[Federal Register Volume 61, Number 189 (Friday, September 27, 1996)]
[Proposed Rules]
[Pages 50778-50787]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-24864]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209826-96]
RIN 1545-AU29


Application of the Grantor Trust Rules to Nonexempt Employees' 
Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
application of the grantor trust rules to nonexempt employees' trusts. 
The proposed regulations clarify that the grantor trust rules generally 
do not apply to domestic nonexempt employees' trusts, and clarify the 
interaction between the grantor trust rules, the rules generally 
governing the taxation of nonqualified deferred compensation 
arrangements, and the antideferral rules for United States persons 
holding interests in foreign entities. The proposed regulations affect 
nonexempt employees' trusts funding deferred compensation arrangements, 
as well as U.S. persons holding interests in certain foreign 
corporations and foreign partnerships with deferred compensation 
arrangements funded through foreign nonexempt employees' trusts. In 
addition, the proposed regulations affect U.S. persons that have 
deferred compensation arrangements funded through certain foreign 
nonexempt employees' trusts. This document also provides notice of a 
public hearing on these proposed regulations.

DATES: Written comments must be received by December 26, 1996. Requests 
to speak (with outlines of oral comments to be discussed) at the public 
hearing scheduled for January 15, 1997, at 10:00 a.m. must be submitted 
by December 24, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209826-96), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209826-96), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., 
Washington, DC. The public hearing will be held in room 2615, Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. 
Alternatively, taxpayers may submit comments electronically via the 
Internet by selecting the ``Tax Regs'' option on the IRS Home Page, or 
by submitting comments directly to the IRS Internet site at http://
www.irs.ustreas.gov/prod/tax__regs/comments.html.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, James A. 
Quinn, (202) 622-3060; Linda S. F. Marshall, (202) 622-6030; Kristine 
K. Schlaman (202) 622-3840; and M. Grace Fleeman (202) 622-3850; 
concerning submissions and the hearing, Michael Slaughter, (202) 622-
7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC 
20224. Comments on the collection of information should be received by 
November 26, 1996. Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec. 1.671-1(h)(3)(iii). This information is required by the IRS to 
determine accurately the portion of certain foreign employees' trusts 
properly treated as owned by the employer. This information will be 
used to notify the Commissioner that certain

[[Page 50779]]

entities are relying on an exception for reasonable funding. The 
collection of information is mandatory. The likely respondents are 
businesses or other for-profit organizations.
    Estimated total annual reporting burden: 1,000 hours.
    The estimated annual burden per respondent varies from .5 hours to 
1.5 hours, depending on individual circumstances, with an estimated 
average of 1 hour.
    Estimated number of respondents: 1,000.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On May 7, 1993, the IRS issued proposed regulations under section 
404A (58 FR 27219). The section 404A proposed regulations provide that 
section 404A is the exclusive means by which an employer may take a 
deduction or reduce earnings and profits for amounts used to fund 
deferred compensation in situations other than those in which a 
deduction or reduction of earnings and profits is permitted under 
section 404 (the ``exclusive means'' rule).
    The section 404A proposed regulations do not provide rules 
regarding the treatment of income and ownership of assets of foreign 
trusts established to fund deferred compensation arrangements, but 
refer to ``other applicable provisions,'' including the grantor trust 
rules of subpart E of the Internal Revenue Code of 1986, as amended. 
Thus, the 1993 proposed section 404A regulations imply that, if an 
employer cannot or does not elect section 404A treatment for a foreign 
trust established to fund the employer's deferred compensation 
arrangements, the employer may be treated as the owner of the entire 
trust for purposes of subtitle A of the Code under sections 671 through 
679 even though all or part of the trust assets are set aside for 
purposes of satisfying liabilities under the plan. Conversely, some 
commentators believe that, for U.S. tax purposes, a foreign employer 
would not be treated as the owner of any portion of a foreign trust 
established to fund a section 404A qualified foreign plan even though 
all or part of the trust assets might be used for purposes other than 
satisfying liabilities under the plan. A number of different rules, in 
addition to the grantor trust rules, potentially affect the taxation of 
foreign trusts established to fund deferred compensation arrangements. 
These rules include: the nonexempt deferred compensation trust rules of 
sections 402(b) and 404(a)(5); the partnership rules of subchapter K; 
and the antideferral rules, which include subpart F and the passive 
foreign investment company (PFIC) rules (sections 1291 through 1297).
    Following publication of the proposed 1993 regulations and 
enactment of section 956A in August of 1993, comments were received 
concerning both the asset ownership rules for foreign employees' trusts 
and the ``exclusive means'' rule for deductions or reductions in 
earnings and profits. These proposed regulations address only comments 
concerning income and asset ownership rules for foreign employees' 
trusts for federal income tax purposes. A foreign employees' trust is a 
nonexempt employees' trust described in section 402(b) that is part of 
a deferred compensation plan, and that is a foreign trust within the 
meaning of section 7701(a)(31). Comments concerning the ``exclusive 
means'' rule will be addressed in future regulations.

Statutory Background

1. Transfers of Property Not Complete for Tax Purposes

    In certain situations, assets that are owned by a trust as a legal 
matter may be treated as owned by another person for tax purposes. 
Thus, assets may be treated as owned by a pension trust for non-tax 
legal purposes but not for tax purposes. This occurs, for example, if 
the person who has purportedly transferred assets to the trust retains 
the benefits and burdens of ownership. See, e.g., Frank Lyon Co. v. 
United States, 435 U.S. 561 (1978); Corliss v. Bowers, 281 U.S. 376 
(1930); Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 
(1981); Rev. Proc. 75-21 (1975-1 C.B. 715). If, under these principles, 
no assets have been transferred to an employees' trust for federal tax 
purposes, these proposed regulations do not apply.

2. Subpart E--Grantors and Others Treated as Substantial Owners

    Even if there has been a completed transfer of trust assets, the 
subpart E rules may apply to treat the grantor as the owner of a 
portion of the trust for federal income tax purposes. Subpart E of part 
I of subchapter J, chapter 1 of the Code (sections 671 through 679) 
taxes income of a trust to the grantor or another person 
notwithstanding that the grantor or other person may not be a 
beneficiary of the trust. Under section 671, a grantor or another 
person includes in computing taxable income and credits those items of 
income, deduction, and credit against tax that are attributable to or 
included in any portion of a trust of which that person is treated as 
the owner.
    Sections 673 through 679 set forth the rules for determining when 
the grantor or another person is treated as the owner of a portion of a 
trust for federal income tax purposes. Under sections 673 through 678, 
the grantor trust rules apply only if the grantor or other person has 
certain powers or interests. For example, section 676 provides that the 
grantor is treated as the owner of a portion of a trust where, at any 
time, the power to revest in the grantor title to that portion is 
exercisable by the grantor or a nonadverse party, or both. A grantor 
who is the owner of a trust under subpart E is treated as the owner of 
the trust property for federal income tax purposes. See Rev. Rul. 85-13 
(1985-1 C.B. 184). This document is made available by the 
Superintendent of Documents, U.S. Government Printing Office, 
Washington, DC 20402.
    Section 679 generally applies to a U.S. person who directly or 
indirectly transfers property to a foreign trust, subject to certain 
exceptions described below. Section 679 generally treats a U.S. person 
transferring property to a foreign trust as the owner of the portion of 
the trust attributable to the transferred property for any taxable year 
of that person for which there is a U.S. beneficiary of any portion of 
the trust. In general, a trust is treated as having a U.S. beneficiary 
for a taxable year of the U.S. transferor unless, under the terms of 
the trust, no part of the income or corpus of the trust may be paid or 
accumulated during the taxable year to or for the benefit of a U.S. 
person, and unless no part of the income or corpus of the trust could 
be paid to or for the benefit of a U.S. person if the trust were 
terminated at any time during the taxable year. A U.S. person is 
treated as having made an indirect transfer to the foreign trust of 
property if a non-U.S. person acts as a conduit with respect to the 
transfer or if the U.S. person has sufficient control over the non-U.S. 
person to direct the transfer by the non-U.S. person rather than 
itself.

[[Page 50780]]

    Section 679(a) provides several exceptions from the application of 
section 679 for certain compensatory trusts. Under these exceptions, 
section 679 does not apply to a trust described in section 404(a)(4) or 
section 404A. Pursuant to amendments made in section 1903(b) of the 
Small Business Job Protection Act of 1996 (SBJPA), section 679 also 
does not apply to any transfer of property after February 6, 1995, to a 
trust described in section 402(b).

3. Taxability of Beneficiary of Nonexempt Employees' Trust

    Section 402(b) provides rules for the taxability of beneficiaries 
of a nonexempt employees' trust. Under section 402(b)(1), employer 
contributions to a nonexempt employees' trust generally are included in 
the gross income of the employee in accordance with section 83. Section 
402(b)(2) provides that amounts distributed or made available from a 
nonexempt employees' trust generally are taxable to the distributee 
under the rules of section 72 in the taxable year in which distributed 
or made available. Section 402(b)(4) provides that, under certain 
circumstances, a highly compensated employee is taxed each year on the 
employee's vested accrued benefit (other than the employee's investment 
in the contract) in a nonexempt employees' trust. Under section 
402(b)(3), a beneficiary of a nonexempt employees' trust generally is 
not treated as the owner of any portion of the trust under subpart E. 
The rules of section 402(b) apply to a beneficiary of a nonexempt 
employees' trust regardless of whether the trust is a domestic trust or 
a foreign trust.

4. Employer Deduction for Contributions to a Nonexempt Employees' Trust

    Section 404(a)(5) provides rules regarding the deductibility of 
contributions to a nonqualified deferred compensation plan. Under 
section 404(a)(5), any contribution paid by an employer under a 
deferred compensation plan, if otherwise deductible under chapter 1 of 
the Code, is deductible only in the taxable year in which an amount 
attributable to the contribution is includible in the gross income of 
employees participating in the plan, and only if separate accounts are 
maintained for each employee. Section 1.404(a)-12(b)(1) clarifies that 
an employer's deduction for contributions to a nonexempt employees' 
trust is restricted to the amount of the contribution, and excludes any 
income received by the trust with respect to contributed amounts.

5. The Partnership Rules of Subchapter K

    A partnership is not subject to income taxation. However, a partner 
must take into account separately on its return its distributive share 
of the partnership's income, gain, loss, deduction, or credit. A U.S. 
partner of a foreign partnership is subject to U.S. tax on its 
distributive share of partnership income. In addition, a foreign 
partnership may have a controlled foreign corporation (CFC) partner 
which must take into account its distributive share of partnership 
income, gain, loss, or deduction in determining its taxable income. 
These distributive share inclusions of the CFC may result in subpart F 
income and thus income to a U.S. shareholder of the CFC. If the grantor 
trust rules do not apply to any portion of a foreign employees' trust, 
a foreign partnership could fund a foreign employees' trust in excess 
of the amount needed to meet its obligations to its employees under its 
deferred compensation plan and yet retain control over the excess 
amount. As a result, the foreign partnership would not have to include 
items in taxable income attributable to the excess amount, and 
consequently the U.S. partner or CFC would not have to include those 
items in its income.

6. The Antideferral Rules of Subpart F, Including Section 956A, and 
PFIC

    A U.S. person that owns stock in a foreign corporation generally 
pays no U.S. tax currently on income earned by the foreign corporation. 
Instead, the United States defers taxation of that income until it is 
distributed to the U.S. person. The antideferral rules, however, which 
include subpart F and the PFIC rules, limit this deferral in certain 
situations.
    Subpart F of part III of Subchapter N (sections 951 through 964) 
applies to CFCs. A foreign corporation is a CFC if more than 50 percent 
of the total voting power of all classes of stock entitled to vote, or 
the total value of the stock in the corporation, is owned by ``U.S. 
shareholders'' (defined as U.S. persons who own ten percent or more of 
the voting power of all classes of stock entitled to vote) on any day 
during the foreign corporation's taxable year. The United States 
generally taxes U.S. shareholders of the CFC currently on their pro 
rata share of the CFC's subpart F income and sections 956 and 956A 
amounts. In effect, the U.S. shareholders are treated as having 
received a distribution out of the earnings and profits (E&P) of the 
CFC.
    The types of income earned by a foreign employees' trust 
(dividends, interest, income equivalent to interest, rents and 
royalties, and annuities) are generally subpart F income. The inclusion 
under section 956 is based on the CFC's investment in U.S. property, 
which generally includes stock of a U.S. shareholder of the CFC. A U.S. 
shareholder's section 956A amount for a taxable year is the lesser of 
two amounts. The first amount is the excess of the U.S. shareholder's 
pro rata share of the CFC's ``excess passive assets'' over the portion 
of the CFC's E&P treated as previously included in gross income by the 
U.S. shareholder under section 956A. For purposes of section 956A, 
``passive asset'' includes any asset which produces (or is held for the 
production of) passive income, and generally includes property that 
produces dividends, interest, income equivalent to interest, rents and 
royalties, and annuities, subject to exceptions that generally are not 
relevant in this context. The second amount is the U.S. shareholder's 
pro rata share of the CFC's ``applicable earnings'' to the extent 
accumulated in taxable years beginning after September 30, 1993.
    Section 1501(a)(2) of SBJPA repeals section 956A. The repeal is 
effective for taxable years of foreign corporations beginning after 
December 31, 1996, and for taxable years of U.S. shareholders with or 
within which such taxable years of foreign corporations end.
    If a CFC employer is not treated for federal income tax purposes as 
the owner of any portion of a foreign employees' trust under the 
grantor trust rules, then to the extent that passive assets contributed 
by a CFC to a nonexempt employees' trust would otherwise result in 
subpart F consequences for the CFC and its shareholders, the CFC's 
contribution could allow those consequences to be avoided. For example, 
a contribution by a CFC of passive assets to its foreign employees' 
trust could reduce the CFC's subpart F earnings and profits, and its 
applicable earnings or passive assets for section 956A purposes, and 
could affect the CFC's increase in investment in U.S. property for 
purposes of section 956, all of which could affect a U.S. shareholder's 
pro rata subpart F inclusions for the taxable year.
    In contrast to the subpart F rules, the PFIC rules apply to any 
U.S. person who directly or indirectly owns any stock in a foreign 
corporation that is a PFIC under either an income or asset test. A 
foreign corporation, including a CFC, is

[[Page 50781]]

a PFIC if either (1) 75 percent or more of its gross income for the 
taxable year is passive income or (2) at least 50 percent of the value 
of the corporation's assets produce passive income or are held for the 
production of passive income. For this purpose, passive income 
generally is the same type of income (dividends, interest, income 
equivalent to interest, rents and royalties, and annuities) that would 
be earned by a foreign employees' trust.
    Under the PFIC rules, a U.S. person who is a direct or indirect 
shareholder of a PFIC is subject to a special tax regime upon either 
disposition of the PFIC's stock or receipt of certain distributions 
(excess distributions) from the PFIC. A shareholder, however, may avoid 
the application of this special regime by electing to include its pro 
rata share of certain of the PFIC's passive income in the year in which 
the foreign corporation earns it.
    If the grantor trust rules did not apply to any portion of a 
foreign employees' trust, a contribution by a foreign corporation of 
passive assets to a nonexempt employees' trust would enable a U.S. 
person to avoid the PFIC rules if those assets would otherwise generate 
PFIC consequences for the foreign corporation and its shareholders. For 
example, by transferring passive assets to its nonexempt employees' 
trust in excess of the amount needed to meet obligations to its 
employees under its deferred compensation plan while retaining control 
over the excess amount, a foreign corporation could divest itself of a 
sufficient amount of passive assets and the passive income they produce 
to avoid meeting the income and asset tests. Furthermore, a foreign 
corporation that is a PFIC could minimize income inclusions for a U.S. 
shareholder that has made an election to include PFIC income currently 
by transferring income-producing assets to a foreign employees' trust.

Overview of Proposed Regulations

    Under the proposed regulations, an employer is not treated as an 
owner of any portion of a domestic nonexempt employees' trust described 
in section 402(b) for federal income tax purposes. Section 404(a)(5) 
and Sec. 1.404(a)-12(b) provide a deduction to the employer solely for 
contributions to a nonexempt employees' trust, and not for any income 
of the trust. This rule is inconsistent with treating the employer as 
owning any portion of a nonexempt employees' trust, which would require 
the employer to recognize the trust's income that it may not deduct 
under section 404(a)(5). Accordingly, such a trust is treated as a 
separate taxable trust that is taxed under the rules of section 641 et 
seq. The rule in the proposed regulations is consistent with the 
holdings of a number of private letter rulings with respect to 
nonexempt employees' trusts and with the Service's treatment of trusts 
that no longer qualify as exempt under 501(a) (because they are no 
longer described in section 401(a)) as separate taxable trusts rather 
than as grantor trusts. See also Rev. Rul. 74-299 (1974-1 C.B. 154). 
This document is made available by the Superintendent of Documents, 
U.S. Government Printing Office, Washington, DC 20402.
    Under the proposed regulations, an employer generally is not 
treated as the owner of any portion of a foreign nonexempt employees' 
trust for federal income tax purposes, except as provided under section 
679. The proposed regulations, however, also provide that the grantor 
trust rules apply to determine whether an employer that is a CFC or a 
U.S. employer is treated as the owner of a specified ``fractional 
interest'' in a foreign employees' trust. This rule applies whether or 
not the employer elects section 404A treatment for the trust. Under the 
proposed regulations, this rule also applies in the case of an employer 
that is a foreign partnership with one or more partners that are U.S. 
persons or CFCs (U.S.-related partnership). Such an employer is treated 
as the owner of a portion of a foreign employees' trust under these 
proposed regulations only if the employer retains a grantor trust power 
or interest over a foreign employees' trust and has a specified 
``fractional interest'' in the trust.
    Under these proposed regulations, the grantor trust rules of 
subpart E do not apply to a foreign employees' trust with respect to a 
foreign employer other than a CFC or a U.S.-related foreign 
partnership, except for cases in which assets are transferred to a 
foreign employees' trust with a principal purpose of avoiding the PFIC 
rules. The IRS and Treasury will continue to consider whether these 
regulations should provide additional antiabuse rules that may be 
necessary for other purposes, including for purposes of calculating 
earnings and profits, determining the foreign tax credit limitation, 
and applying the interest allocation rules of Sec. 1.882-5.

Explanation of Provisions

1. Sec. 1.671-1(g): Domestic Nonexempt Employees' Trusts

    The proposed regulations provide that an employer is not treated 
for federal income tax purposes as an owner of any portion of a 
nonexempt employees' trust described in section 402(b) that is part of 
a deferred compensation plan, and that is not a foreign trust within 
the meaning of section 7701(a)(31), regardless of whether the employer 
has a power or interest described in sections 673 through 677 over any 
portion of the trust. This rule is analogous to the rule set forth in 
Sec. 1.641(a)-0, which provides that subchapter J, including the 
grantor trust rules, does not apply to tax-exempt employees' trusts.

2. Sec. 1.671-1(h): Subpart E Rules for Certain Foreign Employees' 
Trusts

    The proposed regulations provide Subpart E rules for foreign 
employees' trusts of CFCs, foreign partnerships, and U.S. employers 
that apply for all federal income tax purposes. Under the proposed 
regulations, except as provided under section 679 or the proposed 
regulations (as described below), an employer is not treated as an 
owner of any portion of a foreign employees' trust for federal income 
tax purposes. If an employer is treated as the owner of a portion of a 
foreign employees' trust for federal income tax purposes as described 
below, then the employer is considered to own the trust assets 
attributable to that portion of the trust for all federal income tax 
purposes. Thus, for example, if an employer is treated as the owner of 
a portion of a foreign employees' trust for federal income tax purposes 
as described below, then income of the trust that is attributable to 
that portion of the trust increases the employer's earnings and profits 
for purposes of sections 312 and 964.
    A foreign employees' trust is a nonexempt employees' trust 
described in section 402(b) that is part of a deferred compensation 
plan, and that is a foreign trust within the meaning of section 
7701(a)(31). The proposed regulations apply to any foreign employees' 
trust of a CFC or U.S.-related foreign partnership, whether or not a 
trust funds a qualified foreign plan (as defined in section 404A(e)). 
The proposed regulations clarify that the income inclusion and asset 
ownership rules apply to the entity whose employees or independent 
contractors are covered under the deferred compensation plan.
A. Plan of CFC Employer
    The proposed regulations provide that, if a CFC maintains a 
deferred compensation plan funded through a foreign employees' trust, 
then, with respect to the CFC, the provisions of subpart E apply to the 
portion of the

[[Page 50782]]

trust that is the fractional interest of the trust described in the 
proposed regulations.
B. Plan of U.S. Employer
    The proposed regulations provide that if a U.S. person maintains a 
deferred compensation plan funded through a foreign employees' trust, 
then, with respect to the U.S. person, the provisions of subpart E 
apply to the portion of the trust that is the fractional interest of 
the trust described in the proposed regulations.
C. Plan of U.S.-Related Foreign Partnership Employer
    The proposed regulations provide that, if a U.S.-related foreign 
partnership maintains a deferred compensation plan funded through a 
foreign employees' trust, then, with respect to the U.S.-related 
foreign partnership, the provisions of subpart E apply to the portion 
of the trust that is the fractional interest of the trust described in 
the proposed regulations. The IRS and Treasury solicit comments on 
whether these regulations should provide a safe harbor rule for a U.S.-
related foreign partnership that maintains a deferred compensation plan 
funded through a foreign employees' trust if U.S. or CFC partnership 
interests are de minimis. The IRS and Treasury specifically solicit 
comments concerning the amount of U.S. or CFC partnership interests 
that would qualify as ``de minimis.''
D. Plan of Non-CFC Foreign Employer
    The proposed regulations provide that a foreign employer that is 
not a CFC is treated as an owner of a portion of a foreign employees' 
trust only as provided in the antiabuse rule of Sec. 1.1297-4.
E. Fractional Interest
    The fractional interest of a foreign employees' trust described 
above is defined in the proposed regulations as an undivided fractional 
interest in the trust for which the fraction is equal to the relevant 
amount determined for the employer's taxable year divided by the fair 
market value of trust assets determined for the employer's taxable 
year.
F. Relevant Amount
    The relevant amount for the employer's taxable year is defined in 
the proposed regulations as the amount, if any, by which the fair 
market value of trust assets, plus the fair market value of any assets 
available to pay plan liabilities (including any amount held under an 
annuity contract that exceeds the amount that is needed to satisfy the 
liabilities provided for under the contract) that are held in the 
equivalent of a trust within the meaning of section 404A(b)(5)(A), 
exceed the plan's accrued liability, determined using a projected unit 
credit funding method.
    The relevant amount is reduced to the extent the taxpayer 
demonstrates to the Commissioner that the relevant amount is 
attributable to amounts that were properly contributed to the trust 
pursuant to a reasonable funding method, or experience that is 
favorable relative to any actuarial assumptions used that the 
Commissioner determines to be reasonable. In addition, if an employer 
that is a controlled foreign corporation otherwise would be treated as 
the owner of a fractional interest in a foreign employees' trust, the 
taxpayer may rely on this rule only if it so indicates on a statement 
attached to a timely filed Form 5471. The IRS and Treasury solicit 
comments regarding the most appropriate way in which to extend a filing 
requirement to partners in U.S.-related foreign partnerships and other 
affected taxpayers.
G. Plan's Accrued Liability
    Under the proposed regulations, the plan's accrued liability for a 
taxable year of the employer is computed as of the plan's measurement 
date for the employer's taxable year. The plan's accrued liability is 
determined using a projected unit credit funding method, taking into 
account only liabilities relating to services performed for the 
employer or a predecessor employer. In addition, the plan's accrued 
liability is reduced (but not below zero) by any liabilities that are 
provided for under annuity contracts held to satisfy plan liabilities.
    Because CFCs generally are required to determine their taxable 
income by reference to U.S. tax principles, the definition of a plan's 
``accrued liability'' refers to Sec. 1.412(c)(3)-1. This definition 
generally is intended to track the method used for calculating pension 
costs under Statement of Financial Accounting Standards No. 87, 
Employers' Accounting for Pensions (FAS 87), available from the 
Financial Accounting Standards Board, 401 Merritt 7, Norwalk, CT 06856. 
Under the method required to be used to calculate FAS 87's projected 
benefit obligation (PBO), plan costs are based on projected salary 
levels. Because many taxpayers already compute PBO annually to 
determine the pension costs of their nonexempt employees' trusts for 
financial reporting, the timing, interval and method to compute plan 
liabilities under Sec. 1.671-1(h) should minimize taxpayer burden. The 
IRS and Treasury solicit comments regarding the extent to which the 
proposed regulations conform to existing procedures under FAS 87 and 
applicable foreign law, and regarding appropriate conforming 
adjustments.
H. Fair Market Value of Trust Assets
    Under the proposed regulations, for a taxable year of the employer, 
the fair market value of trust assets, and the fair market value of 
retirement annuities or other assets held in the equivalent of a trust, 
equals the fair market value of those assets, as of the measurement 
date for the employer's taxable year. The fair market value of these 
assets is adjusted to include contributions made between the 
measurement date and the end of the employer's taxable year.
I. De Minimis Exception
    The proposed regulations provide an exception to the general rule 
for determining the relevant amount. If the relevant amount would not 
otherwise be greater than the plan's normal cost for the plan year 
ending with or within the employer's taxable year, then the relevant 
amount is considered to be zero.
J. Proposed Effective Date and Transition Rules
    The proposed regulations are proposed to be prospective. For 
taxable years ending prior to September 27, 1996, employers generally 
would not be treated for federal income tax purposes as owning the 
assets of foreign nonexempt employees' trusts (except as provided under 
section 679), consistent with the rules applying to domestic nonexempt 
employees' trusts. A transition rule, for purposes of Sec. 1.671-1(h), 
exempts certain amounts from the application of the proposed 
regulations. This exemption is phased out over a ten-year period. There 
is a special transition rule for any foreign corporation that becomes a 
CFC after September 27, 1996. In addition, there is a special 
transition rule for certain entities that become U.S.-related foreign 
partnerships after September 27, 1996.

3. Sec. 1.671-2: General Asset Ownership Rules

    The proposed regulations provide that a person who is treated as 
the owner of any portion of a trust under subpart E is considered to 
own the trust assets attributable to that portion of the trust for all 
federal income tax purposes.

[[Page 50783]]

4. Sec. 1.1297-4: Subpart E Rules for Foreign Employers That Are Not 
Controlled Foreign Corporations

    Under the proposed regulations, a foreign employer other than a CFC 
is not treated as the owner of any portion of a foreign nonexempt 
employees' trust for purposes of sections 1291 through 1297, except for 
cases in which a principal purpose for transferring property to the 
trust is to avoid classification of a foreign corporation as a PFIC (as 
defined in section 1296) or, if the foreign corporation is classified 
as a PFIC, in cases in which a principal purpose for transferring 
property to the trust is to avoid or to reduce taxation of U.S. 
shareholders of the PFIC under section 1291 or 1293. The effective date 
of this rule is September 27, 1996.

Income Inclusion and Related Asset Ownership Rules for Foreign Welfare 
Benefit Plans

    The IRS and Treasury solicit comments on the need for (and content 
of) income inclusion and asset ownership rules for foreign welfare 
benefit trusts.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that these regulations do not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the fact that these regulations will primarily affect U.S. 
owners of significant interests in foreign entities, which owners 
generally are large multinational corporations. This certification is 
also based on the fact that the burden imposed by the collection of 
information in the regulation, which is a requirement that certain 
entities may rely on an exception for reasonable funding only if they 
indicate such reliance on a statement attached to a timely filed Form 
5471, is minimal, and, therefore, the collection of information will 
not impose a significant economic impact on such entities. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the 
Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for January 15, 1997, at 10:00 
a.m. in room 2615, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington DC. Because of access restrictions, visitors will not 
be admitted beyond the Internal Revenue Building lobby more than 15 
minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by December 26, 1996, and submit an outline of 
the topics to be discussed and the time to be devoted to each topic 
(signed original and eight (8) copies) by December 24, 1996.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are James A. Quinn of 
the Office of Assistant Chief Counsel (Passthroughs and Special 
Industries), Linda S. F. Marshall of the Office of Associate Chief 
Counsel (Employee Benefits and Exempt Organizations), and Kristine K. 
Schlaman and M. Grace Fleeman of the Office of Associate Chief Counsel 
(International). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entry for sections 1.1291-10T, 1.1294-1T, 1.1295-1T, and 
1.1297-3T and adding entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.671-1 also issued under 26 U.S.C. 404A(h) and 
672(f)(2)(B). * * *
    Section 1.1291-10T also issued under 26 U.S.C. 1291(d)(2).
    Section 1.1294-1T also issued under 26 U.S.C. 1294.
    Section 1.1295-1T also issued under 26 U.S.C. 1295.
    Section 1.1297-3T also issued under 26 U.S.C. 1297(b)(1).
    Section 1.1297-4 also issued under 26 U.S.C. 1297(f). * * *

    Par. 2. Section 1.671-1 is amended by adding paragraphs (g) and (h) 
to read as follows:


Sec. 1.671-1  Grantors and others treated as substantial owners; scope.

* * * * *
    (g) Domestic nonexempt employees' trust--(1) General rule. An 
employer is not treated as an owner of any portion of a nonexempt 
employees' trust described in section 402(b) that is part of a deferred 
compensation plan, and that is not a foreign trust within the meaning 
of section 7701(a)(31), regardless of whether the employer has a power 
or interest described in sections 673 through 677 over any portion of 
the trust. See section 402(b)(3) and Sec. 1.402(b)-1(b)(6) for rules 
relating to treatment of a beneficiary of a nonexempt employees' trust 
as the owner of a portion of the trust.
    (2) Example. The following example illustrates the rules of 
paragraph (g)(1) of this section:

    Example. Employer X provides nonqualified deferred compensation 
through Plan A to certain of its management employees. Employer X 
has created Trust T to fund the benefits under Plan A. Assets of 
Trust T may not be used for any purpose other than to satisfy 
benefits provided under Plan A until all plan liabilities have been 
satisfied. Trust T is classified as a trust under Sec. 301.7701-4 of 
this chapter, and is not a foreign trust within the meaning of 
section 7701(a)(31). Under Sec. 1.83-3(e), contributions to Trust T 
are considered transfers of property to participants within the 
meaning of section 83. On these facts, Trust T is a nonexempt 
employees' trust described in section 402(b). Because Trust T is a 
nonexempt employees' trust described in section 402(b) that is part 
of a deferred compensation plan, and that is not a foreign trust 
within the meaning of section 7701(a)(31), Employer X is not treated 
as an owner of any portion of Trust T.

    (h) Foreign employees' trust--(1) General rules. Except as provided 
under section 679 or as provided under this paragraph (h)(1), an 
employer is not treated as an owner of any portion of a foreign 
employees' trust (as defined in paragraph (h)(2) of this section), 
regardless of whether the employer has a power or interest described in 
sections

[[Page 50784]]

673 through 677 over any portion of the trust.
    (i) Plan of CFC employer. If a controlled foreign corporation (as 
defined in section 957) maintains a deferred compensation plan funded 
through a foreign employees' trust, then, with respect to the 
controlled foreign corporation, the provisions of subpart E apply to 
the portion of the trust that is the fractional interest described in 
paragraph (h)(3) of this section.
    (ii) Plan of U.S. employer. If a United States person (as defined 
in section 7701(a)(30)) maintains a deferred compensation plan that is 
funded through a foreign employees' trust, then, with respect to the 
U.S. person, the provisions of subpart E apply to the portion of the 
trust that is the fractional interest described in paragraph (h)(3) of 
this section.
    (iii) Plan of U.S.-related foreign partnership employer--(A) 
General rule. If a U.S.-related foreign partnership (as defined in 
paragraph (h)(1)(iii)(B) of this section) maintains a deferred 
compensation plan funded through a foreign employees' trust, then, with 
respect to the U.S.-related foreign partnership, the provisions of 
subpart E apply to the portion of the trust that is the fractional 
interest described in paragraph (h)(3) of this section.
    (B) U.S.-related foreign partnership. For purposes of this 
paragraph (h), a U.S.-related foreign partnership is a foreign 
partnership in which a U.S. person or a controlled foreign corporation 
owns a partnership interest either directly or indirectly through one 
or more partnerships.
    (iv) Application of Sec. 1.1297-4 to plan of foreign non-CFC 
employer. A foreign employer that is not a controlled foreign 
corporation may be treated as an owner of a portion of a foreign 
employees' trust as provided in Sec. 1.1297-4.
    (v) Application to employer entity. The rules of paragraphs 
(h)(1)(i) through (h)(1)(iv) of this section apply to the employer 
whose employees benefit under the deferred compensation plan funded 
through a foreign employees' trust, or, in the case of a deferred 
compensation plan covering independent contractors, the recipient of 
services performed by those independent contractors, regardless of 
whether the plan is maintained through another entity. Thus, for 
example, where a deferred compensation plan benefitting employees of a 
controlled foreign corporation is funded through a foreign employees' 
trust, the controlled foreign corporation is considered to be the 
grantor of the foreign employees' trust for purposes of applying 
paragraph (h)(1)(i) of this section.
    (2) Foreign employees' trust. A foreign employees' trust is a 
nonexempt employees' trust described in section 402(b) that is part of 
a deferred compensation plan, and that is a foreign trust within the 
meaning of section 7701(a)(31).
    (3) Fractional interest for paragraph (h)(1)--(i) In general. The 
fractional interest for a foreign employees' trust used for purposes of 
paragraph (h)(1) of this section for a taxable year of the employer is 
an undivided fractional interest in the trust for which the fraction is 
equal to the relevant amount for the employer's taxable year divided by 
the fair market value of trust assets for the employer's taxable year.
    (ii) Relevant amount--(A) In general. For purposes of applying 
paragraph (h)(3)(i) of this section, and except as provided in 
paragraph (h)(3)(iii) of this section, the relevant amount for the 
employer's taxable year is the amount, if any, by which the fair market 
value of trust assets, plus the fair market value of any assets 
available to pay plan liabilities that are held in the equivalent of a 
trust within the meaning of section 404A(b)(5)(A), exceed the plan's 
accrued liability. The following rules apply for this purpose:
    (1) The plan's accrued liability is determined using a projected 
unit credit funding method that satisfies the requirements of 
Sec. 1.412(c)(3)-1, taking into account only liabilities relating to 
services performed through the measurement date for the employer or a 
predecessor employer.
    (2) The plan's accrued liability is reduced (but not below zero) by 
any liabilities that are provided for under annuity contracts held to 
satisfy plan liabilities.
    (3) Any amount held under an annuity contract that exceeds the 
amount that is needed to satisfy the liabilities provided for under the 
contract (e.g., the value of a participation right under a 
participating annuity contract) is added to the fair market value of 
any assets available to pay plan liabilities that are held in the 
equivalent of a trust.
    (4) If the relevant amount as determined under this paragraph 
(h)(3)(ii), without regard to this paragraph (h)(3)(ii)(A)(4), is 
greater than the fair market value of trust assets, then the relevant 
amount is equal to the fair market value of trust assets.
    (B) Permissible actuarial assumptions for accrued liability. For 
purposes of paragraph (h)(3)(ii)(A) of this section, a plan's accrued 
liability must be calculated using an interest rate and other actuarial 
assumptions that the Commissioner determines to be reasonable. It is 
appropriate in determining this interest rate to look to available 
information about rates implicit in current prices of annuity 
contracts, and to look to rates of return on high-quality fixed-income 
investments currently available and expected to be available during the 
period prior to maturity of the plan benefits. If the qualified 
business unit computes its income or earnings and profits in dollars 
pursuant to the dollar approximate separate transactions method under 
Sec. 1.985-3, the employer must use an exchange rate that can be 
demonstrated to clearly reflect income, based on all relevant facts and 
circumstances, including appropriate rates of inflation and commercial 
practices.
    (iii) Exception for reasonable funding. The relevant amount does 
not include an amount that the taxpayer demonstrates to the 
Commissioner is attributable to amounts that were properly contributed 
to the trust pursuant to a reasonable funding method, applied using 
actuarial assumptions that the Commissioner determines to be 
reasonable, or any amount that the taxpayer demonstrates to the 
Commissioner is attributable to experience that is favorable relative 
to any actuarial assumptions used that the Commissioner determines to 
be reasonable. For this paragraph (h)(3)(iii) to apply to a controlled 
foreign corporation employer described in paragraph (h)(1)(i) of this 
section, the taxpayer must indicate on a statement attached to a timely 
filed Form 5471 that the taxpayer is relying on this rule. For purposes 
of this paragraph (h)(3)(iii), an amount is considered contributed 
pursuant to a reasonable funding method if the amount is contributed 
pursuant to a funding method permitted to be used under section 412 
(e.g., the entry age normal funding method) that is consistently used 
to determine plan contributions. In addition, for purposes of this 
paragraph (h)(3)(iii), if there has been a change to that method from 
another funding method, an amount is considered contributed pursuant to 
a reasonable funding method only if the prior funding method is also a 
funding method described in the preceding sentence that was 
consistently used to determine plan contributions. For purposes of this 
paragraph (h)(3)(iii), a funding method is considered reasonable only 
if the method provides for any initial unfunded liability to be 
amortized over a period of at least 6 years, and for any net change in 
accrued liability resulting from a change in

[[Page 50785]]

funding method to be amortized over a period of at least 6 years.
    (iv) Reduction for transition amount. The relevant amount is 
reduced (but not below zero) by any transition amount described in 
paragraphs (h)(5), (h)(6), or (h)(7) of this section.
    (v) Fair market value of assets. For purposes of paragraphs (h)(3) 
(i) and (ii) of this section, for a taxable year of the employer, the 
fair market value of trust assets, and the fair market value of other 
assets held in the equivalent of a trust within the meaning of section 
404A(b)(5)(A), equals the fair market value of those assets, as of the 
measurement date for the employer's taxable year, adjusted to include 
contributions made after the measurement date and by the end of the 
employer's taxable year.
    (vi) Annual valuation. For purposes of determining the relevant 
amount for a taxable year of the employer, the fair market value of 
plan assets, and the plan's accrued liability as described in 
paragraphs (h)(3) (ii) and (iii) of this section, and the normal cost 
as described in paragraph (h)(4) of this section, must be determined as 
of a consistently used annual measurement date within the employer's 
taxable year.
    (vii) Special rule for plan funded through multiple trusts. In 
cases in which a plan is funded through more than one foreign 
employees' trust, the fractional interest determined under paragraph 
(h)(3)(i) of this section in each trust is determined by treating all 
of the trusts as if their assets were held in a single trust for which 
the fraction is determined in accordance with the rules of this 
paragraph (h)(3).
    (4) De minimis exception. If the relevant amount is not greater 
than the plan's normal cost for the plan year ending with or within the 
employer's taxable year, computed using a funding method and actuarial 
assumptions as described in paragraph (h)(3)(ii) of this section or as 
described in paragraph (h)(3)(iii) of this section if the requirements 
of that paragraph are met, that are used to determine plan 
contributions, then the relevant amount is considered to be zero for 
purposes of applying paragraph (h)(3)(i) of this section.
    (5) General rule for transition amount--(i) General rule. If 
paragraphs (h)(6) and (h)(7) of this section do not apply to the 
employer, the transition amount for purposes of paragraph (h)(3)(iv) of 
this section is equal to the preexisting amount multiplied by the 
applicable percentage for the year in which the employer's taxable year 
begins.
    (ii) Preexisting amount. The preexisting amount is equal to the 
relevant amount of the trust, determined without regard to paragraphs 
(h)(3)(iv) and (h)(4) of this section, computed as of the measurement 
date that immediately precedes September 27, 1996 disregarding 
contributions to the trust made after the measurement date.
    (iii) Applicable percentage. The applicable percentage is equal to 
100 percent for the employer's first taxable year ending after this 
document is published as a final regulation in the Federal Register and 
prior taxable years of the employer, and is reduced (but not below 
zero) by 10 percentage points for each subsequent taxable year of the 
employer.
    (6) Transition amount for new CFCs--(i) General rule. In the case 
of a new controlled foreign corporation employer, the transition amount 
for purposes of paragraph (h)(3)(iv) is equal to the pre-change amount 
multiplied by the applicable percentage for the year in which the new 
controlled foreign corporation employer's taxable year begins.
    (ii) Pre-change amount. The pre-change amount for purposes of 
paragraph (h)(6)(i) is equal to the relevant amount of the trust, 
determined without regard to paragraphs (h)(3)(iv) and (h)(4) of this 
section and disregarding contributions to the trust made after the 
measurement date, for the new controlled foreign corporation employer's 
last taxable year ending before the corporation becomes a new 
controlled foreign corporation employer.
    (iii) Applicable percentage--(A) General rule. Except as provided 
in paragraph (h)(6)(iii)(B) of this section, the applicable percentage 
is equal to 100 percent for a new controlled foreign corporation 
employer's first taxable year ending after the corporation becomes a 
controlled foreign corporation. The applicable percentage is reduced 
(but not below zero) by 10 percentage points for each subsequent 
taxable year of the new controlled foreign corporation.
    (B) Interim rule. For any taxable year of a new controlled foreign 
corporation employer that ends on or before the date this document is 
published as a final regulation in the Federal Register, the applicable 
percentage is equal to 100 percent. The applicable percentage is 
reduced by 10 percentage points for each subsequent taxable year of the 
new controlled foreign corporation employer that ends after the date 
this document is published as a final regulation in the Federal 
Register.
    (iv) New CFC employer. For purposes of paragraph (h)(6) of this 
section, a new controlled foreign corporation employer is a corporation 
that first becomes a controlled foreign corporation within the meaning 
of section 957 after September 27, 1996. A new controlled foreign 
corporation employer includes a corporation that was a controlled 
foreign corporation prior to, but not on, September 27, 1996 and that 
first becomes a controlled foreign corporation again after September 
27, 1996.
    (v) Anti-stuffing rule. Notwithstanding paragraph (h)(6)(iii) of 
this section, if, prior to becoming a controlled foreign corporation, a 
corporation contributes amounts to a foreign employees' trust with a 
principal purpose of obtaining tax benefits by increasing the pre-
change amount, the applicable percentage with respect to those amounts 
is 0 percent for all taxable years of the new controlled foreign 
corporation employer.
    (7) Transition amount for new U.S.-related foreign partnerships--
(i) General rule. In the case of a new U.S.-related foreign partnership 
employer, the transition amount for purposes of paragraph (h)(3)(iv) of 
this section is equal to the pre-change amount multiplied by the 
applicable percentage for the year in which the new U.S.-related 
foreign partnership employer's taxable year begins.
    (ii) Pre-change amount. The pre-change amount for purposes of 
paragraph (h)(7)(i) of this section is equal to the relevant amount of 
the trust, determined without regard to paragraphs (h)(3)(iv) and 
(h)(4) of this section and disregarding contributions to the trust made 
after the measurement date, for the entity's last taxable year ending 
before the entity becomes a new U.S.-related foreign partnership 
employer.
    (iii) Applicable percentage--(A) General rule. Except as provided 
in paragraph (h)(7)(iii)(B) of this section, the applicable percentage 
is equal to 100 percent for a new U.S.-related foreign partnership 
employer's first taxable year ending after the entity becomes a new 
U.S.-related foreign partnership employer. The applicable percentage is 
reduced (but not below zero) by 10 percentage points for each 
subsequent taxable year of the new U.S.-related foreign partnership 
employer.
    (B) Interim rule. For any taxable year of a new U.S.-related 
foreign partnership employer that ends on or before the date this 
document is published as a final regulation in the Federal Register, 
the applicable percentage is equal to 100 percent. The applicable 
percentage is reduced by 10 percentage points for each subsequent

[[Page 50786]]

taxable year of the new U.S.-related foreign partnership employer that 
ends after the date this document is published as a final regulation in 
the Federal Register.
    (iv) New U.S.-related foreign partnership employer. For purposes of 
paragraph (h)(7) of this section, a new U.S.-related foreign 
partnership employer is an entity that was a foreign corporation other 
than a controlled foreign corporation, or that was a foreign 
partnership other than a U.S.-related foreign partnership, and that 
changes from this status to a U.S.-related foreign partnership after 
September 27, 1996. A new U.S.-related foreign partnership employer 
includes a corporation that was a U.S.-related foreign partnership 
prior to, but not on, September 27, 1996 and that first becomes a U.S.-
related foreign partnership again after September 27, 1996.
    (v) Anti-stuffing rule. Notwithstanding paragraph (h)(7)(iii) of 
this section, if, prior to becoming a new U.S.- related foreign 
partnership employer, an entity contributes amounts to a foreign 
employees' trust with a principal purpose of obtaining tax benefits by 
increasing the pre-change amount, the applicable percentage with 
respect to those amounts is 0 percent for all taxable years of the new 
U.S.-related foreign partnership employer.
    (8) Examples. The following examples illustrate the rules of 
paragraph (h) of this section. In each example, the employer has a 
power or interest described in sections 673 through 677 over the 
foreign employees' trust, and the monetary unit is the applicable 
functional currency (FC) determined in accordance with section 985(b) 
and the regulations thereunder.

    Example 1. (i) Employer X is a controlled foreign corporation 
(as defined in section 957). Employer X maintains a defined benefit 
retirement plan for its employees. Employer X's taxable year is the 
calendar year. Trust T, a foreign employees' trust, is the sole 
funding vehicle for the plan. Both the plan year of the plan and the 
taxable year of Trust T are the calendar year.
    (ii) As of December 31, 1997, Trust T's measurement date, the 
fair market value (as described in paragraph (h)(3)(iv) of this 
section) of Trust T's assets is FC 1,000,000, and the amount of the 
plan's accrued liability is FC 800,000, which includes a normal cost 
for 1997 of FC 50,000. The preexisting amount for Trust T is FC 
40,000. Thus, the relevant amount for 1997 is FC 160,000 (which is 
greater than the plan's normal cost for the year). Employer X's 
shareholder does not indicate on a statement attached to a timely 
filed Form 5471 that any of the relevant amount qualifies for the 
exception described in paragraph (h)(3)(iii) of this section. 
Therefore, the fractional interest for Employer X's taxable year 
ending on December 31, 1997, is 16 percent. Employer X is treated as 
the owner for federal income tax purposes of an undivided 16 percent 
interest in each of Trust T's assets for the period from January 1, 
1997 through December 31, 1997. Employer X must take into account a 
16 percent pro rata share of each item of income, deduction or 
credit of Trust T during this period in computing its federal income 
tax liability.
    Example 2. Assume the same facts as in Example 1, except that 
Employer X's shareholder indicates on a statement attached to a 
timely filed Form 5471 and can demonstrate to the satisfaction of 
the Commissioner that, in reliance on paragraph (h)(3)(iii) of this 
section, FC 100,000 of the fair market value of Trust T's assets is 
attributable to favorable experience relative to reasonable 
actuarial assumptions used. Accordingly, the relevant amount for 
1997 is FC 60,000. Because the plan's normal cost for 1997 is less 
than FC 60,000, the de minimis exception of paragraph (h)(4) of this 
section does not apply. Therefore, the fractional interest for 
Employer X's taxable year ending on December 31, 1997, is 6 percent. 
Employer X is treated as the owner for federal income tax purposes 
of an undivided 6 percent interest in each of Trust T's assets for 
the period from January 1, 1997, through December 31, 1997. Employer 
X must take into account a 6 percent pro rata share of each item of 
income, deduction or credit of Trust T during this period in 
computing its federal income tax liability.

    (9) Effective date. Paragraphs (g) and (h) of this section apply to 
taxable years of an employer ending after September 27, 1996.
    Par. 3. Section 1.671-2 is amended by adding paragraph (f) to read 
as follows:


Sec. 1.671-2  Applicable principles

* * * * *
    (f) For purposes of subtitle A of the Internal Revenue Code, a 
person that is treated as the owner of any portion of a trust under 
subpart E is considered to own the trust assets attributable to that 
portion of the trust.
    Par. 4. Section 1.1297-4 is added to read as follows:


Sec. 1.1297-4  Application of subpart E of subchapter J with respect to 
foreign employees' trusts.

    (a) General rules. For purposes of part VI of subchapter P, chapter 
1 of the Code, a foreign employer that is not a controlled foreign 
corporation is not treated as the owner of any portion of a foreign 
employees' trust (as defined in Sec. 1.671-1(h)(2)) except as provided 
in this paragraph (a), regardless of whether the employer has a power 
or interest described in sections 673 through 677 over any portion of 
the trust.
    (1) Principal purpose to avoid classification as a passive foreign 
investment company. If a principal purpose for a transfer of property 
by any person to a foreign employees' trust (as defined in Sec. 1.671-
1(h)(2)) is to avoid classification of a foreign corporation as a 
passive foreign investment company, then the following rule applies. If 
the foreign employer has a power or interest described in sections 673 
through 677 over the trust, then the grantor trust rules of subpart E 
of part I of subchapter J, chapter 1 of the Code will apply, for 
purposes of part VI of subchapter P, to a fixed dollar amount in the 
trust that is equal to the fair market value of the property that is 
transferred for the purpose of avoiding classification as a passive 
foreign investment company. Whether a principal purpose for a transfer 
is the avoidance of classification as a passive foreign investment 
company will be determined on the basis of all of the facts and 
circumstances, including whether the amount of assets held by the 
foreign employees' trust is reasonably related to the plan's 
anticipated liabilities, taking into account any local law and practice 
relating to proper funding levels.
    (2) Principal purpose to reduce or eliminate taxation under section 
1291 or 1293. If a principal purpose for a transfer of property by any 
person to a foreign employees' trust (as defined in Sec. 1.671-1(h)(2)) 
is to reduce or eliminate taxation under section 1291 or 1293, then the 
following rule applies. If the foreign employer has a power or interest 
described in sections 673 through 677 over the trust, then the 
provisions of subpart E will apply, for purposes of part VI of 
subchapter P, to a fixed dollar amount in the trust that is equal to 
the fair market value of the property transferred for the purpose of 
reducing or eliminating taxation under section 1291 or 1293. Whether a 
principal purpose for a transfer is to reduce or eliminate taxation 
under section 1291 or 1293 will be determined on the basis of all the 
facts and circumstances, including whether the amount of assets held by 
the foreign employees' trust is reasonably related to the plan's 
anticipated liabilities, taking into account any local law and practice 
relating to proper funding levels.
    (3) Application to employer entity. The rules of this section apply 
to the employer whose employees benefit under the deferred compensation 
plan funded through the foreign employees' trust, or, in the case of a 
deferred compensation plan covering independent contractors, the 
recipient of services performed by those independent contractors, 
regardless of whether the plan is maintained through another entity. 
Thus, for example, where a deferred compensation plan benefitting 
employees of a foreign

[[Page 50787]]

employer that is not a controlled foreign corporation is funded through 
a foreign employees' trust, the foreign employer is considered to be 
the grantor of the foreign employees' trust for purposes of this 
paragraph (a).
    (b) Effective date. This section applies to taxable years of a 
foreign corporation ending after September 27, 1996.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-24864 Filed 9-26-96; 8:45 am]
BILLING CODE 4830-01-U