interest is not treated as part of 
the amount realized from the sale or exchange of property (in the case 
of the seller), and is not included in the purchaser's basis in the 
property acquired in the sale or exchange.
    (ii) Method of accounting for interest on contracts subject to 
section 483. Any stated or unstated interest on a contract subject to 
section 483 is taken into account by a taxpayer under the taxpayer's 
regular method of accounting (e.g., an accrual method or the cash 
receipts and disbursements method). See Sec. Sec.  1.446-1, 1.451-1, and 
1.461-1. For purposes of the preceding sentence, the amount of interest 
(including unstated interest) allocable to a payment under a contract to 
which section 483 applies is determined under Sec.  1.446-2(e).
    (b) Definitions--(1) Deferred payments. For purposes of the 
regulations under section 483, a deferred payment means any payment that 
constitutes all or a part of the sales price (as defined in paragraph 
(b)(2) of this section), and that is due more than 6 months after the 
date of the sale or exchange. Except as provided in section 483(c)(2) 
(relating to the treatment of a debt instrument of the purchaser), a 
payment may be made in the form of cash, stock or securities, or other 
property.
    (2) Sales price. For purposes of section 483, the sales price for 
any sale or exchange is the sum of the amount due under the contract 
(other than stated interest) and the amount of any liability included in 
the amount realized from the sale or exchange. See Sec.  1.1001-2. Thus, 
the sales price for any sale or exchange includes any amount of unstated 
interest under the contract.
    (c) Exceptions to and limitations on the application of section 
483--(1) In general. Sections 483(d), 1274(c)(4), and 1275(b) contain 
exceptions to and limitations on the application of section 483.
    (2) Sales price of $3,000 or less. Section 483(d)(2) applies only if 
it can be determined at the time of the sale or exchange that the sales 
price cannot exceed $3,000, regardless of whether the sales price 
eventually paid for the property is less than $3,000.
    (3) Other exceptions and limitations--(i) Certain transfers subject 
to section 1041. Section 483 does not apply to any transfer of property 
subject to section 1041 (relating to transfers of property between 
spouses or incident to divorce).
    (ii) Treatment of certain obligees. Section 483 does not apply to an 
obligee under a contract for the sale or exchange of personal use 
property (within the meaning of section 1275(b)(3)) in the hands of the 
obligor and that evidences a below-market loan described in section 
7872(c)(1).
    (iii) Transactions involving certain demand loans. Section 483 does 
not apply to any payment under a contract that evidences a demand loan 
that is a below-market loan described in section 7872(c)(1).
    (iv) Transactions involving certain annuity contracts. Section 483 
does not apply to any payment under an annuity contract described in 
section 1275(a)(1)(B) (relating to annuity contracts excluded from the 
definition of debt instrument).
    (v) Options. Section 483 does not apply to any payment under an 
option to buy or sell property.
    (d) Assumptions. If a debt instrument is assumed, or property is 
taken subject to a debt instrument, in connection with a sale or 
exchange of property, the debt instrument is treated for purposes of 
section 483 in a manner consistent with the rules of Sec.  1.1274-5.
    (e) Aggregation rule. For purposes of section 483, all sales or 
exchanges that are part of the same transaction (or a series of related 
transactions) are treated as a single sale or exchange, and all 
contracts calling for deferred payments arising from the same 
transaction (or a series of related transactions) are treated as a 
single contract. This rule, however, generally only applies to contracts 
and to sales

[[Page 854]]

or exchanges involving a single buyer and a single seller.
    (f) Effective date. This section applies to sales and exchanges that 
occur on or after April 4, 1994. Taxpayers, however, may rely on this 
section for sales and exchanges that occur after December 21, 1992, and 
before April 4, 1994.

[T.D. 8517, 59 FR 4805, Feb. 2, 1994]



Sec.  1.483-2  Unstated interest.

    (a) In general--(1) Adequate stated interest. For purposes of 
section 483, a contract has unstated interest if the contract does not 
provide for adequate stated interest. A contract does not provide for 
adequate stated interest if the sum of the deferred payments exceeds--
    (i) The sum of the present values of the deferred payments and the 
present values of any stated interest payments due under the contract; 
or
    (ii) In the case of a cash method debt instrument (within the 
meaning of section 1274A(c)(2)) received in exchange for property in a 
potentially abusive situation (as defined in Sec.  1.1274-3), the fair 
market value of the property reduced by the fair market value of any 
consideration other than the debt instrument, and reduced by the sum of 
all principal payments that are not deferred payments.
    (2) Amount of unstated interest. For purposes of section 483, 
unstated interest means an amount equal to the excess of the sum of the 
deferred payments over the amount described in paragraph (a)(1)(i) or 
(a)(1)(ii) of this section, whichever is applicable.
    (b) Operational rules--(1) In general. For purposes of paragraph (a) 
of this section, rules similar to those in Sec.  1.1274-2 apply to 
determine whether a contract has adequate stated interest and the amount 
of unstated interest, if any, on the contract.
    (2) Present value. For purposes of paragraph (a) of this section, 
the present value of any deferred payment or interest payment is 
determined by discounting the payment from the date it becomes due to 
the date of the sale or exchange at the test rate of interest applicable 
to the contract in accordance with Sec.  1.483-3.
    (c) Examples. The following examples illustrate the rules of this 
section.

    Example 1. Contract that does not have adequate stated interest. On 
January 1, 1995, A sells B nonpublicly traded property under a contract 
that calls for a $100,000 payment of principal on January 1, 2005, and 
10 annual interest payments of $9,000 on January 1 of each year, 
beginning on January 1, 1996. Assume that the test rate of interest is 
9.2 percent, compounded annually. The contract does not provide for 
adequate stated interest because it does not provide for interest equal 
to 9.2 percent, compounded annually. The present value of the deferred 
payments is $98,727.69. As a result, the contract has unstated interest 
of $1,272.31 ($100,000 - $98,727.69).
    Example 2. Contract that does not have adequate stated interest; no 
interest for initial short period. On May 1, 1996, A sells B nonpublicly 
traded property under a contract that calls for B to make a principal 
payment of $200,000 on December 31, 1998, and semiannual interest 
payments of $9,000, payable on June 30 and December 31 of each year, 
beginning on December 31, 1996. Assume that the test rate of interest is 
9 percent, compounded semiannually. Even though the contract calls for a 
stated rate of interest no lower than the test rate of interest, the 
contract does not provide for adequate stated interest because the 
stated rate of interest does not apply for the short period from May 1, 
1996, through June 30, 1996.
    Example 3. Potentially abusive situation. (i) Facts. In a 
potentially abusive situation, a contract for the sale of nonpublicly 
traded personal property calls for the issuance of a cash method debt 
instrument (as defined in section 1274A(c)(2)) with a stated principal 
amount of $700,000, payable in 5 years. No other consideration is given. 
The debt instrument calls for annual payments of interest over its 
entire term at a rate of 9.2 percent, compounded annually (the test rate 
of interest applicable to the debt instrument). Thus, the present value 
of the deferred payment and the interest payments is $700,000. Assume 
that the fair market value of the property is $500,000.
    (ii) Amount of unstated interest. A cash method debt instrument 
received in exchange for property in a potentially abusive situation 
provides for adequate stated interest only if the sum of the deferred 
payments under the instrument does not exceed the fair market value of 
the property. Because the deferred payment ($700,000) exceeds the fair 
market value of the property ($500,000), the debt instrument does not 
provide for adequate stated interest. Therefore, the debt instrument has 
unstated interest of $200,000.
    Example 4. Variable rate debt instrument with adequate stated 
interest; variable rate as of the issue date greater than the test rate. 
(i) Facts. A contract for the sale of nonpublicly traded property calls 
for the issuance of a debt instrument in the principal amount of $75,000

[[Page 855]]

due in 10 years. The debt instrument calls for interest payable 
semiannually at a rate of 3 percentage points above the yield on 6-month 
Treasury bills at the mid-point of the semiannual period immediately 
preceding each interest payment date. Assume that the interest rate is a 
qualified floating rate and that the debt instrument is a variable rate 
debt instrument within the meaning of Sec.  1.1275-5.
    (ii) Adequate stated interest. Under paragraph (b)(1) of this 
section, rules similar to those in Sec.  1.1274-2(f) apply to determine 
whether the debt instrument has adequate stated interest. Assume that 
the test rate of interest applicable to the debt instrument is 9 
percent, compounded semiannually. Assume also that the yield on 6-month 
Treasury bills on the date of the sale is 8.89 percent, which is greater 
than the yield on 6-month Treasury bills on the first date on which 
there is a binding written contract that substantially sets forth the 
terms under which the sale is consummated. Under Sec.  1.1274-2(f), the 
debt instrument is tested for adequate stated interest as if it provided 
for a stated rate of interest of 11.89 percent (3 percent plus 8.89 
percent), compounded semiannually, payable over its entire term. Because 
the test rate of interest is 9 percent, compounded semiannually, and the 
debt instrument is treated as providing for stated interest of 11.89 
percent, compounded semiannually, the debt instrument provides for 
adequate stated interest.

    (d) Effective date. This section applies to sales and exchanges that 
occur on or after April 4, 1994. Taxpayers, however, may rely on this 
section for sales and exchanges that occur after December 21, 1992, and 
before April 4, 1994.

[T.D. 8517, 59 FR 4806, Feb. 2, 1994]



Sec.  1.483-3  Test rate of interest applicable to a contract.

    (a) General rule. For purposes of section 483, the test rate of 
interest for a contract is the same as the test rate that would apply 
under Sec.  1.1274-4 if the contract were a debt instrument. Paragraph 
(b) of this section, however, provides for a lower test rate in the case 
of certain sales or exchanges of land between related individuals.
    (b) Lower rate for certain sales or exchanges of land between 
related individuals--(1) Test rate. In the case of a qualified sale or 
exchange of land between related individuals (described in section 
483(e)), the test rate is not greater than 6 percent, compounded 
semiannually, or an equivalent rate based on an appropriate compounding 
period.
    (2) Special rules. The following rules and definitions apply in 
determining whether a sale or exchange is a qualified sale under section 
483(e):
    (i) Definition of family members. The members of an individual's 
family are determined as of the date of the sale or exchange. The 
members of an individual's family include those individuals described in 
section 267(c)(4) and the spouses of those individuals. In addition, for 
purposes of section 267(c)(4), full effect is given to a legal adoption, 
ancestor means parents and grandparents, and lineal descendants means 
children and grandchildren.
    (ii) $500,000 limitation. Section 483(e) does not apply to the 
extent that the stated principal amount of the debt instrument issued in 
the sale or exchange, when added to the aggregate stated principal 
amount of any other debt instruments to which section 483(e) applies 
that were issued in prior qualified sales between the same two 
individuals during the same calendar year, exceeds $500,000. See Example 
3 of paragraph (b)(3) of this section.
    (iii) Other limitations. Section 483(e) does not apply if the 
parties to a contract include persons other than the related individuals 
and the parties enter into the contract with an intent to circumvent the 
purposes of section 483(e). In addition, if the property sold or 
exchanged includes any property other than land, section 483(e) applies 
only to the extent that the stated principal amount of the debt 
instrument issued in the sale or exchange is attributable to the land 
(based on the relative fair market values of the land and the other 
property).
    (3) Examples. The following examples illustrate the rules of this 
paragraph (b).

    Example 1. On January 1, 1995, A sells land to B, A's child, for 
$650,000. The contract for sale calls for B to make a $250,000 down 
payment and issue a debt instrument with a stated principal amount of 
$400,000. Because the stated principal amount of the debt instrument is 
less than $500,000, the sale is a qualified sale and section 483(e) 
applies to the debt instrument.
    Example 2. The facts are the same as in Example 1 of paragraph 
(b)(3) of this section, except that on June 1, 1995, A sells additional

[[Page 856]]

land to B under a contract that calls for B to issue a debt instrument 
with a stated principal amount of $100,000. The stated principal amount 
of this debt instrument ($100,000) when added to the stated principal 
amount of the prior debt instrument ($400,000) does not exceed $500,000. 
Thus, section 483(e) applies to both debt instruments.
    Example 3. The facts are the same as in Example 1 of paragraph 
(b)(3) of this section, except that on June 1, 1995, A sells additional 
land to B under a contract that calls for B to issue a debt instrument 
with a stated principal amount of $150,000. The stated principal amount 
of this debt instrument when added to the stated principal amount of the 
prior debt instrument ($400,000) exceeds $500,000. Thus, for purposes of 
section 483(e), the debt instrument issued in the sale of June 1, 1995, 
is treated as two separate debt instruments: a $100,000 debt instrument 
(to which section 483(e) applies) and a $50,000 debt instrument (to 
which section 1274, if otherwise applicable, applies).

    (c) Effective date. This section applies to sales and exchanges that 
occur on or after April 4, 1994. Taxpayers, however, may rely on this 
section for sales and exchanges that occur after December 21, 1992, and 
before April 4, 1994.

[T.D. 8517, 59 FR 4807, Feb. 2, 1994]



Sec.  1.483-4  Contingent payments.

    (a) In general. This section applies to a contract for the sale or 
exchange of property (the overall contract) if the contract provides for 
one or more contingent payments and the contract is subject to section 
483. This section applies even if the contract provides for adequate 
stated interest under Sec.  1.483-2. If this section applies to a 
contract, interest under the contract is generally computed and 
accounted for using rules similar to those that would apply if the 
contract were a debt instrument subject to Sec.  1.1275-4(c). 
Consequently, all noncontingent payments under the overall contract are 
treated as if made under a separate contract, and interest accruals on 
this separate contract are computed under rules similar to those 
contained in Sec.  1.1275-4(c)(3). Each contingent payment under the 
overall contract is characterized as principal and interest under rules 
similar to those contained in Sec.  1.1275-4(c)(4). However, any 
interest, or amount treated as interest, on a contract subject to this 
section is taken into account by a taxpayer under the taxpayer's regular 
method of accounting (e.g., an accrual method or the cash receipts and 
disbursements method).
    (b) Examples. The following examples illustrate the provisions of 
paragraph (a) of this section:

    Example 1. Deferred payment sale with contingent interest. (i) 
Facts. On December 31, 1996, A sells depreciable personal property to B. 
As consideration for the sale, B issues to A a debt instrument with a 
maturity date of December 31, 2001. The debt instrument provides for a 
principal payment of $200,000 on the maturity date, and a payment of 
interest on December 31 of each year, beginning in 1997, equal to a 
percentage of the total gross income derived from the property in that 
year. However, the total interest payable on the debt instrument over 
its entire term is limited to a maximum of $50,000. Assume that on 
December 31, 1996, the short-term applicable Federal rate is 4 percent, 
compounded annually, and the mid-term applicable Federal rate is 5 
percent, compounded annually.
    (ii) Treatment of noncontingent payment as separate contract. Each 
payment of interest is a contingent payment. Accordingly, under 
paragraph (a) of this section, for purposes of applying section 483 to 
the debt instrument, the right to the noncontingent payment of $200,000 
is treated as a separate contract. The amount of unstated interest on 
this separate contract is equal to $43,295, which is the amount by which 
the payment ($200,000) exceeds the present value of the payment 
($156,705), calculated using the test rate of 5 percent, compounded 
annually. The $200,000 payment is thus treated as consisting of a 
payment of interest of $43,295 and a payment of principal of $156,705. 
The interest is includible in A's gross income, and deductible by B, 
under their respective methods of accounting.
    (iii) Treatment of contingent payments. Assume that the amount of 
the contingent payment that is paid on December 31, 1997, is $20,000. 
Under paragraph (a) of this section, the $20,000 payment is treated as a 
payment of principal of $19,231 (the present value, as of the date of 
sale, of the $20,000 payment, calculated using a test rate equal to 4 
percent, compounded annually) and a payment of interest of $769. The 
$769 interest payment is includible in A's gross income, and deductible 
by B, in their respective taxable years in which the payment occurs. The 
amount treated as principal gives B additional basis in the property on 
December 31, 1997. The remaining contingent payments on the debt 
instrument are accounted for similarly, using a test rate of 4 percent, 
compounded annually, for the payments made on December 31, 1998, and 
December 31, 1999, and a test rate of

[[Page 857]]

5 percent, compounded annually, for the payments made on December 31, 
2000, and December 31, 2001.
    Example 2. Contingent stock payout. (i) Facts. M Corporation and N 
Corporation each owns one-half of the stock of O Corporation. On 
December 31, 1996, pursuant to a reorganization qualifying under section 
368(a)(1)(B), M acquires the one-half interest of O held by N in 
exchange for 30,000 shares of M voting stock and a non-assignable right 
to receive up to 10,000 additional shares of M's voting stock during the 
next 3 years, provided the net profits of O exceed certain amounts 
specified in the contract. No interest is provided for in the contract. 
No additional shares are received in 1997 or in 1998. In 1999, the 
annual earnings of O exceed the specified amount, and, on December 31, 
1999, an additional 3,000 M voting shares are transferred to N. The fair 
market value of the 3,000 shares on December 31, 1999, is $300,000. 
Assume that on December 31, 1996, the short-term applicable Federal rate 
is 4 percent, compounded annually. M and N are calendar year taxpayers.
    (ii) Allocation of interest. Section 1274 does not apply to the 
right to receive the additional shares because the right is not a debt 
instrument for federal income tax purposes. As a result, the transfer of 
the 3,000 M voting shares to N is a deferred payment subject to section 
483 and a portion of the shares is treated as unstated interest under 
that section. The amount of interest allocable to the shares is equal to 
the excess of $300,000 (the fair market value of the shares on December 
31, 1999) over $266,699 (the present value of $300,000, determined by 
discounting the payment at the test rate of 4 percent, compounded 
annually, from December 31, 1999, to December 31, 1996). As a result, 
the amount of interest allocable to the payment of the shares is $33,301 
($300,000-$266,699). Both M and N take the interest into account in 
1999.

    (c) Effective date. This section applies to sales and exchanges that 
occur on or after August 13, 1996.

[T.D. 8674, 61 FR 30138, June 14, 1996]

 regulations applicable for taxable years beginning on or before april 
                                21, 1993



Sec.  1.482-1A  Allocation of income and deductions among taxpayers.

    (a) Definitions. When used in this section and in Sec.  1.482-2--
    (1) The term ``organization'' includes any organization of any kind, 
whether it be a sole proprietorship, a partnership, a trust, an estate, 
an association, or a corporation (as each is defined or understood in 
the Internal Revenue Code or the regulations thereunder), irrespective 
of the place where organized, where operated, or where its trade or 
business is conducted, and regardless of whether domestic or foreign, 
whether exempt, whether affiliated, or whether a party to a consolidated 
return.
    (2) The term ``trade'' or ``business'' includes any trade or 
business activity of any kind, regardless of whether or where organized, 
whether owned individually or otherwise, and regardless of the place 
where carried on.
    (3) The term ``controlled'' includes any kind of control, direct or 
indirect, whether legally enforceable, and however exercisable or 
exercised. It is the reality of the control which is decisive, not its 
form or the mode of its exercise. A presumption of control arises if 
income or deductions have been arbitrarily shifted.
    (4) The term ``controlled taxpayer'' means any one of two or more 
organizations, trades, or businesses owned or controlled directly or 
indirectly by the same interests.
    (5) The terms ``group'' and ``group of controlled taxpayers'' mean 
the organizations, trades, or businesses owned or controlled by the same 
interests.
    (6) The term ``true taxable income'' means, in the case of a 
controlled taxpayer, the taxable income (or, as the case may be, any 
item or element affecting taxable income) which would have resulted to 
the controlled taxpayer, had it in the conduct of its affairs (or, as 
the case may be, in the particular contract, transaction, arrangement, 
or other act) dealt with the other member or members of the group at 
arm's length. It does not mean the income, the deductions, the credits, 
the allowances, or the item or element of income, deductions, credits, 
or allowances, resulting to the controlled taxpayer by reason of the 
particular contract, transaction, or arrangement, the controlled 
taxpayer, or the interests controlling it, chose to make (even though 
such contract, transaction, or arrangement be legally binding upon the 
parties thereto).
    (b) Scope and purpose. (1) The purpose of section 482 is to place a 
controlled taxpayer on a tax parity with an uncontrolled taxpayer, by 
determining,

[[Page 858]]

according to the standard of an uncontrolled taxpayer, the true taxable 
income from the property and business of a controlled taxpayer. The 
interests controlling a group of controlled taxpayers are assumed to 
have complete power to cause each controlled taxpayer so to conduct its 
affairs that its transactions and accounting records truly reflect the 
taxable income from the property and business of each of the controlled 
taxpayers. If, however, this has not been done, and the taxable incomes 
are thereby understated, the district director shall intervene, and, by 
making such distributions, apportionments, or allocations as he may deem 
necessary of gross income, deductions, credits, or allowances, or of any 
item or element affecting taxable income, between or among the 
controlled taxpayers constituting the group, shall determine the true 
taxable income of each controlled taxpayer. The standard to be applied 
in every case is that of an uncontrolled taxpayer dealing at arm's 
length with another uncontrolled taxpayer.
    (2) Section 482 and this section apply to the case of any controlled 
taxpayer, whether such taxpayer makes a separate or a consolidated 
return. If a controlled taxpayer makes a separate return, the 
determination is of its true separate taxable income. If a controlled 
taxpayer is a party to a consolidated return, the true consolidated 
taxable income of the affiliated group and the true separate taxable 
income of the controlled taxpayer are determined consistently with the 
principles of a consolidated return.
    (3) Section 482 grants no right to a controlled taxpayer to apply 
its provisions at will, nor does it grant any right to compel the 
district director to apply such provisions. It is not intended (except 
in the case of the computation of consolidated taxable income under a 
consolidated return) to effect in any case such a distribution, 
apportionment, or allocation of gross income, deductions, credits, or 
allowances, or any item of gross income, deductions, credits, or 
allowances, as would produce a result equivalent to a computation of 
consolidated taxable income under subchapter A, chapter 6 of the Code.
    (c) Application. Transactions between one controlled taxpayer and 
another will be subjected to special scrutiny to ascertain whether the 
common control is being used to reduce, avoid, or escape taxes. In 
determining the true taxable income of a controlled taxpayer, the 
district director is not restricted to the case of improper accounting, 
to the case of a fraudulent, colorable, or sham transaction, or to the 
case of a device designed to reduce or avoid tax by shifting or 
distorting income, deductions, credits, or allowances. The authority to 
determine true taxable income extends to any case in which either by 
inadvertence or design the taxable income, in whole or in part, of a 
controlled taxpayer, is other than it would have been had the taxpayer 
in the conduct of his affairs been an uncontrolled taxpayer dealing at 
arm's length with another uncontrolled taxpayer.
    (d) Method of allocation. (1) The method of allocating, 
apportioning, or distributing income, deductions, credits, and 
allowances to be used by the district director in any case, including 
the form of the adjustments and the character and source of amounts 
allocated, shall be determined with reference to the substance of the 
particular transactions or arrangements which result in the avoidance of 
taxes or the failure to clearly reflect income. The appropriate 
adjustments may take the form of an increase or decrease in gross 
income, increase or decrease in deductions (including depreciation), 
increase or decrease in basis of assets (including inventory), or any 
other adjustment which may be appropriate under the circumstances. See 
Sec.  1.482-2 for specific rules relating to methods of allocation in 
the case of several types of business transactions.
    (2) Whenever the district director makes adjustments to the income 
of one member of a group of controlled taxpayers (such adjustments being 
referred to in this paragraph as ``primary'' adjustments) he shall also 
make appropriate correlative adjustments to the income of any other 
member of the group involved in the allocation. The correlative 
adjustment shall actually be made if the U.S. income tax liability of 
the other member would be affected

[[Page 859]]

for any pending taxable year. Thus, if the district director makes an 
allocation of income, he shall not only increase the income of one 
member of the group, but shall decrease the income of the other member 
if such adjustment would have an effect on the U.S. income tax liability 
of the other member for any pending taxable year. For the purposes of 
this subparagraph, a ``pending taxable year'' is any taxable year with 
respect to which the U.S. income tax return of the other member has been 
filed by the time the allocation is made, and with respect to which a 
credit or refund is not barred by the operation of any law or rule of 
law. If a correlative adjustment is not actually made because it would 
have no effect on the U.S. income tax liability of the other member 
involved in the allocation for any pending taxable year, such adjustment 
shall nevertheless be deemed to have been made for the purpose of 
determining the U.S. income tax liability of such member for a later 
taxable year, or for the purposes of determining the U.S. income tax 
liability of any person for any taxable year. The district director 
shall furnish to the taxpayer with respect to which the primary 
adjustment is made a written statement of the amount and nature of the 
correlative adjustment which is deemed to have been made. For purposes 
of this subparagraph, a primary adjustment shall not be considered to 
have been made (and therefore a correlative adjustment is not required 
to be made) until the first occurring of the following events with 
respect to the primary adjustment:
    (i) The date of assessment of the tax following execution by the 
taxpayer of a Form 870 (Waiver of Restrictions on Assessment and 
Collection of Deficiency in Tax and Acceptance of Overassessment) with 
respect to such adjustment,
    (ii) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on 
Assessment and Collection Deficiency in Tax and Acceptance of 
Overassessment),
    (iii) Payment of the deficiency,
    (iv) Stipulation in the Tax Court of the United States, or
    (v) Final determination of tax liability by offer-in-compromise, 
closing agreement, or court action.

The principles of this subparagraph may be illustrated by the following 
examples in each of which it is assumed that X and Y are members of the 
same group of controlled entities and that they regularly compute their 
incomes on the basis of a calendar year:

    Example 1. Assume that in 1968 the district director proposes to 
adjust X's income for 1966 to reflect an arm's length rental charge for 
Y's use of X's tangible property in 1966; that X consents to an 
assessment reflecting such adjustment by executing a Waiver, Form 870; 
and that an assessment of the tax with respect to such adjustment is 
made in 1968. The primary adjustment is therefore considered to have 
been made in 1968. Assume further that both X and Y are United States 
corporations and that Y had net operating losses in 1963, 1964, 1965, 
1966, and 1967. Although a correlative adjustment would not have an 
effect on Y's U.S. income tax liability for any pending taxable year, an 
adjustment increasing Y's net operating loss for 1966 shall be deemed to 
have been made for the purposes of determining Y's U.S. income tax 
liability for 1968 or a later taxable year to which the increased 
operating loss may be carried. The district director shall notify X in 
writing of the amount and nature of the adjustment which is deemed to 
have been made to Y.
    Example 2. Assume that X and Y are United States corporations; that 
X is in the business of rendering engineering services; that in 1968 the 
district director proposes to adjust X's income for 1966 to reflect an 
arm's length fee for the rendition of engineering services by X in 1966 
relating to the construction of Y's factory; that X consents to an 
assessment reflecting such adjustment by executing a Waiver, Form 870; 
and that an assessment of the tax with respect to such adjustment is 
made in 1968. Assume further that fees for such services would properly 
constitute a capital expenditure by Y, and that Y does not place the 
factory in service until 1969. Although a correlative adjustment 
(increase in basis) would not have an effect on Y's U.S. income tax 
liability for a pending taxable year, an adjustment increasing the basis 
of Y's assets for 1966 shall be deemed to have been made in 1968 for the 
purpose of computing allowable depreciation or gain or loss on 
disposition for 1969 and any future taxable year. The district director 
shall notify X in writing of the amount and nature of the adjustment 
which is deemed to have been made to Y.
    Example 3. Assume that X is a U.S. taxpayer and Y is a foreign 
taxpayer not engaged in a trade or business in the United

[[Page 860]]

States; that in 1968 the district director proposes to adjust X's income 
for 1966 to reflect an arm's length interest charge on a loan made to Y; 
that X consents to an assessment reflecting such allocation by executing 
a Waiver, Form 870; and that an assessment of the tax with respect to 
such adjustment is made in 1968. Although a correlative adjustment would 
not have an effect on Y's U.S. income tax liability, an adjustment in 
Y's income for 1966 shall be deemed to have been made in 1968 for the 
purposes of determining the amount of Y's earnings and profits for 1966 
and subsequent years, and of any other effect it may have on any 
person's U.S. income tax liability for any taxable year. The district 
director shall notify X in writing of the amount and nature of the 
allocation which is deemed to have been made to Y.

    (3) In making distributions, apportionments, or allocations between 
two members of a group of controlled entities with respect to particular 
transactions, the district director shall consider the effect upon such 
members of an arrangement between them for reimbursement within a 
reasonable period before or after the taxable year if the taxpayer can 
establish that such an arrangement in fact existed during the taxable 
year under consideration. The district director shall also consider the 
effect of any other nonarm's length transaction between them in the 
taxable year which, if taken into account, would result in a setoff 
against any allocation which would otherwise be made, provided the 
taxpayer is able to establish with reasonable specificity that the 
transaction was not at arm's length and the amount of the appropriate 
arm's length charge. For purposes of the preceding sentence, the term 
arm's length refers to the amount which was charged or would have been 
charged in independent transactions with unrelated parties under the 
same or similar circumstances considering all the relevant facts and 
without regard to the rules found in Sec.  1.482-2 by which certain 
charges are deemed to be equal to arm's length. For example, assume that 
one member of a group performs services which benefit a second member, 
which would in itself require an allocation to reflect an arm's length 
charge for the performance of such services. Assume further that the 
first member can establish that during the same taxable year the second 
member engages in other nonarm's length transactions which benefit the 
first member, such as by selling products to the first member at a 
discount, or purchasing products from the first member at a premium, or 
paying royalties to the first member in an excessive amount. In such 
case, the value of the benefits received by the first member as a result 
of the other activities will be set-off against the allocation which 
would otherwise be made. If the effect of the set-off is to change the 
characterization or source of the income or deductions, or otherwise 
distort taxable income, in such a manner as to affect the United States 
tax liability of any member, allocations will be made to reflect the 
correct amount of each category of income or deductions. In order to 
establish that a set-off to the adjustments proposed by the district 
director is appropriate, the taxpayer must notify the district director 
of the basis of any claimed set-off at any time before the expiration of 
the period ending 30 days after the date of a letter by which the 
district director transmits an examination report notifying the taxpayer 
of proposed adjustments or before July 16, 1968, whichever is later. The 
principles of this subparagraph may be illustrated by the following 
examples, in each of which it is assumed that P and S are calendar year 
corporations and are both members of the same group of controlled 
entities:

    Example 1. P performs services in 1966 for the benefit of S in 
connection with S's manufacture and sale of a product. S does not pay P 
for such services in 1966, but in consideration for such services, 
agrees in 1966 to pay P a percentage of the amount of sales of the 
product in 1966 through 1970. In 1966 it appeared this agreement would 
provide adequate consideration for the services. No allocation will be 
made with respect to the services performed by P.
    Example 2. P renders services to S in connection with the 
construction of S's factory. An arm's length charge for such services, 
determined under paragraph (b) of Sec.  1.482-2, would be $100,000. 
During the same taxable year P makes available to S a machine to be used 
in such construction. P bills S $125,000 for the services, but does not 
bill for the use of the machine. No allocation will be made with respect 
to the excessive charge for services or the undercharge for the machine 
if P can establish that the excessive charge for services was equal to 
an arm's length charge for the use of the machine, and if the taxable

[[Page 861]]

income and income tax liabilities of P and S are not distorted.
    Example 3. Assume the same facts as in Example 2, except that, if P 
had reported $25,000 as rental income and $25,000 less service income, 
it would have been subject to the tax on personal holding companies. 
Allocations will be made to reflect the correct amounts of rental income 
and service income.

    (4) If the members of a group of controlled taxpayers engage in 
transactions with one another, the district director may distribute, 
apportion, or allocate income, deductions, credits, or allowances to 
reflect the true taxable income of the individual members under the 
standards set forth in this section and in Sec.  1.482-2 notwithstanding 
the fact that the ultimate income anticipated from a series of 
transactions may not be realized or is realized during a later period. 
For example, if one member of a controlled group sells a product at less 
than an arm's length price to a second member of the group in one 
taxable year and the second member resells the product to an unrelated 
party in the next taxable year, the district director may make an 
appropriate allocation to reflect an arm's length price for the sale of 
the product in the first taxable year, notwithstanding that the second 
member of the group had not realized any gross income from the resale of 
the product in the first year. Similarly, if one member of a group lends 
money to a second member of the group in a taxable year, the district 
director may make an appropriate allocation to reflect an arm's length 
charge for interest during such taxable year even if the second member 
does not realize income during such year. The provisions of this 
subparagraph apply even if the gross income contemplated from a series 
of transactions is never, in fact, realized by the other members.
    (5) Section 482 may, when necessary to prevent the avoidance of 
taxes or to clearly reflect income, be applied in circumstances 
described in sections of the Code (such as section 351) providing for 
nonrecognition of gain or loss. See, for example, ``National Securities 
Corporation v. Commissioner of Internal Revenue'', 137 F. 2d 600 (3d 
Cir. 1943), cert. denied 320 U.S. 794 (1943).
    (6) If payment or reimbursement for the sale, exchange, or use of 
property, the rendition of services, or the advance of other 
consideration among members of a group of controlled entities was 
prevented, or would have been prevented, at the time of the transaction 
because of currency or other restrictions imposed under the laws of any 
foreign country, any distributions, apportionments, or allocations which 
may be made under section 482 with respect to such transactions may be 
treated as deferrable income or deductions, providing the taxpayer has, 
for the year to which the distributions, apportionments, or allocations 
relate, elected to use a method of accounting in which the reporting of 
deferrable income is deferred until the income ceases to be deferrable 
income. Under such method of accounting, referred to in this section as 
the deferred income method of accounting, any payments or reimbursements 
which were prevented or would have been prevented, and any deductions 
attributable directly or indirectly to such payments or reimbursements, 
shall be deferred until they cease to be deferrable under such method of 
accounting. If such method of accounting has not been elected with 
respect to the taxable year to which the allocations under section 482 
relate, the taxpayer may elect such method with respect to such 
allocations (but not with respect to other deferrable income) at any 
time before the first occurring of the following events with respect to 
the allocations:
    (i) Execution by the taxpayer of Form 870 (Waiver of Restrictions on 
Assessment and Collection of Deficiency in Tax and Acceptance of 
Overassessment);
    (ii) Expiration of the period ending 30 days after the date of a 
letter by which the district director transmits an examination report 
notifying the taxpayer of proposed adjustments reflecting such 
allocations or before July 16, 1968, whichever is later; or
    (iii) Execution of a closing agreement or offer-in-compromise.

The principles of this subparagraph may be illustrated by the following 
example in which it is assumed that X, a domestic corporation, and Y, a 
foreign corporation, are members of the same group of controlled 
entities:


[[Page 862]]


    Example. X, which is in the business of rendering a certain type of 
service to unrelated parties, renders such services for the benefit of Y 
in 1965. The direct and indirect costs allocable to such services are 
$60,000, and an arm's length charge for such services is $100,000. 
Assume that the district director proposes to increase X's income by 
$100,000, but that the country in which Y is located would have blocked 
payment in 1965 for such services. If, prior to the first occurring of 
the events described in subdivisions (i), (ii), or (iii) of this 
subparagraph, X elects to use the deferred income method of accounting 
with respect to such allocation, the $100,000 allocation and the $60,000 
of costs are deferrable until such amounts cease to be deferrable under 
X's method of accounting.

[T.D. 6595, 27 FR 3598, Apr. 14, 1962, as amended by T.D. 6952, 33 FR 
5848, Apr. 16, 1968. Redesignated by T.D. 8470, 58 FR 5271, Jan. 21, 
1993]



Sec.  1.482-2A  Determination of taxable income in specific situations.

    (a)-(c) For applicable rules, see Sec.  1.482-2T (a) through (c).
    (d) Transfer or use of intangible property--(1) In general. (i) 
Except as otherwise provided in subparagraph (4) of this paragraph, 
where intangible property or an interest therein is transferred, sold, 
assigned, loaned, or otherwise made available in any manner by one 
member of a group of controlled entities (referred to in this paragraph 
as the transferor) to another member of the group (referred to in this 
paragraph as the transferee) for other than an arm's length 
consideration, the district director may make appropriate allocations to 
reflect an arm's length consideration for such property or its use. 
Subparagraph (2) of this paragraph provides rules for determining the 
form an amount of an appropriate allocation, subparagraph (3) of this 
paragraph provides a definition of ``intangible property'', and 
subparagraph (4) of this paragraph provides rules with respect to 
certain cost-sharing arrangements in connection with the development of 
intangible property. For purposes of this paragraph, an interest in 
intangible property may take the form of the right to use such property.
    (ii)(a) In the absence of a bona fide cost-sharing arrangement (as 
defined in subparagraph (4) of this paragraph), where one member of a 
group of related entities undertakes the development of intangible 
property as a developer within the meaning of (c) of this subdivision, 
no allocation with respect to such development activity shall be made 
under the rules of this paragraph or any other paragraph of this section 
(except as provided in (b) of this subdivision) until such time as any 
property developed, or any interest therein, is or is deemed to be 
transferred, sold, assigned, loaned, or otherwise made available in any 
manner by the developer to a related entity in a transfer subject to the 
rules of this paragraph. Where a member of the group other than the 
developer acquires an interest in the property developed by virtue of 
obtaining a patent or copyright, or by any other means, the developer 
shall be deemed to have transferred such interest in such property to 
the acquiring member in a transaction subject to the rules of this 
paragraph. For example, if one member of a group (the developer) 
undertakes to develop a new patentable product and the costs of 
development are incurred by that entity over a period of 3 years, no 
allocation with respect to that entity's activity shall be made during 
such period. The amount of any allocation that may be appropriate at the 
expiration of such development period when, for example, the patent on 
the product is transferred, or deemed transferred, to a related entity 
for other than an arm's length consideration, shall be determined in 
accordance with the rules of this paragraph.
    (b) Where one member of a group renders assistance in the form of 
loans, services, or the use of tangible or intangible property to a 
developer in connection with an attempt to develop intangible property, 
the amount of any allocation that may be appropriate with respect to 
such assistance shall be determined in accordance with the rules of the 
appropriate paragraph or paragraphs of this section. Thus, where one 
entity allows a related entity, which is the developer, to use tangible 
property, such as laboratory equipment, in connection with the 
development of intangible property, the amount of any allocation that 
may be appropriate with respect to such use shall be determined in 
accordance with

[[Page 863]]

the rules of paragraph (c) of this section. In the event that the 
district director does not exercise his discretion to make allocations 
with respect to the assistance rendered to the developer, the value of 
the assistance shall be allowed as a set-off against any allocation that 
the district director may make under this paragraph as a result of the 
transfer of the intangible property to the entity rendering the 
assistance.
    (c) The determination as to which member of a group of related 
entities is a developer and which members of the group are rendering 
assistance to the developer in connection with its development 
activities shall be based upon all the facts and circumstances of the 
individual case. Of all the facts and circumstances to be taken into 
account in making this determination, greatest weight shall be given to 
the relative amounts of all the direct and indirect costs of development 
and the corresponding risks of development borne by the various members 
of the group, and the relative values of the use of any intangible 
property of members of the group which is made available without 
adequate consideration for use in connection with the development 
activity, which property is likely to contribute to a substantial extent 
in the production of intangible property. For this purpose, the risk to 
be borne with respect to development activity is the possibility that 
such activity will not result in the production of intangible property 
or that the intangible property produced will not be of sufficient value 
to allow for the recovery of the costs of developing it. A member will 
not be considered to have borne the costs and corresponding risks of 
development unless such member is committed to bearing such costs in 
advance of, or contemporaneously with, their incurrence and without 
regard to the success of the project. Other factors that may be relevant 
in determining which member of the group is the developer include the 
location of the development activity, the capabilities of the various 
members to carry on the project independently, and the degree of control 
over the project exercised by the various members.
    (d) The principles of this subdivision (ii) may be illustrated by 
the following examples in which it is assumed that X and Y are corporate 
members of the same group:

    Example 1. X, at the request of Y, undertakes to develop a new 
machine which will function effectively in the climate in which Y's 
factory is located. Y agrees to bear all the direct and indirect costs 
of the project whether or not X successfully develops the machine. 
Assume that X does not make any of its own intangible property available 
for use in connection with the project. The machine is successfully 
developed and Y obtains possession of the intangible property necessary 
to produce such machine. Based on the facts and circumstances as stated, 
Y shall be considered to be the developer of the intangible property 
and, therefore, Y shall not be treated as having obtained the property 
in a transfer subject to the rules of this paragraph. Any amount which 
may be allocable with respect to the assistance rendered by X shall be 
determined in accordance with the rules of (b) of this subdivision.
    Example 2. Assume the same facts as in Example 1 except that Y 
agrees to reimburse X for its costs only in the event that the property 
is successfully developed. In such case X is the developer and Y is 
deemed to have received the property in a transfer subject to the rules 
of this paragraph. Therefore, the district director may make an 
allocation to reflect an arm's length consideration for such property.
    Example 3. In 1967 X undertakes to develop product M in its research 
and development department. X incurs direct and indirect costs of $1 
million per year in connection with the project in 1967, 1968, and 1969. 
In connection with the project, X employs the formula for compound N, 
which it owns, and which is likely to contribute substantially to the 
success of the project. The value of the use of the formula for compound 
N in connection with this project is $750,000. In 1968, 4 chemists 
employed by Y spend 6 months working on the project in X's laboratory. 
The salary and other expenses connected with the chemists' employment 
for that period ($100,000) are paid by Y, for which no charge is made to 
X. In 1969, product M is perfected and Y obtains patents thereon. X is 
considered to be the developer of product M since, among other things, 
it bore the greatest relative share of the costs and risks incurred in 
connection with this project and made available intangible property 
(formula for compound N) which was likely to contribute substantially in 
the development of product M. Accordingly, no allocation with respect to 
X's development activity should be made before 1969. The property is 
deemed to have been transferred to Y at that time by

[[Page 864]]

virtue of the fact that Y obtained the patent rights to product M. In 
such case the district director may make an allocation to reflect an 
arm's length consideration for such transfer. In the event that the 
district director makes such an allocation and he has not made or does 
not make an allocation for 1968 with respect to the services of the 
chemists in accordance with the principles of paragraph (b) of this 
section, the value of the assistance shall be allowed as a set-off 
against the amount of the allocation reflecting an arm's length 
consideration for the transfer of the intangible property.

    (2) Arm's length consideration. (i) An arm's length consideration 
shall be in a form which is consistent with the form which would be 
adopted in transactions between unrelated parties under the same 
circumstances. To the extent appropriate, an arm's length consideration 
may take any one or more of the following forms:
    (a) Royalties based on the transferee's output, sales, profits, or 
any other measure;
    (b) Lump-sum payments; or
    (c) Any other form, including reciprocal licensing rights, which 
might reasonably have been adopted by unrelated parties under the 
circumstances, provided that the parties can establish that such form 
was adopted pursuant to an arrangement which in fact existed between 
them.


However, where the transferee pays nominal or no consideration for the 
property or interest therein and where the transferor has retained a 
substantial interest in the property, an allocation shall be presumed 
not to take the form of a lump-sum payment.
    (ii) In determining the amount of an arm's length consideration, the 
standard to be applied is the amount that would have been paid by an 
unrelated party for the same intangible property under the same 
circumstances. Where there have been transfers by the transferor to 
unrelated parties involving the same or similar intangible property 
under the same or similar circumstances the amount of the consideration 
for such transfers shall generally be the best indication of an arm's 
length consideration.
    (iii) Where a sufficiently similar transaction involving an 
unrelated party cannot be found, the following factors, to the extent 
appropriate (depending upon the type of intangible property and the form 
of the transfer), may be considered in arriving at the amount of the 
arm's length consideration:
    (a) The prevailing rates in the same industry or for similar 
property,
    (b) The offers of competing transferors or the bids of competing 
transferees,
    (c) The terms of the transfer, including limitations on the 
geographic area covered and the exclusive or nonexclusive character of 
any rights granted,
    (d) The uniqueness of the property and the period for which it is 
likely to remain unique,
    (e) The degree and duration of protection afforded to the property 
under the laws of the relevant countries.
    (f) Value of services rendered by the transferor to the transferee 
in connection with the transfer within the meaning of paragraph (b)(8) 
of this section,
    (g) Prospective profits to be realized or costs to be saved by the 
transferee through its use or subsequent transfer of the property,
    (h) The capital investment and starting up expenses required of the 
transferee,
    (i) The next subdivision is (j),
    (j) The availability of substitutes for the property transferred,
    (k) The arm's length rates and prices paid by unrelated parties 
where the property is resold or sublicensed to such parties,
    (l) The costs incurred by the transferor in developing the property, 
and
    (m) Any other fact or circumstance which unrelated parties would 
have been likely to consider in determining the amount of an arm's 
length consideration for the property.
    (3) Definition of intangible property. (i) Solely for the purposes 
of this section, intangible property shall consist of the items 
described in subdivision (ii) of this subparagraph, provided that such 
items have substantial value independent of the services of individual 
persons.
    (ii) The items referred to in subdivision (i) of this subparagraph 
are as follows:
    (a) Patents, inventions, formulas, processes, designs, patterns, and 
other similar items;

[[Page 865]]

    (b) Copyrights, literary, musical, or artistic compositions, and 
other similar items;
    (c) Trademarks, trade names, brand names, and other similar items;
    (d) Franchises, licenses, contracts, and other similar items;
    (e) Methods, programs, systems, procedures, campaigns, surveys, 
studies, forecasts, estimates, customer lists, technical data, and other 
similar items.
    (4) Sharing of costs and risks. Where a member of a group of 
controlled entities acquires an interest in intangible property as a 
participating party in a bona fide cost sharing arrangement with respect 
to the development of such intangible property, the district director 
shall not make allocations with respect to such acquisition except as 
may be appropriate to reflect each participant's arm's length share of 
the costs and risks of developing the property. A bona fide cost sharing 
arrangement is an agreement, in writing, between two or more members of 
a group of controlled entities providing for the sharing of the costs 
and risks of developing intangible property in return for a specified 
interest in the intangible property that may be produced. In order for 
the arrangement to qualify as a bona fide arrangement, it must reflect 
an effort in good faith by the participating members to bear their 
respective shares of all the costs and risks of development on an arm's 
length basis. In order for the sharing of costs and risk to be 
considered on an arm's length basis, the terms and conditions must be 
comparable to those which would have been adopted by unrelated parties 
similarly situated had they entered into such an arrangement. If an oral 
cost sharing arrangement, entered into prior to April 16, 1968, and 
continued in effect after that date, is otherwise in compliance with the 
standards prescribed in this subparagraph, it shall constitute a bona 
fide cost sharing arrangement if it is reduced to writing prior to 
January 1, 1969.
    (e) Sales of tangible property--(1) In general. (i) Where one member 
of a group of controlled entities (referred to in this paragraph as the 
``seller'') sells or otherwise disposes of tangible property to another 
member of such group (referred to in this paragraph as the ``buyer'') at 
other than an arm's length price (such a sale being referred to in this 
paragraph as a ``controlled sale''), the district director may make 
appropriate allocations between the seller and the buyer to reflect an 
arm's length price for such sale or disposition. An arm's length price 
is the price that an unrelated party would have paid under the same 
circumstances for the property involved in the controlled sale. Since 
unrelated parties normally sell products at a profit, an arm's length 
price normally involves a profit to the seller.
    (ii) Subparagraphs (2), (3), and (4) of this paragraph describe 
three methods of determining an arm's-length price and the standards for 
applying each method. They are, respectively, the comparable 
uncontrolled price method, the resale price method, and the cost-plus 
method. In addition, a special rule is provided in subdivision (v) of 
this subparagraph for use (notwithstanding any other provision of this 
subdivision) in determining an arm's-length price for an ore or mineral. 
If there are comparable uncontrolled sales as defined in subparagraph 
(2) of this paragraph, the comparable uncontrolled price method must be 
utilized because it is the method likely to result in the most accurate 
estimate of an arm's-length price (for the reason that it is based upon 
the price actually paid by unrelated parties for the same or similar 
products). If there are no comparable uncontrolled sales, then the 
resale price method must be utilized if the standards for its 
application are met because it is the method likely to result in the 
next most accurate estimate in such instances (for the reason that, in 
such instances, the arm's-length price determined under such method is 
based more directly upon actual arm's-length transactions than is the 
cost-plus method). A typical situation where the resale price method may 
be required is where a manufacturer sells products to a related 
distributor which, without further processing, resells the products in 
uncontrolled transactions. If all the standards for the mandatory 
application of the resale price method are not

[[Page 866]]

satisfied, then, as provided in subparagraph (3)(iii) of this paragraph, 
either that method or the cost-plus method may be used, depending upon 
which method is more feasible and is likely to result in a more accurate 
estimate of an arm's-length price. A typical situation where the cost-
plus method may be appropriate is where a manufacturer sells products to 
a related entity which performs substantial manufacturing, assembly, or 
other processing of the product or adds significant value by reason of 
its utilization of its intangible property prior to resale in 
uncontrolled transactions.
    (iii) Where the standards for applying one of the three methods of 
pricing described in subdivision (ii) of this subparagraph are met, such 
method must, for the purposes of this paragraph, be utilized unless the 
taxpayer can establish that, considering all the facts and 
circumstances, some method of pricing other than those described in 
subdivision (ii) of this subparagraph is clearly more appropriate. Where 
none of the three methods of pricing described in subdivision (ii) of 
this subparagraph can reasonably be applied under the facts and 
circumstances as they exist in a particular case, some appropriate 
method of pricing other than those described in subdivision (ii) of this 
subparagraph, or variations on such methods, can be used.
    (iv) The methods of determining arm's length prices described in 
this section are stated in terms of their application to individual 
sales of property. However, because of the possibility that a taxpayer 
may make controlled sales of many different products, or many separate 
sales of the same product, it may be impractical to analyze every sale 
for the purposes of determining the arm's length price. It is therefore 
permissible to determine or verify arm's length prices by applying the 
appropriate methods of pricing to product lines or other groupings where 
it is impractical to ascertain an arm's length price for each product or 
sale. In addition, the district director may determine or verify the 
arm's length price of all sales to a related entity by employing 
reasonable statistical sampling techniques.
    (v) The price for a mineral product which is sold at the stage at 
which mining or extraction ends shall be determined under the provisions 
of Sec. Sec.  1.613-3 and 1.613-4.
    (2) Comparable uncontrolled price method. (i) Under the method of 
pricing described as the ``comparable uncontrolled price method'', the 
arm's length price of a controlled sale is equal to the price paid in 
comparable uncontrolled sales, adjusted as provided in subdivision (ii) 
of this subparagraph.
    (ii) ``Uncontrolled sales'' are sales in which the seller and the 
buyer are not members of the same controlled group. These include (a) 
sales made by a member of the controlled group to an unrelated party, 
(b) sales made to a member of the controlled group by an unrelated 
party, and (c) sales made in which the parties are not members of the 
controlled group and are not related to each other. However, 
uncontrolled sales do not include sales at unrealistic prices, as for 
example where a member makes uncontrolled sales in small quantities at a 
price designed to justify a nonarm's length price on a large volume of 
controlled sales. Uncontrolled sales are considered comparable to 
controlled sales if the physical property and circumstances involved in 
the uncontrolled sales are identical to the physical property and 
circumstances involved in the controlled sales, or if such properties 
and circumstances are so nearly identical that any differences either 
have no effect on price, or such differences can be reflected by a 
reasonable number of adjustments to the price of uncontrolled sales. For 
this purpose, differences can be reflected by adjusting prices only 
where such differences have a definite and reasonably ascertainable 
effect on price. If the differences can be reflected by such adjustment, 
then the price of the uncontrolled sale as adjusted constitutes the 
comparable uncontrolled sale price. Some of the differences which may 
affect the price of property are differences in the quality of the 
product, terms of sale, intangible property associated with the sale, 
time of sale, and the level of the market and the geographic market in 
which the sale takes place. Whether and to what extent differences in 
the various properties and

[[Page 867]]

circumstances affect price, and whether differences render sales 
noncomparable, depends upon the particular circumstances and property 
involved. The principles of this subdivision may be illustrated by the 
following examples, in each of which it is assumed that X makes both 
controlled and uncontrolled sales of the identical property:

    Example 1. Assume that the circumstances surrounding the controlled 
and the uncontrolled sales are identical, except for the fact that the 
controlled sales price is a delivered price and the uncontrolled sales 
are made f.o.b. X's factory. Since differences in terms of 
transportation and insurance generally have a definite and reasonably 
ascertainable effect on price, such differences do not normally render 
the uncontrolled sales noncomparable to the controlled sales.
    Example 2. Assume that the circumstances surrounding the controlled 
and uncontrolled sales are identical, except for the fact that X affixes 
its valuable trademark in the controlled sales, and does not affix its 
trademark in uncontrolled sales. Since the effects on price of 
differences in intangible property associated with the sale of tangible 
property, such as trademarks, are normally not reasonably ascertainable, 
such differences would normally render the uncontrolled sales 
noncomparable.
    Example 3. Assume that the circumstances surrounding the controlled 
and uncontrolled sales are identical, except for the fact that X, a 
manufacturer of business machines, makes certain minor modifications in 
the physical properties of the machines to satisfy safety specifications 
or other specific requirements of a customer in controlled sales, and 
does not make these modifications in uncontrolled sales. Since minor 
physical differences in the product generally have a definite and 
reasonably ascertainable effect on prices, such differences do not 
normally render the uncontrolled sales noncomparable to the controlled 
sales.

    (iii) Where there are two or more comparable uncontrolled sales 
susceptible of adjustment as defined in subdivision (ii) of this 
subparagraph, the comparable uncontrolled sale or sales requiring the 
fewest and simplest adjustments provided in subdivision (ii) of this 
subparagraph should generally be selected. Thus, for example, if a 
taxpayer makes comparable uncontrolled sales of a particular product 
which differ from the controlled sale only with respect to the terms of 
delivery, and makes other comparable uncontrolled sales of the product 
which differ from the controlled sale with respect to both terms of 
delivery and terms of payment, the comparable uncontrolled sales 
differing only with respect to terms of delivery should be selected as 
the comparable uncontrolled sale.
    (iv) One of the circumstances which may affect the price of property 
is the fact that the seller may desire to make sales at less than a 
normal profit for the primary purpose of establishing or maintaining a 
market for his products. Thus, a seller may be willing to reduce the 
price of a product, for a time, in order to introduce his product into 
an area or in order to meet competition. However, controlled sales may 
be priced in such a manner only if such price would have been charged in 
an uncontrolled sale under comparable circumstances. Such fact may be 
demonstrated by showing that the buyer in the controlled sale made 
corresponding reductions in the resale price to uncontrolled purchasers, 
or that such buyer engaged in substantially greater sales promotion 
activities with respect to the product involved in the controlled sale 
than with respect to other products. For example, assume X, a 
manufacturer of batteries, commences to sell car batteries to Y, a 
subsidiary of X, for resale in a new market. In its existing markets X's 
batteries sell to independent retailers at $20 per unit, and X sells 
them to wholesalers at $17 per unit. Y also sells X's batteries to 
independent retailers at $20 per unit. X's batteries are not known in 
the new market in which Y is operating. In order to engage competitively 
in the new market Y incurs selling and advertising costs substantially 
higher than those incurred for its sales of other products. Under these 
circumstances X may sell to Y, for a time, at less than $17 to take into 
account the increased selling and advertising activities of Y in 
penetrating and establishing the new market. This may be done even 
though it may result in a transfer price from X to Y which is below X's 
full costs of manufacturing the product.
    (3) Resale price method. (i) Under the pricing method described as 
the ``resale price method'', the arm's length price

[[Page 868]]

of a controlled sale is equal to the applicable resale price (as defined 
in subdivision (iv) or (v) of this subparagraph), reduced by an 
appropriate markup, and adjusted as provided in subdivision (ix) of this 
subparagraph. An appropriate markup is computed by multiplying the 
applicable resale price by the appropriate markup percentage as defined 
in subdivision (vi) of this subparagraph. Thus, where one member of a 
group of controlled entities sells property to another member which 
resells the property in uncontrolled sales, if the applicable resale 
price of the property involved in the uncontrolled sale is $100 and the 
appropriate markup percentage for resales by the buyer is 20 percent, 
the arm's length price of the controlled sale is $80 ($100 minus 20 
percent x $100), adjusted as provided in subdivision (ix) of this 
subparagraph.
    (ii) The resale price method must be used to compute an arm's length 
price of a controlled sale if all the following circumstances exist:
    (a) There are no comparable uncontrolled sales as defined in 
subparagraph (2) of this paragraph.
    (b) An applicable resale price, as defined in subdivision (iv) or 
(v) of this subparagraph, is available with respect to resales made 
within a reasonable time before or after the time of the controlled 
sale.
    (c) The buyer (reseller) has not added more than an insubstantial 
amount to the value of the property by physically altering the product 
before resale. For this purpose packaging, repacking, labeling, or minor 
assembly of property does not constitute physical alteration.
    (d) The buyer (reseller) has not added more than an insubstantial 
amount to the value of the property by the use of intangible property. 
See Sec.  1.482-2(d)(3) for the definition of intangible property.
    (iii) Notwithstanding the fact that one or both of the requirements 
of subdivision (ii) (c) or (d) of this subparagraph may not be met, the 
resale price method may be used if such method is more feasible and is 
likely to result in a more accurate determination of an arm's length 
price than the use of the cost plus method. Thus, even though one of the 
requirements of such subdivision is not satisfied, the resale price 
method may nevertheless be more appropriate than the cost plus method 
because the computations and evaluations required under the former 
method may be fewer and easier to make than under the latter method. In 
general, the resale price method is more appropriate when the functions 
performed by the seller are more extensive and more difficult to 
evaluate than the functions performed by the buyer (reseller). The 
principle of this subdivision may be illustrated by the following 
examples in each of which it is assumed that corporation X developed a 
valuable patent covering product M which it manufactures and sells to 
corporation Y in a controlled sale, and for which there is no comparable 
uncontrolled sale:

    Example 1. Corporation Y adds a component to product M and resells 
the assembled product in an uncontrolled sale within a reasonable time 
after the controlled sale of product M. Assume further that the addition 
of the component added more than an insubstantial amount to the value of 
product M, but that Y's function in purchasing the component and 
assembling the product prior to sale was subject to reasonably precise 
valuation. Although the controlled sale and resale does not meet the 
requirements of subdivision (ii)(c) of this subparagraph, the resale 
price method may be used under the circumstances because that method 
involves computations and evaluations which are fewer and easier to make 
than under the cost plus method. This is because X's use of a patent may 
be more difficult to evaluate in determining an appropriate gross profit 
percentage under the cost plus method, than is evaluation of Y's 
assembling function in determining the appropriate markup percentage 
under the resale price method.
    Example 2. Corporation Y resells product M in an uncontrolled sale 
within a reasonable time after the controlled sale after attaching its 
valuable trademark to it. Assume further that it can be demonstrated 
through comparison with other uncontrolled sales of Y that the addition 
of Y's trademark to a product usually adds 25 percent to the markup on 
its sales. On the other hand, the effect of X's use of its patent is 
difficult to evaluate in applying the cost plus method because no 
reasonable standard of comparison is available. Although the controlled 
sale and resale does not meet the requirements of subdivision (ii)(d) of 
this subparagraph, the resale price method may be used because that 
method involves computations and evaluation which are fewer and easier 
to make than

[[Page 869]]

under the cost plus method. That is because, under the circumstances, 
X's use of a patent is more difficult to evaluate in determining an 
appropriate gross profit percentage under the cost plus method, than is 
evaluation of the use of Y's trademark in determining the appropriate 
markup percentage under the resale price method.

    (iv) For the purposes of this subparagraph the ``applicable resale 
price'' is the price at which it is anticipated that property purchased 
in the controlled sale will be resold by the buyer in an uncontrolled 
sale. The ``applicable resale price'' will generally be equal to either 
the price at which current resales of the same property are being made 
or the resale price of the particular item of property involved.
    (v) Where the property purchased in the controlled sale is resold in 
another controlled sale, the ``applicable resale price'' is the price at 
which such property is finally resold in an uncontrolled sale, providing 
that the series of sales as a whole meets all the requirements of 
subdivision (ii) of this subparagraph or that the resale price method is 
used pursuant to subdivision (iii) of this subparagraph. In such case, 
the determination of the appropriate markup percentage shall take into 
account the function or functions performed by all members of the group 
participating in the series of sales and resales. Thus, if X sells a 
product to Y in a controlled sale, Y sells the product to Z in a 
controlled sale, and Z sells the product in an uncontrolled sale, the 
resale price method must be used if Y and Z together have not added more 
than an insubstantial amount to the value of the product through 
physical alteration or the application of intangible property, and the 
final resale occurs within a reasonable time of the sale from X to Y. In 
such case, the applicable resale price is the price at which Z sells the 
product in the uncontrolled sale, and the appropriate markup percentage 
shall take into account the functions performed by both Y and Z.
    (vi) For the purposes of this subparagraph, the appropriate markup 
percentage is equal to the percentage of gross profit (expressed as a 
percentage of sales) earned by the buyer (reseller) or another party on 
the resale of property which is both purchased and resold in an 
uncontrolled transaction, which resale is most similar to the applicable 
resale of the property involved in the controlled sale. The following 
are the most important characteristics to be considered in determining 
the similarity of resales:
    (a) The type of property involved in the sales. For example: machine 
tools, men's furnishings, small household appliances.
    (b) The functions performed by the reseller with respect to the 
property. For example: packaging, labeling, delivering, maintenance of 
inventory, minor assembly, advertising, selling at wholesale, selling at 
retail, billing, maintenance of accounts receivable, and servicing.
    (c) The effect on price of any intangible property utilized by the 
reseller in connection with the property resold. For example: patents, 
trademarks, trade names.
    (d) The geographic market in which the functions are performed by 
the reseller.


In general, the similarity to be sought relates to the probable effect 
upon the markup percentage of any differences in such characteristics 
between the uncontrolled purchases and resales on the one hand and the 
controlled purchases and resales on the other hand. Thus, close physical 
similarity of the property involved in the sales compared is not 
required under the resale price method since a lack of close physical 
similarity is not necessarily indicative of dissimilar markup 
percentages.
    (vii) Whenever possible, markup percentages should be derived from 
uncontrolled purchases and resales of the buyer (reseller) involved in 
the controlled sale, because similar characteristics are more likely to 
be found among different resales of property made by the same reseller 
than among sales made by other resellers. In the absence of resales by 
the same buyer (reseller) which meet the standards of subdivision (vi) 
of this subparagraph, evidence of an appropriate markup percentage may 
be derived from resales by other resellers selling in the same or a 
similar market in which the controlled buyer (reseller) is selling 
providing such resellers perform comparable functions. Where the 
function performed by the reseller is similar to the

[[Page 870]]

function performed by a sales agent which does not take title, such 
sales agent will be considered a reseller for the purpose of determining 
an appropriate markup percentage under this subparagraph and the 
commission earned by such sales agent, expressed as a percentage of the 
sales price of the goods, may constitute the appropriate markup 
percentage. If the controlled buyer (reseller) is located in a foreign 
country and information on resales by other resellers in the same 
foreign market is not available, then markup percentages earned by 
United States resellers performing comparable functions may be used. In 
the absence of data on markup percentages of particular sales or groups 
of sales, the prevailing markup percentage in the particular industry 
involved may be appropriate.
    (viii) In calculating the markup percentage earned on uncontrolled 
purchases and resales, and in applying such percentage to the applicable 
resale price to determine the appropriate markup, the same elements 
which enter into the computation of the sales price and the costs of 
goods sold of the property involved in the comparable uncontrolled 
purchases and resales should enter into such computation in the case of 
the property involved in the controlled purchases and resales. Thus, if 
freight-in and packaging expense are elements of the cost of goods sold 
in comparable uncontrolled purchases, then such elements should also be 
taken into account in computing the cost of goods sold of the controlled 
purchase. Similarly, if the comparable markup percentage is based upon 
net sales (after reduction for returns and allowances) of uncontrolled 
resellers, such percentage must be applied to net sales of the buyer 
(reseller).
    (ix) In determining an arm's length price appropriate adjustment 
must be made to reflect any material differences between the 
uncontrolled purchases and resales used as the basis for the calculation 
of the appropriate markup percentage and the resales of property 
involved in the controlled sale. The differences referred to in this 
subdivision are those differences in functions or circumstances which 
have a definite and reasonably ascertainable effect on price. The 
principles of this subdivision may be illustrated by the following 
example:

    Example. Assume that X and Y are members of the same group of 
controlled entities and that Y purchases electric mixers from X and 
electric toasters from uncontrolled entities. Y performs substantially 
similar functions with respect to resales of both the mixers and the 
toasters, except that it does not warrant the toasters, but does provide 
a 90-day warranty for the mixers. Y normally earns a gross profit on 
toasters of 20 percent of gross selling price. The 20-percent gross 
profit on the resale of toasters is an appropriate markup percentage, 
but the price of the controlled sale computed with reference to such 
rate must be adjusted to reflect the difference in terms (the warranty).

    (4) Cost plus method. (i) Under the pricing method described as the 
``cost plus method'', the arm's length price of a controlled sale of 
property shall be computed by adding to the cost of producing such 
property (as computed in subdivision (ii) of this subparagraph), an 
amount which is equal to such cost multiplied by the appropriate gross 
profit percentage (as computed in subdivision (iii) of this 
subparagraph), plus or minus any adjustments as provided in subdivision 
(v) of this subparagraph.
    (ii) For the purposes of this subparagraph, the cost of producing 
the property involved in the controlled sale, and the costs which enter 
into the computation of the appropriate gross profit percentage shall be 
computed in a consistent manner in accordance with sound accounting 
practices for allocating or apportioning costs, which neither favors nor 
burdens controlled sales in comparison with uncontrolled sales. Thus, if 
the costs used in computing the appropriate gross profit percentage are 
comprised of the full cost of goods sold, including direct and indirect 
costs, then the cost of producing the property involved in the 
controlled sales must be comprised of the full cost of goods sold, 
including direct and indirect costs. On the other hand, if the costs 
used in computing the appropriate gross profit percentage are comprised 
only of direct costs, the cost of producing the property involved in the 
controlled sale must be comprised only of direct costs. The term ``cost 
of producing'', as used in this subparagraph,

[[Page 871]]

includes the cost of acquiring property which is held for resale.
    (iii) For the purposes of this subparagraph, the appropriate gross 
profit percentage is equal to the gross profit percentage (expressed as 
a percentage of cost) earned by the seller or another party on the 
uncontrolled sale or sales of property which are most similar to the 
controlled sale in question. The following are the most important 
characteristics to be considered in determining the similarity of the 
uncontrolled sale or sales:
    (a) The type of property involved in the sales. For example: machine 
tools, men's furnishings, small household appliances.
    (b) The functions performed by the seller with respect to the 
property sold. For example: contract manufacturing, product assembly, 
selling activity, processing, servicing, delivering.
    (c) The effect of any intangible property used by the seller in 
connection with the property sold. For example: patents, trademarks, 
trade names.
    (d) The geographic market in which the functions are performed by 
the seller. In general, the similarity to be sought relates to the 
probable effect upon the margin of gross profit of any differences in 
such characteristics between the uncontrolled sales and the controlled 
sale. Thus, close physical similarity of the property involved in the 
sales compared is not required under the cost plus method since a lack 
of close physical similarity is not necessarily indicative of dissimilar 
profit margins. See subparagraph (2)(iv) of this paragraph, relating to 
sales made at less than a normal profit for the primary purpose of 
establishing or maintaining a market.
    (iv) Whenever possible, gross profit percentages should be derived 
from uncontrolled sales made by the seller involved in the controlled 
sale, because similar characteristics are more likely to be found among 
sales of property made by the same seller than among sales made by other 
sellers. In the absence of such sales, evidence of an appropriate gross 
profit percentage may be derived from similar uncontrolled sales by 
other sellers whether or not such sellers are members of the controlled 
group. Where the function performed by the seller is similar to the 
function performed by a purchasing agent which does not take title, such 
purchasing agent will be considered a seller for the purpose of 
determining an appropriate gross profit percentage under this 
subparagraph and the commission earned by such purchasing agent, 
expressed as a percentage of the purchase price of the goods, may 
constitute the appropriate gross profit percentage. In the absence of 
data on gross profit percentages of particular sales or groups of sales 
which are similar to the controlled sale, the prevailing gross profit 
percentages in the particular industry involved may be appropriate.
    (v) Where the most similar sale or sales from which the appropriate 
gross profit percentage is derived differ in any material respect from 
the controlled sale, the arm's length price which is computed by 
applying such percentage must be adjusted to reflect such differences to 
the extent such differences would warrant an adjustment of price in 
uncontrolled transactions. The differences referred to in this 
subdivision are those differences which have a definite and reasonably 
ascertainable effect on price.

(Sec. 385 and 7805 of the Internal Revenue Code of 1954 (83 Stat. 613 
and 68A Stat. 917; 26 U.S.C. 385 and 7805))

[T.D. 6952, 33 FR 5849, Apr. 16, 1968]

    Editorial Note: For Federal Register citations affecting Sec.  
1.482-2A, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.

          Regulations applicable on or before January 4, 2009.



Sec.  1.482-7A  Methods to determine taxable income in connection 
with a cost sharing arrangement.

    (a) In general--(1) Scope and application of the rules in this 
section. A cost sharing arrangement is an agreement under which the 
parties agree to share the costs of development of one or more 
intangibles in proportion to their shares of reasonably anticipated 
benefits from their individual exploitation of the interests in the 
intangibles assigned to them under the arrangement.

[[Page 872]]

A taxpayer may claim that a cost sharing arrangement is a qualified cost 
sharing arrangement only if the agreement meets the requirements of 
paragraph (b) of this section. Consistent with the rules of Sec.  1.482-
1(d)(3)(ii)(B) (Identifying contractual terms), the district director 
may apply the rules of this section to any arrangement that in substance 
constitutes a cost sharing arrangement, notwithstanding a failure to 
comply with any requirement of this section. A qualified cost sharing 
arrangement, or an arrangement to which the district director applies 
the rules of this section, will not be treated as a partnership to which 
the rules of subchapter K apply. See Sec.  301.7701-3(e) of this 
chapter. Furthermore, a participant that is a foreign corporation or 
nonresident alien individual will not be treated as engaged in trade or 
business within the United States solely by reason of its participation 
in such an arrangement. See generally Sec.  1.864-2(a).
    (2) Limitation on allocations. The district director shall not make 
allocations with respect to a qualified cost sharing arrangement except 
to the extent necessary to make each controlled participant's share of 
the costs (as determined under paragraph (d) of this section) of 
intangible development under the qualified cost sharing arrangement 
equal to its share of reasonably anticipated benefits attributable to 
such development, under the rules of this section. If a controlled 
taxpayer acquires an interest in intangible property from another 
controlled taxpayer (other than in consideration for bearing a share of 
the costs of the intangible's development), then the district director 
may make appropriate allocations to reflect an arm's length 
consideration for the acquisition of the interest in such intangible 
under the rules of Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6. See 
paragraph (g) of this section. An interest in an intangible includes any 
commercially transferable interest, the benefits of which are 
susceptible of valuation. See Sec.  1.482-4(b) for the definition of an 
intangible.
    (3) Coordination with Sec.  1.482-1. A qualified cost sharing 
arrangement produces results that are consistent with an arm's length 
result within the meaning of Sec.  1.482-1(b)(1) if, and only if, each 
controlled participant's share of the costs (as determined under 
paragraph (d) of this section) of intangible development under the 
qualified cost sharing arrangement equals its share of reasonably 
anticipated benefits attributable to such development (as required by 
paragraph (a)(2) of this section) and all other requirements of this 
section are satisfied.
    (4) Cross references. Paragraph (c) of this section defines 
participant. Paragraph (d) of this section defines the costs of 
intangible development. Paragraph (e) of this section defines the 
anticipated benefits of intangible development. Paragraph (f) of this 
section provides rules governing cost allocations. Paragraph (g) of this 
section provides rules governing transfers of intangibles other than in 
consideration for bearing a share of the costs of the intangible's 
development. Rules governing the character of payments made pursuant to 
a qualified cost sharing arrangement are provided in paragraph (h) of 
this section. Paragraph (i) of this section provides accounting 
requirements. Paragraph (j) of this section provides administrative 
requirements. Paragraph (k) of this section provides an effective date. 
Paragraph (l) provides a transition rule.
    (b) Qualified cost sharing arrangement. A qualified cost sharing 
arrangement must--
    (1) Include two or more participants;
    (2) Provide a method to calculate each controlled participant's 
share of intangible development costs, based on factors that can 
reasonably be expected to reflect that participant's share of 
anticipated benefits;
    (3) Provide for adjustment to the controlled participants' shares of 
intangible development costs to account for changes in economic 
conditions, the business operations and practices of the participants, 
and the ongoing development of intangibles under the arrangement; and
    (4) Be recorded in a document that is contemporaneous with the 
formation (and any revision) of the cost sharing arrangement and that 
includes--
    (i) A list of the arrangement's participants, and any other member 
of the controlled group that will benefit from

[[Page 873]]

the use of intangibles developed under the cost sharing arrangement;
    (ii) The information described in paragraphs (b)(2) and (b)(3) of 
this section;
    (iii) A description of the scope of the research and development to 
be undertaken, including the intangible or class of intangibles intended 
to be developed;
    (iv) A description of each participant's interest in any covered 
intangibles. A covered intangible is any intangible property that is 
developed as a result of the research and development undertaken under 
the cost sharing arrangement (intangible development area);
    (v) The duration of the arrangement; and
    (vi) The conditions under which the arrangement may be modified or 
terminated and the consequences of such modification or termination, 
such as the interest that each participant will receive in any covered 
intangibles.
    (c) Participant--(1) In general. For purposes of this section, a 
participant is a controlled taxpayer that meets the requirements of this 
paragraph (c)(1) (controlled participant) or an uncontrolled taxpayer 
that is a party to the cost sharing arrangement (uncontrolled 
participant). See Sec.  1.482-1(i)(5) for the definitions of controlled 
and uncontrolled taxpayers. A controlled taxpayer may be a controlled 
participant only if it--
    (i) Reasonably anticipates that it will derive benefits from the use 
of covered intangibles;
    (ii) Substantially complies with the accounting requirements 
described in paragraph (i) of this section; and
    (iii) Substantially complies with the administrative requirements 
described in paragraph (j) of this section.
    (iv) The following example illustrates paragraph (c)(1)(i) of this 
section:

    Example. Foreign Parent (FP) is a foreign corporation engaged in the 
extraction of a natural resource. FP has a U.S. subsidiary (USS) to 
which FP sells supplies of this resource for sale in the United States. 
FP enters into a cost sharing arrangement with USS to develop a new 
machine to extract the natural resource. The machine uses a new 
extraction process that will be patented in the United States and in 
other countries. The cost sharing arrangement provides that USS will 
receive the rights to use the machine in the extraction of the natural 
resource in the United States, and FP will receive the rights in the 
rest of the world. This resource does not, however, exist in the United 
States. Despite the fact that USS has received the right to use this 
process in the United States, USS is not a qualified participant because 
it will not derive a benefit from the use of the intangible developed 
under the cost sharing arrangement.

    (2) Treatment of a controlled taxpayer that is not a controlled 
participant--(i) In general. If a controlled taxpayer that is not a 
controlled participant (within the meaning of this paragraph (c)) 
provides assistance in relation to the research and development 
undertaken in the intangible development area, it must receive 
consideration from the controlled participants under the rules of Sec.  
1.482-4(f)(3)(iii) (Allocations with respect to assistance provided to 
the owner). For purposes of paragraph (d) of this section, such 
consideration is treated as an operating expense and each controlled 
participant must be treated as incurring a share of such consideration 
equal to its share of reasonably anticipated benefits (as defined in 
paragraph (f)(3) of this section).
    (ii) Example. The following example illustrates this paragraph 
(c)(2):

    Example. (i) U.S. Parent (USP), one foreign subsidiary (FS), and a 
second foreign subsidiary constituting the group's research arm (R + D) 
enter into a cost sharing agreement to develop manufacturing intangibles 
for a new product line A. USP and FS are assigned the exclusive rights 
to exploit the intangibles respectively in the United States and the 
rest of the world, where each presently manufactures and sells various 
existing product lines. R + D is not assigned any rights to exploit the 
intangibles. R + D's activity consists solely in carrying out research 
for the group. It is reliably projected that the shares of reasonably 
anticipated benefits of USP and FS will be 66\2/3\% and 33\1/3\, 
respectively, and the parties' agreement provides that USP and FS will 
reimburse 66\2/3\% and 33\1/3\%, respectively, of the intangible 
development costs incurred by R + D with respect to the new intangible.
    (ii) R + D does not qualify as a controlled participant within the 
meaning of paragraph (c) of this section, because it will not derive any 
benefits from the use of covered intangibles. Therefore, R + D is 
treated as a service provider for purposes of this section and must 
receive arm's length consideration for the assistance it is deemed to 
provide to USP and FS, under the rules of Sec.  1.482-4(f)(3)(iii).

[[Page 874]]

Such consideration must be treated as intangible development costs 
incurred by USP and FS in proportion to their shares of reasonably 
anticipated benefits (i.e., 66\2/3\% and 33\1/3\%, respectively). R + D 
will not be considered to bear any share of the intangible development 
costs under the arrangement.

    (3) Treatment of consolidated group. For purposes of this section, 
all members of the same affiliated group (within the meaning of section 
1504(a)) that join in the filing of a consolidated return for the 
taxable year under section 1501 shall be treated as one taxpayer.
    (d) Costs--(1) Intangible development costs. For purposes of this 
section, a controlled participant's costs of developing intangibles for 
a taxable year mean all of the costs incurred by that participant 
related to the intangible development area, plus all of the cost sharing 
payments it makes to other controlled and uncontrolled participants, 
minus all of the cost sharing payments it receives from other controlled 
and uncontrolled participants. Costs incurred related to the intangible 
development area consist of the following items: operating expenses as 
defined in Sec.  1.482-5(d)(3), other than depreciation or amortization 
expense, plus (to the extent not included in such operating expenses, as 
defined in Sec.  1.482-5(d)(3)) the charge for the use of any tangible 
property made available to the qualified cost sharing arrangement. If 
tangible property is made available to the qualified cost sharing 
arrangement by a controlled participant, the determination of the 
appropriate charge will be governed by the rules of Sec.  1.482-2(c) 
(Use of tangible property). Intangible development costs do not include 
the consideration for the use of any intangible property made available 
to the qualified cost sharing arrangement. See paragraph (g)(2) of this 
section. If a particular cost contributes to the intangible development 
area and other areas or other business activities, the cost must be 
allocated between the intangible development area and the other areas or 
business activities on a reasonable basis. In such a case, it is 
necessary to estimate the total benefits attributable to the cost 
incurred. The share of such cost allocated to the intangible development 
area must correspond to covered intangibles' share of the total 
benefits. Costs that do not contribute to the intangible development 
area are not taken into account.
    (2) Stock-based compensation--(i) In general. For purposes of this 
section, a controlled participant's operating expenses include all costs 
attributable to compensation, including stock-based compensation. As 
used in this section, the term stock-based compensation means any 
compensation provided by a controlled participant to an employee or 
independent contractor in the form of equity instruments, options to 
acquire stock (stock options), or rights with respect to (or determined 
by reference to) equity instruments or stock options, including but not 
limited to property to which section 83 applies and stock options to 
which section 421 applies, regardless of whether ultimately settled in 
the form of cash, stock, or other property.
    (ii) Identification of stock-based compensation related to 
intangible development. The determination of whether stock-based 
compensation is related to the intangible development area within the 
meaning of paragraph (d)(1) of this section is made as of the date that 
the stock-based compensation is granted. Accordingly, all stock-based 
compensation that is granted during the term of the qualified cost 
sharing arrangement and is related at date of grant to the development 
of intangibles covered by the arrangement is included as an intangible 
development cost under paragraph (d)(1) of this section. In the case of 
a repricing or other modification of a stock option, the determination 
of whether the repricing or other modification constitutes the grant of 
a new stock option for purposes of this paragraph (d)(2)(ii) will be 
made in accordance with the rules of section 424(h) and related 
regulations.
    (iii) Measurement and timing of stock-based compensation expense--
(A) In general. Except as otherwise provided in this paragraph 
(d)(2)(iii), the operating expense attributable to stock-based 
compensation is equal to the amount allowable to the controlled 
participant as a deduction for Federal income tax purposes with respect 
to that stock-based compensation (for example, under section 83(h)) and 
is taken into account as an operating expense under

[[Page 875]]

this section for the taxable year for which the deduction is allowable.
    (1) Transfers to which section 421 applies. Solely for purposes of 
this paragraph (d)(2)(iii)(A), section 421 does not apply to the 
transfer of stock pursuant to the exercise of an option that meets the 
requirements of section 422(a) or 423(a).
    (2) Deductions of foreign controlled participants. Solely for 
purposes of this paragraph (d)(2)(iii)(A), an amount is treated as an 
allowable deduction of a controlled participant to the extent that a 
deduction would be allowable to a United States taxpayer.
    (3) Modification of stock option. Solely for purposes of this 
paragraph (d)(2)(iii)(A), if the repricing or other modification of a 
stock option is determined, under paragraph (d)(2)(ii) of this section, 
to constitute the grant of a new stock option not related to the 
development of intangibles, the stock option that is repriced or 
otherwise modified will be treated as being exercised immediately before 
the modification, provided that the stock option is then exercisable and 
the fair market value of the underlying stock then exceeds the price at 
which the stock option is exercisable. Accordingly, the amount of the 
deduction that would be allowable (or treated as allowable under this 
paragraph (d)(2)(iii)(A)) to the controlled participant upon exercise of 
the stock option immediately before the modification must be taken into 
account as an operating expense as of the date of the modification.
    (4) Expiration or termination of qualified cost sharing arrangement. 
Solely for purposes of this paragraph (d)(2)(iii)(A), if an item of 
stock-based compensation related to the development of intangibles is 
not exercised during the term of a qualified cost sharing arrangement, 
that item of stock-based compensation will be treated as being exercised 
immediately before the expiration or termination of the qualified cost 
sharing arrangement, provided that the stock-based compensation is then 
exercisable and the fair market value of the underlying stock then 
exceeds the price at which the stock-based compensation is exercisable. 
Accordingly, the amount of the deduction that would be allowable (or 
treated as allowable under this paragraph (d)(2)(iii)(A)) to the 
controlled participant upon exercise of the stock-based compensation 
must be taken into account as an operating expense as of the date of the 
expiration or termination of the qualified cost sharing arrangement.
    (B) Election with respect to options on publicly traded stock--(1) 
In general. With respect to stock-based compensation in the form of 
options on publicly traded stock, the controlled participants in a 
qualified cost sharing arrangement may elect to take into account all 
operating expenses attributable to those stock options in the same 
amount, and as of the same time, as the fair value of the stock options 
reflected as a charge against income in audited financial statements or 
disclosed in footnotes to such financial statements, provided that such 
statements are prepared in accordance with United States generally 
accepted accounting principles by or on behalf of the company issuing 
the publicly traded stock.
    (2) Publicly traded stock. As used in this paragraph (d)(2)(iii)(B), 
the term publicly traded stock means stock that is regularly traded on 
an established United States securities market and is issued by a 
company whose financial statements are prepared in accordance with 
United States generally accepted accounting principles for the taxable 
year.
    (3) Generally accepted accounting principles. For purposes of this 
paragraph (d)(2)(iii)(B), a financial statement prepared in accordance 
with a comprehensive body of generally accepted accounting principles 
other than United States generally accepted accounting principles is 
considered to be prepared in accordance with United States generally 
accepted accounting principles provided that either--
    (i) The fair value of the stock options under consideration is 
reflected in the reconciliation between such other accounting principles 
and United States generally accepted accounting principles required to 
be incorporated into the financial statement by the securities laws 
governing companies whose stock is regularly traded on United States 
securities markets; or

[[Page 876]]

    (ii) In the absence of a reconciliation between such other 
accounting principles and United States generally accepted accounting 
principles that reflects the fair value of the stock options under 
consideration, such other accounting principles require that the fair 
value of the stock options under consideration be reflected as a charge 
against income in audited financial statements or disclosed in footnotes 
to such statements.
    (4) Time and manner of making the election. The election described 
in this paragraph (d)(2)(iii)(B) is made by an explicit reference to the 
election in the written cost sharing agreement required by paragraph 
(b)(4) of this section or in a written amendment to the cost sharing 
agreement entered into with the consent of the Commissioner pursuant to 
paragraph (d)(2)(iii)(C) of this section. In the case of a qualified 
cost sharing arrangement in existence on August 26, 2003, the election 
must be made by written amendment to the cost sharing agreement not 
later than the latest due date (with regard to extensions) of a Federal 
income tax return of any controlled participant for the first taxable 
year beginning after August 26, 2003, and the consent of the 
Commissioner is not required.
    (C) Consistency. Generally, all controlled participants in a 
qualified cost sharing arrangement taking options on publicly traded 
stock into account under paragraph (d)(2)(iii)(A) or (B) of this section 
must use that same method of measurement and timing for all options on 
publicly traded stock with respect to that qualified cost sharing 
arrangement. Controlled participants may change their method only with 
the consent of the Commissioner and only with respect to stock options 
granted during taxable years subsequent to the taxable year in which the 
Commissioner's consent is obtained. All controlled participants in the 
qualified cost sharing arrangement must join in requests for the 
Commissioner's consent under this paragraph. Thus, for example, if the 
controlled participants make the election described in paragraph 
(d)(2)(iii)(B) of this section upon the formation of the qualified cost 
sharing arrangement, the election may be revoked only with the consent 
of the Commissioner, and the consent will apply only to stock options 
granted in taxable years subsequent to the taxable year in which consent 
is obtained. Similarly, if controlled participants already have granted 
stock options that have been or will be taken into account under the 
general rule of paragraph (d)(2)(iii)(A) of this section, then except in 
cases specified in the last sentence of paragraph (d)(2)(iii)(B)(4) of 
this section, the controlled participants may make the election 
described in paragraph (d)(2)(iii)(B) of this section only with the 
consent of the Commissioner, and the consent will apply only to stock 
options granted in taxable years subsequent to the taxable year in which 
consent is obtained.
    (3) Examples. The following examples illustrate this paragraph (d):

    Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a qualified cost sharing arrangement to develop a better mousetrap. USS 
and FP share the costs of FP's research and development facility that 
will be exclusively dedicated to this research, the salaries of the 
researchers, and reasonable overhead costs attributable to the project. 
They also share the cost of a conference facility that is at the 
disposal of the senior executive management of each company but does not 
contribute to the research and development activities in any measurable 
way. In this case, the cost of the conference facility must be excluded 
from the amount of intangible development costs.
    Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a qualified cost sharing arrangement to develop a new device. USP and FS 
share the costs of a research and development facility, the salaries of 
researchers, and reasonable overhead costs attributable to the project. 
USP also incurs costs related to field testing of the device, but does 
not include them in the amount of intangible development costs of the 
cost sharing arrangement. The district director may determine that the 
field testing costs are intangible development costs that must be 
shared.

    (e) Anticipated benefits--(1) Benefits. Benefits are additional 
income generated or costs saved by the use of covered intangibles.
    (2) Reasonably anticipated benefits. For purposes of this section, a 
controlled participant's reasonably anticipated benefits are the 
aggregate benefits that it reasonably anticipates that it will derive 
from covered intangibles.

[[Page 877]]

    (f) Cost allocations--(1) In general. For purposes of determining 
whether a cost allocation authorized by paragraph (a)(2) of this section 
is appropriate for a taxable year, a controlled participant's share of 
intangible development costs for the taxable year under a qualified cost 
sharing arrangement must be compared to its share of reasonably 
anticipated benefits under the arrangement. A controlled participant's 
share of intangible development costs is determined under paragraph 
(f)(2) of this section. A controlled participant's share of reasonably 
anticipated benefits under the arrangement is determined under paragraph 
(f)(3) of this section. In determining whether benefits were reasonably 
anticipated, it may be appropriate to compare actual benefits to 
anticipated benefits, as described in paragraph (f)(3)(iv) of this 
section.
    (2) Share of intangible development costs--(i) In general. A 
controlled participant's share of intangible development costs for a 
taxable year is equal to its intangible development costs for the 
taxable year (as defined in paragraph (d) of this section), divided by 
the sum of the intangible development costs for the taxable year (as 
defined in paragraph (d) of this section) of all the controlled 
participants.
    (ii) Example. The following example illustrates this paragraph 
(f)(2):

    Example. (i) U.S. Parent (USP), Foreign Subsidiary (FS), and 
Unrelated Third Party (UTP) enter into a cost sharing arrangement to 
develop new audio technology. In the first year of the arrangement, the 
controlled participants incur $2,250,000 in the intangible development 
area, all of which is incurred directly by USP. In the first year, UTP 
makes a $250,000 cost sharing payment to USP, and FS makes a $800,000 
cost sharing payment to USP, under the terms of the arrangement. For 
that year, the intangible development costs borne by USP are $1,200,000 
(its $2,250,000 intangible development costs directly incurred, minus 
the cost sharing payments it receives of $250,000 from UTP and $800,000 
from FS); the intangible development costs borne by FS are $800,000 (its 
cost sharing payment); and the intangible development costs borne by all 
of the controlled participants are $2,000,000 (the sum of the intangible 
development costs borne by USP and FS of $1,200,000 and $800,000, 
respectively). Thus, for the first year, USP's share of intangible 
development costs is 60% ($1,200,000 divided by $2,000,000), and FS's 
share of intangible development costs is 40% ($800,000 divided by 
$2,000,000).
    (ii) For purposes of determining whether a cost allocation 
authorized by paragraph Sec.  1.482-7(a)(2) is appropriate for the first 
year, the district director must compare USP's and FS's shares of 
intangible development costs for that year to their shares of reasonably 
anticipated benefits. See paragraph (f)(3) of this section.

    (3) Share of reasonably anticipated benefits--(i) In general. A 
controlled participant's share of reasonably anticipated benefits under 
a qualified cost sharing arrangement is equal to its reasonably 
anticipated benefits (as defined in paragraph (e)(2) of this section), 
divided by the sum of the reasonably anticipated benefits (as defined in 
paragraph (e)(2) of this section) of all the controlled participants. 
The anticipated benefits of an uncontrolled participant will not be 
included for purposes of determining each controlled participant's share 
of anticipated benefits. A controlled participant's share of reasonably 
anticipated benefits will be determined using the most reliable estimate 
of reasonably anticipated benefits. In determining which of two or more 
available estimates is most reliable, the quality of the data and 
assumptions used in the analysis must be taken into account, consistent 
with Sec.  1.482-1(c)(2)(ii) (Data and assumptions). Thus, the 
reliability of an estimate will depend largely on the completeness and 
accuracy of the data, the soundness of the assumptions, and the relative 
effects of particular deficiencies in data or assumptions on different 
estimates. If two estimates are equally reliable, no adjustment should 
be made based on differences in the results. The following factors will 
be particularly relevant in determining the reliability of an estimate 
of anticipated benefits--
    (A) The reliability of the basis used for measuring benefits, as 
described in paragraph (f)(3)(ii) of this section; and
    (B) The reliability of the projections used to estimate benefits, as 
described in paragraph (f)(3)(iv) of this section.
    (ii) Measure of benefits. In order to estimate a controlled 
participant's share of anticipated benefits from covered intangibles, 
the amount of benefits that each of the controlled participants is 
reasonably anticipated to derive from

[[Page 878]]

covered intangibles must be measured on a basis that is consistent for 
all such participants. See paragraph (f)(3)(iii)(E), Example 8, of this 
section. If a controlled participant transfers covered intangibles to 
another controlled taxpayer, such participant's benefits from the 
transferred intangibles must be measured by reference to the 
transferee's benefits, disregarding any consideration paid by the 
transferee to the controlled participant (such as a royalty pursuant to 
a license agreement). Anticipated benefits are measured either on a 
direct basis, by reference to estimated additional income to be 
generated or costs to be saved by the use of covered intangibles, or on 
an indirect basis, by reference to certain measurements that reasonably 
can be assumed to be related to income generated or costs saved. Such 
indirect bases of measurement of anticipated benefits are described in 
paragraph (f)(3)(iii) of this section. A controlled participant's 
anticipated benefits must be measured on the most reliable basis, 
whether direct or indirect. In determining which of two bases of 
measurement of reasonably anticipated benefits is most reliable, the 
factors set forth in Sec.  1.482-1(c)(2)(ii) (Data and assumptions) must 
be taken into account. It normally will be expected that the basis that 
provided the most reliable estimate for a particular year will continue 
to provide the most reliable estimate in subsequent years, absent a 
material change in the factors that affect the reliability of the 
estimate. Regardless of whether a direct or indirect basis of 
measurement is used, adjustments may be required to account for material 
differences in the activities that controlled participants undertake to 
exploit their interests in covered intangibles. See Example 6 of 
paragraph (f)(3)(iii)(E) of this section.
    (iii) Indirect bases for measuring anticipated benefits. Indirect 
bases for measuring anticipated benefits from participation in a 
qualified cost sharing arrangement include the following:
    (A) Units used, produced or sold. Units of items used, produced or 
sold by each controlled participant in the business activities in which 
covered intangibles are exploited may be used as an indirect basis for 
measuring its anticipated benefits. This basis of measurement will be 
more reliable to the extent that each controlled participant is expected 
to have a similar increase in net profit or decrease in net loss 
attributable to the covered intangibles per unit of the item or items 
used, produced or sold. This circumstance is most likely to arise when 
the covered intangibles are exploited by the controlled participants in 
the use, production or sale of substantially uniform items under similar 
economic conditions.
    (B) Sales. Sales by each controlled participant in the business 
activities in which covered intangibles are exploited may be used as an 
indirect basis for measuring its anticipated benefits. This basis of 
measurement will be more reliable to the extent that each controlled 
participant is expected to have a similar increase in net profit or 
decrease in net loss attributable to covered intangibles per dollar of 
sales. This circumstance is most likely to arise if the costs of 
exploiting covered intangibles are not substantial relative to the 
revenues generated, or if the principal effect of using covered 
intangibles is to increase the controlled participants' revenues (e.g., 
through a price premium on the products they sell) without affecting 
their costs substantially. Sales by each controlled participant are 
unlikely to provide a reliable basis for measuring benefits unless each 
controlled participant operates at the same market level (e.g., 
manufacturing, distribution, etc.).
    (C) Operating profit. Operating profit of each controlled 
participant from the activities in which covered intangibles are 
exploited may be used as an indirect basis for measuring its anticipated 
benefits. This basis of measurement will be more reliable to the extent 
that such profit is largely attributable to the use of covered 
intangibles, or if the share of profits attributable to the use of 
covered intangibles is expected to be similar for each controlled 
participant. This circumstance is most likely to arise when covered 
intangibles are integral to the activity that generates the profit and 
the activity could not be carried on or would generate little profit 
without use of those intangibles.

[[Page 879]]

    (D) Other bases for measuring anticipated benefits. Other bases for 
measuring anticipated benefits may, in some circumstances, be 
appropriate, but only to the extent that there is expected to be a 
reasonably identifiable relationship between the basis of measurement 
used and additional income generated or costs saved by the use of 
covered intangibles. For example, a division of costs based on employee 
compensation would be considered unreliable unless there were a 
relationship between the amount of compensation and the expected income 
of the controlled participants from the use of covered intangibles.
    (E) Examples. The following examples illustrate this paragraph 
(f)(3)(iii):

    Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) both 
produce a feedstock for the manufacture of various high-performance 
plastic products. Producing the feedstock requires large amounts of 
electricity, which accounts for a significant portion of its production 
cost. FP and USS enter into a cost sharing arrangement to develop a new 
process that will reduce the amount of electricity required to produce a 
unit of the feedstock. FP and USS currently both incur an electricity 
cost of X% of its other production costs and rates for each are expected 
to remain similar in the future. How much the new process, if it is 
successful, will reduce the amount of electricity required to produce a 
unit of the feedstock is uncertain, but it will be about the same amount 
for both companies. Therefore, the cost savings each company is expected 
to achieve after implementing the new process are similar relative to 
the total amount of the feedstock produced. Under the cost sharing 
arrangement FP and USS divide the costs of developing the new process 
based on the units of the feedstock each is anticipated to produce in 
the future. In this case, units produced is the most reliable basis for 
measuring benefits and dividing the intangible development costs because 
each participant is expected to have a similar decrease in costs per 
unit of the feedstock produced.
    Example 2. The facts are the same as in Example 1, except that USS 
pays X% of its other production costs for electricity while FP pays 2X% 
of its other production costs. In this case, units produced is not the 
most reliable basis for measuring benefits and dividing the intangible 
development costs because the participants do not expect to have a 
similar decrease in costs per unit of the feedstock produced. The 
district director determines that the most reliable measure of benefit 
shares may be based on units of the feedstock produced if FP's units are 
weighted relative to USS's units by a factor of 2. This reflects the 
fact that FP pays twice as much as USS as a percentage of its other 
production costs for electricity and, therefore, FP's savings per unit 
of the feedstock would be twice USS's savings from any new process 
eventually developed.
    Example 3. The facts are the same as in Example 2, except that to 
supply the particular needs of the U.S. market USS manufactures the 
feedstock with somewhat different properties than FP's feedstock. This 
requires USS to employ a somewhat different production process than does 
FP. Because of this difference, it will be more costly for USS to adopt 
any new process that may be developed under the cost sharing agreement. 
In this case, units produced is not the most reliable basis for 
measuring benefit shares. In order to reliably determine benefit shares, 
the district director offsets the reasonably anticipated costs of 
adopting the new process against the reasonably anticipated total 
savings in electricity costs.
    Example 4. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a cost sharing arrangement to develop new anesthetic drugs. USP obtains 
the right to use any resulting patent in the U.S. market, and FS obtains 
the right to use the patent in the European market. USP and FS divide 
costs on the basis of anticipated operating profit from each patent 
under development. USP anticipates that it will receive a much higher 
profit than FS per unit sold because drug prices are uncontrolled in the 
U.S., whereas drug prices are regulated in many European countries. In 
this case, the controlled taxpayers' basis for measuring benefits is the 
most reliable.
    Example 5. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) both 
manufacture and sell fertilizers. They enter into a cost sharing 
arrangement to develop a new pellet form of a common agricultural 
fertilizer that is currently available only in powder form. Under the 
cost sharing arrangement, USS obtains the rights to produce and sell the 
new form of fertilizer for the U.S. market while FP obtains the rights 
to produce and sell the fertilizer for the rest of the world. The costs 
of developing the new form of fertilizer are divided on the basis of the 
anticipated sales of fertilizer in the participants' respective markets.
    (ii) If the research and development is successful the pellet form 
will deliver the fertilizer more efficiently to crops and less 
fertilizer will be required to achieve the same effect on crop growth. 
The pellet form of fertilizer can be expected to sell at a price premium 
over the powder form of fertilizer based on the savings in the amount of 
fertilizer that needs to be used. If the research and development is 
successful, the costs of producing pellet fertilizer are expected to be

[[Page 880]]

approximately the same as the costs of producing powder fertilizer and 
the same for both FP and USS. Both FP and USS operate at approximately 
the same market levels, selling their fertilizers largely to independent 
distributors.
    (iii) In this case, the controlled taxpayers' basis for measuring 
benefits is the most reliable.
    Example 6. The facts are the same as in Example 5, except that FP 
distributes its fertilizers directly while USS sells to independent 
distributors. In this case, sales of USS and FP are not the most 
reliable basis for measuring benefits unless adjustments are made to 
account for the difference in market levels at which the sales occur.
    Example 7. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a cost sharing arrangement to develop materials that will be used to 
train all new entry-level employees. FP and USS determine that the new 
materials will save approximately ten hours of training time per 
employee. Because their entry-level employees are paid on differing wage 
scales, FP and USS decide that they should not divide costs based on the 
number of entry-level employees hired by each. Rather, they divide costs 
based on compensation paid to the entry-level employees hired by each. 
In this case, the basis used for measuring benefits is the most reliable 
because there is a direct relationship between compensation paid to new 
entry-level employees and costs saved by FP and USS from the use of the 
new training materials.
    Example 8. U.S. Parent (USP), Foreign Subsidiary 1 (FS1) and Foreign 
Subsidiary 2 (FS2) enter into a cost sharing arrangement to develop 
computer software that each will market and install on customers' 
computer systems. The participants divide costs on the basis of 
projected sales by USP, FS1, and FS2 of the software in their respective 
geographic areas. However, FS1 plans not only to sell but also to 
license the software to unrelated customers, and FS1's licensing income 
(which is a percentage of the licensees' sales) is not counted in the 
projected benefits. In this case, the basis used for measuring the 
benefits of each participant is not the most reliable because all of the 
benefits received by participants are not taken into account. In order 
to reliably determine benefit shares, FS1's projected benefits from 
licensing must be included in the measurement on a basis that is the 
same as that used to measure its own and the other participants' 
projected benefits from sales (e.g., all participants might measure 
their benefits on the basis of operating profit).

    (iv) Projections used to estimate anticipated benefits--(A) In 
general. The reliability of an estimate of anticipated benefits also 
depends upon the reliability of projections used in making the estimate. 
Projections required for this purpose generally include a determination 
of the time period between the inception of the research and development 
and the receipt of benefits, a projection of the time over which 
benefits will be received, and a projection of the benefits anticipated 
for each year in which it is anticipated that the intangible will 
generate benefits. A projection of the relevant basis for measuring 
anticipated benefits may require a projection of the factors that 
underlie it. For example, a projection of operating profits may require 
a projection of sales, cost of sales, operating expenses, and other 
factors that affect operating profits. If it is anticipated that there 
will be significant variation among controlled participants in the 
timing of their receipt of benefits, and consequently benefit shares are 
expected to vary significantly over the years in which benefits will be 
received, it may be necessary to use the present discounted value of the 
projected benefits to reliably determine each controlled participant's 
share of those benefits. If it is not anticipated that benefit shares 
will significantly change over time, current annual benefit shares may 
provide a reliable projection of anticipated benefit shares. This 
circumstance is most likely to occur when the cost sharing arrangement 
is a long-term arrangement, the arrangement covers a wide variety of 
intangibles, the composition of the covered intangibles is unlikely to 
change, the covered intangibles are unlikely to generate unusual 
profits, and each controlled participant's share of the market is 
stable.
    (B) Unreliable projections. A significant divergence between 
projected benefit shares and actual benefit shares may indicate that the 
projections were not reliable. In such a case, the district director may 
use actual benefits as the most reliable measure of anticipated 
benefits. If benefits are projected over a period of years, and the 
projections for initial years of the period prove to be unreliable, this 
may indicate that the projections for the remaining years of the period 
are also unreliable and thus should be adjusted. Projections will not be 
considered unreliable based on a divergence between a controlled

[[Page 881]]

participant's projected benefit share and actual benefit share if the 
amount of such divergence for every controlled participant is less than 
or equal to 20% of the participant's projected benefit share. Further, 
the district director will not make an allocation based on such 
divergence if the difference is due to an extraordinary event, beyond 
the control of the participants, that could not reasonably have been 
anticipated at the time that costs were shared. For purposes of this 
paragraph, all controlled participants that are not U.S. persons will be 
treated as a single controlled participant. Therefore, an adjustment 
based on an unreliable projection will be made to the cost shares of 
foreign controlled participants only if there is a matching adjustment 
to the cost shares of controlled participants that are U.S. persons. 
Nothing in this paragraph (f)(3)(iv)(B) will prevent the district 
director from making an allocation if the taxpayer did not use the most 
reliable basis for measuring anticipated benefits. For example, if the 
taxpayer measures anticipated benefits based on units sold, and the 
district director determines that another basis is more reliable for 
measuring anticipated benefits, then the fact that actual units sold 
were within 20% of the projected unit sales will not preclude an 
allocation under this section.
    (C) Foreign-to-foreign adjustments. Notwithstanding the limitations 
on adjustments provided in paragraph (f)(3)(iv)(B) of this section, 
adjustments to cost shares based on an unreliable projection also may be 
made solely among foreign controlled participants if the variation 
between actual and projected benefits has the effect of substantially 
reducing U.S. tax.
    (D) Examples. The following examples illustrate this paragraph 
(f)(3)(iv):

    Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) enter 
into a cost sharing arrangement to develop a new car model. The 
participants plan to spend four years developing the new model and four 
years producing and selling the new model. USS and FP project total 
sales of $4 billion and $2 billion, respectively, over the planned four 
years of exploitation of the new model. Cost shares are divided for each 
year based on projected total sales. Therefore, USS bears 66\2/3\% of 
each year's intangible development costs and FP bears 33\1/3\% of such 
costs.
    (ii) USS typically begins producing and selling new car models a 
year after FP begins producing and selling new car models. The district 
director determines that in order to reflect USS's one-year lag in 
introducing new car models, a more reliable projection of each 
participant's share of benefits would be based on a projection of all 
four years of sales for each participant, discounted to present value.
    Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a cost sharing arrangement to develop new and improved household 
cleaning products. Both participants have sold household cleaning 
products for many years and have stable market shares. The products 
under development are unlikely to produce unusual profits for either 
participant. The participants divide costs on the basis of each 
participant's current sales of household cleaning products. In this 
case, the participants' future benefit shares are reliably projected by 
current sales of cleaning products.
    Example 3. The facts are the same as in Example 2, except that FS's 
market share is rapidly expanding because of the business failure of a 
competitor in its geographic area. The district director determines that 
the participants' future benefit shares are not reliably projected by 
current sales of cleaning products and that FS's benefit projections 
should take into account its growth in sales.
    Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into 
a cost sharing arrangement to develop synthetic fertilizers and 
insecticides. FP and USS share costs on the basis of each participant's 
current sales of fertilizers and insecticides. The market shares of the 
participants have been stable for fertilizers, but FP's market share for 
insecticides has been expanding. The district director determines that 
the participants' projections of benefit shares are reliable with regard 
to fertilizers, but not reliable with regard to insecticides; a more 
reliable projection of benefit shares would take into account the 
expanding market share for insecticides.
    Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into 
a cost sharing arrangement to develop new food products, dividing costs 
on the basis of projected sales two years in the future. In year 1, USP 
and FS project that their sales in year 3 will be equal, and they divide 
costs accordingly. In year 3, the district director examines the 
participants' method for dividing costs. USP and FS actually accounted 
for 42% and 58% of total sales, respectively. The district director 
agrees that sales two years in the future provide a reliable basis for 
estimating benefit shares. Because the differences between USP's and 
FS's actual and projected

[[Page 882]]

benefit shares are less than 20% of their projected benefit shares, the 
projection of future benefits for year 3 is reliable.
    Example 6. The facts are the same as in Example 5, except that the 
in year 3 USP and FS actually accounted for 35% and 65% of total sales, 
respectively. The divergence between USP's projected and actual benefit 
shares is greater than 20% of USP's projected benefit share and is not 
due to an extraordinary event beyond the control of the participants. 
The district director concludes that the projection of anticipated 
benefit shares was unreliable, and uses actual benefits as the basis for 
an adjustment to the cost shares borne by USP and FS.
    Example 7. U.S. Parent (USP), a U.S. corporation, and its foreign 
subsidiary (FS) enter a cost sharing arrangement in year 1. They project 
that they will begin to receive benefits from covered intangibles in 
years 4 through 6, and that USP will receive 60% of total benefits and 
FS 40% of total benefits. In years 4 through 6, USP and FS actually 
receive 50% each of the total benefits. In evaluating the reliability of 
the participants' projections, the district director compares these 
actual benefit shares to the projected benefit shares. Although USP's 
actual benefit share (50%) is within 20% of its projected benefit share 
(60%), FS's actual benefit share (50%) is not within 20% of its 
projected benefit share (40%). Based on this discrepancy, the district 
director may conclude that the participants' projections were not 
reliable and may use actual benefit shares as the basis for an 
adjustment to the cost shares borne by USP and FS.
    Example 8. Three controlled taxpayers, USP, FS1 and FS2 enter into a 
cost sharing arrangement. FS1 and FS2 are foreign. USP is a United 
States corporation that controls all the stock of FS1 and FS2. The 
participants project that they will share the total benefits of the 
covered intangibles in the following percentages: USP 50%; FS1 30%; and 
FS2 20%. Actual benefit shares are as follows: USP 45%; FS1 25%; and FS2 
30%. In evaluating the reliability of the participants' projections, the 
district director compares these actual benefit shares to the projected 
benefit shares. For this purpose, FS1 and FS2 are treated as a single 
participant. The actual benefit share received by USP (45%) is within 
20% of its projected benefit share (50%). In addition, the non-US 
participants' actual benefit share (55%) is also within 20% of their 
projected benefit share (50%). Therefore, the district director 
concludes that the participants' projections of future benefits were 
reliable, despite the fact that FS2's actual benefit share (30%) is not 
within 20% of its projected benefit share (20%).
    Example 9. The facts are the same as in Example 8. In addition, the 
district director determines that FS2 has significant operating losses 
and has no earnings and profits, and that FS1 is profitable and has 
earnings and profits. Based on all the evidence, the district director 
concludes that the participants arranged that FS1 would bear a larger 
cost share than appropriate in order to reduce FS1's earnings and 
profits and thereby reduce inclusions USP otherwise would be deemed to 
have on account of FS1 under subpart F. Pursuant to Sec.  1.482-7 
(f)(3)(iv)(C), the district director may make an adjustment solely to 
the cost shares borne by FS1 and FS2 because FS2's projection of future 
benefits was unreliable and the variation between actual and projected 
benefits had the effect of substantially reducing USP's U.S. income tax 
liability (on account of FS1 subpart F income).
    Example 10. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS) 
enter into a cost sharing arrangement in 1996 to develop a new treatment 
for baldness. USS's interest in any treatment developed is the right to 
produce and sell the treatment in the U.S. market while FP retains 
rights to produce and sell the treatment in the rest of the world. USS 
and FP measure their anticipated benefits from the cost sharing 
arrangement based on their respective projected future sales of the 
baldness treatment. The following sales projections are used:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                              USS     FP
------------------------------------------------------------------------
1997....................................................       5      10
1998....................................................      20      20
1999....................................................      30      30
2000....................................................      40      40
2001....................................................      40      40
2002....................................................      40      40
2003....................................................      40      40
2004....................................................      20      20
2005....................................................      10      10
2006....................................................       5       5
------------------------------------------------------------------------

    (B) In 1997, the first year of sales, USS is projected to have lower 
sales than FP due to lags in U.S. regulatory approval for the baldness 
treatment. In each subsequent year USS and FP are projected to have 
equal sales. Sales are projected to build over the first three years of 
the period, level off for several years, and then decline over the final 
years of the period as new and improved baldness treatments reach the 
market.
    (ii) To account for USS's lag in sales in the first year, the 
present discounted value of sales over the period is used as the basis 
for measuring benefits. Based on the risk associated with this venture, 
a discount rate of 10 percent is selected. The present discounted value 
of projected sales is determined to be approximately $154.4 million for 
USS and $158.9 million for FP. On this basis USS and FP are projected to 
obtain approximately

[[Page 883]]

49.3% and 50.7% of the benefit, respectively, and the costs of 
developing the baldness treatment are shared accordingly.
    (iii) (A) In the year 2002 the district director examines the cost 
sharing arrangement. USS and FP have obtained the following sales 
results through the year 2001:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                              USS     FP
------------------------------------------------------------------------
1997....................................................       0      17
1998....................................................      17      35
1999....................................................      25      41
2000....................................................      38      41
2001....................................................      39      41
------------------------------------------------------------------------

    (B) USS's sales initially grew more slowly than projected while FP's 
sales grew more quickly. In each of the first three years of the period 
the share of total sales of at least one of the parties diverged by over 
20% from its projected share of sales. However, by the year 2001 both 
parties' sales had leveled off at approximately their projected values. 
Taking into account this leveling off of sales and all the facts and 
circumstances, the district director determines that it is appropriate 
to use the original projections for the remaining years of sales. 
Combining the actual results through the year 2001 with the projections 
for subsequent years, and using a discount rate of 10%, the present 
discounted value of sales is approximately $141.6 million for USS and 
$187.3 million for FP. This result implies that USS and FP obtain 
approximately 43.1% and 56.9%, respectively, of the anticipated benefits 
from the baldness treatment. Because these benefit shares are within 20% 
of the benefit shares calculated based on the original sales 
projections, the district director determines that, based on the 
difference between actual and projected benefit shares, the original 
projections were not unreliable. No adjustment is made based on the 
difference between actual and projected benefit shares.
    Example 11. (i) The facts are the same as in Example 10, except that 
the actual sales results through the year 2001 are as follows:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                              USS     FP
------------------------------------------------------------------------
1997....................................................       0      17
1998....................................................      17      35
1999....................................................      25      44
2000....................................................      34      54
2001....................................................      36      55
------------------------------------------------------------------------

    (ii) Based on the discrepancy between the projections and the actual 
results and on consideration of all the facts, the district director 
determines that for the remaining years the following sales projections 
are more reliable than the original projections:

                                  Sales
                        [In millions of dollars]
------------------------------------------------------------------------
                          Year                             USS      FP
------------------------------------------------------------------------
2002...................................................     36        55
2003...................................................     36        55
2004...................................................     18        28
2005...................................................      9        14
2006...................................................      4.5       7
------------------------------------------------------------------------

    (iii) Combining the actual results through the year 2001 with the 
projections for subsequent years, and using a discount rate of 10%, the 
present discounted value of sales is approximately $131.2 million for 
USS and $229.4 million for FP. This result implies that USS and FP 
obtain approximately 35.4% and 63.6%, respectively, of the anticipated 
benefits from the baldness treatment. These benefit shares diverge by 
greater than 20% from the benefit shares calculated based on the 
original sales projections, and the district director determines that, 
based on the difference between actual and projected benefit shares, the 
original projections were unreliable. The district director adjusts 
costs shares for each of the taxable years under examination to conform 
them to the recalculated shares of anticipated benefits.

    (4) Timing of allocations. If the district director reallocates 
costs under the provisions of this paragraph (f), the allocation must be 
reflected for tax purposes in the year in which the costs were incurred. 
When a cost sharing payment is owed by one member of a qualified cost 
sharing arrangement to another member, the district director may make 
appropriate allocations to reflect an arm's length rate of interest for 
the time value of money, consistent with the provisions of Sec.  1.482-
2(a) (Loans or advances).
    (g) Allocations of income, deductions or other tax items to reflect 
transfers of intangibles (buy-in)--(1) In general. A controlled 
participant that makes intangible property available to a qualified cost 
sharing arrangement will be treated as having transferred interests in 
such property to the other controlled participants, and such other 
controlled participants must make buy-in payments to it, as provided in 
paragraph (g)(2) of this section. If the other controlled participants 
fail to make such payments, the district director may make appropriate 
allocations, under the provisions of Sec. Sec.  1.482-1 and 1.482-4

[[Page 884]]

through 1.482-6, to reflect an arm's length consideration for the 
transferred intangible property. Further, if a group of controlled 
taxpayers participates in a qualified cost sharing arrangement, any 
change in the controlled participants' interests in covered intangibles, 
whether by reason of entry of a new participant or otherwise by reason 
of transfers (including deemed transfers) of interests among existing 
participants, is a transfer of intangible property, and the district 
director may make appropriate allocations, under the provisions of 
Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6, to reflect an arm's 
length consideration for the transfer. See paragraphs (g) (3), (4), and 
(5) of this section. Paragraph (g)(6) of this section provides rules for 
assigning unassigned interests under a qualified cost sharing 
arrangement.
    (2) Pre-existing intangibles. If a controlled participant makes pre-
existing intangible property in which it owns an interest available to 
other controlled participants for purposes of research in the intangible 
development area under a qualified cost sharing arrangement, then each 
such other controlled participant must make a buy-in payment to the 
owner. The buy-in payment by each such other controlled participant is 
the arm's length charge for the use of the intangible under the rules of 
Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6, multiplied by the 
controlled participant's share of reasonably anticipated benefits (as 
defined in paragraph (f)(3) of this section). A controlled participant's 
payment required under this paragraph (g)(2) is deemed to be reduced to 
the extent of any payments owed to it under this paragraph (g)(2) from 
other controlled participants. Each payment received by a payee will be 
treated as coming pro rata out of payments made by all payors. See 
paragraph (g)(8), Example 4, of this section. Such payments will be 
treated as consideration for a transfer of an interest in the intangible 
property made available to the qualified cost sharing arrangement by the 
payee. Any payment to or from an uncontrolled participant in 
consideration for intangible property made available to the qualified 
cost sharing arrangement will be shared by the controlled participants 
in accordance with their shares of reasonably anticipated benefits (as 
defined in paragraph (f)(3) of this section). A controlled participant's 
payment required under this paragraph (g)(2) is deemed to be reduced by 
such a share of payments owed from an uncontrolled participant to the 
same extent as by any payments owed from other controlled participants 
under this paragraph (g)(2). See paragraph (g)(8), Example 5, of this 
section.
    (3) New controlled participant. If a new controlled participant 
enters a qualified cost sharing arrangement and acquires any interest in 
the covered intangibles, then the new participant must pay an arm's 
length consideration, under the provisions of Sec. Sec.  1.482-1 and 
1.482-4 through 1.482-6, for such interest to each controlled 
participant from whom such interest was acquired.
    (4) Controlled participant relinquishes interests. A controlled 
participant in a qualified cost sharing arrangement may be deemed to 
have acquired an interest in one or more covered intangibles if another 
controlled participant transfers, abandons, or otherwise relinquishes an 
interest under the arrangement, to the benefit of the first participant. 
If such a relinquishment occurs, the participant relinquishing the 
interest must receive an arm's length consideration, under the 
provisions of Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6, for its 
interest. If the controlled participant that has relinquished its 
interest subsequently uses that interest, then that participant must pay 
an arm's length consideration, under the provisions of Sec. Sec.  1.482-
1 and 1.482-4 through 1.482-6, to the controlled participant that 
acquired the interest.
    (5) Conduct inconsistent with the terms of a cost sharing 
arrangement. If, after any cost allocations authorized by paragraph 
(a)(2) of this section, a controlled participant bears costs of 
intangible development that over a period of years are consistently and 
materially greater or lesser than its share of reasonably anticipated 
benefits, then the district director may conclude that the economic 
substance of the arrangement between the controlled participants is 
inconsistent with the terms of the cost sharing arrangement. In such a 
case, the district director may disregard such terms and impute an

[[Page 885]]

agreement consistent with the controlled participants' course of 
conduct, under which a controlled participant that bore a 
disproportionately greater share of costs received additional interests 
in covered intangibles. See Sec.  1.482-1(d)(3)(ii)(B) (Identifying 
contractual terms) and Sec.  1.482- 4(f)(3)(ii) (Identification of 
owner). Accordingly, that participant must receive an arm's length 
payment from any controlled participant whose share of the intangible 
development costs is less than its share of reasonably anticipated 
benefits over time, under the provisions of Sec. Sec.  1.482-1 and 
1.482-4 through 1.482-6.
    (6) Failure to assign interests under a qualified cost sharing 
arrangement. If a qualified cost sharing arrangement fails to assign an 
interest in a covered intangible, then each controlled participant will 
be deemed to hold a share in such interest equal to its share of the 
costs of developing such intangible. For this purpose, if cost shares 
have varied materially over the period during which such intangible was 
developed, then the costs of developing the intangible must be measured 
by their present discounted value as of the date when the first such 
costs were incurred.
    (7) Form of consideration. The consideration for an acquisition 
described in this paragraph (g) may take any of the following forms:
    (i) Lump sum payments. For the treatment of lump sum payments, see 
Sec.  1.482-4(f)(5) (Lump sum payments);
    (ii) Installment payments. Installment payments spread over the 
period of use of the intangible by the transferee, with interest 
calculated in accordance with Sec.  1.482-2(a) (Loans or advances); and
    (iii) Royalties. Royalties or other payments contingent on the use 
of the intangible by the transferee.
    (8) Examples. The following examples illustrate allocations 
described in this paragraph (g):

    Example 1. In year one, four members of a controlled group enter 
into a cost sharing arrangement to develop a commercially feasible 
process for capturing energy from nuclear fusion. Based on a reliable 
projection of their future benefits, each cost sharing participant bears 
an equal share of the costs. The cost of developing intangibles for each 
participant with respect to the project is approximately $1 million per 
year. In year ten, a fifth member of the controlled group joins the cost 
sharing group and agrees to bear one-fifth of the future costs in 
exchange for part of the fourth member's territory reasonably 
anticipated to yield benefits amounting to one-fifth of the total 
benefits. The fair market value of intangible property within the 
arrangement at the time the fifth company joins the arrangement is $45 
million. The new member must pay one-fifth of that amount (that is, $9 
million total) to the fourth member from whom it acquired its interest 
in covered intangibles.
    Example 2. U.S. Subsidiary (USS), Foreign Subsidiary (FS) and 
Foreign Parent (FP) enter into a cost sharing arrangement to develop new 
products within the Group X product line. USS manufactures and sells 
Group X products in North America, FS manufactures and sells Group X 
products in South America, and FP manufactures and sells Group X 
products in the rest of the world. USS, FS and FP project that each will 
manufacture and sell a third of the Group X products under development, 
and they share costs on the basis of projected sales of manufactured 
products. When the new Group X products are developed, however, USS 
ceases to manufacture Group X products, and FP sells its Group X 
products to USS for resale in the North American market. USS earns a 
return on its resale activity that is appropriate given its function as 
a distributor, but does not earn a return attributable to exploiting 
covered intangibles. The district director determines that USS's share 
of the costs (one-third) was greater than its share of reasonably 
anticipated benefits (zero) and that it has transferred an interest in 
the intangibles for which it should receive a payment from FP, whose 
share of the intangible development costs (one-third) was less than its 
share of reasonably anticipated benefits over time (two-thirds). An 
allocation is made under Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6 
from FP to USS to recognize USS' one-third interest in the intangibles. 
No allocation is made from FS to USS because FS did not exploit USS's 
interest in covered intangibles.
    Example 3. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and 
Foreign Subsidiary 2 (FS2) enter into a cost sharing arrangement to 
develop a cure for the common cold. Costs are shared USP-50%, FS1-40% 
and FS2-10% on the basis of projected units of cold medicine to be 
produced by each. After ten years of research and development, FS1 
withdraws from the arrangement, transferring its interests in the 
intangibles under development to USP in exchange for a lump sum payment 
of $10 million. The district director may review this lump sum payment, 
under the provisions of Sec.  1.482-4(f)(5), to ensure that the amount 
is commensurate with the income attributable to the intangibles.

[[Page 886]]

    Example 4. (i) Four members A, B, C, and D of a controlled group 
form a cost sharing arrangement to develop the next generation 
technology for their business. Based on a reliable projection of their 
future benefits, the participants agree to bear shares of the costs 
incurred during the term of the agreement in the following percentages: 
A 40%; B 15%; C 25%; and D 20%. The arm's length charges, under the 
rules of Sec. Sec.  1.482-1 and 1.482-4 through 1.482-6, for the use of 
the existing intangible property they respectively make available to the 
cost sharing arrangement are in the following amounts for the taxable 
year: A 80X; B 40X; C 30X; and D 30X. The provisional (before offsets) 
and final buy-in payments/receipts among A, B, C, and D are shown in the 
table as follows:

                       [All amounts stated in X's]
------------------------------------------------------------------------
                                      A         B         C         D
------------------------------------------------------------------------
Payments........................  <40
Sec. Sec.  1.484-1.500  [Reserved]

[[Page 889]]



                              FINDING AIDS




  --------------------------------------------------------------------

  A list of CFR titles, subtitles, chapters, subchapters and parts and 
an alphabetical list of agencies publishing in the CFR are included in 
the CFR Index and Finding Aids volume to the Code of Federal Regulations 
which is published separately and revised annually.

  Table of CFR Titles and Chapters
  Alphabetical List of Agencies Appearing in the CFR
  Table of OMB Control Numbers
  List of CFR Sections Affected

[[Page 891]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2022)

                      Title 1--General Provisions

         I  Administrative Committee of the Federal Register 
                (Parts 1--49)
        II  Office of the Federal Register (Parts 50--299)
       III  Administrative Conference of the United States (Parts 
                300--399)
        IV  Miscellaneous Agencies (Parts 400--599)
        VI  National Capital Planning Commission (Parts 600--699)

                    Title 2--Grants and Agreements

            Subtitle A--Office of Management and Budget Guidance 
                for Grants and Agreements
         I  Office of Management and Budget Governmentwide 
                Guidance for Grants and Agreements (Parts 2--199)
        II  Office of Management and Budget Guidance (Parts 200--
                299)
            Subtitle B--Federal Agency Regulations for Grants and 
                Agreements
       III  Department of Health and Human Services (Parts 300--
                399)
        IV  Department of Agriculture (Parts 400--499)
        VI  Department of State (Parts 600--699)
       VII  Agency for International Development (Parts 700--799)
      VIII  Department of Veterans Affairs (Parts 800--899)
        IX  Department of Energy (Parts 900--999)
         X  Department of the Treasury (Parts 1000--1099)
        XI  Department of Defense (Parts 1100--1199)
       XII  Department of Transportation (Parts 1200--1299)
      XIII  Department of Commerce (Parts 1300--1399)
       XIV  Department of the Interior (Parts 1400--1499)
        XV  Environmental Protection Agency (Parts 1500--1599)
     XVIII  National Aeronautics and Space Administration (Parts 
                1800--1899)
        XX  United States Nuclear Regulatory Commission (Parts 
                2000--2099)
      XXII  Corporation for National and Community Service (Parts 
                2200--2299)
     XXIII  Social Security Administration (Parts 2300--2399)
      XXIV  Department of Housing and Urban Development (Parts 
                2400--2499)
       XXV  National Science Foundation (Parts 2500--2599)
      XXVI  National Archives and Records Administration (Parts 
                2600--2699)

[[Page 892]]

     XXVII  Small Business Administration (Parts 2700--2799)
    XXVIII  Department of Justice (Parts 2800--2899)
      XXIX  Department of Labor (Parts 2900--2999)
       XXX  Department of Homeland Security (Parts 3000--3099)
      XXXI  Institute of Museum and Library Services (Parts 3100--
                3199)
     XXXII  National Endowment for the Arts (Parts 3200--3299)
    XXXIII  National Endowment for the Humanities (Parts 3300--
                3399)
     XXXIV  Department of Education (Parts 3400--3499)
      XXXV  Export-Import Bank of the United States (Parts 3500--
                3599)
     XXXVI  Office of National Drug Control Policy, Executive 
                Office of the President (Parts 3600--3699)
    XXXVII  Peace Corps (Parts 3700--3799)
     LVIII  Election Assistance Commission (Parts 5800--5899)
       LIX  Gulf Coast Ecosystem Restoration Council (Parts 5900--
                5999)

                        Title 3--The President

         I  Executive Office of the President (Parts 100--199)

                           Title 4--Accounts

         I  Government Accountability Office (Parts 1--199)

                   Title 5--Administrative Personnel

         I  Office of Personnel Management (Parts 1--1199)
        II  Merit Systems Protection Board (Parts 1200--1299)
       III  Office of Management and Budget (Parts 1300--1399)
        IV  Office of Personnel Management and Office of the 
                Director of National Intelligence (Parts 1400--
                1499)
         V  The International Organizations Employees Loyalty 
                Board (Parts 1500--1599)
        VI  Federal Retirement Thrift Investment Board (Parts 
                1600--1699)
      VIII  Office of Special Counsel (Parts 1800--1899)
        IX  Appalachian Regional Commission (Parts 1900--1999)
        XI  Armed Forces Retirement Home (Parts 2100--2199)
       XIV  Federal Labor Relations Authority, General Counsel of 
                the Federal Labor Relations Authority and Federal 
                Service Impasses Panel (Parts 2400--2499)
       XVI  Office of Government Ethics (Parts 2600--2699)
       XXI  Department of the Treasury (Parts 3100--3199)
      XXII  Federal Deposit Insurance Corporation (Parts 3200--
                3299)
     XXIII  Department of Energy (Parts 3300--3399)
      XXIV  Federal Energy Regulatory Commission (Parts 3400--
                3499)
       XXV  Department of the Interior (Parts 3500--3599)
      XXVI  Department of Defense (Parts 3600--3699)

[[Page 893]]

    XXVIII  Department of Justice (Parts 3800--3899)
      XXIX  Federal Communications Commission (Parts 3900--3999)
       XXX  Farm Credit System Insurance Corporation (Parts 4000--
                4099)
      XXXI  Farm Credit Administration (Parts 4100--4199)
    XXXIII  U.S. International Development Finance Corporation 
                (Parts 4300--4399)
     XXXIV  Securities and Exchange Commission (Parts 4400--4499)
      XXXV  Office of Personnel Management (Parts 4500--4599)
     XXXVI  Department of Homeland Security (Parts 4600--4699)
    XXXVII  Federal Election Commission (Parts 4700--4799)
        XL  Interstate Commerce Commission (Parts 5000--5099)
       XLI  Commodity Futures Trading Commission (Parts 5100--
                5199)
      XLII  Department of Labor (Parts 5200--5299)
     XLIII  National Science Foundation (Parts 5300--5399)
       XLV  Department of Health and Human Services (Parts 5500--
                5599)
      XLVI  Postal Rate Commission (Parts 5600--5699)
     XLVII  Federal Trade Commission (Parts 5700--5799)
    XLVIII  Nuclear Regulatory Commission (Parts 5800--5899)
      XLIX  Federal Labor Relations Authority (Parts 5900--5999)
         L  Department of Transportation (Parts 6000--6099)
       LII  Export-Import Bank of the United States (Parts 6200--
                6299)
      LIII  Department of Education (Parts 6300--6399)
       LIV  Environmental Protection Agency (Parts 6400--6499)
        LV  National Endowment for the Arts (Parts 6500--6599)
       LVI  National Endowment for the Humanities (Parts 6600--
                6699)
      LVII  General Services Administration (Parts 6700--6799)
     LVIII  Board of Governors of the Federal Reserve System 
                (Parts 6800--6899)
       LIX  National Aeronautics and Space Administration (Parts 
                6900--6999)
        LX  United States Postal Service (Parts 7000--7099)
       LXI  National Labor Relations Board (Parts 7100--7199)
      LXII  Equal Employment Opportunity Commission (Parts 7200--
                7299)
     LXIII  Inter-American Foundation (Parts 7300--7399)
      LXIV  Merit Systems Protection Board (Parts 7400--7499)
       LXV  Department of Housing and Urban Development (Parts 
                7500--7599)
      LXVI  National Archives and Records Administration (Parts 
                7600--7699)
     LXVII  Institute of Museum and Library Services (Parts 7700--
                7799)
    LXVIII  Commission on Civil Rights (Parts 7800--7899)
      LXIX  Tennessee Valley Authority (Parts 7900--7999)
       LXX  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 8000--8099)
      LXXI  Consumer Product Safety Commission (Parts 8100--8199)
    LXXIII  Department of Agriculture (Parts 8300--8399)

[[Page 894]]

     LXXIV  Federal Mine Safety and Health Review Commission 
                (Parts 8400--8499)
     LXXVI  Federal Retirement Thrift Investment Board (Parts 
                8600--8699)
    LXXVII  Office of Management and Budget (Parts 8700--8799)
      LXXX  Federal Housing Finance Agency (Parts 9000--9099)
   LXXXIII  Special Inspector General for Afghanistan 
                Reconstruction (Parts 9300--9399)
    LXXXIV  Bureau of Consumer Financial Protection (Parts 9400--
                9499)
    LXXXVI  National Credit Union Administration (Parts 9600--
                9699)
     XCVII  Department of Homeland Security Human Resources 
                Management System (Department of Homeland 
                Security--Office of Personnel Management) (Parts 
                9700--9799)
    XCVIII  Council of the Inspectors General on Integrity and 
                Efficiency (Parts 9800--9899)
      XCIX  Military Compensation and Retirement Modernization 
                Commission (Parts 9900--9999)
         C  National Council on Disability (Parts 10000--10049)
        CI  National Mediation Board (Parts 10100--10199)
       CII  U.S. Office of Special Counsel (Parts 10200--10299)

                      Title 6--Domestic Security

         I  Department of Homeland Security, Office of the 
                Secretary (Parts 1--199)
         X  Privacy and Civil Liberties Oversight Board (Parts 
                1000--1099)

                         Title 7--Agriculture

            Subtitle A--Office of the Secretary of Agriculture 
                (Parts 0--26)
            Subtitle B--Regulations of the Department of 
                Agriculture
         I  Agricultural Marketing Service (Standards, 
                Inspections, Marketing Practices), Department of 
                Agriculture (Parts 27--209)
        II  Food and Nutrition Service, Department of Agriculture 
                (Parts 210--299)
       III  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 300--399)
        IV  Federal Crop Insurance Corporation, Department of 
                Agriculture (Parts 400--499)
         V  Agricultural Research Service, Department of 
                Agriculture (Parts 500--599)
        VI  Natural Resources Conservation Service, Department of 
                Agriculture (Parts 600--699)
       VII  Farm Service Agency, Department of Agriculture (Parts 
                700--799)
      VIII  Agricultural Marketing Service (Federal Grain 
                Inspection Service, Fair Trade Practices Program), 
                Department of Agriculture (Parts 800--899)

[[Page 895]]

        IX  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Fruits, Vegetables, Nuts), Department 
                of Agriculture (Parts 900--999)
         X  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Milk), Department of Agriculture 
                (Parts 1000--1199)
        XI  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Miscellaneous Commodities), Department 
                of Agriculture (Parts 1200--1299)
       XIV  Commodity Credit Corporation, Department of 
                Agriculture (Parts 1400--1499)
        XV  Foreign Agricultural Service, Department of 
                Agriculture (Parts 1500--1599)
       XVI  [Reserved]
      XVII  Rural Utilities Service, Department of Agriculture 
                (Parts 1700--1799)
     XVIII  Rural Housing Service, Rural Business-Cooperative 
                Service, Rural Utilities Service, and Farm Service 
                Agency, Department of Agriculture (Parts 1800--
                2099)
        XX  [Reserved]
       XXV  Office of Advocacy and Outreach, Department of 
                Agriculture (Parts 2500--2599)
      XXVI  Office of Inspector General, Department of Agriculture 
                (Parts 2600--2699)
     XXVII  Office of Information Resources Management, Department 
                of Agriculture (Parts 2700--2799)
    XXVIII  Office of Operations, Department of Agriculture (Parts 
                2800--2899)
      XXIX  Office of Energy Policy and New Uses, Department of 
                Agriculture (Parts 2900--2999)
       XXX  Office of the Chief Financial Officer, Department of 
                Agriculture (Parts 3000--3099)
      XXXI  Office of Environmental Quality, Department of 
                Agriculture (Parts 3100--3199)
     XXXII  Office of Procurement and Property Management, 
                Department of Agriculture (Parts 3200--3299)
    XXXIII  Office of Transportation, Department of Agriculture 
                (Parts 3300--3399)
     XXXIV  National Institute of Food and Agriculture (Parts 
                3400--3499)
      XXXV  Rural Housing Service, Department of Agriculture 
                (Parts 3500--3599)
     XXXVI  National Agricultural Statistics Service, Department 
                of Agriculture (Parts 3600--3699)
    XXXVII  Economic Research Service, Department of Agriculture 
                (Parts 3700--3799)
   XXXVIII  World Agricultural Outlook Board, Department of 
                Agriculture (Parts 3800--3899)
       XLI  [Reserved]
      XLII  Rural Business-Cooperative Service and Rural Utilities 
                Service, Department of Agriculture (Parts 4200--
                4299)

[[Page 896]]

         L  Rural Business-Cooperative Service, and Rural 
                Utilities Service, Department of Agriculture 
                (Parts 5000--5099)

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (Parts 1--499)
         V  Executive Office for Immigration Review, Department of 
                Justice (Parts 1000--1399)

                 Title 9--Animals and Animal Products

         I  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 1--199)
        II  Agricultural Marketing Service (Fair Trade Practices 
                Program), Department of Agriculture (Parts 200--
                299)
       III  Food Safety and Inspection Service, Department of 
                Agriculture (Parts 300--599)

                           Title 10--Energy

         I  Nuclear Regulatory Commission (Parts 0--199)
        II  Department of Energy (Parts 200--699)
       III  Department of Energy (Parts 700--999)
         X  Department of Energy (General Provisions) (Parts 
                1000--1099)
      XIII  Nuclear Waste Technical Review Board (Parts 1300--
                1399)
      XVII  Defense Nuclear Facilities Safety Board (Parts 1700--
                1799)
     XVIII  Northeast Interstate Low-Level Radioactive Waste 
                Commission (Parts 1800--1899)

                      Title 11--Federal Elections

         I  Federal Election Commission (Parts 1--9099)
        II  Election Assistance Commission (Parts 9400--9499)

                      Title 12--Banks and Banking

         I  Comptroller of the Currency, Department of the 
                Treasury (Parts 1--199)
        II  Federal Reserve System (Parts 200--299)
       III  Federal Deposit Insurance Corporation (Parts 300--399)
        IV  Export-Import Bank of the United States (Parts 400--
                499)
         V  [Reserved]
        VI  Farm Credit Administration (Parts 600--699)
       VII  National Credit Union Administration (Parts 700--799)
      VIII  Federal Financing Bank (Parts 800--899)
        IX  (Parts 900--999) [Reserved]
         X  Bureau of Consumer Financial Protection (Parts 1000--
                1099)

[[Page 897]]

        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XII  Federal Housing Finance Agency (Parts 1200--1299)
      XIII  Financial Stability Oversight Council (Parts 1300--
                1399)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        XV  Department of the Treasury (Parts 1500--1599)
       XVI  Office of Financial Research, Department of the 
                Treasury (Parts 1600--1699)
      XVII  Office of Federal Housing Enterprise Oversight, 
                Department of Housing and Urban Development (Parts 
                1700--1799)
     XVIII  Community Development Financial Institutions Fund, 
                Department of the Treasury (Parts 1800--1899)

               Title 13--Business Credit and Assistance

         I  Small Business Administration (Parts 1--199)
       III  Economic Development Administration, Department of 
                Commerce (Parts 300--399)
        IV  Emergency Steel Guarantee Loan Board (Parts 400--499)
         V  Emergency Oil and Gas Guaranteed Loan Board (Parts 
                500--599)

                    Title 14--Aeronautics and Space

         I  Federal Aviation Administration, Department of 
                Transportation (Parts 1--199)
        II  Office of the Secretary, Department of Transportation 
                (Aviation Proceedings) (Parts 200--399)
       III  Commercial Space Transportation, Federal Aviation 
                Administration, Department of Transportation 
                (Parts 400--1199)
         V  National Aeronautics and Space Administration (Parts 
                1200--1299)
        VI  Air Transportation System Stabilization (Parts 1300--
                1399)

                 Title 15--Commerce and Foreign Trade

            Subtitle A--Office of the Secretary of Commerce (Parts 
                0--29)
            Subtitle B--Regulations Relating to Commerce and 
                Foreign Trade
         I  Bureau of the Census, Department of Commerce (Parts 
                30--199)
        II  National Institute of Standards and Technology, 
                Department of Commerce (Parts 200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  Foreign-Trade Zones Board, Department of Commerce 
                (Parts 400--499)
       VII  Bureau of Industry and Security, Department of 
                Commerce (Parts 700--799)

[[Page 898]]

      VIII  Bureau of Economic Analysis, Department of Commerce 
                (Parts 800--899)
        IX  National Oceanic and Atmospheric Administration, 
                Department of Commerce (Parts 900--999)
        XI  National Technical Information Service, Department of 
                Commerce (Parts 1100--1199)
      XIII  East-West Foreign Trade Board (Parts 1300--1399)
       XIV  Minority Business Development Agency (Parts 1400--
                1499)
        XV  Office of the Under-Secretary for Economic Affairs, 
                Department of Commerce (Parts 1500--1599)
            Subtitle C--Regulations Relating to Foreign Trade 
                Agreements
        XX  Office of the United States Trade Representative 
                (Parts 2000--2099)
            Subtitle D--Regulations Relating to Telecommunications 
                and Information
     XXIII  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                2300--2399) [Reserved]

                    Title 16--Commercial Practices

         I  Federal Trade Commission (Parts 0--999)
        II  Consumer Product Safety Commission (Parts 1000--1799)

             Title 17--Commodity and Securities Exchanges

         I  Commodity Futures Trading Commission (Parts 1--199)
        II  Securities and Exchange Commission (Parts 200--399)
        IV  Department of the Treasury (Parts 400--499)

          Title 18--Conservation of Power and Water Resources

         I  Federal Energy Regulatory Commission, Department of 
                Energy (Parts 1--399)
       III  Delaware River Basin Commission (Parts 400--499)
        VI  Water Resources Council (Parts 700--799)
      VIII  Susquehanna River Basin Commission (Parts 800--899)
      XIII  Tennessee Valley Authority (Parts 1300--1399)

                       Title 19--Customs Duties

         I  U.S. Customs and Border Protection, Department of 
                Homeland Security; Department of the Treasury 
                (Parts 0--199)
        II  United States International Trade Commission (Parts 
                200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  U.S. Immigration and Customs Enforcement, Department 
                of Homeland Security (Parts 400--599) [Reserved]

[[Page 899]]

                     Title 20--Employees' Benefits

         I  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 1--199)
        II  Railroad Retirement Board (Parts 200--399)
       III  Social Security Administration (Parts 400--499)
        IV  Employees' Compensation Appeals Board, Department of 
                Labor (Parts 500--599)
         V  Employment and Training Administration, Department of 
                Labor (Parts 600--699)
        VI  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 700--799)
       VII  Benefits Review Board, Department of Labor (Parts 
                800--899)
      VIII  Joint Board for the Enrollment of Actuaries (Parts 
                900--999)
        IX  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 1000--1099)

                       Title 21--Food and Drugs

         I  Food and Drug Administration, Department of Health and 
                Human Services (Parts 1--1299)
        II  Drug Enforcement Administration, Department of Justice 
                (Parts 1300--1399)
       III  Office of National Drug Control Policy (Parts 1400--
                1499)

                      Title 22--Foreign Relations

         I  Department of State (Parts 1--199)
        II  Agency for International Development (Parts 200--299)
       III  Peace Corps (Parts 300--399)
        IV  International Joint Commission, United States and 
                Canada (Parts 400--499)
         V  United States Agency for Global Media (Parts 500--599)
       VII  U.S. International Development Finance Corporation 
                (Parts 700--799)
        IX  Foreign Service Grievance Board (Parts 900--999)
         X  Inter-American Foundation (Parts 1000--1099)
        XI  International Boundary and Water Commission, United 
                States and Mexico, United States Section (Parts 
                1100--1199)
       XII  United States International Development Cooperation 
                Agency (Parts 1200--1299)
      XIII  Millennium Challenge Corporation (Parts 1300--1399)
       XIV  Foreign Service Labor Relations Board; Federal Labor 
                Relations Authority; General Counsel of the 
                Federal Labor Relations Authority; and the Foreign 
                Service Impasse Disputes Panel (Parts 1400--1499)
        XV  African Development Foundation (Parts 1500--1599)
       XVI  Japan-United States Friendship Commission (Parts 
                1600--1699)
      XVII  United States Institute of Peace (Parts 1700--1799)

[[Page 900]]

                          Title 23--Highways

         I  Federal Highway Administration, Department of 
                Transportation (Parts 1--999)
        II  National Highway Traffic Safety Administration and 
                Federal Highway Administration, Department of 
                Transportation (Parts 1200--1299)
       III  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 1300--1399)

                Title 24--Housing and Urban Development

            Subtitle A--Office of the Secretary, Department of 
                Housing and Urban Development (Parts 0--99)
            Subtitle B--Regulations Relating to Housing and Urban 
                Development
         I  Office of Assistant Secretary for Equal Opportunity, 
                Department of Housing and Urban Development (Parts 
                100--199)
        II  Office of Assistant Secretary for Housing-Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 200--299)
       III  Government National Mortgage Association, Department 
                of Housing and Urban Development (Parts 300--399)
        IV  Office of Housing and Office of Multifamily Housing 
                Assistance Restructuring, Department of Housing 
                and Urban Development (Parts 400--499)
         V  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 500--599)
        VI  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 600--699) [Reserved]
       VII  Office of the Secretary, Department of Housing and 
                Urban Development (Housing Assistance Programs and 
                Public and Indian Housing Programs) (Parts 700--
                799)
      VIII  Office of the Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Section 8 Housing Assistance 
                Programs, Section 202 Direct Loan Program, Section 
                202 Supportive Housing for the Elderly Program and 
                Section 811 Supportive Housing for Persons With 
                Disabilities Program) (Parts 800--899)
        IX  Office of Assistant Secretary for Public and Indian 
                Housing, Department of Housing and Urban 
                Development (Parts 900--1699)
         X  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Interstate Land Sales 
                Registration Program) (Parts 1700--1799) 
                [Reserved]
       XII  Office of Inspector General, Department of Housing and 
                Urban Development (Parts 2000--2099)
        XV  Emergency Mortgage Insurance and Loan Programs, 
                Department of Housing and Urban Development (Parts 
                2700--2799) [Reserved]

[[Page 901]]

        XX  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 3200--3899)
      XXIV  Board of Directors of the HOPE for Homeowners Program 
                (Parts 4000--4099) [Reserved]
       XXV  Neighborhood Reinvestment Corporation (Parts 4100--
                4199)

                           Title 25--Indians

         I  Bureau of Indian Affairs, Department of the Interior 
                (Parts 1--299)
        II  Indian Arts and Crafts Board, Department of the 
                Interior (Parts 300--399)
       III  National Indian Gaming Commission, Department of the 
                Interior (Parts 500--599)
        IV  Office of Navajo and Hopi Indian Relocation (Parts 
                700--899)
         V  Bureau of Indian Affairs, Department of the Interior, 
                and Indian Health Service, Department of Health 
                and Human Services (Part 900--999)
        VI  Office of the Assistant Secretary, Indian Affairs, 
                Department of the Interior (Parts 1000--1199)
       VII  Office of the Special Trustee for American Indians, 
                Department of the Interior (Parts 1200--1299)

                      Title 26--Internal Revenue

         I  Internal Revenue Service, Department of the Treasury 
                (Parts 1--End)

           Title 27--Alcohol, Tobacco Products and Firearms

         I  Alcohol and Tobacco Tax and Trade Bureau, Department 
                of the Treasury (Parts 1--399)
        II  Bureau of Alcohol, Tobacco, Firearms, and Explosives, 
                Department of Justice (Parts 400--799)

                   Title 28--Judicial Administration

         I  Department of Justice (Parts 0--299)
       III  Federal Prison Industries, Inc., Department of Justice 
                (Parts 300--399)
         V  Bureau of Prisons, Department of Justice (Parts 500--
                599)
        VI  Offices of Independent Counsel, Department of Justice 
                (Parts 600--699)
       VII  Office of Independent Counsel (Parts 700--799)
      VIII  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 800--899)
        IX  National Crime Prevention and Privacy Compact Council 
                (Parts 900--999)

[[Page 902]]

        XI  Department of Justice and Department of State (Parts 
                1100--1199)

                            Title 29--Labor

            Subtitle A--Office of the Secretary of Labor (Parts 
                0--99)
            Subtitle B--Regulations Relating to Labor
         I  National Labor Relations Board (Parts 100--199)
        II  Office of Labor-Management Standards, Department of 
                Labor (Parts 200--299)
       III  National Railroad Adjustment Board (Parts 300--399)
        IV  Office of Labor-Management Standards, Department of 
                Labor (Parts 400--499)
         V  Wage and Hour Division, Department of Labor (Parts 
                500--899)
        IX  Construction Industry Collective Bargaining Commission 
                (Parts 900--999)
         X  National Mediation Board (Parts 1200--1299)
       XII  Federal Mediation and Conciliation Service (Parts 
                1400--1499)
       XIV  Equal Employment Opportunity Commission (Parts 1600--
                1699)
      XVII  Occupational Safety and Health Administration, 
                Department of Labor (Parts 1900--1999)
        XX  Occupational Safety and Health Review Commission 
                (Parts 2200--2499)
       XXV  Employee Benefits Security Administration, Department 
                of Labor (Parts 2500--2599)
     XXVII  Federal Mine Safety and Health Review Commission 
                (Parts 2700--2799)
        XL  Pension Benefit Guaranty Corporation (Parts 4000--
                4999)

                      Title 30--Mineral Resources

         I  Mine Safety and Health Administration, Department of 
                Labor (Parts 1--199)
        II  Bureau of Safety and Environmental Enforcement, 
                Department of the Interior (Parts 200--299)
        IV  Geological Survey, Department of the Interior (Parts 
                400--499)
         V  Bureau of Ocean Energy Management, Department of the 
                Interior (Parts 500--599)
       VII  Office of Surface Mining Reclamation and Enforcement, 
                Department of the Interior (Parts 700--999)
       XII  Office of Natural Resources Revenue, Department of the 
                Interior (Parts 1200--1299)

                 Title 31--Money and Finance: Treasury

            Subtitle A--Office of the Secretary of the Treasury 
                (Parts 0--50)
            Subtitle B--Regulations Relating to Money and Finance

[[Page 903]]

         I  Monetary Offices, Department of the Treasury (Parts 
                51--199)
        II  Fiscal Service, Department of the Treasury (Parts 
                200--399)
        IV  Secret Service, Department of the Treasury (Parts 
                400--499)
         V  Office of Foreign Assets Control, Department of the 
                Treasury (Parts 500--599)
        VI  Bureau of Engraving and Printing, Department of the 
                Treasury (Parts 600--699)
       VII  Federal Law Enforcement Training Center, Department of 
                the Treasury (Parts 700--799)
      VIII  Office of Investment Security, Department of the 
                Treasury (Parts 800--899)
        IX  Federal Claims Collection Standards (Department of the 
                Treasury--Department of Justice) (Parts 900--999)
         X  Financial Crimes Enforcement Network, Department of 
                the Treasury (Parts 1000--1099)

                      Title 32--National Defense

            Subtitle A--Department of Defense
         I  Office of the Secretary of Defense (Parts 1--399)
         V  Department of the Army (Parts 400--699)
        VI  Department of the Navy (Parts 700--799)
       VII  Department of the Air Force (Parts 800--1099)
            Subtitle B--Other Regulations Relating to National 
                Defense
       XII  Department of Defense, Defense Logistics Agency (Parts 
                1200--1299)
       XVI  Selective Service System (Parts 1600--1699)
      XVII  Office of the Director of National Intelligence (Parts 
                1700--1799)
     XVIII  National Counterintelligence Center (Parts 1800--1899)
       XIX  Central Intelligence Agency (Parts 1900--1999)
        XX  Information Security Oversight Office, National 
                Archives and Records Administration (Parts 2000--
                2099)
       XXI  National Security Council (Parts 2100--2199)
      XXIV  Office of Science and Technology Policy (Parts 2400--
                2499)
     XXVII  Office for Micronesian Status Negotiations (Parts 
                2700--2799)
    XXVIII  Office of the Vice President of the United States 
                (Parts 2800--2899)

               Title 33--Navigation and Navigable Waters

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Corps of Engineers, Department of the Army, Department 
                of Defense (Parts 200--399)
        IV  Great Lakes St. Lawrence Seaway Development 
                Corporation, Department of Transportation (Parts 
                400--499)

[[Page 904]]

                          Title 34--Education

            Subtitle A--Office of the Secretary, Department of 
                Education (Parts 1--99)
            Subtitle B--Regulations of the Offices of the 
                Department of Education
         I  Office for Civil Rights, Department of Education 
                (Parts 100--199)
        II  Office of Elementary and Secondary Education, 
                Department of Education (Parts 200--299)
       III  Office of Special Education and Rehabilitative 
                Services, Department of Education (Parts 300--399)
        IV  Office of Career, Technical, and Adult Education, 
                Department of Education (Parts 400--499)
         V  Office of Bilingual Education and Minority Languages 
                Affairs, Department of Education (Parts 500--599) 
                [Reserved]
        VI  Office of Postsecondary Education, Department of 
                Education (Parts 600--699)
       VII  Office of Educational Research and Improvement, 
                Department of Education (Parts 700--799) 
                [Reserved]
            Subtitle C--Regulations Relating to Education
        XI  [Reserved]
       XII  National Council on Disability (Parts 1200--1299)

                          Title 35 [Reserved]

             Title 36--Parks, Forests, and Public Property

         I  National Park Service, Department of the Interior 
                (Parts 1--199)
        II  Forest Service, Department of Agriculture (Parts 200--
                299)
       III  Corps of Engineers, Department of the Army (Parts 
                300--399)
        IV  American Battle Monuments Commission (Parts 400--499)
         V  Smithsonian Institution (Parts 500--599)
        VI  [Reserved]
       VII  Library of Congress (Parts 700--799)
      VIII  Advisory Council on Historic Preservation (Parts 800--
                899)
        IX  Pennsylvania Avenue Development Corporation (Parts 
                900--999)
         X  Presidio Trust (Parts 1000--1099)
        XI  Architectural and Transportation Barriers Compliance 
                Board (Parts 1100--1199)
       XII  National Archives and Records Administration (Parts 
                1200--1299)
        XV  Oklahoma City National Memorial Trust (Parts 1500--
                1599)
       XVI  Morris K. Udall Scholarship and Excellence in National 
                Environmental Policy Foundation (Parts 1600--1699)

             Title 37--Patents, Trademarks, and Copyrights

         I  United States Patent and Trademark Office, Department 
                of Commerce (Parts 1--199)
        II  U.S. Copyright Office, Library of Congress (Parts 
                200--299)

[[Page 905]]

       III  Copyright Royalty Board, Library of Congress (Parts 
                300--399)
        IV  National Institute of Standards and Technology, 
                Department of Commerce (Parts 400--599)

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--199)
        II  Armed Forces Retirement Home (Parts 200--299)

                       Title 39--Postal Service

         I  United States Postal Service (Parts 1--999)
       III  Postal Regulatory Commission (Parts 3000--3099)

                  Title 40--Protection of Environment

         I  Environmental Protection Agency (Parts 1--1099)
        IV  Environmental Protection Agency and Department of 
                Justice (Parts 1400--1499)
         V  Council on Environmental Quality (Parts 1500--1599)
        VI  Chemical Safety and Hazard Investigation Board (Parts 
                1600--1699)
       VII  Environmental Protection Agency and Department of 
                Defense; Uniform National Discharge Standards for 
                Vessels of the Armed Forces (Parts 1700--1799)
      VIII  Gulf Coast Ecosystem Restoration Council (Parts 1800--
                1899)
        IX  Federal Permitting Improvement Steering Council (Part 
                1900)

          Title 41--Public Contracts and Property Management

            Subtitle A--Federal Procurement Regulations System 
                [Note]
            Subtitle B--Other Provisions Relating to Public 
                Contracts
        50  Public Contracts, Department of Labor (Parts 50-1--50-
                999)
        51  Committee for Purchase From People Who Are Blind or 
                Severely Disabled (Parts 51-1--51-99)
        60  Office of Federal Contract Compliance Programs, Equal 
                Employment Opportunity, Department of Labor (Parts 
                60-1--60-999)
        61  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 61-1--61-999)
   62--100  [Reserved]
            Subtitle C--Federal Property Management Regulations 
                System
       101  Federal Property Management Regulations (Parts 101-1--
                101-99)
       102  Federal Management Regulation (Parts 102-1--102-299)
  103--104  [Reserved]
       105  General Services Administration (Parts 105-1--105-999)

[[Page 906]]

       109  Department of Energy Property Management Regulations 
                (Parts 109-1--109-99)
       114  Department of the Interior (Parts 114-1--114-99)
       115  Environmental Protection Agency (Parts 115-1--115-99)
       128  Department of Justice (Parts 128-1--128-99)
  129--200  [Reserved]
            Subtitle D--Federal Acquisition Supply Chain Security
       201  Federal Acquisition Security Council (Part 201)
            Subtitle E [Reserved]
            Subtitle F--Federal Travel Regulation System
       300  General (Parts 300-1--300-99)
       301  Temporary Duty (TDY) Travel Allowances (Parts 301-1--
                301-99)
       302  Relocation Allowances (Parts 302-1--302-99)
       303  Payment of Expenses Connected with the Death of 
                Certain Employees (Part 303-1--303-99)
       304  Payment of Travel Expenses from a Non-Federal Source 
                (Parts 304-1--304-99)

                        Title 42--Public Health

         I  Public Health Service, Department of Health and Human 
                Services (Parts 1--199)
   II--III  [Reserved]
        IV  Centers for Medicare & Medicaid Services, Department 
                of Health and Human Services (Parts 400--699)
         V  Office of Inspector General-Health Care, Department of 
                Health and Human Services (Parts 1000--1099)

                   Title 43--Public Lands: Interior

            Subtitle A--Office of the Secretary of the Interior 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Lands
         I  Bureau of Reclamation, Department of the Interior 
                (Parts 400--999)
        II  Bureau of Land Management, Department of the Interior 
                (Parts 1000--9999)
       III  Utah Reclamation Mitigation and Conservation 
                Commission (Parts 10000--10099)

             Title 44--Emergency Management and Assistance

         I  Federal Emergency Management Agency, Department of 
                Homeland Security (Parts 0--399)
        IV  Department of Commerce and Department of 
                Transportation (Parts 400--499)

[[Page 907]]

                       Title 45--Public Welfare

            Subtitle A--Department of Health and Human Services 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Welfare
        II  Office of Family Assistance (Assistance Programs), 
                Administration for Children and Families, 
                Department of Health and Human Services (Parts 
                200--299)
       III  Office of Child Support Enforcement (Child Support 
                Enforcement Program), Administration for Children 
                and Families, Department of Health and Human 
                Services (Parts 300--399)
        IV  Office of Refugee Resettlement, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 400--499)
         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)
        VI  National Science Foundation (Parts 600--699)
       VII  Commission on Civil Rights (Parts 700--799)
      VIII  Office of Personnel Management (Parts 800--899)
        IX  Denali Commission (Parts 900--999)
         X  Office of Community Services, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 1000--1099)
        XI  National Foundation on the Arts and the Humanities 
                (Parts 1100--1199)
       XII  Corporation for National and Community Service (Parts 
                1200--1299)
      XIII  Administration for Children and Families, Department 
                of Health and Human Services (Parts 1300--1399)
       XVI  Legal Services Corporation (Parts 1600--1699)
      XVII  National Commission on Libraries and Information 
                Science (Parts 1700--1799)
     XVIII  Harry S. Truman Scholarship Foundation (Parts 1800--
                1899)
       XXI  Commission of Fine Arts (Parts 2100--2199)
     XXIII  Arctic Research Commission (Parts 2300--2399)
      XXIV  James Madison Memorial Fellowship Foundation (Parts 
                2400--2499)
       XXV  Corporation for National and Community Service (Parts 
                2500--2599)

                          Title 46--Shipping

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Maritime Administration, Department of Transportation 
                (Parts 200--399)
       III  Coast Guard (Great Lakes Pilotage), Department of 
                Homeland Security (Parts 400--499)
        IV  Federal Maritime Commission (Parts 500--599)

[[Page 908]]

                      Title 47--Telecommunication

         I  Federal Communications Commission (Parts 0--199)
        II  Office of Science and Technology Policy and National 
                Security Council (Parts 200--299)
       III  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                300--399)
        IV  National Telecommunications and Information 
                Administration, Department of Commerce, and 
                National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 400--499)
         V  The First Responder Network Authority (Parts 500--599)

           Title 48--Federal Acquisition Regulations System

         1  Federal Acquisition Regulation (Parts 1--99)
         2  Defense Acquisition Regulations System, Department of 
                Defense (Parts 200--299)
         3  Department of Health and Human Services (Parts 300--
                399)
         4  Department of Agriculture (Parts 400--499)
         5  General Services Administration (Parts 500--599)
         6  Department of State (Parts 600--699)
         7  Agency for International Development (Parts 700--799)
         8  Department of Veterans Affairs (Parts 800--899)
         9  Department of Energy (Parts 900--999)
        10  Department of the Treasury (Parts 1000--1099)
        12  Department of Transportation (Parts 1200--1299)
        13  Department of Commerce (Parts 1300--1399)
        14  Department of the Interior (Parts 1400--1499)
        15  Environmental Protection Agency (Parts 1500--1599)
        16  Office of Personnel Management Federal Employees 
                Health Benefits Acquisition Regulation (Parts 
                1600--1699)
        17  Office of Personnel Management (Parts 1700--1799)
        18  National Aeronautics and Space Administration (Parts 
                1800--1899)
        19  Broadcasting Board of Governors (Parts 1900--1999)
        20  Nuclear Regulatory Commission (Parts 2000--2099)
        21  Office of Personnel Management, Federal Employees 
                Group Life Insurance Federal Acquisition 
                Regulation (Parts 2100--2199)
        23  Social Security Administration (Parts 2300--2399)
        24  Department of Housing and Urban Development (Parts 
                2400--2499)
        25  National Science Foundation (Parts 2500--2599)
        28  Department of Justice (Parts 2800--2899)
        29  Department of Labor (Parts 2900--2999)
        30  Department of Homeland Security, Homeland Security 
                Acquisition Regulation (HSAR) (Parts 3000--3099)
        34  Department of Education Acquisition Regulation (Parts 
                3400--3499)

[[Page 909]]

        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199) [Reserved]
        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)
        53  Department of the Air Force Federal Acquisition 
                Regulation Supplement (Parts 5300--5399) 
                [Reserved]
        54  Defense Logistics Agency, Department of Defense (Parts 
                5400--5499)
        57  African Development Foundation (Parts 5700--5799)
        61  Civilian Board of Contract Appeals, General Services 
                Administration (Parts 6100--6199)
        99  Cost Accounting Standards Board, Office of Federal 
                Procurement Policy, Office of Management and 
                Budget (Parts 9900--9999)

                       Title 49--Transportation

            Subtitle A--Office of the Secretary of Transportation 
                (Parts 1--99)
            Subtitle B--Other Regulations Relating to 
                Transportation
         I  Pipeline and Hazardous Materials Safety 
                Administration, Department of Transportation 
                (Parts 100--199)
        II  Federal Railroad Administration, Department of 
                Transportation (Parts 200--299)
       III  Federal Motor Carrier Safety Administration, 
                Department of Transportation (Parts 300--399)
        IV  Coast Guard, Department of Homeland Security (Parts 
                400--499)
         V  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 500--599)
        VI  Federal Transit Administration, Department of 
                Transportation (Parts 600--699)
       VII  National Railroad Passenger Corporation (AMTRAK) 
                (Parts 700--799)
      VIII  National Transportation Safety Board (Parts 800--999)
         X  Surface Transportation Board (Parts 1000--1399)
        XI  Research and Innovative Technology Administration, 
                Department of Transportation (Parts 1400--1499) 
                [Reserved]
       XII  Transportation Security Administration, Department of 
                Homeland Security (Parts 1500--1699)

                   Title 50--Wildlife and Fisheries

         I  United States Fish and Wildlife Service, Department of 
                the Interior (Parts 1--199)
        II  National Marine Fisheries Service, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 200--299)
       III  International Fishing and Related Activities (Parts 
                300--399)

[[Page 910]]

        IV  Joint Regulations (United States Fish and Wildlife 
                Service, Department of the Interior and National 
                Marine Fisheries Service, National Oceanic and 
                Atmospheric Administration, Department of 
                Commerce); Endangered Species Committee 
                Regulations (Parts 400--499)
         V  Marine Mammal Commission (Parts 500--599)
        VI  Fishery Conservation and Management, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 600--699)

[[Page 911]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2022)

                                                  CFR Title, Subtitle or 
                     Agency                               Chapter

Administrative Conference of the United States    1, III
Advisory Council on Historic Preservation         36, VIII
Advocacy and Outreach, Office of                  7, XXV
Afghanistan Reconstruction, Special Inspector     5, LXXXIII
     General for
African Development Foundation                    22, XV
  Federal Acquisition Regulation                  48, 57
Agency for International Development              2, VII; 22, II
  Federal Acquisition Regulation                  48, 7
Agricultural Marketing Service                    7, I, VIII, IX, X, XI; 9, 
                                                  II
Agricultural Research Service                     7, V
Agriculture, Department of                        2, IV; 5, LXXIII
  Advocacy and Outreach, Office of                7, XXV
  Agricultural Marketing Service                  7, I, VIII, IX, X, XI; 9, 
                                                  II
  Agricultural Research Service                   7, V
  Animal and Plant Health Inspection Service      7, III; 9, I
  Chief Financial Officer, Office of              7, XXX
  Commodity Credit Corporation                    7, XIV
  Economic Research Service                       7, XXXVII
  Energy Policy and New Uses, Office of           2, IX; 7, XXIX
  Environmental Quality, Office of                7, XXXI
  Farm Service Agency                             7, VII, XVIII
  Federal Acquisition Regulation                  48, 4
  Federal Crop Insurance Corporation              7, IV
  Food and Nutrition Service                      7, II
  Food Safety and Inspection Service              9, III
  Foreign Agricultural Service                    7, XV
  Forest Service                                  36, II
  Information Resources Management, Office of     7, XXVII
  Inspector General, Office of                    7, XXVI
  National Agricultural Library                   7, XLI
  National Agricultural Statistics Service        7, XXXVI
  National Institute of Food and Agriculture      7, XXXIV
  Natural Resources Conservation Service          7, VI
  Operations, Office of                           7, XXVIII
  Procurement and Property Management, Office of  7, XXXII
  Rural Business-Cooperative Service              7, XVIII, XLII
  Rural Development Administration                7, XLII
  Rural Housing Service                           7, XVIII, XXXV
  Rural Utilities Service                         7, XVII, XVIII, XLII
  Secretary of Agriculture, Office of             7, Subtitle A
  Transportation, Office of                       7, XXXIII
  World Agricultural Outlook Board                7, XXXVIII
Air Force, Department of                          32, VII
  Federal Acquisition Regulation Supplement       48, 53
Air Transportation Stabilization Board            14, VI
Alcohol and Tobacco Tax and Trade Bureau          27, I
Alcohol, Tobacco, Firearms, and Explosives,       27, II
     Bureau of
AMTRAK                                            49, VII
American Battle Monuments Commission              36, IV
American Indians, Office of the Special Trustee   25, VII
Animal and Plant Health Inspection Service        7, III; 9, I
Appalachian Regional Commission                   5, IX
Architectural and Transportation Barriers         36, XI
   Compliance Board
[[Page 912]]

Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI; 38, II
Army, Department of                               32, V
  Engineers, Corps of                             33, II; 36, III
  Federal Acquisition Regulation                  48, 51
Benefits Review Board                             20, VII
Bilingual Education and Minority Languages        34, V
     Affairs, Office of
Blind or Severely Disabled, Committee for         41, 51
     Purchase from People Who Are
  Federal Acquisition Regulation                  48, 19
Career, Technical, and Adult Education, Office    34, IV
     of
Census Bureau                                     15, I
Centers for Medicare & Medicaid Services          42, IV
Central Intelligence Agency                       32, XIX
Chemical Safety and Hazard Investigation Board    40, VI
Chief Financial Officer, Office of                7, XXX
Child Support Enforcement, Office of              45, III
Children and Families, Administration for         45, II, III, IV, X, XIII
Civil Rights, Commission on                       5, LXVIII; 45, VII
Civil Rights, Office for                          34, I
Coast Guard                                       33, I; 46, I; 49, IV
Coast Guard (Great Lakes Pilotage)                46, III
Commerce, Department of                           2, XIII; 44, IV; 50, VI
  Census Bureau                                   15, I
  Economic Affairs, Office of the Under-          15, XV
       Secretary for
  Economic Analysis, Bureau of                    15, VIII
  Economic Development Administration             13, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 13
  Foreign-Trade Zones Board                       15, IV
  Industry and Security, Bureau of                15, VII
  International Trade Administration              15, III; 19, III
  National Institute of Standards and Technology  15, II; 37, IV
  National Marine Fisheries Service               50, II, IV
  National Oceanic and Atmospheric                15, IX; 50, II, III, IV, 
       Administration                             VI
  National Technical Information Service          15, XI
  National Telecommunications and Information     15, XXIII; 47, III, IV
       Administration
  National Weather Service                        15, IX
  Patent and Trademark Office, United States      37, I
  Secretary of Commerce, Office of                15, Subtitle A
Commercial Space Transportation                   14, III
Commodity Credit Corporation                      7, XIV
Commodity Futures Trading Commission              5, XLI; 17, I
Community Planning and Development, Office of     24, V, VI
     Assistant Secretary for
Community Services, Office of                     45, X
Comptroller of the Currency                       12, I
Construction Industry Collective Bargaining       29, IX
     Commission
Consumer Financial Protection Bureau              5, LXXXIV; 12, X
Consumer Product Safety Commission                5, LXXI; 16, II
Copyright Royalty Board                           37, III
Corporation for National and Community Service    2, XXII; 45, XII, XXV
Cost Accounting Standards Board                   48, 99
Council on Environmental Quality                  40, V
Council of the Inspectors General on Integrity    5, XCVIII
     and Efficiency
Court Services and Offender Supervision Agency    5, LXX; 28, VIII
     for the District of Columbia
Customs and Border Protection                     19, I
Defense, Department of                            2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII
  Army Department                                 32, V; 33, II; 36, III; 
                                                  48, 51
  Defense Acquisition Regulations System          48, 2
  Defense Intelligence Agency                     32, I

[[Page 913]]

  Defense Logistics Agency                        32, I, XII; 48, 54
  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy, Department of                             32, VI; 48, 52
  Secretary of Defense, Office of                 2, XI; 32, I
Defense Contract Audit Agency                     32, I
Defense Intelligence Agency                       32, I
Defense Logistics Agency                          32, XII; 48, 54
Defense Nuclear Facilities Safety Board           10, XVII
Delaware River Basin Commission                   18, III
Denali Commission                                 45, IX
Disability, National Council on                   5, C; 34, XII
District of Columbia, Court Services and          5, LXX; 28, VIII
     Offender Supervision Agency for the
Drug Enforcement Administration                   21, II
East-West Foreign Trade Board                     15, XIII
Economic Affairs, Office of the Under-Secretary   15, XV
     for
Economic Analysis, Bureau of                      15, VIII
Economic Development Administration               13, III
Economic Research Service                         7, XXXVII
Education, Department of                          2, XXXIV; 5, LIII
  Bilingual Education and Minority Languages      34, V
       Affairs, Office of
  Career, Technical, and Adult Education, Office  34, IV
       of
  Civil Rights, Office for                        34, I
  Educational Research and Improvement, Office    34, VII
       of
  Elementary and Secondary Education, Office of   34, II
  Federal Acquisition Regulation                  48, 34
  Postsecondary Education, Office of              34, VI
  Secretary of Education, Office of               34, Subtitle A
  Special Education and Rehabilitative Services,  34, III
       Office of
Educational Research and Improvement, Office of   34, VII
Election Assistance Commission                    2, LVIII; 11, II
Elementary and Secondary Education, Office of     34, II
Emergency Oil and Gas Guaranteed Loan Board       13, V
Emergency Steel Guarantee Loan Board              13, IV
Employee Benefits Security Administration         29, XXV
Employees' Compensation Appeals Board             20, IV
Employees Loyalty Board                           5, V
Employment and Training Administration            20, V
Employment Policy, National Commission for        1, IV
Employment Standards Administration               20, VI
Endangered Species Committee                      50, IV
Energy, Department of                             2, IX; 5, XXIII; 10, II, 
                                                  III, X
  Federal Acquisition Regulation                  48, 9
  Federal Energy Regulatory Commission            5, XXIV; 18, I
  Property Management Regulations                 41, 109
Energy, Office of                                 7, XXIX
Engineers, Corps of                               33, II; 36, III
Engraving and Printing, Bureau of                 31, VI
Environmental Protection Agency                   2, XV; 5, LIV; 40, I, IV, 
                                                  VII
  Federal Acquisition Regulation                  48, 15
  Property Management Regulations                 41, 115
Environmental Quality, Office of                  7, XXXI
Equal Employment Opportunity Commission           5, LXII; 29, XIV
Equal Opportunity, Office of Assistant Secretary  24, I
     for
Executive Office of the President                 3, I
  Environmental Quality, Council on               40, V
  Management and Budget, Office of                2, Subtitle A; 5, III, 
                                                  LXXVII; 14, VI; 48, 99
  National Drug Control Policy, Office of         2, XXXVI; 21, III
  National Security Council                       32, XXI; 47, II
  Science and Technology Policy, Office of        32, XXIV; 47, II
  Trade Representative, Office of the United      15, XX
       States
Export-Import Bank of the United States           2, XXXV; 5, LII; 12, IV

[[Page 914]]

Family Assistance, Office of                      45, II
Farm Credit Administration                        5, XXXI; 12, VI
Farm Credit System Insurance Corporation          5, XXX; 12, XIV
Farm Service Agency                               7, VII, XVIII
Federal Acquisition Regulation                    48, 1
Federal Acquisition Security Council              41, 201
Federal Aviation Administration                   14, I
  Commercial Space Transportation                 14, III
Federal Claims Collection Standards               31, IX
Federal Communications Commission                 5, XXIX; 47, I
Federal Contract Compliance Programs, Office of   41, 60
Federal Crop Insurance Corporation                7, IV
Federal Deposit Insurance Corporation             5, XXII; 12, III
Federal Election Commission                       5, XXXVII; 11, I
Federal Emergency Management Agency               44, I
Federal Employees Group Life Insurance Federal    48, 21
     Acquisition Regulation
Federal Employees Health Benefits Acquisition     48, 16
     Regulation
Federal Energy Regulatory Commission              5, XXIV; 18, I
Federal Financial Institutions Examination        12, XI
     Council
Federal Financing Bank                            12, VIII
Federal Highway Administration                    23, I, II
Federal Home Loan Mortgage Corporation            1, IV
Federal Housing Enterprise Oversight Office       12, XVII
Federal Housing Finance Agency                    5, LXXX; 12, XII
Federal Labor Relations Authority                 5, XIV, XLIX; 22, XIV
Federal Law Enforcement Training Center           31, VII
Federal Management Regulation                     41, 102
Federal Maritime Commission                       46, IV
Federal Mediation and Conciliation Service        29, XII
Federal Mine Safety and Health Review Commission  5, LXXIV; 29, XXVII
Federal Motor Carrier Safety Administration       49, III
Federal Permitting Improvement Steering Council   40, IX
Federal Prison Industries, Inc.                   28, III
Federal Procurement Policy Office                 48, 99
Federal Property Management Regulations           41, 101
Federal Railroad Administration                   49, II
Federal Register, Administrative Committee of     1, I
Federal Register, Office of                       1, II
Federal Reserve System                            12, II
  Board of Governors                              5, LVIII
Federal Retirement Thrift Investment Board        5, VI, LXXVI
Federal Service Impasses Panel                    5, XIV
Federal Trade Commission                          5, XLVII; 16, I
Federal Transit Administration                    49, VI
Federal Travel Regulation System                  41, Subtitle F
Financial Crimes Enforcement Network              31, X
Financial Research Office                         12, XVI
Financial Stability Oversight Council             12, XIII
Fine Arts, Commission of                          45, XXI
Fiscal Service                                    31, II
Fish and Wildlife Service, United States          50, I, IV
Food and Drug Administration                      21, I
Food and Nutrition Service                        7, II
Food Safety and Inspection Service                9, III
Foreign Agricultural Service                      7, XV
Foreign Assets Control, Office of                 31, V
Foreign Claims Settlement Commission of the       45, V
     United States
Foreign Service Grievance Board                   22, IX
Foreign Service Impasse Disputes Panel            22, XIV
Foreign Service Labor Relations Board             22, XIV
Foreign-Trade Zones Board                         15, IV
Forest Service                                    36, II
General Services Administration                   5, LVII; 41, 105
  Contract Appeals, Board of                      48, 61
  Federal Acquisition Regulation                  48, 5
  Federal Management Regulation                   41, 102

[[Page 915]]

  Federal Property Management Regulations         41, 101
  Federal Travel Regulation System                41, Subtitle F
  General                                         41, 300
  Payment From a Non-Federal Source for Travel    41, 304
       Expenses
  Payment of Expenses Connected With the Death    41, 303
       of Certain Employees
  Relocation Allowances                           41, 302
  Temporary Duty (TDY) Travel Allowances          41, 301
Geological Survey                                 30, IV
Government Accountability Office                  4, I
Government Ethics, Office of                      5, XVI
Government National Mortgage Association          24, III
Grain Inspection, Packers and Stockyards          7, VIII; 9, II
     Administration
Great Lakes St. Lawrence Seaway Development       33, IV
     Corporation
Gulf Coast Ecosystem Restoration Council          2, LIX; 40, VIII
Harry S. Truman Scholarship Foundation            45, XVIII
Health and Human Services, Department of          2, III; 5, XLV; 45, 
                                                  Subtitle A
  Centers for Medicare & Medicaid Services        42, IV
  Child Support Enforcement, Office of            45, III
  Children and Families, Administration for       45, II, III, IV, X, XIII
  Community Services, Office of                   45, X
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  Indian Health Service                           25, V
  Inspector General (Health Care), Office of      42, V
  Public Health Service                           42, I
  Refugee Resettlement, Office of                 45, IV
Homeland Security, Department of                  2, XXX; 5, XXXVI; 6, I; 8, 
                                                  I
  Coast Guard                                     33, I; 46, I; 49, IV
  Coast Guard (Great Lakes Pilotage)              46, III
  Customs and Border Protection                   19, I
  Federal Emergency Management Agency             44, I
  Human Resources Management and Labor Relations  5, XCVII
       Systems
  Immigration and Customs Enforcement Bureau      19, IV
  Transportation Security Administration          49, XII
HOPE for Homeowners Program, Board of Directors   24, XXIV
     of
Housing, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office of
Housing and Urban Development, Department of      2, XXIV; 5, LXV; 24, 
                                                  Subtitle B
  Community Planning and Development, Office of   24, V, VI
       Assistant Secretary for
  Equal Opportunity, Office of Assistant          24, I
       Secretary for
  Federal Acquisition Regulation                  48, 24
  Federal Housing Enterprise Oversight, Office    12, XVII
       of
  Government National Mortgage Association        24, III
  Housing--Federal Housing Commissioner, Office   24, II, VIII, X, XX
       of Assistant Secretary for
  Housing, Office of, and Multifamily Housing     24, IV
       Assistance Restructuring, Office of
  Inspector General, Office of                    24, XII
  Public and Indian Housing, Office of Assistant  24, IX
       Secretary for
  Secretary, Office of                            24, Subtitle A, VII
Housing--Federal Housing Commissioner, Office of  24, II, VIII, X, XX
     Assistant Secretary for
Housing, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office of
Immigration and Customs Enforcement Bureau        19, IV
Immigration Review, Executive Office for          8, V
Independent Counsel, Office of                    28, VII
Independent Counsel, Offices of                   28, VI
Indian Affairs, Bureau of                         25, I, V
Indian Affairs, Office of the Assistant           25, VI
   Secretary
[[Page 916]]

Indian Arts and Crafts Board                      25, II
Indian Health Service                             25, V
Industry and Security, Bureau of                  15, VII
Information Resources Management, Office of       7, XXVII
Information Security Oversight Office, National   32, XX
     Archives and Records Administration
Inspector General
  Agriculture Department                          7, XXVI
  Health and Human Services Department            42, V
  Housing and Urban Development Department        24, XII, XV
Institute of Peace, United States                 22, XVII
Inter-American Foundation                         5, LXIII; 22, X
Interior, Department of                           2, XIV
  American Indians, Office of the Special         25, VII
       Trustee
  Endangered Species Committee                    50, IV
  Federal Acquisition Regulation                  48, 14
  Federal Property Management Regulations System  41, 114
  Fish and Wildlife Service, United States        50, I, IV
  Geological Survey                               30, IV
  Indian Affairs, Bureau of                       25, I, V
  Indian Affairs, Office of the Assistant         25, VI
       Secretary
  Indian Arts and Crafts Board                    25, II
  Land Management, Bureau of                      43, II
  National Indian Gaming Commission               25, III
  National Park Service                           36, I
  Natural Resource Revenue, Office of             30, XII
  Ocean Energy Management, Bureau of              30, V
  Reclamation, Bureau of                          43, I
  Safety and Environmental Enforcement, Bureau    30, II
       of
  Secretary of the Interior, Office of            2, XIV; 43, Subtitle A
  Surface Mining Reclamation and Enforcement,     30, VII
       Office of
Internal Revenue Service                          26, I
International Boundary and Water Commission,      22, XI
     United States and Mexico, United States 
     Section
International Development, United States Agency   22, II
     for
  Federal Acquisition Regulation                  48, 7
International Development Cooperation Agency,     22, XII
     United States
International Development Finance Corporation,    5, XXXIII; 22, VII
     U.S.
International Joint Commission, United States     22, IV
     and Canada
International Organizations Employees Loyalty     5, V
     Board
International Trade Administration                15, III; 19, III
International Trade Commission, United States     19, II
Interstate Commerce Commission                    5, XL
Investment Security, Office of                    31, VIII
James Madison Memorial Fellowship Foundation      45, XXIV
Japan-United States Friendship Commission         22, XVI
Joint Board for the Enrollment of Actuaries       20, VIII
Justice, Department of                            2, XXVIII; 5, XXVIII; 28, 
                                                  I, XI; 40, IV
  Alcohol, Tobacco, Firearms, and Explosives,     27, II
       Bureau of
  Drug Enforcement Administration                 21, II
  Federal Acquisition Regulation                  48, 28
  Federal Claims Collection Standards             31, IX
  Federal Prison Industries, Inc.                 28, III
  Foreign Claims Settlement Commission of the     45, V
       United States
  Immigration Review, Executive Office for        8, V
  Independent Counsel, Offices of                 28, VI
  Prisons, Bureau of                              28, V
  Property Management Regulations                 41, 128
Labor, Department of                              2, XXIX; 5, XLII
  Benefits Review Board                           20, VII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV
  Employment and Training Administration          20, V
  Federal Acquisition Regulation                  48, 29

[[Page 917]]

  Federal Contract Compliance Programs, Office    41, 60
       of
  Federal Procurement Regulations System          41, 50
  Labor-Management Standards, Office of           29, II, IV
  Mine Safety and Health Administration           30, I
  Occupational Safety and Health Administration   29, XVII
  Public Contracts                                41, 50
  Secretary of Labor, Office of                   29, Subtitle A
  Veterans' Employment and Training Service,      41, 61; 20, IX
       Office of the Assistant Secretary for
  Wage and Hour Division                          29, V
  Workers' Compensation Programs, Office of       20, I, VI
Labor-Management Standards, Office of             29, II, IV
Land Management, Bureau of                        43, II
Legal Services Corporation                        45, XVI
Libraries and Information Science, National       45, XVII
     Commission on
Library of Congress                               36, VII
  Copyright Royalty Board                         37, III
  U.S. Copyright Office                           37, II
Management and Budget, Office of                  5, III, LXXVII; 14, VI; 
                                                  48, 99
Marine Mammal Commission                          50, V
Maritime Administration                           46, II
Merit Systems Protection Board                    5, II, LXIV
Micronesian Status Negotiations, Office for       32, XXVII
Military Compensation and Retirement              5, XCIX
     Modernization Commission
Millennium Challenge Corporation                  22, XIII
Mine Safety and Health Administration             30, I
Minority Business Development Agency              15, XIV
Miscellaneous Agencies                            1, IV
Monetary Offices                                  31, I
Morris K. Udall Scholarship and Excellence in     36, XVI
     National Environmental Policy Foundation
Museum and Library Services, Institute of         2, XXXI
National Aeronautics and Space Administration     2, XVIII; 5, LIX; 14, V
  Federal Acquisition Regulation                  48, 18
National Agricultural Library                     7, XLI
National Agricultural Statistics Service          7, XXXVI
National and Community Service, Corporation for   2, XXII; 45, XII, XXV
National Archives and Records Administration      2, XXVI; 5, LXVI; 36, XII
  Information Security Oversight Office           32, XX
National Capital Planning Commission              1, IV, VI
National Counterintelligence Center               32, XVIII
National Credit Union Administration              5, LXXXVI; 12, VII
National Crime Prevention and Privacy Compact     28, IX
     Council
National Drug Control Policy, Office of           2, XXXVI; 21, III
National Endowment for the Arts                   2, XXXII
National Endowment for the Humanities             2, XXXIII
National Foundation on the Arts and the           45, XI
     Humanities
National Geospatial-Intelligence Agency           32, I
National Highway Traffic Safety Administration    23, II, III; 47, VI; 49, V
National Imagery and Mapping Agency               32, I
National Indian Gaming Commission                 25, III
National Institute of Food and Agriculture        7, XXXIV
National Institute of Standards and Technology    15, II; 37, IV
National Intelligence, Office of Director of      5, IV; 32, XVII
National Labor Relations Board                    5, LXI; 29, I
National Marine Fisheries Service                 50, II, IV
National Mediation Board                          5, CI; 29, X
National Oceanic and Atmospheric Administration   15, IX; 50, II, III, IV, 
                                                  VI
National Park Service                             36, I
National Railroad Adjustment Board                29, III
National Railroad Passenger Corporation (AMTRAK)  49, VII
National Science Foundation                       2, XXV; 5, XLIII; 45, VI
  Federal Acquisition Regulation                  48, 25
National Security Council                         32, XXI; 47, II

[[Page 918]]

National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
     Administration
National Transportation Safety Board              49, VIII
Natural Resource Revenue, Office of               30, XII
Natural Resources Conservation Service            7, VI
Navajo and Hopi Indian Relocation, Office of      25, IV
Navy, Department of                               32, VI
  Federal Acquisition Regulation                  48, 52
Neighborhood Reinvestment Corporation             24, XXV
Northeast Interstate Low-Level Radioactive Waste  10, XVIII
     Commission
Nuclear Regulatory Commission                     2, XX; 5, XLVIII; 10, I
  Federal Acquisition Regulation                  48, 20
Occupational Safety and Health Administration     29, XVII
Occupational Safety and Health Review Commission  29, XX
Ocean Energy Management, Bureau of                30, V
Oklahoma City National Memorial Trust             36, XV
Operations Office                                 7, XXVIII
Patent and Trademark Office, United States        37, I
Payment From a Non-Federal Source for Travel      41, 304
     Expenses
Payment of Expenses Connected With the Death of   41, 303
     Certain Employees
Peace Corps                                       2, XXXVII; 22, III
Pennsylvania Avenue Development Corporation       36, IX
Pension Benefit Guaranty Corporation              29, XL
Personnel Management, Office of                   5, I, IV, XXXV; 45, VIII
  Federal Acquisition Regulation                  48, 17
  Federal Employees Group Life Insurance Federal  48, 21
       Acquisition Regulation
  Federal Employees Health Benefits Acquisition   48, 16
       Regulation
  Human Resources Management and Labor Relations  5, XCVII
       Systems, Department of Homeland Security
Pipeline and Hazardous Materials Safety           49, I
     Administration
Postal Regulatory Commission                      5, XLVI; 39, III
Postal Service, United States                     5, LX; 39, I
Postsecondary Education, Office of                34, VI
President's Commission on White House             1, IV
     Fellowships
Presidential Documents                            3
Presidio Trust                                    36, X
Prisons, Bureau of                                28, V
Privacy and Civil Liberties Oversight Board       6, X
Procurement and Property Management, Office of    7, XXXII
Public and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Contracts, Department of Labor             41, 50
Public Health Service                             42, I
Railroad Retirement Board                         20, II
Reclamation, Bureau of                            43, I
Refugee Resettlement, Office of                   45, IV
Relocation Allowances                             41, 302
Research and Innovative Technology                49, XI
     Administration
Rural Business-Cooperative Service                7, XVIII, XLII
Rural Development Administration                  7, XLII
Rural Housing Service                             7, XVIII, XXXV
Rural Utilities Service                           7, XVII, XVIII, XLII
Safety and Environmental Enforcement, Bureau of   30, II
Science and Technology Policy, Office of          32, XXIV; 47, II
Secret Service                                    31, IV
Securities and Exchange Commission                5, XXXIV; 17, II
Selective Service System                          32, XVI
Small Business Administration                     2, XXVII; 13, I
Smithsonian Institution                           36, V
Social Security Administration                    2, XXIII; 20, III; 48, 23
Soldiers' and Airmen's Home, United States        5, XI
Special Counsel, Office of                        5, VIII
Special Education and Rehabilitative Services,    34, III
     Office of
State, Department of                              2, VI; 22, I; 28, XI

[[Page 919]]

  Federal Acquisition Regulation                  48, 6
Surface Mining Reclamation and Enforcement,       30, VII
     Office of
Surface Transportation Board                      49, X
Susquehanna River Basin Commission                18, VIII
Tennessee Valley Authority                        5, LXIX; 18, XIII
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     2, XII; 5, L
  Commercial Space Transportation                 14, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 12
Federal Acquisition Security Council              41, 201
  Federal Aviation Administration                 14, I
  Federal Highway Administration                  23, I, II
  Federal Motor Carrier Safety Administration     49, III
  Federal Railroad Administration                 49, II
  Federal Transit Administration                  49, VI
  Great Lakes St. Lawrence Seaway Development     33, IV
       Corporation
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 47, IV; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  Secretary of Transportation, Office of          14, II; 49, Subtitle A
  Transportation Statistics Bureau                49, XI
Transportation, Office of                         7, XXXIII
Transportation Security Administration            49, XII
Transportation Statistics Bureau                  49, XI
Travel Allowances, Temporary Duty (TDY)           41, 301
Treasury, Department of the                       2, X; 5, XXI; 12, XV; 17, 
                                                  IV; 31, IX
  Alcohol and Tobacco Tax and Trade Bureau        27, I
  Community Development Financial Institutions    12, XVIII
       Fund
  Comptroller of the Currency                     12, I
  Customs and Border Protection                   19, I
  Engraving and Printing, Bureau of               31, VI
  Federal Acquisition Regulation                  48, 10
  Federal Claims Collection Standards             31, IX
  Federal Law Enforcement Training Center         31, VII
  Financial Crimes Enforcement Network            31, X
  Fiscal Service                                  31, II
  Foreign Assets Control, Office of               31, V
  Internal Revenue Service                        26, I
  Investment Security, Office of                  31, VIII
  Monetary Offices                                31, I
  Secret Service                                  31, IV
  Secretary of the Treasury, Office of            31, Subtitle A
Truman, Harry S. Scholarship Foundation           45, XVIII
United States Agency for Global Media             22, V
United States and Canada, International Joint     22, IV
     Commission
United States and Mexico, International Boundary  22, XI
     and Water Commission, United States Section
U.S. Copyright Office                             37, II
U.S. Office of Special Counsel                    5, CII
Utah Reclamation Mitigation and Conservation      43, III
     Commission
Veterans Affairs, Department of                   2, VIII; 38, I
  Federal Acquisition Regulation                  48, 8
Veterans' Employment and Training Service,        41, 61; 20, IX
     Office of the Assistant Secretary for
Vice President of the United States, Office of    32, XXVIII
Wage and Hour Division                            29, V
Water Resources Council                           18, VI
Workers' Compensation Programs, Office of         20, I, VII
World Agricultural Outlook Board                  7, XXXVIII

[[Page 921]]







                      Table of OMB Control Numbers



The OMB control numbers for chapter I of title 26 were consolidated into 
Sec. Sec.  601.9000 and 602.101 at 50 FR 10221, Mar. 14, 1985. At 61 FR 
58008, Nov. 12, 1996, Sec.  601.9000 was removed. Section 602.101 is 
reprinted below for the convenience of the user.



PART 602_OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT--Table of Contents



    Authority: 26 U.S.C. 7805.



Sec.  602.101  OMB Control numbers.

    (a) Purpose. This part collects and displays the control numbers 
assigned to collections of information in Internal Revenue Service 
regulations by the Office of Management and Budget (OMB) under the 
Paperwork Reduction Act of 1980. The Internal Revenue Service intends 
that this part comply with the requirements of Sec. Sec.  1320.7(f), 
1320.12, 1320.13, and 1320.14 of 5 CFR part 1320 (OMB regulations 
implementing the Paperwork Reduction Act), for the display of control 
numbers assigned by OMB to collections of information in Internal 
Revenue Service regulations. This part does not display control numbers 
assigned by the Office of Management and Budget to collections of 
information of the Bureau of Alcohol, Tobacco, and Firearms.
    (b) Display.

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
1.1(h)-1(e)................................................    1545-1654
1.25-1T....................................................    1545-0922
                                                               1545-0930
1.25-2T....................................................    1545-0922
                                                               1545-0930
1.25-3T....................................................    1545-0922
                                                               1545-0930
1.25-4T....................................................    1545-0922
1.25-5T....................................................    1545-0922
1.25-6T....................................................    1545-0922
1.25-7T....................................................    1545-0922
1.25-8T....................................................    1545-0922
1.25A-1....................................................    1545-1630
1.28-1.....................................................    1545-0619
1.31-2.....................................................    1545-0074
1.32-2.....................................................    1545-0074
1.32-3.....................................................    1545-1575
1.36B-5....................................................    1545-2232
1.37-1.....................................................    1545-0074
1.37-3.....................................................    1545-0074
1.41-2.....................................................    1545-0619
1.41-3.....................................................    1545-0619
1.41-4A....................................................    1545-0074
1.41-4 (b) and (c).........................................    1545-0074
1.41-8(b)..................................................    1545-1625
1.41-8(d)..................................................    1545-0732
1.41-9.....................................................    1545-0619
1.42-1T....................................................    1545-0984
                                                               1545-0988
1.42-5.....................................................    1545-1357
1.42-6.....................................................    1545-1102
1.42-8.....................................................    1545-1102
1.42-10....................................................    1545-1102
1.42-13....................................................    1545-1357
1.42-14....................................................    1545-1423
1.42-17....................................................    1545-1357
1.42-18....................................................    1545-2088
1.43-3(a)(3)...............................................    1545-1292
1.43-3(b)(3)...............................................    1545-1292
1.44B-1....................................................    1545-0219
1.45D-1....................................................    1545-1765
1.45G-1....................................................    1545-2031
1.46-1.....................................................    1545-0123
                                                               1545-0155
1.46-3.....................................................    1545-0155
1.46-4.....................................................    1545-0155
1.46-5.....................................................    1545-0155
1.46-6.....................................................    1545-0155
1.46-8.....................................................    1545-0155
1.46-9.....................................................    1545-0155
1.46-10....................................................    1545-0118
1.47-1.....................................................    1545-0155
                                                               1545-0166
1.47-3.....................................................    1545-0155
                                                               1545-0166
1.47-4.....................................................    1545-0123
1.47-5.....................................................    1545-0092
1.47-6.....................................................    1545-0099
1.48-3.....................................................    1545-0155
1.48-4.....................................................    1545-0155
                                                               1545-0808
1.48-5.....................................................    1545-0155
1.48-6.....................................................    1545-0155
1.48-12....................................................    1545-0155
                                                               1545-1783
1.50A-1....................................................    1545-0895
1.50A-2....................................................    1545-0895
1.50A-3....................................................    1545-0895
1.50A-4....................................................    1545-0895
1.50A-5....................................................    1545-0895
1.50A-6....................................................    1545-0895
1.50A-7....................................................    1545-0895
1.50B-1....................................................    1545-0895
1.50B-2....................................................    1545-0895
1.50B-3....................................................    1545-0895
1.50B-4....................................................    1545-0895

[[Page 922]]

 
1.50B-5....................................................    1545-0895
1.51-1.....................................................    1545-0219
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219
1.52-3.....................................................    1545-0219
1.56(g)-1..................................................    1545-1233
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.59-1.....................................................    1545-1903
1.61-2.....................................................    1545-0771
1.61-4.....................................................    1545-0187
1.61-15....................................................    1545-0074
1.62-2.....................................................    1545-1148
1.63-1.....................................................    1545-0074
1.66-4.....................................................    1545-1770
1.67-2T....................................................    1545-0110
1.67-3.....................................................    1545-1018
1.67-3T....................................................    1545-0118
1.71-1T....................................................    1545-0074
1.72-4.....................................................    1545-0074
1.72-6.....................................................    1545-0074
1.72-9.....................................................    1545-0074
1.72-17....................................................    1545-0074
1.72-17A...................................................    1545-0074
1.72-18....................................................    1545-0074
1.74-1.....................................................    1545-1100
1.79-2.....................................................    1545-0074
1.79-3.....................................................    1545-0074
1.83-2.....................................................    1545-0074
1.83-5.....................................................    1545-0074
1.83-6.....................................................    1545-1448
1.103-10...................................................    1545-0123
                                                               1545-0940
1.103A-2...................................................    1545-0720
1.105-4....................................................    1545-0074
1.105-5....................................................    1545-0074
1.105-6....................................................    1545-0074
1.108-4....................................................    1545-1539
1.108-5....................................................    1545-1421
1.108-7....................................................    1545-2155
1.108(i)-1.................................................    1545-2147
1.108(i)-2.................................................    1545-2147
1.110-1....................................................    1545-1661
1.117-5....................................................    1545-0869
1.118-2....................................................    1545-1639
1.119-1....................................................    1545-0067
1.120-3....................................................    1545-0057
1.121-1....................................................    1545-0072
1.121-2....................................................    1545-0072
1.121-3....................................................    1545-0072
1.121-4....................................................    1545-0072
                                                               1545-0091
1.121-5....................................................    1545-0072
1.127-2....................................................    1545-0768
1.132-2....................................................    1545-0771
1.132-5....................................................    1545-0771
1.132-9(b).................................................    1545-1676
1.141-1....................................................    1545-1451
1.141-12...................................................    1545-1451
1.142-2....................................................    1545-1451
1.142(f)(4)-1..............................................    1545-1730
1.148-0....................................................    1545-1098
1.148-1....................................................    1545-1098
1.148-2....................................................    1545-1098
                                                               1545-1347
1.148-3....................................................    1545-1098
                                                               1545-1347
1.148-4....................................................    1545-1098
                                                               1545-1347
1.148-5....................................................    1545-1098
                                                               1545-1490
1.148-6....................................................    1545-1098
                                                               1545-1451
1.148-7....................................................    1545-1098
                                                               1545-1347
1.148-8....................................................    1545-1098
1.148-11...................................................    1545-1098
                                                               1545-1347
1.149(e)-1.................................................    1545-0720
1.150-1....................................................    1545-1347
1.151-1....................................................    1545-0074
1.152-3....................................................    1545-0071
                                                               1545-1783
1.152-4....................................................    1545-0074
1.152-4T...................................................    1545-0074
1.162-1....................................................    1545-0139
1.162-2....................................................    1545-0139
1.162-3....................................................    1545-0139
1.162-4....................................................    1545-0139
1.162-5....................................................    1545-0139
1.162-6....................................................    1545-0139
1.162-7....................................................    1545-0139
1.162-8....................................................    1545-0139
1.162-9....................................................    1545-0139
1.162-10...................................................    1545-0139
1.162-11...................................................    1545-0139
1.162-12...................................................    1545-0139
1.162-13...................................................    1545-0139
1.162-14...................................................    1545-0139
1.162-15...................................................    1545-0139
1.162-16...................................................    1545-0139
1.162-17...................................................    1545-0139
1.162-18...................................................    1545-0139
1.162-19...................................................    1545-0139
1.162-20...................................................    1545-0139
1.162-24...................................................    1545-2115
1.162-27...................................................    1545-1466
1.163-5....................................................    1545-0786
                                                               1545-1132
1.163-8T...................................................    1545-0995
1.163-10T..................................................    1545-0074
1.163-13...................................................    1545-1491
1.163(d)-1.................................................    1545-1421
1.165-1....................................................    1545-0177
1.165-2....................................................    1545-0177
1.165-3....................................................    1545-0177
1.165-4....................................................    1545-0177
1.165-5....................................................    1545-0177
1.165-6....................................................    1545-0177
1.165-7....................................................    1545-0177
1.165-8....................................................    1545-0177
1.165-9....................................................    1545-0177
1.165-10...................................................    1545-0177
1.165-11...................................................    1545-0074
                                                               1545-0177
                                                               1545-0786
1.165-12...................................................    1545-0786
1.166-1....................................................    1545-0123
1.166-2....................................................    1545-1254
1.166-4....................................................    1545-0123
1.166-10...................................................    1545-0123
1.167(a)-5T................................................    1545-1021
1.167(a)-7.................................................    1545-0172
1.167(a)-11................................................    1545-0152
                                                               1545-0172
1.167(a)-12................................................    1545-0172
1.167(d)-1.................................................    1545-0172
1.167(e)-1.................................................    1545-0172
1.167(f)-11................................................    1545-0172
1.167(l)-1.................................................    1545-0172
1.168(d)-1.................................................    1545-1146
1.168(i)-1.................................................    1545-1331

[[Page 923]]

 
1.168-5....................................................    1545-0172
1.169-4....................................................    1545-0172
1.170-1....................................................    1545-0074
1.170-2....................................................    1545-0074
1.170-3....................................................    1545-0123
1.170A-1...................................................    1545-0074
1.170A-2...................................................    1545-0074
1.170A-4(A)(b).............................................    1545-0123
1.170A-8...................................................    1545-0074
1.170A-9...................................................    1545-0052
                                                               1545-0074
1.170A-11..................................................    1545-0074
                                                               1545-0123
                                                               1545-1868
1.170A-12..................................................    1545-0020
                                                               1545-0074
1.170A-13..................................................    1545-0074
                                                               1545-0754
                                                               1545-0908
                                                               1545-1431
1.170A-13(f)...............................................    1545-1464
1.170A-14..................................................    1545-0763
1.170A-15..................................................    1545-1953
1.170A-16..................................................    1545-1953
1.170A-17..................................................    1545-1953
1.170A-18..................................................    1545-1953
1.171-4....................................................    1545-1491
1.171-5....................................................    1545-1491
1.172-1....................................................    1545-0172
1.172-13...................................................    1545-0863
1.173-1....................................................    1545-0172
1.174-3....................................................    1545-0152
1.174-4....................................................    1545-0152
1.175-3....................................................    1545-0187
1.175-6....................................................    1545-0152
1.179-2....................................................    1545-1201
1.179-3....................................................    1545-1201
1.179-5....................................................    1545-0172
                                                               1545-1201
1.179B-1T..................................................    1545-2076
1.179C-1...................................................    1545-2103
1.179C-1T..................................................    1545-2103
1.180-2....................................................    1545-0074
1.181-1....................................................    1545-2059
1.181-2....................................................    1545-2059
1.181-3....................................................    1545-2059
1.182-6....................................................    1545-0074
1.183-1....................................................    1545-0195
1.183-2....................................................    1545-0195
1.183-3....................................................    1545-0195
1.183-4....................................................    1545-0195
1.190-3....................................................    1545-0074
1.194-2....................................................    1545-0735
1.194-4....................................................    1545-0735
1.195-1....................................................    1545-1582
1.197-1T...................................................    1545-1425
1.197-2....................................................    1545-1671
1.199-6....................................................    1545-1966
1.213-1....................................................    1545-0074
1.215-1T...................................................    1545-0074
1.217-2....................................................    1545-0182
1.243-3....................................................    1545-0123
1.243-4....................................................    1545-0123
1.243-5....................................................    1545-0123
1.248-1....................................................    1545-0172
1.261-1....................................................    1545-1041
1.263(a)-1.................................................    1545-2248
1.263(a)-3.................................................    1545-2248
1.263(a)-5.................................................    1545-1870
1.263(e)-1.................................................    1545-0123
1.263A-1...................................................    1545-0987
1.263A-1T..................................................    1545-0187
1.263A-2...................................................    1545-0987
1.263A-3...................................................    1545-0987
1.263A-8(b)(2)(iii)........................................    1545-1265
1.263A-9(d)(1).............................................    1545-1265
1.263A-9(f)(1)(ii).........................................    1545-1265
1.263A-9(f)(2)(iv).........................................    1545-1265
1.263A-9(g)(2)(iv)(C)......................................    1545-1265
1.263A-9(g)(3)(iv).........................................    1545-1265
1.265-1....................................................    1545-0074
1.265-2....................................................    1545-0123
1.266-1....................................................    1545-0123
1.267(f)-1.................................................    1545-0885
1.268-1....................................................    1545-0184
1.274-1....................................................    1545-0139
1.274-2....................................................    1545-0139
1.274-3....................................................    1545-0139
1.274-4....................................................    1545-0139
1.274-5....................................................    1545-0771
1.274-5A...................................................    1545-0139
                                                               1545-0771
1.274-5T...................................................    1545-0074
                                                               1545-0172
                                                               1545-0771
1.274-6....................................................    1545-0139
                                                               1545-0771
1.274-6T...................................................    1545-0074
                                                               1545-0771
1.274-7....................................................    1545-0139
1.274-8....................................................    1545-0139
1.279-6....................................................    1545-0123
1.280C-4...................................................    1545-1155
1.280F-3T..................................................    1545-0074
1.280G-1...................................................    1545-1851
1.281-4....................................................    1545-0123
1.302-4....................................................    1545-0074
1.305-3....................................................    1545-0123
1.305-5....................................................    1545-1438
1.307-2....................................................    1545-0074
1.312-15...................................................    1545-0172
1.316-1....................................................    1545-0123
1.331-1....................................................    1545-0074
1.332-4....................................................    1545-0123
1.332-6....................................................    1545-2019
1.336-2....................................................    1545-2125
1.336-4....................................................    1545-2125
1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
                                                               1545-1774
1.337(d)-4.................................................    1545-1633
1.337(d)-5.................................................    1545-1672
1.337(d)-6.................................................    1545-1672
1.337(d)-7.................................................    1545-1672
1.338-2....................................................    1545-1658
1.338-5....................................................    1545-1658
1.338-10...................................................    1545-1658
1.338-11...................................................    1545-1990
1.338(h)(10)-1.............................................    1545-1658
1.338(i)-1.................................................    1545-1990
1.351-3....................................................    1545-2019
1.355-5....................................................    1545-2019
1.362-2....................................................    1545-0123
1.362-4....................................................    1545-2247
1.367(a)-1T................................................    1545-0026
1.367(a)-2T................................................    1545-0026
1.367(a)-3.................................................    1545-0026
                                                               1545-1478
1.367(a)-3T................................................    1545-2183
1.367(a)-6T................................................    1545-0026
1.367(a)-7.................................................    1545-2183
1.367(a)-7T................................................    1545-2183
1.367(a)-8.................................................    1545-1271
                                                               1545-2056

[[Page 924]]

 
                                                               1545-2183
1.367(b)-1.................................................    1545-1271
1.367(b)-3T................................................    1545-1666
1.367(d)-1T................................................    1545-0026
1.367(e)-1.................................................    1545-1487
1.367(e)-2.................................................    1545-1487
1.368-1....................................................    1545-1691
1.368-3....................................................    1545-2019
1.371-1....................................................    1545-0123
1.371-2....................................................    1545-0123
1.374-3....................................................    1545-0123
1.381(b)-1.................................................    1545-0123
1.381(c)(4)-1..............................................    1545-0123
                                                               1545-0152
                                                               1545-0879
1.381(c)(5)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(6)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(8)-1..............................................    1545-0123
1.381(c)(10)-1.............................................    1545-0123
1.381(c)(11)-1(k)..........................................    1545-0123
1.381(c)(13)-1.............................................    1545-0123
1.381(c)(17)-1.............................................    1545-0045
1.381(c)(22)-1.............................................    1545-1990
1.381(c)(25)-1.............................................    1545-0045
1.382-1T...................................................    1545-0123
1.382-2....................................................    1545-0123
1.382-2T...................................................    1545-0123
1.382-3....................................................    1545-1281
                                                               1545-1345
1.382-4....................................................    1545-1120
1.382-6....................................................    1545-1381
1.382-8....................................................    1545-1434
1.382-9....................................................    1545-1120
                                                               1545-1260
                                                               1545-1275
                                                               1545-1324
1.382-11...................................................    1545-2019
1.382-91...................................................    1545-1260
                                                               1545-1324
1.383-1....................................................    1545-0074
                                                               1545-1120
1.401-1....................................................    1545-0020
                                                               1545-0197
                                                               1545-0200
                                                               1545-0534
                                                               1545-0710
1.401(a)-11................................................    1545-0710
1.401(a)-20................................................    1545-0928
1.401(a)-31................................................    1545-1341
1.401(a)-50................................................    1545-0710
1.401(a)(9)-1..............................................    1545-1573
1.401(a)(9)-3..............................................    1545-1466
1.401(a)(9)-4..............................................    1545-1573
1.401(a)(9)-6..............................................    1545-2234
1.401(a)(31)-1.............................................    1545-1341
1.401(b)-1.................................................    1545-0197
1.401(f)-1.................................................    1545-0710
1.401(k)-1.................................................    1545-1039
                                                               1545-1069
                                                               1545-1669
                                                               1545-1930
1.401(k)-2.................................................    1545-1669
1.401(k)-3.................................................    1545-1669
1.401(k)-4.................................................    1545-1669
1.401(m)-3.................................................    1545-1699
1.401-14...................................................    1545-0710
1.402(c)-2.................................................    1545-1341
1.402(f)-1.................................................    1545-1341
                                                               1545-1632
1.402A-1...................................................    1545-1992
1.403(b)-1.................................................    1545-0710
1.403(b)-3.................................................    1545-0996
1.403(b)-7.................................................    1545-1341
1.403(b)-10................................................    1545-2068
1.404(a)-12................................................    1545-0710
1.404A-2...................................................    1545-0123
1.404A-6...................................................    1545-0123
1.408-2....................................................    1545-0390
1.408-5....................................................    1545-0747
1.408-6....................................................    1545-0203
                                                               1545-0390
1.408-7....................................................    1545-0119
1.408(q)-1.................................................    1545-1841
1.408A-2...................................................    1545-1616
1.408A-4...................................................    1545-1616
1.408A-5...................................................    1545-1616
1.408A-7...................................................    1545-1616
1.410(a)-2.................................................    1545-0710
1.410(d)-1.................................................    1545-0710
1.411(a)-11................................................    1545-1471
                                                               1545-1632
1.411(d)-4.................................................    1545-1545
1.411(d)-6.................................................    1545-1477
1.412(c)(1)-2..............................................    1545-0710
1.412(c)(2)-1..............................................    1545-0710
1.412(c)(3)-2..............................................    1545-0710
1.414(c)-5.................................................    1545-0797
1.414(r)-1.................................................    1545-1221
1.415-2....................................................    1545-0710
1.415-6....................................................    1545-0710
1.417(a)(3)-1..............................................    1545-0928
1.417(e)-1.................................................    1545-1471
                                                               1545-1724
1.417(e)-1T................................................    1545-1471
1.419A(f)(6)-1.............................................    1545-1795
1.422-1....................................................    1545-0820
1.430(f)-1.................................................    1545-2095
1.430(g)-1.................................................    1545-2095
1.430(h)(2)-1..............................................    1545-2095
1.432(e)(9)-1T.............................................    1545-2260
1.436-1....................................................    1545-2095
1.441-2....................................................    1545-1748
1.442-1....................................................    1545-0074
                                                               1545-0123
                                                               1545-0134
                                                               1545-0152
                                                               1545-0820
                                                               1545-1748
1.443-1....................................................    1545-0123
1.444-3T...................................................    1545-1036
1.444-4....................................................    1545-1591
1.446-1....................................................    1545-0074
                                                               1545-0152
1.446-4(d).................................................    1545-1412
1.448-1(g).................................................    1545-0152
1.448-1(h).................................................    1545-0152
1.448-1(i).................................................    1545-0152
1.448-2....................................................    1545-1855
1.448-2T...................................................    1545-0152
                                                               1545-1855
1.451-1....................................................    1545-0091
1.451-4....................................................    1545-0123
1.451-6....................................................    1545-0074
1.451-7....................................................    1545-0074
1.453-1....................................................    1545-0152
1.453-2....................................................    1545-0152
1.453-8....................................................    1545-0152
                                                               1545-0228
1.453A-1...................................................    1545-0152
                                                               1545-1134
1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074

[[Page 925]]

 
1.455-2....................................................    1545-0152
1.455-6....................................................    1545-0123
1.456-2....................................................    1545-0123
1.456-6....................................................    1545-0123
1.456-7....................................................    1545-0123
1.457-8....................................................    1545-1580
1.458-1....................................................    1545-0879
1.458-2....................................................    1545-0152
1.460-1....................................................    1545-1650
1.460-6....................................................    1545-1031
                                                               1545-1572
                                                               1545-1732
1.461-1....................................................    1545-0074
1.461-2....................................................    1545-0096
1.461-4....................................................    1545-0917
1.461-5....................................................    1545-0917
1.463-1T...................................................    1545-0916
1.465-1T...................................................    1545-0712
1.466-1T...................................................    1545-0152
1.466-4....................................................    1545-0152
1.468A-3...................................................    1545-1269
                                                               1545-1378
                                                               1545-1511
1.468A-3(h), 1.468A-7, and 1.468A-8(d).....................    1545-2091
1.468A-4...................................................    1545-0954
1.468A-7...................................................    1545-0954
                                                               1545-1511
1.468A-8...................................................    1545-1269
1.468B-1...................................................    1545-1631
1.468B-1(j)................................................    1545-1299
1.468B-2(k)................................................    1545-1299
1.468B-2(l)................................................    1545-1299
1.468B-3(b)................................................    1545-1299
1.468B-3(e)................................................    1545-1299
1.468B-5(b)................................................    1545-1299
1.468B-9...................................................    1545-1631
1.469-1....................................................    1545-1008
1.469-2T...................................................    1545-0712
                                                               1545-1091
1.469-4T...................................................    1545-0985
                                                               1545-1037
1.469-7....................................................    1545-1244
1.471-2....................................................    1545-0123
1.471-5....................................................    1545-0123
1.471-6....................................................    1545-0123
1.471-8....................................................    1545-0123
1.471-11...................................................    1545-0123
                                                               1545-0152
1.472-1....................................................    1545-0042
                                                               1545-0152
1.472-2....................................................    1545-0152
1.472-3....................................................    1545-0042
1.472-5....................................................    1545-0152
1.472-8....................................................    1545-0028
                                                               1545-0042
                                                               1545-1767
1.475(a)-4.................................................    1545-1945
1.481-4....................................................    1545-0152
1.481-5....................................................    1545-0152
1.482-1....................................................    1545-1364
1.482-4....................................................    1545-1364
1.482-7....................................................    1545-1364
                                                               1545-1794
1.482-9(b).................................................    1545-2149
1.501(a)-1.................................................    1545-0056
                                                               1545-0057
1.501(c)(3)-1..............................................    1545-0056
1.501(c)(9)-5..............................................    1545-0047
1.501(c)(17)-3.............................................    1545-0047
1.501(e)-1.................................................    1545-0814
1.501(r)-3.................................................    1545-0047
1.501(r)-4.................................................    1545-0047
1.501(r)-6.................................................    1545-0047
1.503(c)-1.................................................    1545-0047
                                                               1545-0052
1.505(c)-1T................................................    1545-0916
1.506-1....................................................    1545-2268
1.507-1....................................................    1545-0052
1.507-2....................................................    1545-0052
1.508-1....................................................    1545-0052
                                                               1545-0056
1.509(a)-3.................................................    1545-0047
1.509(a)-4.................................................    1545-2157
1.509(a)-5.................................................    1545-0047
1.509(c)-1.................................................    1545-0052
1.512(a)-1.................................................    1545-0687
1.512(a)-4.................................................    1545-0047
                                                               1545-0687
1.521-1....................................................    1545-0051
                                                               1545-0058
1.527-2....................................................    1545-0129
1.527-5....................................................    1545-0129
1.527-6....................................................    1545-0129
1.527-9....................................................    1545-0129
1.528-8....................................................    1545-0127
1.529A-2...................................................    1545-2293
1.529A-5...................................................    1545-2262
1.529A-6...................................................    1545-2262
1.529A-7...................................................    1545-2262
1.533-2....................................................    1545-0123
1.534-2....................................................    1545-0123
1.542-3....................................................    1545-0123
1.545-2....................................................    1545-0123
1.545-3....................................................    1545-0123
1.547-2....................................................    1545-0045
                                                               1545-0123
1.547-3....................................................    1545-0123
1.561-1....................................................    1545-0044
1.561-2....................................................    1545-0123
1.562-3....................................................    1545-0123
1.563-2....................................................    1545-0123
1.564-1....................................................    1545-0123
1.565-1....................................................    1545-0043
                                                               1545-0123
1.565-2....................................................    1545-0043
1.565-3....................................................    1545-0043
1.565-5....................................................    1545-0043
1.565-6....................................................    1545-0043
1.585-1....................................................    1545-0123
1.585-3....................................................    1545-0123
1.585-8....................................................    1545-1290
1.597-2....................................................    1545-1300
1.597-4....................................................    1545-1300
1.597-6....................................................    1545-1300
1.597-7....................................................    1545-1300
1.611-2....................................................    1545-0099
1.611-3....................................................    1545-0007
                                                               1545-0099
                                                               1545-1784
1.612-4....................................................    1545-0074
1.612-5....................................................    1545-0099
1.613-3....................................................    1545-0099
1.613-4....................................................    1545-0099
1.613-6....................................................    1545-0099
1.613-7....................................................    1545-0099
1.613A-3...................................................    1545-0919
1.613A-3(e)................................................    1545-1251
1.613A-3(l)................................................    1545-0919
1.613A-5...................................................    1545-0099
1.613A-6...................................................    1545-0099
1.614-2....................................................    1545-0099
1.614-3....................................................    1545-0099
1.614-5....................................................    1545-0099
1.614-6....................................................    1545-0099

[[Page 926]]

 
1.614-8....................................................    1545-0099
1.617-1....................................................    1545-0099
1.617-3....................................................    1545-0099
1.617-4....................................................    1545-0099
1.631-1....................................................    1545-0007
1.631-2....................................................    1545-0007
1.641(b)-2.................................................    1545-0092
1.642(c)-1.................................................    1545-0092
1.642(c)-2.................................................    1545-0092
1.642(c)-5.................................................    1545-0074
1.642(c)-6.................................................    1545-0020
                                                               1545-0074
                                                               1545-0092
1.642(g)-1.................................................    1545-0092
1.642(i)-1.................................................    1545-0092
1.645-1....................................................    1545-1578
1.663(b)-2.................................................    1545-0092
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-1(c).................................................    1545-2101
1.664-2....................................................    1545-0196
1.664-3....................................................    1545-0196
1.664-4....................................................    1545-0020
                                                               1545-0196
1.665(a)-0A through
1.665(g)-2A................................................    1545-0192
1.666(d)-1A................................................    1545-0092
1.671-4....................................................    1545-1442
1.671-5....................................................    1545-1540
1.701-1....................................................    1545-0099
1.702-1....................................................    1545-0074
1.703-1....................................................    1545-0099
1.704-2....................................................    1545-1090
1.706-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.706-4(f).................................................    1545-0123
1.707-3(c)(2)..............................................    1545-1243
1.707-5(a)(7)(ii)..........................................    1545-1243
1.707-6(c).................................................    1545-1243
1.707-8....................................................    1545-1243
1.708-1....................................................    1545-0099
1.732-1....................................................    1545-0099
                                                               1545-1588
1.736-1....................................................    1545-0074
1.743-1....................................................    1545-0074
                                                               1545-1588
1.751-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0941
1.752-2....................................................    1545-1905
1.752-5....................................................    1545-1090
1.752-7....................................................    1545-1843
1.754-1....................................................    1545-0099
1.755-1....................................................    1545-0099
1.761-2....................................................    1545-1338
1.801-1....................................................    1545-0123
                                                               1545-0128
1.801-3....................................................    1545-0123
1.801-5....................................................    1545-0128
1.801-8....................................................    1545-0128
1.804-4....................................................    1545-0128
1.811-2....................................................    1545-0128
1.812-2....................................................    1545-0128
1.815-6....................................................    1545-0128
1.818-4....................................................    1545-0128
1.818-5....................................................    1545-0128
1.818-8....................................................    1545-0128
1.819-2....................................................    1545-0128
1.822-5....................................................    1545-1027
1.822-6....................................................    1545-1027
1.822-8....................................................    1545-1027
1.822-9....................................................    1545-1027
1.826-1....................................................    1545-1027
1.826-2....................................................    1545-1027
1.826-3....................................................    1545-1027
1.826-4....................................................    1545-1027
1.826-6....................................................    1545-1027
1.831-3....................................................    1545-0123
1.832-4....................................................    1545-1227
1.832-5....................................................    1545-0123
1.848-2(g)(8)..............................................    1545-1287
1.848-2(h)(3)..............................................    1545-1287
1.848-2(i)(4)..............................................    1545-1287
1.851-2....................................................    1545-1010
1.851-4....................................................    1545-0123
1.852-1....................................................    1545-0123
1.852-4....................................................    1545-0123
                                                               1545-0145
1.852-6....................................................    1545-0123
                                                               1545-0144
1.852-7....................................................    1545-0074
1.852-9....................................................    1545-0074
                                                               1545-0123
                                                               1545-0144
                                                               1545-0145
                                                               1545-1783
1.852-11...................................................    1545-1094
1.853-3....................................................    1545-2035
1.853-4....................................................    1545-2035
1.854-2....................................................    1545-0123
1.855-1....................................................    1545-0123
1.856-2....................................................    1545-0123
                                                               1545-1004
1.856-6....................................................    1545-0123
1.856-7....................................................    1545-0123
1.856-8....................................................    1545-0123
1.857-8....................................................    1545-0123
1.857-9....................................................    1545-0074
1.858-1....................................................    1545-0123
1.860-2....................................................    1545-0045
1.860-4....................................................    1545-0045
                                                               1545-1054
                                                               1545-1057
1.860E-1...................................................    1545-1675
1.860E-2(a)(5).............................................    1545-1276
1.860E-2(a)(7).............................................    1545-1276
1.860E-2(b)(2).............................................    1545-1276
1.860G-2...................................................    1545-2110
1.861-2....................................................    1545-0089
1.861-3....................................................    1545-0089
1.861-4....................................................    1545-1900
1.861-8....................................................    1545-0126
1.861-8(e)(6) and (g)......................................    1545-1224
1.861-9T...................................................    1545-0121
                                                               1545-1072
1.861-18...................................................    1545-1594
1.863-1....................................................    1545-1476
1.863-3....................................................    1545-1476
                                                               1545-1556
1.863-3A...................................................    1545-0126
1.863-4....................................................    1545-0126
1.863-7....................................................    1545-0132
1.863-8....................................................    1545-1718
1.863-9....................................................    1545-1718
1.864-4....................................................    1545-0126
1.871-1....................................................    1545-0096
1.871-6....................................................    1545-0795
1.871-7....................................................    1545-0089
1.871-10...................................................    1545-0089
                                                               1545-0165
1.874-1....................................................    1545-0089
1.881-4....................................................    1545-1440

[[Page 927]]

 
1.882-4....................................................    1545-0126
1.883-0....................................................    1545-1677
1.883-1....................................................    1545-1677
1.883-2....................................................    1545-1677
1.883-3....................................................    1545-1677
1.883-4....................................................    1545-1677
1.883-5....................................................    1545-1677
1.884-0....................................................    1545-1070
1.884-1....................................................    1545-1070
1.884-2....................................................    1545-1070
1.884-2T...................................................    1545-0126
                                                               1545-1070
1.884-4....................................................    1545-1070
1.884-5....................................................    1545-1070
1.892-1T...................................................    1545-1053
1.892-2T...................................................    1545-1053
1.892-3T...................................................    1545-1053
1.892-4T...................................................    1545-1053
1.892-5T...................................................    1545-1053
1.892-6T...................................................    1545-1053
1.892-7T...................................................    1545-1053
1.897-2....................................................    1545-0123
                                                               1545-0902
1.897-3....................................................    1545-0123
1.897-5T...................................................    1545-0902
1.897-6T...................................................    1545-0902
1.901-2....................................................    1545-0746
1.901-2A...................................................    1545-0746
1.901-3....................................................    1545-0122
1.902-1....................................................    1545-0122
                                                               1545-1458
1.904-1....................................................    1545-0121
                                                               1545-0122
1.904-2....................................................    1545-0121
                                                               1545-0122
1.904-3....................................................    1545-0121
1.904-4....................................................    1545-0121
1.904-5....................................................    1545-0121
1.904-7....................................................    1545-2104
1.904-7T...................................................    1545-2104
1.904(f)-1.................................................    1545-0121
                                                               1545-0122
1.904(f)-2.................................................    1545-0121
1.904(f)-3.................................................    1545-0121
1.904(f)-4.................................................    1545-0121
1.904(f)-5.................................................    1545-0121
1.904(f)-6.................................................    1545-0121
1.904(f)-7.................................................    1545-1127
1.905-2....................................................    1545-0122
1.905-3T...................................................    1545-1056
1.905-4T...................................................    1545-1056
1.905-5T...................................................    1545-1056
1.911-1....................................................    1545-0067
                                                               1545-0070
1.911-2....................................................    1545-0067
                                                               1545-0070
1.911-3....................................................    1545-0067
                                                               1545-0070
1.911-4....................................................    1545-0067
                                                               1545-0070
1.911-5....................................................    1545-0067
                                                               1545-0070
1.911-6....................................................    1545-0067
                                                               1545-0070
1.911-7....................................................    1545-0067
                                                               1545-0070
1.913-13...................................................    1545-0067
1.921-1T...................................................    1545-0190
                                                               1545-0884
                                                               1545-0935
                                                               1545-0939
1.921-2....................................................    1545-0884
1.927(a)-1T................................................    1545-0935
1.927(d)-2T................................................    1545-0935
1.931-1....................................................    1545-0074
                                                               1545-0123
1.934-1....................................................    1545-0782
1.935-1....................................................    1545-0074
                                                               1545-0087
                                                               1545-0803
1.936-1....................................................    1545-0215
                                                               1545-0217
1.936-4....................................................    1545-0215
1.936-5....................................................    1545-0704
1.936-6....................................................    1545-0215
1.936-7....................................................    1545-0215
1.936-10(c)................................................    1545-1138
1.937-1....................................................    1545-1930
1.952-2....................................................    1545-0126
1.953-2....................................................    1545-0126
1.954-1....................................................    1545-1068
1.954-2....................................................    1545-1068
1.955-2....................................................    1545-0123
1.955-3....................................................    1545-0123
1.955A-2...................................................    1545-0755
1.955A-3...................................................    1545-0755
1.956-1....................................................    1545-0704
1.956-2....................................................    1545-0704
1.959-1....................................................    1545-0704
1.959-2....................................................    1545-0704
1.960-1....................................................    1545-0122
1.962-2....................................................    1545-0704
1.962-3....................................................    1545-0704
1.964-1....................................................    1545-0126
                                                               1545-0704
                                                               1545-1072
                                                               1545-2104
1.964-3....................................................    1545-0126
1.970-2....................................................    1545-0126
1.985-2....................................................    1545-1051
                                                               1545-1131
1.985-3....................................................    1545-1051
1.987-1....................................................    1545-2265
1.987-3....................................................    1545-2265
1.987-9....................................................    1545-2265
1.987-10...................................................    1545-2265
1.988-0....................................................    1545-1131
1.988-1....................................................    1545-1131
1.988-2....................................................    1545-1131
1.988-3....................................................    1545-1131
1.988-4....................................................    1545-1131
1.988-5....................................................    1545-1131
1.988-6....................................................    1545-1831
1.992-1....................................................    1545-0190
                                                               1545-0938
1.992-2....................................................    1545-0190
                                                               1545-0884
                                                               1545-0938
1.992-3....................................................    1545-0190
                                                               1545-0938
1.992-4....................................................    1545-0190
                                                               1545-0938
1.993-3....................................................    1545-0938
1.993-4....................................................    1545-0938
1.994-1....................................................    1545-0938
1.995-5....................................................    1545-0938
1.1001-1...................................................    1545-1902
1.1012-1...................................................    1545-0074
                                                               1545-1139
1.1014-4...................................................    1545-0184
1.1015-1...................................................    1545-0020
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1.1041-1T..................................................    1545-0074
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1.1042-1T..................................................    1545-0916
1.1044(a)-1................................................    1545-1421
1.1045-1...................................................    1545-1893
1.1060-1...................................................    1545-1658
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1.1071-1...................................................    1545-0184
1.1071-4...................................................    1545-0184
1.1081-4...................................................    1545-0028
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1.1092(b)-1T...............................................    1545-0644
1.1092(b)-2T...............................................    1545-0644
1.1092(b)-3T...............................................    1545-0644
1.1092(b)-4T...............................................    1545-0644
1.1092(b)-5T...............................................    1545-0644
1.1211-1...................................................    1545-0074
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1.1221-2...................................................    1545-1480
1.1231-1...................................................    1545-0177
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1.1237-1...................................................    1545-0184
1.1239-1...................................................    1545-0091
1.1242-1...................................................    1545-0184
1.1243-1...................................................    1545-0123
1.1244(e)-1................................................    1545-0123
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1.1245-1...................................................    1545-0184
1.1245-2...................................................    1545-0184
1.1245-3...................................................    1545-0184
1.1245-4...................................................    1545-0184
1.1245-5...................................................    1545-0184
1.1245-6...................................................    1545-0184
1.1248-7...................................................    1545-0074
1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
1.1250-1...................................................    1545-0184
1.1250-2...................................................    1545-0184
1.1250-3...................................................    1545-0184
1.1250-4...................................................    1545-0184
1.1250-5...................................................    1545-0184
1.1251-1...................................................    1545-0184
1.1251-2...................................................    1545-0074
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1.1251-3...................................................    1545-0184
1.1251-4...................................................    1545-0184
1.1252-1...................................................    1545-0184
1.1252-2...................................................    1545-0184
1.1254-1(c)(3).............................................    1545-1352
1.1254-4...................................................    1545-1493
1.1254-5(d)(2).............................................    1545-1352
1.1258-1...................................................    1545-1452
1.1272-3...................................................    1545-1353
1.1273-2(f)(9).............................................    1545-1353
1.1273-2(h)(2).............................................    1545-1353
1.1274-3(d)................................................    1545-1353
1.1274-5(b)................................................    1545-1353
1.1274A-1(c)...............................................    1545-1353
1.1275-2...................................................    1545-1450
1.1275-3...................................................    1545-0887
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1.1275-4...................................................    1545-1450
1.1275-6...................................................    1545-1450
1.1287-1...................................................    1545-0786
1.1291-9...................................................    1545-1507
1.1291-10..................................................    1545-1304
                                                               1545-1507
1.1294-1T..................................................    1545-1002
                                                               1545-1028
1.1295-1...................................................    1545-1555
1.1295-3...................................................    1545-1555
1.1298-3...................................................    1545-1507
1.1301-1...................................................    1545-1662
1.1311(a)-1................................................    1545-0074
1.1361-1...................................................    1545-0731
                                                               1545-1591
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1.1361-3...................................................    1545-1590
1.1361-5...................................................    1545-1590
1.1362-1...................................................    1545-1308
1.1362-2...................................................    1545-1308
1.1362-3...................................................    1545-1308
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1.1362-5...................................................    1545-1308
1.1362-6...................................................    1545-1308
1.1362-7...................................................    1545-1308
1.1362-8...................................................    1545-1590
1.1363-2...................................................    1545-1906
1.1366-1...................................................    1545-1613
1.1367-1(f)................................................    1545-1139
1.1368-1(f)(2).............................................    1545-1139
1.1368-1(f)(3).............................................    1545-1139
1.1368-1(f)(4).............................................    1545-1139
1.1368-1(g)(2).............................................    1545-1139
1.1374-1A..................................................    1545-0130
1.1377-1...................................................    1545-1462
1.1378-1...................................................    1545-1748
1.1383-1...................................................    1545-0074
1.1385-1...................................................    1545-0074
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1.1388-1...................................................    1545-0118
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1.1397E-1..................................................    1545-1908
1.1398-1...................................................    1545-1375
1.1398-2...................................................    1545-1375
1.1402(a)-2................................................    1545-0074
1.1402(a)-5................................................    1545-0074
1.1402(a)-11...............................................    1545-0074
1.1402(a)-15...............................................    1545-0074
1.1402(a)-16...............................................    1545-0074
1.1402(b)-1................................................    1545-0171
1.1402(c)-2................................................    1545-0074
1.1402(e)(1)-1.............................................    1545-0074
1.1402(e)(2)-1.............................................    1545-0074
1.1402(e)-1A...............................................    1545-0168
1.1402(e)-2A...............................................    1545-0168
1.1402(e)-3A...............................................    1545-0168
1.1402(e)-4A...............................................    1545-0168
1.1402(e)-5A...............................................    1545-0168
1.1402(f)-1................................................    1545-0074
1.1402(h)-1................................................    1545-0064
1.1411-10(g)...............................................    1545-2227
1.1441-1...................................................    1545-1484
1.1441-2...................................................    1545-0795
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1.1445-9T..................................................    1545-0902
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1.1502-5...................................................    1545-0257
1.1502-9...................................................    1545-1634
1.1502-9A..................................................    1545-0121
1.1502-13..................................................    1545-0123
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1.1502-16..................................................    1545-0123
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1.1502-20..................................................    1545-1774
1.1502-21..................................................    1545-1237
1.1502.21T.................................................    1545-0123
1.1502-31..................................................    1545-1344
1.1502-32..................................................    1545-1344
                                                               1545-1774
1.1502-33..................................................    1545-1344
1.1502-35..................................................    1545-1828
1.1502-36..................................................    1545-2096
1.1502-47..................................................    1545-0123
1.1502-75..................................................    1545-0025
                                                               1545-0123
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1.1502-76..................................................    1545-1344
1.1502-76T.................................................    1545-2019
1.1502-77..................................................    1545-1699
1.1502-77A.................................................    1545-0123
                                                               1545-1046
1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
1.1502-95..................................................    1545-1218
1.1502-95A.................................................    1545-1218
1.1502-96..................................................    1545-1218
1.1503-2...................................................    1545-1583
1.1503-2A..................................................    1545-1083
1.1503(d)-1................................................    1545-1946
1.1503(d)-3................................................    1545-1946
1.1503(d)-4................................................    1545-1946
1.1503(d)-5................................................    1545-1946
1.1503(d)-6................................................    1545-1946
1.1552-1...................................................    1545-0123
1.1561-3...................................................    1545-0123
1.1563-1...................................................    1545-0123
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1.1563-3...................................................    1545-0123
1.5000A-3..................................................    1545-0074
1.5000A-4..................................................    1545-0074
1.5000C-2..................................................    1545-0096
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1.5000C-3..................................................    1545-0096
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1.5000C-4..................................................    1545-1223
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1.6001-1...................................................    1545-0058
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1.6011-1...................................................    1545-0055
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1.6011-2...................................................    1545-0055
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1.6011-3...................................................    1545-0238
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1.6011-4...................................................    1545-1685
1.6012-1...................................................    1545-0067
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1.6012-2...................................................    1545-0047
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1.6012-3...................................................    1545-0047
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1.6012-6...................................................    1545-0067
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1.6013-1...................................................    1545-0074
1.6013-2...................................................    1545-0091
1.6013-6...................................................    1545-0074
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1.6015-5...................................................    1545-1719
1.6015(a)-1................................................    1545-0087
1.6015(b)-1................................................    1545-0087
1.6015(d)-1................................................    1545-0087
1.6015(e)-1................................................    1545-0087
1.6015(f)-1................................................    1545-0087
1.6015(g)-1................................................    1545-0087
1.6015(h)-1................................................    1545-0087
1.6015(i)-1................................................    1545-0087
1.6017-1...................................................    1545-0074
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1.6031(a)-1................................................    1545-1583
1.6031(b)-1T...............................................    1545-0099
1.6031(c)-1T...............................................    1545-0099
1.6032-1...................................................    1545-0099
1.6033-2...................................................    1545-0047
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1.6033-3...................................................    1545-0052
1.6034-1...................................................    1545-0092
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1.6035-2...................................................    1545-0704
1.6037-1...................................................    1545-0130
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1.6038-2...................................................    1545-1617
                                                               1545-2020
1.6038-3...................................................    1545-1617
1.6038A-2..................................................    1545-1191
1.6038A-3..................................................    1545-1191
                                                               1545-1440
1.6038B-1..................................................    1545-1617
                                                               1545-2183
1.6038B-1T.................................................    1545-0026
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1.6038B-2..................................................    1545-1617
1.6039-2...................................................    1545-0820
1.6041-1...................................................    1545-0008
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1.6041-2...................................................    1545-0008
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1.6041-3...................................................    1545-1148
1.6041-4...................................................    1545-0115
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1.6041-5...................................................    1545-0295
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1.6041-6...................................................    1545-0008
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1.6041-7...................................................    1545-0112
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1.6042-1...................................................    1545-0110
1.6042-2...................................................    1545-0110
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1.6042-3...................................................    1545-0295
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1.6042-4...................................................    1545-0110
1.6043-1...................................................    1545-0041
1.6043-2...................................................    1545-0041
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1.6043-3...................................................    1545-0047
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1.6044-4...................................................    1545-0118
1.6044-5...................................................    1545-0118
1.6045-1...................................................    1545-0715
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1.6045-1(c)(3)(xi)(C)......................................    1545-2186
1.6045-1(n)(5).............................................    1545-2186
1.6045A-1..................................................    1545-2186
1.6045-2...................................................    1545-0115
1.6045-4...................................................    1545-1085
1.6046-1...................................................    1545-0704
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1.6046-2...................................................    1545-0704
1.6046-3...................................................    1545-0704
1.6046A....................................................    1545-1646
1.6047-1...................................................    1545-0119
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1.6047-2...................................................    1545-2234
1.6049-1...................................................    1545-0112
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1.6049-2...................................................    1545-0117
1.6049-3...................................................    1545-0117
1.6049-4...................................................    1545-0096
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1.6050A-1..................................................    1545-0115
1.6050B-1..................................................    1545-0120
1.6050D-1..................................................    1545-0120
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1.6050E-1..................................................    1545-0120
1.6050H-1..................................................    1545-0901
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1.6050H-2..................................................    1545-0901
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1.6050I-2..................................................    1545-1449
1.6050J-1T.................................................    1545-0877
1.6050K-1..................................................    1545-0941
1.6050S-1..................................................    1545-1678
1.6050S-2..................................................    1545-1729
1.6050S-3..................................................    1545-1678
1.6050S-4..................................................    1545-1729
1.6052-1...................................................    1545-0008
1.6052-2...................................................    1545-0008
1.6055-1...................................................    1545-2252
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1.6060-1...................................................    1545-0074
1.6060-1(a)(1).............................................    1545-1231
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1.6081-1...................................................    1545-0066
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1.6081-6...................................................    1545-0148
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1.6081-7...................................................    1545-0148
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1.6091-3...................................................    1545-0089
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1.6109-2...................................................    1545-2176
1.6115-1...................................................    1545-1464
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1.6164-5...................................................    1545-0135
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1.6302-1...................................................    1545-0257
1.6302-2...................................................    1545-0098
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1.6411-2...................................................    1545-0098
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1.6411-3...................................................    1545-0098
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1.6411-4...................................................    1545-0582
1.6414-1...................................................    1545-0096
1.6425-1...................................................    1545-0170
1.6425-2...................................................    1545-0170
1.6425-3...................................................    1545-0170
1.6654-1...................................................    1545-0087
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1.6654-2...................................................    1545-0087
1.6654-3...................................................    1545-0087
1.6655(e)-1................................................    1545-1421
1.6662-3(c)................................................    1545-0889
1.6662-4(e) and (f)........................................    1545-0889
1.6662-6...................................................    1545-1426
1.6694-1...................................................    1545-0074
1.6694-2...................................................    1545-0074
1.6694-2(c)................................................    1545-1231
1.6694-2(c)(3).............................................    1545-1231
1.6694-3(e)................................................    1545-1231
1.6695-1...................................................    1545-0074
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1.6696-1...................................................    1545-0074
                                                               1545-0240
1.6851-1...................................................    1545-0086
                                                               1545-0138
1.6851-2...................................................    1545-0086
                                                               1545-0138
1.7476-1...................................................    1545-0197
1.7476-2...................................................    1545-0197
1.7519-2T..................................................    1545-1036
1.7520-1...................................................    1545-1343
1.7520-2...................................................    1545-1343
1.7520-3...................................................    1545-1343
1.7520-4...................................................    1545-1343
1.7701(l)-3................................................    1545-1642
1.7872-15..................................................    1545-1792
1.9100-1...................................................    1545-0074
1.9101-1...................................................    1545-0008
2.1-4......................................................    1545-0123
2.1-5......................................................    1545-0123
2.1-6......................................................    1545-0123
2.1-10.....................................................    1545-0123
2.1-11.....................................................    1545-0123
2.1-12.....................................................    1545-0123
2.1-13.....................................................    1545-0123
2.1-20.....................................................    1545-0123
2.1-22.....................................................    1545-0123
2.1-26.....................................................    1545-0123
3.2........................................................    1545-0123
4.954-1....................................................    1545-1068
4.954-2....................................................    1545-1068
5.6411-1...................................................    1545-0042
                                                               1545-0074
                                                               1545-0098
                                                               1545-0129
                                                               1545-0172
                                                               1545-0582
                                                               1545-0619

[[Page 932]]

 
5c.44F-1...................................................    1545-0619
5c.128-1...................................................    1545-0123
5c.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    1545-0720
5f.6045-1..................................................    1545-0715
6a.103A-2..................................................    1545-0123
                                                               1545-0720
6a.103A-3..................................................    1545-0720
7.465-1....................................................    1545-0712
7.465-2....................................................    1545-0712
7.465-3....................................................    1545-0712
7.465-4....................................................    1545-0712
7.465-5....................................................    1545-0712
7.936-1....................................................    1545-0217
7.999-1....................................................    1545-0216
7.6039A-1..................................................    1545-0015
7.6041-1...................................................    1545-0115
11.410-1...................................................    1545-0710
11.412(c)-7................................................    1545-0710
11.412(c)-11...............................................    1545-0710
12.7.......................................................    1545-0190
12.8.......................................................    1545-0191
12.9.......................................................    1545-0195
14a.422A-1.................................................    1545-0123
15A.453-1..................................................    1545-0228
16A.126-2..................................................    1545-0074
16A.1255-1.................................................    1545-0184
16A.1255-2.................................................    1545-0184
18.1371-1..................................................    1545-0130
18.1378-1..................................................    1545-0130
18.1379-1..................................................    1545-0130
18.1379-2..................................................    1545-0130
20.2010-2..................................................    1545-0015
20.2011-1..................................................    1545-0015
20.2014-5..................................................    1545-0015
                                                               1545-0260
20.2014-6..................................................    1545-0015
20.2016-1..................................................    1545-0015
20.2031-2..................................................    1545-0015
20.2031-3..................................................    1545-0015
20.2031-4..................................................    1545-0015
20.2031-6..................................................    1545-0015
20.2031-7..................................................    1545-0020
20.2031-10.................................................    1545-0015
20.2032-1..................................................    1545-0015
20.2032A-3.................................................    1545-0015
20.2032A-4.................................................    1545-0015
20.2032A-8.................................................    1545-0015
20.2039-4..................................................    1545-0015
20.2051-1..................................................    1545-0015
20.2053-3..................................................    1545-0015
20.2053-9..................................................    1545-0015
20.2053-10.................................................    1545-0015
20.2055-1..................................................    1545-0015
20.2055-2..................................................    1545-0015
                                                               1545-0092
20.2055-3..................................................    1545-0015
20.2056(b)-4...............................................    1545-0015
20.2056(b)-7...............................................    1545-0015
                                                               1545-1612
20.2056A-2.................................................    1545-1443
20.2056A-3.................................................    1545-1360
20.2056A-4.................................................    1545-1360
20.2056A-10................................................    1545-1360
20.2106-1..................................................    1545-0015
20.2106-2..................................................    1545-0015
20.2204-1..................................................    1545-0015
20.2204-2..................................................    1545-0015
20.6001-1..................................................    1545-0015
20.6011-1..................................................    1545-0015
20.6018-1..................................................    1545-0015
                                                               1545-0531
20.6018-2..................................................    1545-0015
20.6018-3..................................................    1545-0015
20.6018-4..................................................    1545-0015
                                                               1545-0022
20.6036-2..................................................    1545-0015
20.6060-1(a)(1)............................................    1545-1231
20.6061-1..................................................    1545-0015
20.6065-1..................................................    1545-0015
20.6075-1..................................................    1545-0015
20.6081-1..................................................    1545-0015
                                                               1545-0181
                                                               1545-1707
20.6091-1..................................................    1545-0015
20.6107-1..................................................    1545-1231
20.6161-1..................................................    1545-0015
                                                               1545-0181
20.6161-2..................................................    1545-0015
                                                               1545-0181
20.6163-1..................................................    1545-0015
20.6166-1..................................................    1545-0181
20.6166A-1.................................................    1545-0015
20.6166A-3.................................................    1545-0015
20.6324A-1.................................................    1545-0754
20.7520-1..................................................    1545-1343
20.7520-2..................................................    1545-1343
20.7520-3..................................................    1545-1343
20.7520-4..................................................    1545-1343
22.0.......................................................    1545-0015
25.2511-2..................................................    1545-0020
25.2512-2..................................................    1545-0020
25.2512-3..................................................    1545-0020
25.2512-5..................................................    1545-0020
25.2512-9..................................................    1545-0020
25.2513-1..................................................    1545-0020
25.2513-2..................................................    1545-0020
                                                               1545-0021
25.2513-3..................................................    1545-0020
25.2518-2..................................................    1545-0959
25.2522(a)-1...............................................    1545-0196
25.2522(c)-3...............................................    1545-0020
                                                               1545-0196
25.2523(a)-1...............................................    1545-0020
                                                               1545-0196
25.2523(f)-1...............................................    1545-0015
25.2701-2..................................................    1545-1241
25.2701-4..................................................    1545-1241
25.2701-5..................................................    1545-1273
25.2702-5..................................................    1545-1485
25.2702-6..................................................    1545-1273
25.6001-1..................................................    1545-0020
                                                               1545-0022
25.6011-1..................................................    1545-0020
25.6019-1..................................................    1545-0020
25.6019-2..................................................    1545-0020
25.6019-3..................................................    1545-0020
25.6019-4..................................................    1545-0020
25.6060-1(a)(1)............................................    1545-1231
25.6061-1..................................................    1545-0020
25.6065-1..................................................    1545-0020
25.6075-1..................................................    1545-0020
25.6081-1..................................................    1545-0020
25.6091-1..................................................    1545-0020
25.6091-2..................................................    1545-0020
25.6107-1..................................................    1545-1231
25.6151-1..................................................    1545-0020
25.6161-1..................................................    1545-0020
25.7520-1..................................................    1545-1343
25.7520-2..................................................    1545-1343
25.7520-3..................................................    1545-1343
25.7520-4..................................................    1545-1343
26.2601-1..................................................    1545-0985

[[Page 933]]

 
26.2632-1..................................................    1545-0985
                                                               1545-1892
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985
26.2642-4..................................................    1545-0985
26.2642-6..................................................    1545-1902
26.2652-2..................................................    1545-0985
26.2654-1..................................................    1545-1902
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
26.6060-1(a)(1)............................................    1545-1231
26.6107-1..................................................    1545-1231
31.3102-3..................................................    1545-0029
                                                               1545-0059
                                                               1545-0065
31.3121(b)(19)-1...........................................    1545-0029
31.3121(d)-1...............................................    1545-0004
31.3121(i)-1...............................................    1545-0034
31.3121(r)-1...............................................    1545-0029
31.3121(s)-1...............................................    1545-0029
31.3121(v)(2)-1............................................    1545-1643
31.3302(a)-2...............................................    1545-0028
31.3302(a)-3...............................................    1545-0028
31.3302(b)-2...............................................    1545-0028
31.3302(e)-1...............................................    1545-0028
31.3306(c)(18)-1...........................................    1545-0029
31.3401(a)-1...............................................    1545-0029
31.3401(a)(6)..............................................    1545-1484
31.3401(a)(6)-1............................................    1545-0029
                                                               1545-0096
                                                               1545-0795
31.3401(a)(7)-1............................................    1545-0029
31.3401(a)(8)(A)-1 ........................................    1545-0029
                                                               1545-0666
31.3401(a)(8)(C)-1 ........................................    1545-0029
31.3401(a)(15)-1...........................................    1545-0182
31.3401(c)-1...............................................    1545-0004
31.3402(b)-1...............................................    1545-0010
31.3402(c)-1...............................................    1545-0010
31.3402(f)(1)-1............................................    1545-0010
31.3402(f)(2)-1............................................    1545-0010
                                                               1545-0410
31.3402(f)(3)-1............................................    1545-0010
31.3402(f)(4)-1............................................    1545-0010
31.3402(f)(4)-2............................................    1545-0010
31.3402(f)(5)-1............................................    1545-0010
                                                               1545-1435
31.3402(h)(1)-1............................................    1545-0029
31.3402(h)(3)-1............................................    1545-0010
                                                               1545-0029
31.3402(h)(4)-1............................................    1545-0010
31.3402(i)-(1).............................................    1545-0010
31.3402(i)-(2).............................................    1545-0010
31.3402(k)-1...............................................    1545-0065
31.3402(l)-(1).............................................    1545-0010
31.3402(m)-(1).............................................    1545-0010
31.3402(n)-(1).............................................    1545-0010
31.3402(o)-2...............................................    1545-0415
31.3402(o)-3...............................................    1545-0008
                                                               1545-0010
                                                               1545-0415
                                                               1545-0717
31.3402(p)-1...............................................    1545-0415
                                                               1545-0717
31.3402(q)-1...............................................    1545-0238
                                                               1545-0239
31.3404-1..................................................    1545-0029
31.3405(c)-1...............................................    1545-1341
31.3406(a)-1...............................................    1545-0112
31.3406(a)-2...............................................    1545-0112
31.3406(a)-3...............................................    1545-0112
31.3406(a)-4...............................................    1545-0112
31.3406(b)(2)-1............................................    1545-0112
31.3406(b)(2)-2............................................    1545-0112
31.3406(b)(2)-3............................................    1545-0112
31.3406(b)(2)-4............................................    1545-0112
31.3406(b)(2)-5............................................    1545-0112
31.3406(b)(3)-1............................................    1545-0112
31.3406(b)(3)-2............................................    1545-0112
31.3406(b)(3)-3............................................    1545-0112
31.3406(b)(3)-4............................................    1545-0112
31.3406(b)(4)-1............................................    1545-0112
31.3406(c)-1...............................................    1545-0112
31.3406(d)-1...............................................    1545-0112
31.3406(d)-2...............................................    1545-0112
31.3406(d)-3...............................................    1545-0112
31.3406(d)-4...............................................    1545-0112
31.3406(d)-5...............................................    1545-0112
31.3406(e)-1...............................................    1545-0112
31.3406(f)-1...............................................    1545-0112
31.3406(g)-1...............................................    1545-0096
                                                               1545-0112
                                                               1545-1819
31.3406(g)-2...............................................    1545-0112
31.3406(g)-3...............................................    1545-0112
31.3406(h)-1...............................................    1545-0112
31.3406(h)-2...............................................    1545-0112
31.3406(h)-3...............................................    1545-0112
31.3406(i)-1...............................................    1545-0112
31.3501(a)-1T..............................................    1545-0771
31.3503-1..................................................    1545-0024
31.3504-1..................................................    1545-0029
31.3511-1..................................................    1545-2266
31.6001-1..................................................    1545-0798
31.6001-2..................................................    1545-0034
                                                               1545-0798
31.6001-3..................................................    1545-0798
31.6001-4..................................................    1545-0028
31.6001-5..................................................    1545-0798
31.6001-6..................................................    1545-0029
                                                               1459-0798
31.6011(a)-1...............................................    1545-0029
                                                               1545-0034
                                                               1545-0035
                                                               1545-0059
                                                               1545-0074
                                                               1545-0256
                                                               1545-0718
                                                               1545-2097
31.6011(a)-2...............................................    1545-0001
                                                               1545-0002
31.6011(a)-3...............................................    1545-0028
31.6011(a)-3A..............................................    1545-0955
31.6011(a)-4...............................................    1545-0034
                                                               1545-0035
                                                               1545-0718
                                                               1545-1413
                                                               1545-2097
31.6011(a)-5...............................................    1545-0028
                                                               1545-0718
                                                               1545-2097
31.6011(a)-6...............................................    1545-0028
31.6011(a)-7...............................................    1545-0074
31.6011(a)-8...............................................    1545-0028
31.6011(a)-9...............................................    1545-0028
31.6011(a)-10..............................................    1545-0112
31.6011(b)-1...............................................    1545-0003
31.6011(b)-2...............................................    1545-0029
31.6051-1..................................................    1545-0008
                                                               1545-0182
                                                               1545-0458
                                                               1545-1729

[[Page 934]]

 
31.6051-2..................................................    1545-0008
31.6051-3..................................................    1545-0008
31.6053-1..................................................    1545-0029
                                                               1545-0062
                                                               1545-0064
                                                               1545-0065
                                                               1545-1603
31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
                                                               1545-0714
31.6053-4..................................................    1545-0065
                                                               1545-1603
31.6060-1(a)(1)............................................    1545-1231
31.6065(a)-1...............................................    1545-0029
31.6071(a)-1...............................................    1545-0001
                                                               1545-0028
                                                               1545-0029
31.6071(a)-1A..............................................    1545-0955
31.6081(a)-1...............................................    1545-0008
                                                               1545-0028
31.6091-1..................................................    1545-0028
                                                               1545-0029
31.6107-1..................................................    1545-1231
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
                                                               1545-2097
31.6301(c)-1AT.............................................    1545-0035
                                                               1545-0112
                                                               1545-0257
31.6302-1..................................................    1545-1413
31.6302-2..................................................    1545-1413
31.6302-3..................................................    1545-1413
31.6302-4..................................................    1545-1413
31.6302(c)-2...............................................    1545-0001
                                                               1545-0257
31.6302(c)-2A..............................................    1545-0955
31.6302(c)-3...............................................    1545-0257
31.6402(a)-2...............................................    1545-0256
                                                               1545-2097
31.6413(a)-1...............................................    1545-0029
                                                               1545-2097
31.6413(a)-2...............................................    1545-0029
                                                               1545-0256
                                                               1545-2097
31.6413(c)-1...............................................    1545-0029
                                                               1545-0171
31.6414-1..................................................    1545-0029
                                                               1545-2097
32.1.......................................................    1545-0029
                                                               1545-0415
32.2.......................................................    1545-0029
35a.3406-2.................................................    1545-0112
35a.9999-5.................................................    1545-0029
36.3121(l)(1)-1............................................    1545-0137
36.3121(l)(1)-2............................................    1545-0137
36.3121(l)(3)-1............................................    1545-0123
36.3121(1)(7)-1............................................    1545-0123
36.3121(1)(10)-1...........................................    1545-0029
36.3121(1)(10)-3...........................................    1545-0029
36.3121(1)(10)-4...........................................    1545-0257
40.6060-1(a)(1)............................................    1545-1231
40.6107-1..................................................    1545-1231
40.6302(c)-3(b)(2)(ii).....................................    1545-1296
40.6302(c)-3(b)(2)(iii)....................................    1545-1296
40.6302(c)-3(e)............................................    1545-1296
40.6302(c)-3(f)(2)(ii).....................................    1545-1296
41.4481-1..................................................    1545-0143
41.4481-2..................................................    1545-0143
41.4483-3..................................................    1545-0143
41.6001-1..................................................    1545-0143
41.6001-2..................................................    1545-0143
41.6001-3..................................................    1545-0143
41.6060-1(a)(1)............................................    1545-1231
41.6071(a)-1...............................................    1545-0143
41.6081(a)-1...............................................    1545-0143
41.6091-1..................................................    1545-0143
41.6107-1..................................................    1545-1231
41.6109-1..................................................    1545-0143
41.6151(a)-1...............................................    1545-0143
41.6156-1..................................................    1545-0143
41.6161(a)(1)-1............................................    1545-0143
44.4401-1..................................................    1545-0235
44.4403-1..................................................    1545-0235
44.4412-1..................................................    1545-0236
44.4901-1..................................................    1545-0236
44.4905-1..................................................    1545-0236
44.4905-2..................................................    1545-0236
44.6001-1..................................................    1545-0235
44.6011(a)-1...............................................    1545-0235
                                                               1545-0236
44.6060-1(a)(1)............................................    1545-1231
44.6071-1..................................................    1545-0235
44.6091-1..................................................    1545-0235
44.6107-1..................................................    1545-1231
44.6151-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-2..................................................    1545-0235
46.4371-4..................................................    1545-0023
46.4374-1..................................................    1545-0023
46.4375-1..................................................    1545-2238
46.4376-1..................................................    1545-2238
46.4701-1..................................................    1545-0023
                                                               1545-0257
48.4041-4..................................................    1545-0023
48.4041-5..................................................    1545-0023
48.4041-6..................................................    1545-0023
48.4041-7..................................................    1545-0023
48.4041-9..................................................    1545-0023
48.4041-10.................................................    1545-0023
48.4041-11.................................................    1545-0023
48.4041-12.................................................    1545-0023
48.4041-13.................................................    1545-0023
48.4041-19.................................................    1545-0023
48.4041-20.................................................    1545-0023
48.4041-21.................................................    1545-1270
48.4042-2..................................................    1545-0023
48.4052-1..................................................    1545-1418
48.4061(a)-1...............................................    1545-0023
48.4061(a)-2...............................................    1545-0023
48.4061(b)-3...............................................    1545-0023
48.4064-1..................................................    1545-0014
                                                               1545-0242
48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
                                                               1545-1074
                                                               1545-1087
48.4081-2..................................................    1545-1270
                                                               1545-1418
48.4081-3..................................................    1545-1270
                                                               1545-1418
                                                               1545-1897
48.4081-4(b)(2)(ii)........................................    1545-1270
48.4081-4(b)(3)(i).........................................    1545-1270
48.4081-4(c)...............................................    1545-1270
48.4081-6(c)(1)(ii)........................................    1545-1270
48.4081-7..................................................    1545-1270
                                                               1545-1418
48.4082-1T.................................................    1545-1418
48.4082-2..................................................    1545-1418
48.4082-6..................................................    1545-1418
48.4082-7..................................................    1545-1418
48.4101-1..................................................    1545-1418
48.4101-1T.................................................    1545-1418

[[Page 935]]

 
48.4101-2..................................................    1545-1418
48.4161(a)-1...............................................    1545-0723
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    1545-0723
48.4216(a)-2...............................................    1545-0023
48.4216(a)-3...............................................    1545-0023
48.4216(c)-1...............................................    1545-0023
48.4221-1..................................................    1545-0023
48.4221-2..................................................    1545-0023
48.4221-3..................................................    1545-0023
48.4221-4..................................................    1545-0023
48.4221-5..................................................    1545-0023
48.4221-6..................................................    1545-0023
48.4221-7..................................................    1545-0023
48.4222(a)-1...............................................    1545-0014
                                                               1545-0023
48.4223-1..................................................    1545-0023
                                                               1545-0257
                                                               1545-0723
48.6302(c)-1...............................................    1545-0023
                                                               1545-0257
48.6412-1..................................................    1545-0723
48.6416(a)-1...............................................    1545-0023
                                                               1545-0723
48.6416(a)-2...............................................    1545-0723
48.6416(a)-3...............................................    1545-0723
48.6416(b)(1)-1............................................    1545-0723
48.6416(b)(1)-2............................................    1545-0723
48.6416(b)(1)-3............................................    1545-0723
48.6416(b)(1)-4............................................    1545-0723
48.6416(b)(2)-1............................................    1545-0723
48.6416(b)(2)-2............................................    1545-0723
48.6416(b)(2)-3............................................    1545-0723
                                                               1545-1087
48.6416(b)(2)-4............................................    1545-0723
48.6416(b)(3)-1............................................    1545-0723
48.6416(b)(3)-2............................................    1545-0723
48.6416(b)(3)-3............................................    1545-0723
48.6416(b)(4)-1............................................    1545-0723
48.6416(b)(5)-1............................................    1545-0723
48.6416(c)-1...............................................    1545-0723
48.6416(e)-1...............................................    1545-0023
                                                               1545-0723
48.6416(f)-1...............................................    1545-0023
                                                               1545-0723
48.6416(g)-1...............................................    1545-0723
48.6416(h)-1...............................................    1545-0723
48.6420(c)-2...............................................    1545-0023
48.6420(f)-1...............................................    1545-0023
48.6420-1..................................................    1545-0162
                                                               1545-0723
48.6420-2..................................................    1545-0162
                                                               1545-0723
48.6420-3..................................................    1545-0162
                                                               1545-0723
48.6420-4..................................................    1545-0162
                                                               1545-0723
48.6420-5..................................................    1545-0162
                                                               1545-0723
48.6420-6..................................................    1545-0162
                                                               1545-0723
48.6421-0..................................................    1545-0162
                                                               1545-0723
48.6421-1..................................................    1545-0162
                                                               1545-0723
48.6421-2..................................................    1545-0162
                                                               1545-0723
48.6421-3..................................................    1545-0162
                                                               1545-0723
48.6421-4..................................................    1545-0162
                                                               1545-0723
48.6421-5..................................................    1545-0162
                                                               1545-0723
48.6421-6..................................................    1545-0162
                                                               1545-0723
48.6421-7..................................................    1545-0162
                                                               1545-0723
48.6424-0..................................................    1545-0723
48.6424-1..................................................    1545-0723
48.6424-2..................................................    1545-0723
48.6424-3..................................................    1545-0723
48.6424-4..................................................    1545-0723
48.6424-5..................................................    1545-0723
48.6424-6..................................................    1545-0723
48.6427-0..................................................    1545-0723
48.6427-1..................................................    1545-0023
                                                               1545-0162
                                                               1545-0723
48.6427-2..................................................    1545-0162
                                                               1545-0723
48.6427-3..................................................    1545-0723
48.6427-4..................................................    1545-0723
48.6427-5..................................................    1545-0723
48.6427-8..................................................    1545-1418
48.6427-9..................................................    1545-1418
48.6427-10.................................................    1545-1418
48.6427-11.................................................    1545-1418
49.4251-1..................................................    1545-1075
49.4251-2..................................................    1545-1075
49.4251-4(d)(2)............................................    1545-1628
49.4253-3..................................................    1545-0023
49.4253-4..................................................    1545-0023
49.4264(b)-1...............................................    1545-0023
                                                               1545-0224
                                                               1545-0225
                                                               1545-0226
                                                               1545-0230
                                                               1545-0257
                                                               1545-0912
49.4271-1(d)...............................................    1545-0685
49.5000B-1.................................................    1545-2177
51.2(f)(2)(ii).............................................    1545-2209
51.7.......................................................    1545-2209
52.4682-1(b)(2)(iii).......................................    1545-1153
52.4682-2(b)...............................................    1545-1153
                                                               1545-1361
52.4682-2(d)...............................................    1545-1153
                                                               1545-1361
52.4682-3(c)(2)............................................    1545-1153
52.4682-3(g)...............................................    1545-1153
52.4682-4(f)...............................................    1545-0257
                                                               1545-1153
52.4682-5(d)...............................................    1545-1361
52.4682-5(f)...............................................    1545-1361
53.4940-1..................................................    1545-0052
                                                               1545-0196
53.4942(a)-1...............................................    1545-0052
53.4942(a)-2...............................................    1545-0052
53.4942(a)-3...............................................    1545-0052
53.4942(b)-3...............................................    1545-0052
53.4945-1..................................................    1545-0052
53.4945-4..................................................    1545-0052
53.4945-5..................................................    1545-0052
53.4945-6..................................................    1545-0052
53.4947-1..................................................    1545-0196
53.4947-2..................................................    1545-0196
53.4948-1..................................................    1545-0052
53.4958-6..................................................    1545-1623
53.4961-2..................................................    1545-0024
53.4963-1..................................................    1545-0024
53.6001-1..................................................    1545-0052
53.6011-1..................................................    1545-0049
                                                               1545-0052

[[Page 936]]

 
                                                               1545-0092
                                                               1545-0196
53.6060-1(a)(1)............................................    1545-1231
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
53.6081-1..................................................    1545-0066
                                                               1545-0148
53.6107-1..................................................    1545-1231
53.6161-1..................................................    1545-0575
54.4975-7..................................................    1545-0575
54.4977-1T.................................................    1545-0771
54.4980B-6.................................................    1545-1581
54.4980B-7.................................................    1545-1581
54.4980B-8.................................................    1545-1581
54.4980F-1.................................................    1545-1780
54.6011-1..................................................    1545-0575
54.6011-1T.................................................    1545-0575
54.6060-1(a)(1)............................................    1545-1231
54.6107-1..................................................    1545-1231
54.9801-3..................................................    1545-1537
54.9801-4..................................................    1545-1537
54.9801-5..................................................    1545-1537
54.9801-6..................................................    1545-1537
54.9812-1T.................................................    1545-2165
54.9815-1251T..............................................    1545-2178
54.9815-2711T..............................................    1545-2179
54.9815-2712T..............................................    1545-2180
54.9815-2714T..............................................    1545-2172
54.9815-2715...............................................    1545-2229
54.9815-2719AT.............................................    1545-2181
54.9815-2719T..............................................    1545-2182
55.6001-1..................................................    1545-0123
55.6011-1..................................................    1545-0123
                                                               1545-0999
                                                               1545-1016
55.6060-1(a)(1)............................................    1545-1231
55.6061-1..................................................    1545-0999
55.6071-1..................................................    1545-0999
55.6107-1..................................................    1545-1231
56.4911-6..................................................    1545-0052
56.4911-7..................................................    1545-0052
56.4911-9..................................................    1545-0052
56.4911-10.................................................    1545-0052
56.6001-1..................................................    1545-1049
56.6011-1..................................................    1545-1049
56.6060-1(a)(1)............................................    1545-1231
56.6081-1..................................................    1545-1049
56.6107-1..................................................    1545-1231
56.6161-1..................................................    1545-0257
                                                               1545-1049
57.2(e)(2)(i)..............................................    1545-2249
145.4051-1.................................................    1545-0745
145.4052-1.................................................    1545-0120
                                                               1545-0745
                                                               1545-1076
145.4061-1.................................................    1545-0224
                                                               1545-0230
                                                               1545-0257
                                                               1545-0745
156.6001-1.................................................    1545-1049
156.6011-1.................................................    1545-1049
156.6060-1(a)(1)...........................................    1545-1231
156.6081-1.................................................    1545-1049
156.6107-1.................................................    1545-1231
156.6161-1.................................................    1545-1049
157.6001-1.................................................    1545-1824
157.6011-1.................................................    1545-1824
157.6060-1(a)(1)...........................................    1545-1231
157.6081-1.................................................    1545-1824
157.6107-1.................................................    1545-1231
157.6161-1.................................................    1545-1824
301.6011-2.................................................    1545-0225
                                                               1545-0350
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
301.6011(g)-1..............................................    1545-2079
301.6017-1.................................................    1545-0090
301.6034-1.................................................    1545-0092
301.6036-1.................................................    1545-0013
                                                               1545-0773
301.6047-1.................................................    1545-0367
                                                               1545-0957
301.6056-1.................................................    1545-2251
301.6056-2.................................................    1545-2251
301.6057-1.................................................    1545-0710
301.6057-2.................................................    1545-0710
301.6058-1.................................................    1545-0710
301.6059-1.................................................    1545-0710
301.6103(c)-1..............................................    1545-1816
301.6103(n)-1..............................................    1545-1841
301.6103(p)(2)(B)-1........................................    1545-1757
301.6104(a)-1..............................................    1545-0495
301.6104(a)-5..............................................    1545-0056
301.6104(a)-6..............................................    1545-0056
301.6104(b)-1..............................................    1545-0094
                                                               1545-0742
301.6104(d)-1..............................................    1545-1655
301.6104(d)-2..............................................    1545-1655
301.6104(d)-3..............................................    1545-1655
301.6109-1.................................................    1545-0003
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
                                                               1545-1461
                                                               1545-2242
301.6109-3.................................................    1545-1564
301.6110-3.................................................    1545-0074
301.6110-5.................................................    1545-0074
301.6111-1T................................................    1545-0865
                                                               1545-0881
301.6111-2.................................................    1545-0865
                                                               1545-1687
301.6112-1.................................................    1545-0865
                                                               1545-1686
301.6112-1T................................................    1545-0865
                                                               1545-1686
301.6114-1.................................................    1545-1126
                                                               1545-1484
301.6222(a)-2..............................................    1545-0790
301.6222(b)-1..............................................    1545-0790
301.6222(b)-2..............................................    1545-0790
301.6222(b)-3..............................................    1545-0790
301.6223(b)-1..............................................    1545-0790
301.6223(c)-1..............................................    1545-0790
301.6223(e)-2..............................................    1545-0790
301.6223(g)-1..............................................    1545-0790
301.6223(h)-1..............................................    1545-0790
301.6224(b)-1..............................................    1545-0790
301.6224(c)-1..............................................    1545-0790
301.6224(c)-3..............................................    1545-0790
301.6227(c)-1..............................................    1545-0790
301.6227(d)-1..............................................    1545-0790
301.6229(b)-2..............................................    1545-0790
301.6230(b)-1..............................................    1545-0790
301.6230(e)-1..............................................    1545-0790
301.6231(a)(1)-1...........................................    1545-0790
301.6231(a)(7)-1...........................................    1545-0790
301.6231(c)-1..............................................    1545-0790
301.6231(c)-2..............................................    1545-0790
301.6316-4.................................................    1545-0074
301.6316-5.................................................    1545-0074
301.6316-6.................................................    1545-0074

[[Page 937]]

 
301.6316-7.................................................    1545-0029
301.6324A-1................................................    1545-0015
301.6361-1.................................................    1545-0024
                                                               1545-0074
301.6361-2.................................................    1545-0024
301.6361-3.................................................    1545-0074
301.6402-2.................................................    1545-0024
                                                               1545-0073
                                                               1545-0091
301.6402-3.................................................    1545-0055
                                                               1545-0073
                                                               1545-0091
                                                               1545-0132
                                                               1545-1484
301.6402-5.................................................    1545-0928
301.6404-1.................................................    1545-0024
301.6404-2T................................................    1545-0024
301.6404-3.................................................    1545-0024
301.6405-1.................................................    1545-0024
301.6501(c)-1..............................................    1545-1241
                                                               1545-1637
301.6501(d)-1..............................................    1545-0074
                                                               1545-0430
301.6511(d)-1..............................................    1545-0024
                                                               1545-0582
301.6511(d)-2..............................................    1545-0024
                                                               1545-0582
301.6511(d)-3..............................................    1545-0024
                                                               1545-0582
301.6652-2.................................................    1545-0092
301.6685-1.................................................    1545-0092
301.6689-1T................................................    1545-1056
301.6707-1T................................................    1545-0865
                                                               1545-0881
301.6708-1T................................................    1545-0865
301.6712-1.................................................    1545-1126
301.6903-1.................................................    1545-0013
                                                               1545-1783
301.6905-1.................................................    1545-0074
301.7001-1.................................................    1545-0123
301.7101-1.................................................    1545-1029
301.7207-1.................................................    1545-0092
301.7216-2.................................................    1545-0074
301.7216-2(o)..............................................    1545-1209
301.7425-3.................................................    1545-0854
301.7430-2(c)..............................................    1545-1356
301.7502-1.................................................    1545-1899
301.7507-8.................................................    1545-0123
301.7507-9.................................................    1545-0123
301.7513-1.................................................    1545-0429
301.7517-1.................................................    1545-0015
301.7605-1.................................................    1545-0795
301.7623-1.................................................    1545-0409
                                                               1545-1534
301.7654-1.................................................    1545-0803
301.7701-3.................................................    1545-1486
301.7701-4.................................................    1545-1465
301.7701-7.................................................    1545-1600
301.7701-16................................................    1545-0795
301.7701(b)-1..............................................    1545-0089
301.7701(b)-2..............................................    1545-0089
301.7701(b)-3..............................................    1545-0089
301.7701(b)-4..............................................    1545-0089
301.7701(b)-5..............................................    1545-0089
301.7701(b)-6..............................................    1545-0089
301.7701(b)-7..............................................    1545-0089
                                                               1545-1126
301.7701(b)-9..............................................    1545-0089
301.7705-1.................................................    1545-2266
301.7705-2.................................................    1545-2266
301.7805-1.................................................    1545-0805
301.9000-5.................................................    1545-1850
301.9001-1.................................................    1545-0220
301.9100-2.................................................    1545-1488
301.9100-3.................................................    1545-1488
301.9100-4T................................................    1545-0016
                                                               1545-0042
                                                               1545-0074
                                                               1545-0129
                                                               1545-0172
                                                               1545-0619
301.9100-6T................................................    1545-0872
301.9100-7T................................................    1545-0982
301.9100-8.................................................    1545-1112
301.9100-11T...............................................    1545-0123
301.9100-12T...............................................    1545-0026
                                                               1545-0074
                                                               1545-0172
                                                               1545-1027
301.9100-14T...............................................    1545-0046
301.9100-15T...............................................    1545-0046
301.9100-16T...............................................    1545-0152
302.1-7....................................................    1545-0024
305.7701-1.................................................    1545-0823
305.7871-1.................................................    1545-0823
420.0-1....................................................    1545-0710
Part 509...................................................    1545-0846
Part 513...................................................    1545-0834
Part 514...................................................    1545-0845
Part 521...................................................    1545-0848
601.104....................................................    1545-0233
601.105....................................................    1545-0091
601.201....................................................    1545-0019
                                                               1545-0819
601.204....................................................    1545-0152
601.401....................................................    1545-0257
601.504....................................................    1545-0150
601.601....................................................    1545-0800
601.602....................................................    1545-0295
                                                               1545-0387
                                                               1545-0957
601.702....................................................    1545-0429
------------------------------------------------------------------------


[T.D. 8011, 50 FR 10222, Mar. 14, 1985]

    Editorial Note: For Federal Register citations affecting Sec.  
602.101, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.

[[Page 939]]



List of CFR Sections Affected



All changes in this volume of the Code of Federal Regulations (CFR) that 
were made by documents published in the Federal Register since January 
1, 2017 are enumerated in the following list. Entries indicate the 
nature of the changes effected. Page numbers refer to Federal Register 
pages. The user should consult the entries for chapters, parts and 
subparts as well as sections for revisions.
For changes to this volume of the CFR prior to this listing, consult the 
annual edition of the monthly List of CFR Sections Affected (LSA). The 
LSA is available at www.govinfo.gov For changes to this volume of the 
CFR prior to 2001, see the ``List of CFR Sections Affected, 1949-1963, 
1964-1972, 1973-1985, and 1986-2000'' published in 11 separate volumes. 
The ``List of CFR Sections Affected 1986-2000'' is available at 
www.govinfo.gov.

                                  2017

26 CFR
                                                                   82 FR
                                                                    Page
Chapter I
1.467-7 (c)(2) revised; (c)(4) amended..............................6238
1.467-9 Heading revised; (f) added..................................6238

                                  2018

26 CFR
                                                                   83 FR
                                                                    Page
Chapter I
1.471-3 (b) revised................................................58498

                                  2019

26 CFR
                                                                   84 FR
                                                                    Page
Chapter I
1.441-1 (b)(2)(i)(A) removed........................................9234
1.451-5 Removed....................................................33692
1.453-4 Removed.....................................................9235
1.453-5 Removed.....................................................9235
1.453-6 Removed.....................................................9235
1.453-10 Removed....................................................9235
1.453A-0 Amended....................................................9235
1.453A-1 (a) amended................................................9235
1.453A-2 Removed....................................................9235
1.475-0 Amended.....................................................9235
1.475(b)-4 Removed..................................................9235
1.475(g)-1 (h) removed..............................................9235

                                  2020

26 CFR
                                                                   85 FR
                                                                    Page
Chapter I
1.446-3 (g)(4) and (j)(2) revised..................................56839
1.468A-1 (b)(6)(i) and (ii) added..................................55190
1.468A-5 Heading, (b)(2)(i), (v), and (d)(3)(i) revised............55190
1.468A-9 Revised...................................................55190
1.469-9 (b)(2) revised.............................................56840
1.469-11 Heading, (a)(3) revised; (a)(4) and (5) redesignated as 
        (a)(5) and (6); (a)(1) amended; new (a)(4) added...........56842
1.481-5 Redesignated as 1.481-6; new section added.................66476
1.481-6 Redesignated from 1.481-5..................................66476
1.481-6 Revised....................................................66478

                                  2021

26 CFR
                                                                   86 FR
                                                                    Page
Chapter I
1.446-1 (a)(4)(i) amended; (c)(2)(i) revised; (c)(3) added...........268
1.446-1 (c)(1)(ii)(A) amended; eff. 12-30-21.........................836
1.446-2 (a)(2)(i)(E) and (F) amended; (a)(2)(i)(G) added; eff. 12-
        30-21........................................................836
1.448-1 (g)(1) and (h)(1) amended....................................268

[[Page 940]]

1.448-2 Redesignated as 1.448-3; new 1.448-1 added...................269
1.448-2 Correction: (g)(1) amended.................................32186
1.448-3 Redesignated from 1.448-2....................................269
1.448-3 (a)(2) and (h) revised.......................................272
1.451-1 (a) amended; (b) through (g) redesignated as (d) through 
        (i); new (b) and new (c) added; eff. 12-30-21................836
1.451-3 Added; eff. 12-30-21.........................................836
1.451-8 Added; eff. 12-30-21.........................................852
1.460-0 Amended......................................................272
1.460-0 Correction: Table amended..................................32186
1.460-1 (f)(3) amended; (h)(3) added.................................272
1.460-3 (b)(1)(ii) and (3) revised; (d) added........................272
1.460-3 Correction: (b)(3)((ii)(D) heading amended.................32186
1.460-4 (f)(1) amended; (i) added....................................273
1.460-5 (d)(1) amended; (d)(3) revised...............................273
1.460-6 (b)(3)(ii) and (h)(8)(ii) Example 7 designated as 
        (b)(3)(iii) and (h)(8)(iii); (b)(2) introductory text, 
        (ii), new (3)(iii), (c)(1)(i), (2)(i), (iv), (3)(ii), 
        (vi), and (d)(2)(i) amended; (d)(4)(i)(A) and new 
        (h)(8)(iii) revised; (k) added...............................273
1.460-6 Correction: (c)(3)(vi) amended.............................32186
1.469-4 (d)(6) added................................................5540
1.469-9 (b)(2)(ii)(A) and (B) added.................................5540
1.469-11 (a)(1) and (4) revised.....................................5540
1.471-1 Existing text designated as (a); new (a) heading, (b), and 
        (c) added....................................................275

                                  2022

   (Regulations published from January 1, 2022, through April 1, 2022)

26 CFR
                                                                   87 FR
                                                                    Page
Chapter I
1.461-1 (a)(4) amended...............................................325


                                  [all]