[Federal Register Volume 64, Number 153 (Tuesday, August 10, 1999)]
[Rules and Regulations]
[Pages 43267-43280]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-19928]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8831]
RIN 1545-AU90


Inbound Grantor Trusts With Foreign Grantors

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains regulations implementing sections 
672(f) and 643(h) of the Internal Revenue Code, as amended by the Small 
Business Job Protection Act of 1996, which relate to the application of 
the grantor trust rules to certain trusts established by foreign 
persons. These regulations affect primarily U.S. persons who are 
beneficiaries of trusts established by foreign persons. This document 
also contains temporary regulations defining the term grantor for 
purposes of part I of subchapter J, chapter 1 of the Internal Revenue 
Code. The text of these temporary regulations serves as the text of the 
proposed regulations set forth in the notice of proposed rulemaking 
published elsewhere in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective August 10, 1999.
    Applicability Dates: For dates of applicability of Sec. 1.643(h)-1, 
see Sec. 1.643(h)-1(h). For dates of applicability of Sec. 1.671-2T(e), 
see Sec. 1.671-2T(e)(7). For dates of applicability of Secs. 1.672(f)-1 
through 1.672(f)-5, see Secs. 1.672(f)-1(c), 1.672(f)-2(e), 1.672(f)-
3(e), 1.672(f)-4(h), and 1.672(f)-5(c).

FOR FURTHER INFORMATION CONTACT: M. Grace Fleeman (202) 622-3880 
concerning the regulations generally, and James A. Quinn (202) 0622-
3060 concerning Sec. 1.671-2T(e) and Sec. 1.672(f)-1 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Background

    On June 5, 1997 (62 FR 37819) Treasury and the IRS published a 
notice of proposed rulemaking (REG-252487-96) under sections 643(h), 
671, 672(f), and 7701 of the Internal Revenue Code (Code). Comments 
responding to the notice were received and a public hearing was held on 
August 27, 1997. After consideration of the comments, the proposed 
regulations under sections 643(h) and 672(f) are adopted as final 
regulations as revised by this Treasury decision. The proposed 
regulations under section 671 are issued as revised by this Treasury 
decision as temporary regulations. The revisions are discussed below. 
The proposed regulations under section 7701 are withdrawn. The 
temporary regulations under section 671 are also being issued as 
proposed regulations published elsewhere in this issue of the Federal 
Register.

[[Page 43268]]

Explanation of Provisions and Revisions

1. Comments and Changes to Sec. 1.643(h)-1: Distributions by Certain 
Foreign Trusts Through Intermediaries

    Under the proposed regulations, any amount that was derived, 
directly or indirectly, by a U.S. person from a foreign trust through 
an intermediary generally was deemed to have been transferred directly 
by the foreign trust to the U.S. person if any one of three specified 
conditions was satisfied. In cases where the transfer from the 
intermediary to the U.S. person did not occur in the same taxable year 
of the U.S. person as the transfer from the foreign trust to the 
intermediary, the proposed regulations looked to generally applicable 
agency principles to determine when the transfer to the U.S. person was 
deemed to occur.
    Commenters said the proposed rules were too broad and could reach 
virtually any transfer made to a U.S. person by any person who has 
received a distribution from a foreign trust. They suggested that the 
basic requirement for treating a transfer to a U.S. person as a 
transfer directly from a foreign trust should be the existence of an 
intention to avoid U.S. tax. Alternatively, they said there should at 
least be a time limitation so that the rule would not apply to a 
transfer of property received from a foreign trust more than, for 
example, one year before the transfer to the U.S. person. In addition, 
they said the proposed rule relying on generally applicable agency 
principles for determining whether an intermediary is the agent of the 
foreign trust or of the U.S. person would be difficult to apply because 
different countries have different laws and the U.S. person should be 
taxed prior to receipt only if the intermediary is clearly a nominee or 
agent for the U.S. person.
    In response to the comments, the final regulations treat any 
property (including cash) that is transferred to a U.S. person by an 
intermediary who has received property from a foreign trust as property 
transferred directly by the foreign trust to the U.S. person if the 
intermediary received the property from the foreign trust pursuant to a 
plan one of the principal purposes of which was the avoidance of U.S. 
tax. A transfer of property will be deemed to have been made pursuant 
to a plan one of the principal purposes of which was the avoidance of 
U.S. tax if all of certain specified factors are present. However, the 
Commissioner may find that a transfer was made pursuant to a plan one 
of the principal purposes of which was the avoidance of U.S. tax 
whether or not any of the specified factors is present.
    The factors that will cause a transfer to be deemed to have been 
made pursuant to a plan one of the principal purposes of which was the 
avoidance of U.S. tax are the following: (i) the U.S. person is related 
to a grantor of the foreign trust or has another relationship with a 
grantor of the foreign trust that establishes a reasonable basis for 
concluding that the grantor of the foreign trust would make a 
gratuitous transfer to the U.S. person; (ii) the U.S. person receives 
from the intermediary, within the period beginning twenty-four months 
before and ending twenty-four months after the intermediary's receipt 
of property from the foreign trust, either the property the 
intermediary received from the foreign trust, proceeds from such 
property, or property in substitution for such property; and (iii) the 
U.S. person cannot demonstrate to the satisfaction of the Commissioner 
that (A) the intermediary has a relationship with the U.S. person that 
establishes a reasonable basis for concluding that the intermediary 
would make a gratuitous transfer to the U.S. person, (B) the 
intermediary acted independently of the grantor and the trustee, (C) 
the intermediary is not an agent of the U.S. person under generally 
applicable U.S. agency principles, and (D) the U.S. person timely 
complied with the reporting requirement of section 6039F, if 
applicable, if the intermediary is a foreign person. See Notice 97-34 
(1997-1 C.B. 422).
    The final regulations also have been modified with respect to the 
application of generally applicable agency principles. Under the final 
regulations, property is treated as transferred to the U.S. person in 
the year it is actually transferred to the U.S. person by the 
intermediary unless the Commissioner determines, or the taxpayer can 
demonstrate to the satisfaction of the Commissioner, that the 
intermediary is an agent of the U.S. person under generally applicable 
agency principles, in which case the property will be treated as 
transferred to the U.S. person by the trust in the year the property 
was transferred to the intermediary by the trust. As a corollary, the 
final regulations provide that the fair market value of the property is 
determined as of the date of the transfer to the U.S. person, unless 
the intermediary is treated as an agent of the U.S. person, in which 
case the fair market value will be determined as of the date of the 
transfer to the intermediary. Examples illustrate the effect of changes 
in the fair market value between the date of the transfer to the 
intermediary and the date of the transfer to the U.S. person.
    The final regulations clarify that they apply only to gratuitous 
transfers. They also clarify that if property is treated as transferred 
directly by a foreign trust to a U.S. person pursuant to the 
regulations, the same property will not be taken into account in 
computing the gross income of the intermediary (if such property would 
otherwise be required to be so taken into account).
    The final regulations under section 643(h) are applicable to 
transfers made to U.S. persons after August 10, 1999.

2. Comments and Changes to Sec. 1.671-2(e): Definition of Grantor

    The proposed regulations provided a definition of grantor for 
purposes of part I of subchapter J, chapter 1 of the Code. This 
document replaces the proposed regulations with temporary regulations 
that are effective August 10, 1999. These temporary regulations are 
also being issued as proposed regulations published elsewhere in this 
issue of the Federal Register. In accordance with section 7805(e)(2), 
the temporary regulations will expire before August 12, 2002.
    Under the original proposed regulations, a grantor was defined to 
include any person to the extent such person either (i) creates a trust 
or (ii) directly or indirectly makes a gratuitous transfer to a trust. 
Commenters questioned why a nominal creator who has made no transfer to 
a trust should be treated as a grantor and asked for an explanation of 
the tax significance of such treatment.
    Treating a nominal creator as a grantor ensures that someone will 
be responsible for reporting the creation of a foreign trust by a U.S. 
person even if the trust is not immediately funded. See section 
6048(a)(3)(A)(i) and (a)(4)(A). At the same time, Treasury and the IRS 
believe that an accommodation grantor, such as an attorney who creates 
a trust on behalf of a client, (although a grantor) should not be 
treated as an owner of the trust. Accordingly, the temporary 
regulations provide that a person who either creates a trust, or funds 
a trust with an amount that is directly repaid to such person within a 
reasonable period of time, but who makes no other transfers to the 
trust that constitute gratuitous transfers, will not be treated as an 
owner of any portion of the trust under sections 671 through 677 or 
679.
    Commenters also questioned a provision in the proposed regulations 
that treated a distribution from one trust to another trust that is a 
beneficiary of the first trust as a gratuitous transfer,

[[Page 43269]]

with the result that the first trust was a grantor of the second trust. 
Under the temporary regulations, if a trust makes a gratuitous transfer 
of property to another trust, the grantor of the transferor trust 
generally is treated as the grantor of the transferee trust. However, 
if a person with a general power of appointment over the transferor 
trust exercises that power in favor of another trust, such person is 
treated as the grantor of the transferee trust, even if the grantor of 
the transferor trust is treated as the owner of the transferor trust 
under subpart E of part I, subchapter J, chapter 1 of the Code. (These 
rules do not affect the determination of whether or not the gratuitous 
transfer from the transferor trust is a distribution subject to 
sections 651 or 661.)
    The proposed regulations provided that a person who acquires an 
interest in a fixed investment trust from a grantor of the trust also 
will be treated as a grantor of the trust. In response to comments 
received, the temporary regulations extend the same treatment to 
persons who acquire an interest in a liquidating trust or an 
environmental remediation trust.
    The temporary regulations include a new section that applies to 
gratuitous transfers to trusts by partnerships and corporations. If the 
transfer is entered into for a business purpose of the partnership or 
corporation, the partnership or corporation, as the case may be, 
generally is treated as the grantor of the trust. However, if the 
transfer is not entered into for a business purpose of the partnership 
or corporation--for example, if it is for the personal purposes of one 
or more of the partners or shareholders--the transfer is treated as a 
constructive distribution to such partners or shareholders under 
federal tax principles, and the partners or shareholders, as the case 
may be, are treated as the grantors of the trust. See, for example, 
Epstein v. Commissioner, 53 T.C. 459 (1969), acq. on another issue, 
1970-2 C.B. xix.
    Commenters asked for guidance concerning the identification of the 
grantor when the property contributed to the trust is jointly owned. 
These temporary regulations do not provide specific guidance on the 
treatment of joint owners that contribute property to a trust. Treasury 
and the IRS invite comments with specific examples of areas that may 
need clarification, such as, for example, the treatment of community 
property or the joint ownership of property by noncitizen spouses.

3. Comments and Changes to Sec. 1.672(f)-1: Foreign Persons Not Treated 
as Owners

    The proposed regulations prescribed a two-step analysis for 
implementing the general rule of section 672(f). First, the grantor 
trust rules other than section 672(f) (the basic grantor trust rules) 
were applied to determine the worldwide amount and the U.S. amount. 
Then, the trust was treated as partially or wholly owned by a foreign 
person based on an annual year-end comparison of the worldwide amount 
and the U.S. amount. Commenters suggested that the two-step analysis 
was unnecessarily complex and questioned whether it might produce 
results that were unintended or inconsistent with the statute.
    In response to these concerns, the final regulations provide that 
the grantor trust rules other than section 672(f) must be applied first 
to determine whether, under such rules, any portion of the trust would 
be treated as owned by a person other than a U.S. citizen or resident 
or domestic corporation. The determination of the portion of the trust 
that is treated as owned by a grantor or other person is to be made 
based on the terms of the trust and the application of the grantor 
trust rules as found in Sec. 1.671-1 et seq. If it is determined that 
any portion of the trust would be treated as owned by a person other 
than a U.S. citizen or resident or domestic corporation, such person 
will be treated as the owner of such portion only if such person is a 
foreign corporation described in Sec. 1.672(f)-2(a) or if such portion 
of the trust qualifies for one of the exceptions in Sec. 1.672(f)-3.
    The final regulations under the general rule are generally 
applicable to taxable years of a trust beginning after August 10, 1999.

4. Comments and Changes to Sec. 1.672(f)-2: Certain Foreign 
Corporations

    Under the proposed regulations, a controlled foreign corporation 
(CFC) that created or funded a trust was treated as a domestic 
corporation for purposes of section 672(f) only to the extent the 
trust's income was subpart F income that was currently taken into 
account in computing the gross income of a U.S. citizen, U.S. resident, 
or domestic corporation. There were similar rules for passive foreign 
investment companies (PFICs) and foreign personal holding companies 
(FPHCs). Commenters questioned whether the proposed rules were 
consistent with the statutory antideferral regime and the legislative 
history. There also were suggestions that the proposed rules should not 
apply where a CFC is wholly owned, directly or indirectly, by U.S. 
shareholders. In addition, there were requests for simplification of 
the rules pertaining to annual fluctuations in the portion of a trust 
that is treated as owned by the grantor.
    In response to the comments, Treasury and the IRS have developed 
rules that are narrowly targeted to potentially abusive situations and 
therefore are not inconsistent with the antideferral regime. Under the 
final regulations, if the owner of a trust upon application of the 
grantor trust rules without regard to section 672(f) is a CFC, PFIC, or 
FPHC, the CFC, PFIC, or FPHC, as the case may be, will be treated as a 
domestic corporation for purposes of applying the general rule of 
Sec. 1.672(f)-1. Consequently, a CFC, PFIC, or FPHC generally will be 
treated as an owner of a trust if it would be so treated under sections 
671 through 678 without regard to section 672(f). A CFC, PFIC, or FPHC 
will be treated as a domestic corporation solely for purposes of 
applying the general rule of Sec. 1.672(f)-1. Thus, a CFC, PFIC, or 
FPHC will be treated as a foreign corporation for purposes of 
Sec. 1.672(f)-4, which is discussed below in part 6 of this 
explanation.
    If a trust to which a CFC, PFIC, or FPHC has made a gratuitous 
transfer makes a gratuitous transfer to a U.S. person, the CFC, PFIC, 
or FPHC, as the case may be, will be treated as a foreign corporation 
for purposes of determining how the transfer will be treated in the 
hands of the U.S. person, and the rules of Sec. 1.672(f)-4(c) will 
apply. If a trust that a CFC, PFIC, or FPHC is treated as owning under 
section 678 makes a gratuitous transfer to a U.S. person, the rules of 
Sec. 1.672(f)-4(c) will apply as if the CFC, PFIC, or FPHC had made a 
gratuitous transfer to the trust.
    The final regulations for CFCs, PFICs, and FPHCs are generally 
applicable to taxable years of shareholders of CFCs, PFICs, and FPHCs 
beginning after August 10, 1999 and taxable years of CFCs, PFICs, and 
FPHCs ending with or within such taxable years of the shareholders.

5. Comments and Changes to Sec. 1.672(f)-3: Exceptions To General Rule

A. Certain Revocable Trusts
    Under the proposed regulations, the general rule of Sec. 1.672(f)-
1(a) did not apply to any portion of a trust if the power to revest 
absolutely in the grantor title to such portion was exercisable solely 
by the grantor without the approval or consent of any other person

[[Page 43270]]

for a period or periods aggregating 183 days or more during the taxable 
year of the trust. The 183-day rule is targeted at potentially abusive 
situations in which a power to revest is so limited that it is not 
likely to be exercised.
    In response to comments received, the final regulations clarify 
that if the first or last taxable year of the trust is less than 183 
days, the revocable trust exception will apply if the grantor has a 
power to revest on each day of the first or last taxable year 
(including the year of the grantor's death), as the case may be. The 
final regulations also clarify that, consistent with the principle that 
statutory exceptions should be construed narrowly, if a trust fails to 
qualify for the revocable trust exception in a particular year, the 
exception cannot apply in a later year even if the requirements would 
otherwise be satisfied in such later year.
    Commenters asked whether the revocable trust exception continues to 
apply if the grantor becomes incapacitated. The final regulations 
provide that the exception will continue to apply if, but only if, 
there is a guardian or other person who has unrestricted authority to 
exercise the necessary power on the grantor's behalf.
    Some commenters disagreed with the result in Sec. 1.672(f)-3(a)(4) 
Example 3 of the proposed regulations, which concluded that the 
revocable trust exception does not apply where the grantor of the trust 
can replace the trustee, who is not a related or subordinate party, at 
any time for any reason. They said the example was inconsistent with 
the existing grantor trust rules. See, e.g., Sec. 1.674(d)-2(a). After 
careful consideration, Treasury and the IRS have concluded that Example 
3 is consistent with the purposes of section 672(f) and should be 
retained.
    Commenters raised a number of issues concerning the grandfather 
rules in Sec. 1.672(f)-3 (a)(2) and (b)(4) of the proposed regulations 
for certain trusts that were in existence on September 19, 1995. In 
response to the comments, the final regulations confirm that physical 
separation of amounts that were gratuitously transferred to the trust 
after September 19, 1995, is not required. The final regulations 
further provide that initial separate accountings may be prepared at 
any time up until the due date (including extensions) for the tax 
return for the first taxable year of the trust beginning after August 
10, 1999. In response to requests for more specific guidance, the final 
regulations provide that the grandfather rules apply only if any 
amounts that were gratuitously transferred to the trust after September 
19, 1995, are treated as a separate portion of the trust that is 
accounted for under the rules of Sec. 1.671-3(a)(2).
B. Certain Trusts That Can Distribute Only to the Grantor or the Spouse 
of the Grantor
    Under the proposed regulations, the general rule of Sec. 1.672(f)-1 
did not apply if the only amounts distributable from a trust (or 
portion of a trust) during the lifetime of the grantor were amounts 
distributable to the grantor or the grantor's spouse. Treasury and the 
IRS contemplate that the fact that the grantor and his or her spouse 
might someday divorce or legally separate will be disregarded for 
purposes of determining whether the exception is applicable.
    Under the proposed regulations, amounts distributable in discharge 
of a legal obligation of the grantor or the grantor's spouse generally 
were treated as amounts distributable to the grantor or the grantor's 
spouse. Commenters said these proposed rules were inconsistent with the 
manner in which distributions in discharge of obligations are treated 
in regulations promulgated under other provisions of the Code. For 
example, under sections 677(a) and 662(a)(2), there is no exception for 
obligations to family members that are not based on full and adequate 
consideration in money or money's worth. Commenters also said the 
proposed rules were likely to exclude most trusts from qualification 
for the exception because, in most jurisdictions, a trust provision 
that permits distributions to a particular person is construed to 
permit distributions to be made in satisfaction of that person's 
obligations, regardless of the source of the obligations.
    Treasury and the IRS believe it is neither necessary nor 
appropriate for the regulations promulgated under the statutory 
exceptions to section 672(f) to be consistent with the regulations 
promulgated under other provisions of part I of subchapter J, chapter 1 
of the Code. Section 672(f) reflects a policy determination that 
foreign persons should not be allowed ``to affirmatively use the 
domestic anti-abuse rules concerning grantor trusts'' to avoid U.S. tax 
on trust income distributed to U.S. beneficiaries. Dept. of the 
Treasury, General Explanations of the Administration's Revenue 
Proposals, at 12 (1995). Section 672(f) operates to implement that 
policy determination by providing that the grantor trust rules 
generally do not apply where their effect would be to treat a foreign 
person as the owner of any portion of a trust. S. Rep. No. 35, 104th 
Cong., 1st Sess. 161 (1995). The exceptions in section 672(f)(2) must 
be interpreted narrowly to preserve the primary operation of the 
general rule. See, for example, Commissioner v. Clark, 489 U.S. 726, 
739 (1989) (``In construing provisions * * * in which a general 
statement of policy is qualified by an exception, we usually read the 
exception narrowly in order to preserve the primary operation of the 
provision.'').
    The final regulations continue to provide that a trust will not 
fail to qualify for the exception solely because amounts are 
distributable from the trust in discharge of a legal obligation of the 
grantor (or grantor's spouse). An obligation to a related person is not 
generally treated as a legal obligation unless it was contracted bona 
fide and for adequate and full consideration in money or money's worth. 
However, obligations to support certain individuals will be treated as 
legal obligations if the individual is either permanently and totally 
disabled or less than 19 years old. The final regulations expand the 
list of potentially eligible individuals to include certain individuals 
who are members of the grantor's (or grantor's spouse's) household and 
have as their principal place of abode the grantor's (or grantor's 
spouse's) home, but are not related to the grantor (or grantor's 
spouse) through one of the relationships listed in section 152(a)(1) 
through (8). The fact that amounts might become distributable from a 
trust to support an individual who is not described in the regulations 
will be disregarded if, at the time the applicability of the exception 
is being determined, the potential obligation is not reasonably 
expected to arise under the facts and circumstances.
    Some commenters said the limitation in proposed Sec. 1.672(f)-
3(b)(2)(ii) for legal obligations to related persons is not needed in 
the case of reinsurance trusts because, regardless of the sufficiency 
of the consideration for the reinsurance, the funds in a reinsurance 
trust can be utilized only to satisfy the legal obligations of the 
reinsurer (or will be distributed to the reinsurer). In addition, 
commenters pointed out that there already are other provisions, such as 
sections 482 and 845, that apply to related-party reinsurance 
arrangements.
    The final regulations reserve on the application of the related-
party rule to reinsurance trusts. Treasury and the IRS are looking 
carefully at this area, and they invite additional comments.
    Commenters raised a number of issues concerning the grandfather 
rules in Sec. 1.672(f)-3(b)(4) of the proposed regulations. These 
issues are discussed above in connection with the

[[Page 43271]]

grandfather rules under Sec. 1.672(f)-3(a)(2) of the proposed 
regulations.
C. Compensatory Trusts
    The proposed regulations listed categories of trusts that 
constitute compensatory trusts, without regard to whether any portion 
of a particular trust would ever be treated as owned by the grantor or 
another person under the grantor trust rules. Treasury and the IRS are 
concerned that some taxpayers may find such a comprehensive list 
confusing. Accordingly, the final regulations provide that the trusts 
to which the compensatory trust exception applies are those to which 
the application of section 672(f) is likely to be relevant: (i) 
nonexempt employees' trusts described in section 402(b) and (ii) so-
called ``rabbi'' trusts. Treasury and the IRS believe the issue of 
whether tax-exempt compensatory trusts can be treated as owned by a 
foreign person is moot because there are special statutory rules that 
govern those trusts.
    Treasury and the IRS contemplate that a nonexempt employees' trust 
described in section 402(b) will be treated as owned by a beneficiary 
of the trust only to the extent provided in regulations section 
1.402(b)-1(b)(6). See also proposed regulations Sec. 1.671-1(g) and 
Sec. 1.671-1(h), which were published in the Federal Register (61 FR 
50778) on September 27, 1996, for proposed rules describing when an 
employer will be 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.
    The final regulations also provide that the Commissioner may 
designate additional categories of trusts to which the compensatory 
trust exception applies.

6. Comments and Changes to Sec. 1.672(f)-4: Recharacterization of 
Purported Gifts

    The proposed regulations provided that a U.S. donee generally must 
treat a purported gift from a foreign corporation as a distribution 
from the foreign corporation unless the U.S. donee can establish that a 
U.S. citizen or resident alien is a shareholder of the transferor and 
that the U.S. citizen or resident took the amount into account for U.S. 
tax purposes and subsequently made a gift to the U.S. donee. Similar 
rules were proposed for purported gifts from partnerships (whether 
domestic or foreign). There were exceptions for charitable 
contributions to donees described in section 170(c) and for purported 
gifts that did not exceed $10,000.
    Section 1.672(f)-4(c) of the proposed regulations provided rules 
for gratuitous transfers to U.S. donees from trusts created by 
partnerships or foreign corporations. Under the proposed regulations, 
if the partnership or foreign corporation was treated as the owner of 
the trust under the grantor trust rules, the transfer was treated as a 
purported gift from the partnership or foreign corporation. If the 
partnership or foreign corporation was not treated as the owner of the 
trust, the transfer was treated as an accumulation distribution from 
the trust unless the resulting U.S. tax liability was less than the 
U.S. tax that would be due if the transfer were treated as a purported 
gift from the partnership or foreign corporation.
    Commenters said the proposed regulations were overly broad and 
exceeded the scope of the regulatory authority granted by Congress. 
They suggested that a purported gift from a partnership or foreign 
corporation should be treated as a deemed distribution to the partner 
or shareholder followed by a deemed transfer to the U.S. donee. 
Commenters also suggested that purported gifts should not be 
recharacterized as taxable distributions unless it appeared, based on 
all the facts and circumstances, that the partnership or foreign 
corporation was being used principally as a device to avoid U.S. tax.
    Treasury and the IRS believe the basic approach taken by the 
proposed regulations is both necessary and appropriate to prevent the 
avoidance of the purposes of section 672(f). See Code section 672(f)(4) 
and (6). A rule that would recharacterize purported gifts only in 
situations where the partnership or foreign corporation was being used 
principally as a device to avoid U.S. tax would be unadministrable. It 
would place a nearly insurmountable burden on the IRS to obtain 
information, much of it outside the United States, and to establish 
that the partnership or foreign corporation was being used to avoid 
U.S. tax. Further, individuals do not normally receive gifts from 
partnerships and corporations. See, for example, Commissioner v. 
Duberstein, 363 U.S. 278 (1960).
    The final regulations leave the basic approach essentially 
unaltered, but expand the number of exceptions to the general rule. 
They retain the exception for cases where the U.S. donee can establish 
that a U.S. citizen or resident alien treated (and reported) the 
purported gift for U.S. tax purposes as a distribution from the 
partnership or foreign corporation and a subsequent gift to the donee. 
In response to the commenters' concerns, they provide an additional 
exception for cases where the U.S. donee can establish that a 
nonresident alien individual treated and reported the purported gift 
for purposes of the tax laws of the country in which the nonresident 
alien is resident as a distribution from the partnership or foreign 
corporation and a subsequent gift to the donee, provided the U.S. donee 
timely complied with the filing requirements of section 6039F, if 
applicable. Finally, they provide another new exception for purported 
gifts from domestic partnerships that are beneficially owned (within 
the meaning of Sec. 1.1441-1(c)(6)) exclusively by U.S. citizens or 
residents or domestic corporations.
    In response to other comments, the final regulations clarify that a 
transfer to a U.S. donee that is a corporation will not be subject to 
the general rule of Sec. 1.672(f)-4(a) to the extent the donee can 
establish that the transfer was a contribution to capital. The final 
regulations also expand the scope of the charitable contribution 
exception to include a transfer from a transferor that has received a 
ruling or determination letter from the Internal Revenue Service 
recognizing its exempt status under section 501(c)(3), provided that 
the transfer was made pursuant to the transferor's exempt purpose, the 
ruling or determination letter has not been revoked or modified, and 
there has been no material change, inconsistent with exemption, in the 
character, purpose, or method of operation of the organization.
    The final regulations revise the rules for gratuitous transfers to 
U.S. donees from trusts to which partnerships or foreign corporations 
have made gratuitous transfers. The revisions reflect the fact that, 
under U.S. domestic law principles, the partners or shareholders might 
be treated as grantors of the trust. See Sec. 1.671-2T(e)(4).
    The final regulations also clarify that if the transferring 
partnership or foreign corporation receives some consideration from the 
U.S. donee, but the consideration is less than the fair market value of 
the property transferred, only the excess will be treated as a 
purported gift. Further, no portion will be treated as a purported gift 
if the U.S. donee can establish that the U.S. donee is neither related 
to a partner or shareholder of the transferor within the meaning of 
Sec. 1.643(h)-1(e) nor has another relationship with a partner or 
shareholder of the transferor such that there is a reasonable basis for 
concluding that the partner or shareholder would make a gratuitous 
transfer to the U.S. donee.
    Commenters said the proposed regulations overturned an early 
Supreme Court decision, Bogardus v.

[[Page 43272]]

Commissioner, 302 U.S. 34 (1937), which treated certain payments by an 
acquiring corporation in a reorganization that were paid at the 
instigation of former shareholders of the target corporation to 
employees and former employees of the target corporation as nontaxable 
gifts rather than as compensation. The result in Bogardus might well be 
different today under section 102(c)(1) (enacted in 1986), which 
provides that the exclusion from gross income for the value of property 
acquired by gift does not apply to any amount transferred by or for an 
employer to, or for the benefit of, an employee. Further, and more 
importantly, the payor corporation in Bogardus was a domestic 
corporation that did not treat the payments as a deductible expense and 
there was no avoidance of U.S. tax. Thus, Bogardus is distinguishable 
on its facts from a situation where a foreign corporation transfers 
property to a U.S. person who treats the transfer as a gift or bequest 
and there will be avoidance of U.S. tax if the purported gift is not 
recharacterized.
    The final regulations for purported gifts are generally applicable 
to transfers made after August 10, 1999 by partnerships or foreign 
corporations, or by trusts to which partnerships or foreign 
corporations made gratuitous transfers after August 10, 1999.

7. Comments and Changes to Sec. 1.672(f)-5: Special Rules

    Section 1.672(f)-5(b) of the proposed regulations provided that, 
for purposes of Sec. 1.672(f)-1, where the taxable year of a trust was 
different from the taxable year of a person who was taking an amount 
into account, the amount was taken into account for the taxable year of 
the person that included the last day of the taxable year of the trust. 
This rule was deleted from the final regulations, because it is no 
longer needed in light of the revisions to Sec. 1.672(f)-1, which are 
described above in part 3 of this explanation.
    Section 1.672(f)-5(c) of the proposed regulations provided that, 
for purposes of Sec. 1.672(f)-4, a wholly owned business entity must be 
treated as a corporation, separate from its single owner. Absent this 
rule, an entity having a single owner could avoid the purported gift 
rule by electing to be disregarded, with the result that the purported 
gift would be received from the owner of the entity, rather than from 
the entity itself. The final regulations clarify that this special rule 
(renumbered as Sec. 1.672(f)-5(b)) applies solely for purposes of 
Sec. 1.672(f)-4. Thus, it does not apply for purposes of 
Secs. 1.672(f)-1 through 1.672(f)-3 or Sec. 1.672(f)-5 or for purposes 
of any other provision of the Code or regulations.
    Section 301.7701-2(c)(2)(iii) of the proposed regulations provided 
that, solely for purposes of applying the rules of section 672(f)(4), a 
wholly owned business entity will be treated as a corporation, separate 
from its owner. This provision, which repeated the rule in 
Sec. 1.672(f)-5(c) (renumbered as Sec. 1.672(f)-5(b)), is not included 
in the final regulations.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and, because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Small 
Business Administration for comment on the regulation's impact on small 
business.
    Drafting Information. The principal authors of these regulations 
are M. Grace Fleeman of the Office of Associate Chief Counsel 
(International) and James A. Quinn of the Office of the Assistant Chief 
Counsel (Passthroughs and Special Industries). 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.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.643(h)-1 also issued under 26 U.S.C. 643(a)(7).
    Section 1.671-2T also issued under 26 U.S.C. 643(a)(7) and 
672(f)(6).
    Section 1.672(f)-1 also issued under 26 U.S.C. 643(a)(7) and 
672(f)(6).
    Section 1.672(f)-2 also issued under 26 U.S.C. 643(a)(7) and 
672(f)(3) and (6).
    Section 1.672(f)-3 also issued under 26 U.S.C. 643(a)(7) and 
672(f)(2) and (6).
    Section 1.672(f)-4 also issued under 26 U.S.C. 643(a)(7) and 
672(f)(4) and (6).
    Section 1.672(f)-5 also issued under 26 U.S.C. 643(a)(7) and 
672(f)(6). * * *

    Par. 2. Section 1.643(h)-1 is added to read as follows:


Sec. 1.643(h)-1  Distributions by certain foreign trusts through 
intermediaries.

    (a) In general--(1) Principal purpose of tax avoidance. Except as 
provided in paragraph (b) of this section, for purposes of part I of 
subchapter J, chapter 1 of the Internal Revenue Code, and section 6048, 
any property (within the meaning of paragraph (f) of this section) that 
is transferred to a United States person by another person (an 
intermediary) who has received property from a foreign trust will be 
treated as property transferred directly by the foreign trust to the 
United States person if the intermediary received the property from the 
foreign trust pursuant to a plan one of the principal purposes of which 
was the avoidance of United States tax.
    (2) Principal purpose of tax avoidance deemed to exist. For 
purposes of paragraph (a)(1) of this section, a transfer will be deemed 
to have been made pursuant to a plan one of the principal purposes of 
which was the avoidance of United States tax if the United States 
person--
    (i) Is related (within the meaning of paragraph (e) of this 
section) to a grantor of the foreign trust, or has another relationship 
with a grantor of the foreign trust that establishes a reasonable basis 
for concluding that the grantor of the foreign trust would make a 
gratuitous transfer (within the meaning of Sec. 1.671-2T(e)(2)) to the 
United States person;
    (ii) Receives from the intermediary, within the period beginning 
twenty-four months before and ending twenty-four months after the 
intermediary's receipt of property from the foreign trust, either the 
property the intermediary received from the foreign trust, proceeds 
from such property, or property in substitution for such property; and
    (iii) Cannot demonstrate to the satisfaction of the Commissioner 
that--
    (A) The intermediary has a relationship with the United
    States person that establishes a reasonable basis for concluding 
that the intermediary would make a gratuitous transfer to the United 
States person;
    (B) The intermediary acted independently of the grantor and the 
trustee of the foreign trust;
    (C) The intermediary is not an agent of the United States person 
under generally applicable United States agency principles; and

[[Page 43273]]

    (D) The United States person timely complied with the reporting 
requirements of section 6039F, if applicable, if the intermediary is a 
foreign person.
    (b) Exceptions--(1) Nongratuitous transfers. Paragraph (a) of this 
section does not apply to the extent that either the transfer from the 
foreign trust to the intermediary or the transfer from the intermediary 
to the United States person is a transfer that is not a gratuitous 
transfer within the meaning of Sec. 1.671-2T(e)(2).
    (2) Grantor as intermediary. Paragraph (a) of this section does not 
apply if the intermediary is the grantor of the portion of the trust 
from which the property that is transferred is derived. For the 
definition of grantor, see Sec. 1.671-2T(e).
    (c) Effect of disregarding intermediary--(1) General rule. Except 
as provided in paragraph (c)(2) of this section, the intermediary is 
treated as an agent of the foreign trust, and the property is treated 
as transferred to the United States person in the year the property is 
transferred, or made available, by the intermediary to the United 
States person. The fair market value of the property transferred is 
determined as of the date of the transfer by the intermediary to the 
United States person. For purposes of section 665(d)(2), the term taxes 
imposed on the trust includes any income, war profits, and excess 
profits taxes imposed by any foreign country or possession of the 
United States on the intermediary with respect to the property 
transferred.
    (2) Exception. If the Commissioner determines, or if the taxpayer 
can demonstrate to the satisfaction of the Commissioner, that the 
intermediary is an agent of the United States person under generally 
applicable United States agency principles, the property will be 
treated as transferred to the United States person in the year the 
intermediary receives the property from the foreign trust. The fair 
market value of the property transferred will be determined as of the 
date of the transfer by the foreign trust to the intermediary. For 
purposes of section 901(b), any income, war profits, and excess profits 
taxes imposed by any foreign country or possession of the United States 
on the intermediary with respect to the property transferred will be 
treated as having been imposed on the United States person.
    (3) Computation of gross income of intermediary. If property is 
treated as transferred directly by the foreign trust to a United States 
person pursuant to this section, the fair market value of such property 
is not taken into account in computing the gross income of the 
intermediary (if otherwise required to be taken into account by the 
intermediary but for paragraph (a) of this section).
    (d) Transfers not in excess of $10,000. This section does not apply 
if, during the taxable year of the United States person, the aggregate 
fair market value of all property transferred to such person from all 
foreign trusts either directly or through one or more intermediaries 
does not exceed $10,000.
    (e) Related parties. For purposes of this section, a United States 
person is treated as related to a grantor of a foreign trust if the 
United States person and the grantor are related for purposes of 
section 643(i)(2)(B), with the following modifications--
    (1) For purposes of applying section 267 (other than section 
267(f)) and section 707(b)(1), ``at least 10 percent'' is used instead 
of ``more than 50 percent'' each place it appears; and
    (2) The principles of section 267(b)(10), using ``at least 10 
percent'' instead of ``more than 50 percent,'' apply to determine 
whether two corporations are related.
    (f) Definition of property. For purposes of this section, the term 
property includes cash.
    (g) Examples. The following examples illustrate the rules of this 
section. In each example, FT is an irrevocable foreign trust that is 
not treated as owned by any other person and the fair market value of 
the property that is transferred exceeds $10,000. The examples are as 
follows:

    Example 1. Principal purpose of tax avoidance. FT was created in 
1980 by A, a nonresident alien, for the benefit of his children and 
their descendants. FT's trustee, T, determines that 1000X of 
accumulated income should be distributed to A's granddaughter, B, 
who is a resident alien. Pursuant to a plan with a principal purpose 
of avoiding the interest charge that would be imposed by section 
668, T causes FT to make a gratuitous transfer (within the meaning 
of Sec. 1.671-2T(e)(2)) of 1000X to I, a foreign person. I 
subsequently makes a gratuitous transfer of 1000X to B. Under 
paragraph (a)(1) of this section, FT is deemed to have made an 
accumulation distribution of 1000X directly to B.
    Example 2. United States person unable to demonstrate that 
intermediary acted independently. GM and her daughter, M, are both 
nonresident aliens. M's daughter, D, is a resident alien. GM creates 
and funds FT for the benefit of her children. On July 1, 2001, FT 
makes a gratuitous transfer of XYZ stock to M. M immediately sells 
the XYZ stock and uses the proceeds to purchase ABC stock. On 
January 1, 2002, M makes a gratuitous transfer of the ABC stock to 
D. D is unable to demonstrate that M acted independently of GM and 
the trustee of FT in making the transfer to D. Under paragraph 
(a)(2) of this section, FT is deemed to have distributed the ABC 
stock to D. Under paragraph (c)(1) of this section, M is treated as 
an agent of FT, and the distribution is deemed to have been made on 
January 1, 2002.
    Example 3. United States person demonstrates that specified 
conditions are satisfied. Assume the same facts as in Example 2, 
except that M receives 1000X cash from FT instead of XYZ stock. M 
gives 1000X cash to D on January 1, 2002. Also assume that M 
receives annual income of 5000X from her own investments and that M 
has given D 1000X at the beginning of each year for the past ten 
years. Based on this and additional information provided by D, D 
demonstrates to the satisfaction of the Commissioner that M has a 
relationship with D that establishes a reasonable basis for 
concluding that M would make a gratuitous transfer to D, that M 
acted independently of GM and the trustee of FT, that M is not an 
agent of D under generally applicable United States agency 
principles, and that D timely complied with the reporting 
requirements of section 6039F. FT will not be deemed under paragraph 
(a)(2) of this section to have made a distribution to D.
    Example 4. Transfer to United States person less than 24 months 
before transfer to intermediary. Several years ago, A, a nonresident 
alien, created and funded FT for the benefit of his children and 
their descendants. A has a close friend, C, who also is a 
nonresident alien. A's granddaughter, B, is a resident alien. On 
December 31, 2001, C makes a gratuitous transfer of 1000X to B. On 
January 15, 2002, FT makes a gratuitous transfer of 1000X to C. B is 
unable to demonstrate that C has a relationship with B that would 
establish a reasonable basis for concluding that C would make a 
gratuitous transfer to B or that C acted independently of A and the 
trustee of FT in making the transfer to B. Under paragraph (a)(2) of 
this section, FT is deemed to have distributed 1000X directly to B. 
Under paragraph (c)(1) of this section, C is treated as an agent of 
FT, and the distribution is deemed to have been made on December 31, 
2001.
    Example 5. United States person receives property in 
substitution for property transferred to intermediary. GM and her 
son, S, are both nonresident aliens. S's daughter, GD, is a resident 
alien. GM creates and funds FT for the benefit of her children and 
their descendants. On July 1, 2001, FT makes a gratuitous transfer 
of ABC stock with a fair market value of approximately 1000X to S. 
On January 1, 2002, S makes a gratuitous transfer of DEF stock with 
a fair market value of approximately 1000X to GD. GD is unable to 
demonstrate that S acted independently of GM and the trustee of FT 
in transferring the DEF stock to GD. Under paragraph (a)(2) of this 
section, FT is deemed to have distributed the DEF stock to GD. Under 
paragraph (c)(1) of this section, S is treated as an agent of FT, 
and the distribution is deemed to have been made on January 1, 2002.
    Example 6. United States person receives indirect loan from 
foreign trust. Several years ago, A, a nonresident alien, created 
and funded FT for the benefit of her children and their descendants. 
A's daughter, B, is a

[[Page 43274]]

resident alien. B needs funds temporarily while she is starting up 
her own business. If FT were to loan money directly to B, section 
643(i) would apply. FT deposits 500X with FB, a foreign bank, on 
June 30, 2001. On July 1, 2001, FB loans 400X to B. Repayment of the 
loan is guaranteed by FT's 500X deposit. B is unable to demonstrate 
to the satisfaction of the Commissioner that FB has a relationship 
with B that establishes a reasonable basis for concluding that FB 
would make a loan to B or that FB acted independently of A and the 
trustee of FT in making the loan. Under paragraph (a)(2) of this 
section, FT is deemed to have loaned 400X directly to B on July 1, 
2001. Under paragraph (c)(1) of this section, FB is treated as an 
agent of FT. For the treatment of loans from foreign trusts, see 
section 643(i).
    Example 7. United States person demonstrates that specified 
conditions are satisfied. GM, a nonresident alien, created and 
funded FT for the benefit of her children and their descendants. One 
of GM's children is M, who is a resident alien. During the year 
2001, FT makes a gratuitous transfer of 500X to M. M reports the 
500X on Form 3520 as a distribution received from a foreign trust. 
During the year 2002, M makes a gratuitous transfer of 400X to her 
son, S, who also is a resident alien. M files a Form 709 treating 
the gratuitous transfer to S as a gift. Based on this and additional 
information provided by S, S demonstrates to the satisfaction of the 
Commissioner that M has a relationship with S that establishes a 
reasonable basis for concluding that M would make a gratuitous 
transfer to S, that M acted independently of GM and the trustee of 
FT, and that M is not an agent of S under generally applicable 
United States agency principles. FT will not be deemed under 
paragraph (a)(2) of this section to have made a distribution to S.
    Example 8. Intermediary as agent of trust; increase in FMV. A, a 
nonresident alien, created and funded FT for the benefit of his 
children and their descendants. On December 1, 2001, FT makes a 
gratuitous transfer of XYZ stock with a fair market value of 85X to 
B, a nonresident alien. On November 1, 2002, B sells the XYZ stock 
to a third party in an arm's length transaction for 100X in cash. On 
November 1, 2002, B makes a gratuitous transfer of 98X to A's 
grandson, C, a resident alien. C is unable to demonstrate to the 
satisfaction of the Commissioner that B acted independently of A and 
the trustee of FT in making the transfer. Under paragraph (a)(2) of 
this section, FT is deemed to have made a distribution directly to 
C. Under paragraph (c)(1) of this section, B is treated as an agent 
of FT, and FT is deemed to have distributed 98X to C on November 1, 
2002.
    Example 9. Intermediary as agent of United States person; 
increase in FMV. Assume the same facts as in Example 8, except that 
the Commissioner determines that B is an agent of C under generally 
applicable United States agency principles. Under paragraph (c)(2) 
of this section, FT is deemed to have distributed 85X to C on 
December 1, 2001. C must take the gain of 15X into account in the 
year 2002.
    Example 10. Intermediary as agent of trust; decrease in FMV. 
Assume the same facts as in Example 8, except that the value of the 
XYZ stock on November 1, 2002, is only 80X. Instead of selling the 
XYZ stock to a third party and transferring cash to C, B transfers 
the XYZ stock to C in a gratuitous transfer. Under paragraph (c)(1) 
of this section, FT is deemed to have distributed XYZ stock with a 
value of 80X to C on November 1, 2002.
    Example 11. Intermediary as agent of United States person; 
decrease in FMV. Assume the same facts as in Example 10, except that 
the Commissioner determines that B is an agent of C under generally 
applicable United States agency principles. Under paragraph (c)(2) 
of this section, FT is deemed to have distributed XYZ stock with a 
value of 85X to C on December 1, 2001.

    (h) Effective date. The rules of this section are applicable to 
transfers made to United States persons after August 10, 1999.
    Par. 3. In Sec. 1.671-2, paragraph (e) is revised to read as 
follows:


Sec. 1.671-2  Applicable principles.

* * * * *
    (e) [Reserved] For further guidance, see Sec. 1.671-2T(e).
    Par. 4. Section 1.671-2T is added to read as follows:


Sec. 1.671-2T  Applicable principles (temporary).

    (a) Athrough (d) [Reserved]. For further guidance, see Sec. 1.671-
2(a) through (d).
    (e)(1) For purposes of part I of subchapter J, chapter 1 of the 
Internal Revenue Code, a grantor includes any person to the extent such 
person either creates a trust, or directly or indirectly makes a 
gratuitous transfer (within the meaning of paragraph (e)(2) of this 
section) of property to a trust. For purposes of this section, the term 
property includes cash. If a person creates or funds a trust on behalf 
of another person, both persons are treated as grantors of the trust. 
(See section 6048 for reporting requirements that apply to grantors of 
foreign trusts.) However, a person who creates a trust but makes no 
gratuitous transfers to the trust is not treated as an owner of any 
portion of the trust under sections 671 through 677 or 679. Also, a 
person who funds a trust with an amount that is directly reimbursed to 
such person within a reasonable period of time and who makes no other 
transfers to the trust that constitute gratuitous transfers is not 
treated as an owner of any portion of the trust under sections 671 
through 677 or 679. See also Sec. 1.672(f)-5(a).
    (2)(i) A gratuitous transfer is any transfer other than a transfer 
for fair market value. A transfer of property to a trust may be 
considered a gratuitous transfer without regard to whether the transfer 
is treated as a gift for gift tax purposes.
    (ii) For purposes of this paragraph (e), a transfer is for fair 
market value only to the extent of the value of property received from 
the trust, services rendered by the trust, or the right to use property 
of the trust. For example, rents, royalties, interest, and compensation 
paid to a trust are transfers for fair market value only to the extent 
that the payments reflect an arm's length price for the use of the 
property of, or for the services rendered by, the trust. For purposes 
of this determination, an interest in the trust is not property 
received from the trust. In addition, a person will not be treated as 
making a transfer for fair market value merely because the transferor 
recognizes gain on the transaction. See, for example, section 684 
regarding the recognition of gain on certain transfers to foreign 
trusts.
    (iii) For purposes of this paragraph (e), a gratuitous transfer 
does not include a distribution to a trust with respect to an interest 
held by such trust in either a trust described in paragraph (e)(3) of 
this section or an entity other than a trust. For example, a 
distribution to a trust by a corporation with respect to its stock 
described in section 301 is not a gratuitous transfer.
    (3) A grantor includes any person who acquires an interest in a 
trust from a grantor of the trust if the interest acquired is an 
interest in certain investment trusts described in Sec. 301.7701-4(c) 
of this chapter, liquidating trusts described in Sec. 301.7701-4(d) of 
this chapter, or environmental remediation trusts described in 
Sec. 301.7701-4(e) of this chapter.
    (4) If a gratuitous transfer is made by a partnership or 
corporation to a trust and is for a business purpose of the partnership 
or corporation, the partnership or corporation will generally be 
treated as the grantor of the trust. For example, if a partnership 
makes a gratuitous transfer to a trust in order to secure a legal 
obligation of the partnership to a third party unrelated to the 
partnership, the partnership will be treated as the grantor of the 
trust. However, if a partnership or a corporation makes a gratuitous 
transfer to a trust that is not for a business purpose of the 
partnership or corporation but is, e.g., for the personal purposes of 
one or more of the partners or shareholders, the gratuitous transfer 
will be treated as a constructive distribution to such partners or 
shareholders under federal tax principles and the partners or the 
shareholders will be treated as the grantors of the trust. For example, 
if a partnership makes a gratuitous transfer to a trust that is for the 
benefit of a child of a partner, the gratuitous transfer will

[[Page 43275]]

be treated as a distribution to the partner under section 731 and a 
subsequent gratuitous transfer by the partner to the trust.
    (5) If a trust makes a gratuitous transfer of property to another 
trust, the grantor of the transferor trust generally will be treated as 
the grantor of the transferee trust. However, if a person with a 
general power of appointment over the transferor trust exercises that 
power in favor of another trust, then such person will be treated as 
the grantor of the transferee trust, even if the grantor of the 
transferor trust is treated as the owner of the transferor trust under 
subpart E of part I, subchapter J, chapter 1 of the Internal Revenue 
Code.
    (6) The following examples illustrate the rules of this paragraph 
(e). Unless otherwise indicated, all trusts are domestic trusts and all 
other persons are United States persons.
    The examples are as follows:

    Example 1. A creates and funds a trust, T, for the benefit of 
her children. B subsequently makes a gratuitous transfer to T. Under 
paragraph (e)(1) of this section, both A and B are grantors of T.
    Example 2. A makes an investment in a fixed investment trust, T, 
that is classified as a trust under Sec. 301.7701-4(c)(1) of this 
chapter. A is a grantor of T. B subsequently acquires A's entire 
interest in T. Under paragraph (e)(3) of this section, B is a 
grantor of T with respect to such interest.
    Example 3. A, an attorney, creates a foreign trust, FT, on 
behalf of A's client, B, and transfers $100 to FT out of A's funds. 
A is reimbursed by B for the $100 transferred to FT. The trust 
instrument states that the trustee has discretion to distribute the 
income or corpus of FT to B, and B's children. Both A and B are 
treated as grantors of FT under paragraph (e)(1) of this section. In 
addition, B is treated as the owner of the entire trust under 
section 677. Because A is reimbursed for the $100 transferred to FT 
on behalf of B, A is not treated as transferring any property to FT. 
Therefore, A is not an owner of any portion of T under sections 671 
through 677 regardless of whether A retained any power over or 
interest in T described in sections 673 through 677. A also is not 
treated as an owner of any portion of T under section 679. Both A 
and B are responsible parties for purposes of the reporting 
requirements in section 6048.
    Example 4. A creates and funds a trust, T. A is not treated as 
an owner of any portion of the trust under subpart E. B holds an 
unrestricted power, exercisable solely by B, to withdraw certain 
amounts contributed to the trust before the end of the calendar year 
and to vest those amounts in B. B is treated as an owner of the 
portion of T that is subject to the withdrawal power under section 
678(a)(1). However, B is not a grantor of T under paragraph (e)(1) 
of this section because B neither created T nor made a gratuitous 
transfer to T.
    Example 5. A transfers cash to a trust, T, through a broker, in 
exchange for units in T. The units in T are not property for 
purposes of determining whether A has received fair market value 
under paragraph (e)(2)(ii) of this section. Therefore, A has made a 
gratuitous transfer to T, and, under paragraph (e)(1) of this 
section, A is a grantor of T.
    Example 6. A borrows cash from T, a trust. A has not made any 
gratuitous transfers to T. Arm's length interest payments by A to T 
will not be treated as gratuitous transfers under paragraph 
(e)(2)(ii) of this section. Therefore, under paragraph (e)(1) of 
this section, A is not a grantor of T with respect to the interest 
payments.
    Example 7. A, B's brother, creates a trust, T, for B's benefit 
and contributes $50,000 to T. The trustee invests the $50,000 in 
stock of Company X. C, B's uncle, sells property with a fair market 
value of $1,000,000 to T in exchange for the stock when it has 
appreciated to a fair market value of $100,000. Under paragraph 
(e)(2)(ii) of this section, the $900,000 excess value is a 
gratuitous transfer by C. Therefore, under paragraph (e)(1) of this 
section, A is a grantor with respect to the portion of the trust 
valued at $100,000, and C is a grantor of T with respect to the 
portion of the trust valued at $900,000. In addition, A or C or both 
will be treated as the owners of the respective portions of the 
trust of which each person is a grantor if A or C or both retain 
powers over or interests in such portions under sections 673 through 
677.
    Example 8. G creates and funds a trust, T1, for the benefit of 
G's children and grandchildren. After G's death, under authority 
granted to the trustees in the trust instrument, the trustees of T1 
transfer a portion of the assets of T1 to another trust, T2, and 
retain a power to revoke T2 and revest the assets of T2 in T1. Under 
paragraphs (e)(1) and (5) of this section, G is the grantor of T1 
and T2. In addition, because the trustees of T1 have retained a 
power to revest the assets of T2 in T1, T1 is treated as the owner 
of T2 under section 678(a).
    Example 9. G creates and funds a trust, T1, for the benefit of 
B. G retains a power to revest the assets of T1 in G within the 
meaning of section 676. Under the trust agreement, B is given a 
general power of appointment over the assets of T1. B exercises the 
general power of appointment with respect to one-half of the corpus 
of T1 in favor of a trust, T2, that is for the benefit of C, B's 
child. Under paragraph (e)(1) of this section, G is the grantor of 
T1, and under paragraphs (e)(1) and (5) of this section, B is the 
grantor of T2.

    (7) The rules of this section are applicable to any transfer to a 
trust, or transfer of an interest in a trust, on or after August 10, 
1999. In accordance with section 7805(e)(2), the rules of this section 
will expire before August 12, 2002.
    Par. 5. Sections 1.672(f)-1, 1.672(f)-2, 1.672(f)-3, 1.672(f)-4, 
and 1.672(f)-5 are added to read as follows:


Sec. 1.672(f)-1  Foreign persons not treated as owners.

    (a) General rule--(1) Application of the general rule. Section 
672(f)(1) provides that subpart E of part I, subchapter J, chapter 1 of 
the Internal Revenue Code (the grantor trust rules) shall apply only to 
the extent such application results in an amount (if any) being 
currently taken into account (directly or through one or more entities) 
in computing the income of a citizen or resident of the United States 
or a domestic corporation. Accordingly, the grantor trust rules apply 
to the extent that any portion of the trust, upon application of the 
grantor trust rules without regard to section 672(f), is treated as 
owned by a United States citizen or resident or domestic corporation. 
The grantor trust rules do not apply to any portion of the trust to the 
extent that, upon application of the grantor trust rules without regard 
to section 672(f), that portion is treated as owned by a person other 
than a United States citizen or resident or domestic corporation, 
unless the person is described in Sec. 1.672(f)-2(a) (relating to 
certain foreign corporations treated as domestic corporations), or one 
of the exceptions set forth in Sec. 1.672(f)-3 is met, (relating to: 
trusts where the grantor can revest trust assets; trusts where the only 
amounts distributable are to the grantor or the grantor's spouse; and 
compensatory trusts). Section 672(f) applies to domestic and foreign 
trusts. Any portion of the trust that is not treated as owned by a 
grantor or another person is subject to the rules of subparts A through 
D (section 641 and following), part I, subchapter J, chapter 1 of the 
Internal Revenue Code.
    (2) Determination of portion based on application of the grantor 
trust rules. The determination of the portion of a trust treated as 
owned by the grantor or other person is to be made based on the terms 
of the trust and the application of the grantor trust rules and section 
671 and the regulations thereunder.
    (b) Example. The following example illustrates the rules of this 
section:

    Example. (i) A, a nonresident alien, funds an irrevocable 
domestic trust, DT, for the benefit of his son, B, who is a United 
States citizen, with stock of Corporation X. A's brother, C, who 
also is a United States citizen, contributes stock of Corporation Y 
to the trust for the benefit of B. A has a reversionary interest 
within the meaning of section 673 in the X stock that would cause A 
to be treated as the owner of the X stock upon application of the 
grantor trust rules without regard to section 672(f). C has a 
reversionary interest within the meaning of section 673 in the Y 
stock that would cause C to be treated as the owner of the Y stock 
upon application of the grantor trust rules without regard to 
section 672(f). The trustee has discretion to accumulate or 
currently distribute income of DT to B.

[[Page 43276]]

    (ii) Because A is a nonresident alien, application of the 
grantor trust rules without regard to section 672(f) would not 
result in the portion of the trust consisting of the X stock being 
treated as owned by a United States citizen or resident. None of the 
exceptions in Sec. 1.672(f)-3 applies because A cannot revest the X 
stock in A, amounts may be distributed during A's lifetime to B, who 
is neither a grantor nor a spouse of a grantor, and the trust is not 
a compensatory trust. Therefore, pursuant to paragraph (a)(1) of 
this section, A is not treated as an owner under subpart E of part 
I, subchapter J, chapter 1 of the Internal Revenue Code, of the 
portion of the trust consisting of the X stock. Any distributions 
from such portion of the trust are subject to the rules of subparts 
A through D (641 and following), part I, subchapter J, chapter 1 of 
the Internal Revenue Code.
    (iii) Because C is a United States citizen, paragraph (a)(1) of 
this section does not prevent C from being treated under section 673 
as the owner of the portion of the trust consisting of the Y stock.

    (c) Effective date. The rules of this section are applicable to 
taxable years of a trust beginning after August 10, 1999.


Sec. 1.672(f)-2  Certain foreign corporations.

    (a) Application of general rule. Subject to the provisions of 
paragraph (b) of this section, if the owner of any portion of a trust 
upon application of the grantor trust rules without regard to section 
672(f) is a controlled foreign corporation (as defined in section 957), 
a passive foreign investment company (as defined in section 1297), or a 
foreign personal holding company (as defined in section 552), the 
corporation will be treated as a domestic corporation for purposes of 
applying the rules of Sec. 1.672(f)-1.
    (b) Gratuitous transfers to United States persons--(1) Transfer 
from trust to which corporation made a gratuitous transfer. If a trust 
(or portion of a trust) to which a controlled foreign corporation, 
passive foreign investment company, or foreign personal holding company 
has made a gratuitous transfer (within the meaning of Sec. 1.671-
2T(e)(2)), makes a gratuitous transfer to a United States person, the 
controlled foreign corporation, passive foreign investment company, or 
foreign personal holding company, as the case may be, is treated as a 
foreign corporation for purposes of Sec. 1.672(f)-4(c), relating to 
gratuitous transfers from trusts (or portions of trusts) to which a 
partnership or foreign corporation has made a gratuitous transfer.
    (2) Transfer from trust over which corporation has a section 678 
power. If a trust (or portion of a trust) that a controlled foreign 
corporation, passive foreign investment company, or foreign personal 
holding company is treated as owning under section 678 makes a 
gratuitous transfer to a United States person, the controlled foreign 
corporation, passive foreign investment company, or foreign personal 
holding company, as the case may be, is treated as a foreign 
corporation that had made a gratuitous transfer to the trust (or 
portion of a trust) and the rules of Sec. 1.672(f)-4(c) apply.
    (c) Special rules for passive foreign investment companies--(1) 
Application of section 1297. For purposes of determining whether a 
foreign corporation is a passive foreign investment company as defined 
in section 1297, the grantor trust rules apply as if section 672(f) had 
not come into effect.
    (2) References to renumbered Internal Revenue Code section. For 
taxable years of shareholders beginning on or before December 31, 1997, 
and taxable years of passive foreign investment companies ending with 
or within such taxable years of the shareholders, all references in 
this Sec. 1.672(f)-2 to section 1297 are deemed to be references to 
section 1296.
    (d) Examples. The following examples illustrate the rules of this 
section. In each example, FT is an irrevocable foreign trust, and CFC 
is a controlled foreign corporation. The examples are as follows:

    Example 1. Application of general rule. CFC creates and funds 
FT. CFC is the grantor of FT within the meaning of Sec. 1.671-2T(e). 
CFC has a reversionary interest in FT within the meaning of section 
673 that would cause CFC to be treated as the owner of FT upon 
application of the grantor trust rules without regard to section 
672(f). Under paragraph (a) of this section, CFC is treated as a 
domestic corporation for purposes of applying the general rule of 
Sec. 1.672(f)-1. Thus, Sec. 1.672(f)-1 does not prevent CFC from 
being treated as the owner of FT under section 673.
    Example 2. Distribution from trust to which CFC made gratuitous 
transfer. A, a nonresident alien, owns 40 percent of the stock of 
CFC. A's brother B, a resident alien, owns the other 60 percent of 
the stock of CFC. CFC makes a gratuitous transfer to FT. FT makes a 
gratuitous transfer to A's daughter, C, who is a resident alien. 
Under paragraph (b)(1) of this section, CFC will be treated as a 
foreign corporation for purposes of Sec. 1.672(f)-4(c). For further 
guidance, see Sec. 1.672(f)-4(g) Example 2 through Example 4.

    (e) Effective date. The rules of this section are generally 
applicable to taxable years of shareholders of controlled foreign 
corporations, passive foreign investment companies, and foreign 
personal holding companies beginning after August 10, 1999, and taxable 
years of controlled foreign corporations, passive foreign investment 
companies, and foreign personal holding companies ending with or within 
such taxable years of the shareholders.


Sec. 1.672(f)-3  Exceptions to general rule.

    (a) Certain revocable trusts--(1) In general. Subject to the 
provisions of paragraph (a)(2) of this section, the general rule of 
Sec. 1.672(f)-1 does not apply to any portion of a trust for a taxable 
year of the trust if the power to revest absolutely in the grantor 
title to such portion is exercisable solely by the grantor (or, in the 
event of the grantor's incapacity, by a guardian or other person who 
has unrestricted authority to exercise such power on the grantor's 
behalf) without the approval or consent of any other person. If the 
grantor can exercise such power only with the approval of a related or 
subordinate party who is subservient to the grantor, such power is 
treated as exercisable solely by the grantor. For the definition of 
grantor, see Sec. 1.671-2T(e). For the definition of related or 
subordinate party, see Sec. 1.672(c)-1. For purposes of this paragraph 
(a), a related or subordinate party is subservient to the grantor 
unless the presumption in the last sentence of Sec. 1.672(c)-1 is 
rebutted by a preponderance of the evidence. A trust (or portion of a 
trust) that fails to qualify for the exception provided by this 
paragraph (a) for a particular taxable year of the trust will be 
subject to the general rule of Sec. 1.672(f)-1 for that taxable year 
and all subsequent taxable years of the trust.
    (2) 183-day rule. For purposes of paragraph (a)(1) of this section, 
the grantor is treated as having a power to revest for a taxable year 
of the trust only if the grantor has such power for a total of 183 or 
more days during the taxable year of the trust. If the first or last 
taxable year of the trust (including the year of the grantor's death) 
is less than 183 days, the grantor is treated as having a power to 
revest for purposes of paragraph (a)(1) of this section if the grantor 
has such power for each day of the first or last taxable year, as the 
case may be.
    (3) Grandfather rule for certain revocable trusts in existence on 
September 19, 1995. Subject to the rules of paragraph (d) of this 
section (relating to separate accounting for gratuitous transfers to 
the trust after September 19, 1995), the general rule of Sec. 1.672(f)-
1 does not apply to any portion of a trust that was treated as owned by 
the grantor under section 676 on September 19, 1995, as long as the 
trust would continue to be so treated thereafter. However, the 
preceding sentence does not apply to any portion of the trust 
attributable to gratuitous transfers to the trust after September 19, 
1995.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (a):


[[Page 43277]]


    Example 1. Grantor is owner. FP1, a foreign person, creates and 
funds a revocable trust, T, for the benefit of FP1's children, who 
are resident aliens. The trustee is a foreign bank, FB, that is 
owned and controlled by FP1 and FP2, who is FP1's brother. The power 
to revoke T and revest absolutely in FP1 title to the trust property 
is exercisable by FP1, but only with the approval or consent of FB. 
The trust instrument contains no standard that FB must apply in 
determining whether to approve or consent to the revocation of T. 
There are no facts that would suggest that FB is not subservient to 
FP1. Therefore, the exception in paragraph (a)(1) of this section is 
applicable.
    Example 2. Death of grantor. Assume the same facts as in Example 
1, except that FP1 dies. After FP1's death, FP2 has the power to 
withdraw the assets of T, but only with the approval of FB. There 
are no facts that would suggest that FB is not subservient to FP2. 
However, the exception in paragraph (a)(1) of this section is no 
longer applicable, because FP2 is not a grantor of T within the 
meaning of Sec. 1.671-2T(e).
    Example 3. Trustee is not related or subordinate party. Assume 
the same facts as in Example 1, except that neither FP1 nor any 
member of FP1's family has any substantial ownership interest or 
other connection with FB. FP1 can remove and replace FB at any time 
for any reason. Although FP1 can replace FB with a related or 
subordinate party if FB refuses to approve or consent to FP1's 
decision to revest the trust property in himself, FB is not a 
related or subordinate party. Therefore, the exception in paragraph 
(a)(1) of this section is not applicable.
    Example 4. Unrelated trustee will consent to revocation. FP, a 
foreign person, creates and funds an irrevocable trust, T. The 
trustee is a foreign bank, FB, that is not a related or subordinate 
party within the meaning of Sec. 1.672(c)-1. FB has the discretion 
to distribute trust income or corpus to beneficiaries of T, 
including FP. Even if FB would in fact distribute all the trust 
property to FP if requested to do so by FP, the exception in 
paragraph (a)(1) of this section is not applicable, because FP does 
not have the power to revoke T.

    (b) Certain trusts that can distribute only to the grantor or the 
spouse of the grantor--(1) In general. The general rule of 
Sec. 1.672(f)-1 does not apply to any trust (or portion of a trust) if 
at all times during the lifetime of the grantor the only amounts 
distributable (whether income or corpus) from such trust (or portion 
thereof) are amounts distributable to the grantor or the spouse of the 
grantor. For purposes of this paragraph (b), payments of amounts that 
are not gratuitous transfers (within the meaning of Sec. 1.671-
2T(e)(2)) are not amounts distributable. For the definition of grantor, 
see Sec. 1.671-2T(e).
    (2) Amounts distributable in discharge of legal obligations--(i) In 
general. A trust (or portion of a trust) does not fail to satisfy 
paragraph (b)(1) of this section solely because amounts are 
distributable from the trust (or portion thereof) in discharge of a 
legal obligation of the grantor or the spouse of the grantor. Subject 
to the provisions of paragraph (b)(2)(ii) of this section, an 
obligation is considered a legal obligation for purposes of this 
paragraph (b)(2)(i) if it is enforceable under the local law of the 
jurisdiction in which the grantor (or the spouse of the grantor) 
resides.
    (ii) Related parties--(A) In general. Except as provided in 
paragraph (b)(2)(ii)(B) of this section, an obligation to a person who 
is a related person for purposes of Sec. 1.643(h)-1(e) (other than an 
individual who is legally separated from the grantor under a decree of 
divorce or of separate maintenance) is not a legal obligation for 
purposes of paragraph (b)(2)(i) of this section unless it was 
contracted bona fide and for adequate and full consideration in money 
or money's worth (see Sec. 20.2043-1 of this chapter).
    (B) Exceptions--(1) Amounts distributable in support of certain 
individuals. Paragraph (b)(2)(ii)(A) of this section does not apply 
with respect to amounts that are distributable from the trust (or 
portion thereof) to support an individual who--
    (i) Would be treated as a dependent of the grantor or the spouse of 
the grantor under section 152(a)(1) through (9), without regard to the 
requirement that over half of the individual's support be received from 
the grantor or the spouse of the grantor; and
    (ii) Is either permanently and totally disabled (within the meaning 
of section 22(e)(3)), or less than 19 years old.
    (2) Certain potential support obligations. The fact that amounts 
might become distributable from a trust (or portion of a trust) in 
discharge of a potential obligation under local law to support an 
individual other than an individual described in paragraph 
(b)(2)(ii)(B)(1) of this section is disregarded if such potential 
obligation is not reasonably expected to arise under the facts and 
circumstances.
    (3) Reinsurance trusts. [Reserved]
    (3) Grandfather rule for certain section 677 trusts in existence on 
September 19, 1995. Subject to the rules of paragraph (d) of this 
section (relating to separate accounting for gratuitous transfers to 
the trust after September 19, 1995), the general rule of Sec. 1.672(f)-
1 does not apply to any portion of a trust that was treated as owned by 
the grantor under section 677 (other than section 677(a)(3)) on 
September 19, 1995, as long as the trust would continue to be so 
treated thereafter. However, the preceding sentence does not apply to 
any portion of the trust attributable to gratuitous transfers to the 
trust after September 19, 1995.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. Amounts distributable only to grantor or grantor's 
spouse. H and his wife, W, are both nonresident aliens. H is 70 
years old, and W is 65. H and W have a 30-year-old child, C, a 
resident alien. There is no reasonable expectation that H or W will 
ever have an obligation under local law to support C or any other 
individual. H creates and funds an irrevocable trust, FT, using only 
his separate property. H is the grantor of FT within the meaning of 
Sec. 1.671-2T(e). Under the terms of FT, the only amounts 
distributable (whether income or corpus) from FT as long as either H 
or W is alive are amounts distributable to H or W. Upon the death of 
both H and W, C may receive distributions from FT. During H's 
lifetime, the exception in paragraph (b)(1) of this section is 
applicable.
    Example 2. Effect of grantor's death. Assume the same facts as 
in Example 1. H predeceases W. Assume that W would be treated as 
owning FT under section 678 if the grantor trust rules were applied 
without regard to section 672(f). The exception in paragraph (b)(1) 
of this section is no longer applicable, because W is not a grantor 
of FT within the meaning of Sec. 1.671-2T(e).
    Example 3. Amounts temporarily distributable to person other 
than grantor or grantor's spouse. Assume the same facts as in 
Example 1, except that C (age 30) is a law student at the time FT is 
created and the trust instrument provides that, as long as C is in 
law school, amounts may be distributed from FT to pay C's expenses. 
Thereafter, the only amounts distributable from FT as long as either 
H or W is alive will be amounts distributable to H or W. Even 
assuming there is an enforceable obligation under local law for H 
and W to support C while he is in school, distributions from FT in 
payment of C's expenses cannot qualify as distributions in discharge 
of a legal obligation under paragraph (b)(2) of this section, 
because C is neither permanently and totally disabled nor less than 
19 years old. The exception in paragraph (b)(1) of this section is 
not applicable. After C graduates from law school, the exception in 
paragraph (b)(1) still will not be applicable, because amounts were 
distributable to C during the lifetime of H.
    Example 4. Fixed investment trust. FC, a foreign corporation, 
invests in a domestic fixed investment trust, DT, that is classified 
as a trust under Sec. 301.7701-4(c)(1) of this chapter. Under the 
terms of DT, the only amounts that are distributable from FC's 
portion of DT are amounts distributable to FC. The exception in 
paragraph (b)(1) of this section is applicable to FC's portion of 
DT.
    Example 5. Reinsurance trust. A domestic insurance company, DI, 
reinsures a portion of its business with an unrelated foreign 
insurance company, FI. To satisfy state regulatory requirements, FI 
places the premiums in an irrevocable domestic trust, DT. The trust 
funds are held by a United States bank and may be used only to pay 
claims arising out of the reinsurance policies, which are legally 
enforceable under the local

[[Page 43278]]

law of the jurisdiction in which FI resides. On the termination of 
DT, any assets remaining will revert to FI. Because the only amounts 
that are distributable from DT are distributable either to FI or in 
discharge of FI's legal obligations within the meaning of paragraph 
(b)(2)(i) of this section, the exception in paragraph (b)(1) of this 
section is applicable.
    Example 6. Trust that provides security for loan. FC, a foreign 
corporation, borrows money from B, an unrelated bank, to finance the 
purchase of an airplane. FC creates a foreign trust, FT, to hold the 
airplane as security for the loan from B. The only amounts that are 
distributable from FT while the loan is outstanding are amounts 
distributable to B in the event that FC defaults on its loan from B. 
When FC repays the loan, the trust assets will revert to FC. The 
loan is a legal obligation of FC within the meaning of paragraph 
(b)(2)(i) of this section, because it is enforceable under the local 
law of the country in which FC is incorporated. Paragraph (b)(2)(ii) 
of this section is not applicable, because B is not a related person 
for purposes of Sec. 1.643(h)-1(e). The exception in paragraph 
(b)(1) of this section is applicable.

    (c) Compensatory trusts--(1) In general. The general rule of 
Sec. 1.672(f)-1 does not apply to any portion of--
    (i) A nonexempt employees' trust described in section 402(b), 
including a trust created on behalf of a self-employed individual;
    (ii) A trust, including a trust created on behalf of a self-
employed individual, that would be a nonexempt employees' trust 
described in section 402(b) but for the fact that the trust's assets 
are not set aside from the claims of creditors of the actual or deemed 
transferor within the meaning of Sec. 1.83-3(e); and
    (iii) Any additional category of trust that the Commissioner may 
designate in revenue procedures, notices, or other guidance published 
in the Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this 
chapter).
    (2) Exceptions. The Commissioner may, in revenue rulings, notices, 
or other guidance published in the Internal Revenue Bulletin (see 
Sec. 601.601(d)(2) of this chapter), designate categories of 
compensatory trusts to which the general rule of paragraph (c)(1) of 
this section does not apply.
    (d) Separate accounting for gratuitous transfers to grandfathered 
trusts after September 19, 1995. If a trust that was treated as owned 
by the grantor under section 676 or 677 (other than section 677(a)(3)) 
on September 19, 1995, contains both amounts held in the trust on 
September 19, 1995, and amounts that were gratuitously transferred to 
the trust after September 19, 1995, paragraphs (a)(3) and (b)(3) of 
this section apply only if the amounts that were gratuitously 
transferred to the trust after September 19, 1995, are treated as a 
separate portion of the trust that is accounted for under the rules of 
Sec. 1.671-3(a)(2). If the amounts that were gratuitously transferred 
to the trust after September 19, 1995 are not so accounted for, the 
general rule of Sec. 1.672(f)-1 applies to the entire trust. If such 
amounts are so accounted for, and without regard to whether there is 
physical separation of the assets, the general rule of Sec. 1.672(f)-1 
does not apply to the portion of the trust that is attributable to 
amounts that were held in the trust on September 19, 1995.
    (e) Effective date. The rules of this section are generally 
applicable to taxable years of a trust beginning after August 10, 1999. 
The initial separate accounting required by paragraph (d) of this 
section must be prepared by the due date (including extensions) for the 
tax return of the trust for the first taxable year of the trust 
beginning after August 10, 1999.


Sec. 1.672(f)-4  Recharacterization of purported gifts.

    (a) In general--(1) Purported gifts from partnerships. Except as 
provided in paragraphs (b), (e), and (f) of this section, and without 
regard to the existence of any trust, if a United States person (United 
States donee) directly or indirectly receives a purported gift or 
bequest (as defined in paragraph (d) of this section) from a 
partnership, the purported gift or bequest must be included in the 
United States donee's gross income as ordinary income.
    (2) Purported gifts from foreign corporations. Except as provided 
in paragraphs (b), (e), and (f) of this section, and without regard to 
the existence of any trust, if a United States donee directly or 
indirectly receives a purported gift or bequest (as defined in 
paragraph (d) of this section) from any foreign corporation, the 
purported gift or bequest must be included in the United States donee's 
gross income as if it were a distribution from the foreign corporation. 
If the foreign corporation is a passive foreign investment company 
(within the meaning of section 1297), the rules of section 1291 apply. 
For purposes of section 1012, the United States donee is not treated as 
having basis in the stock of the foreign corporation. However, for 
purposes of section 1223, the United States donee is treated as having 
a holding period in the stock of the foreign corporation on the date of 
the deemed distribution equal to the weighted average of the holding 
periods of the actual interest holders (other than any interest holders 
who treat the portion of the purported gift attributable to their 
interest in the foreign corporation in the manner described in 
paragraph (b)(1) of this section). For purposes of section 902, a 
United States donee that is a domestic corporation is not treated as 
owning any voting stock of the foreign corporation.
    (b) Exceptions--(1) Partner or shareholder treats transfer as 
distribution and gift. Paragraph (a) of this section does not apply to 
the extent the United States donee can demonstrate to the satisfaction 
of the Commissioner that either--
    (i) A United States citizen or resident alien individual who 
directly or indirectly holds an interest in the partnership or foreign 
corporation treated and reported the purported gift or bequest for 
United States tax purposes as a distribution to such individual and a 
subsequent gift or bequest to the United States donee; or
    (ii) A nonresident alien individual who directly or indirectly 
holds an interest in the partnership or foreign corporation treated and 
reported the purported gift or bequest for purposes of the tax laws of 
the nonresident alien individual's country of residence as a 
distribution to such individual and a subsequent gift or bequest to the 
United States donee, and the United States donee timely complied with 
the reporting requirements of section 6039F, if applicable.
    (2) All beneficial owners of domestic partnership are United States 
citizens or residents or domestic corporations. Paragraph (a)(1) of 
this section does not apply to a purported gift or bequest from a 
domestic partnership if the United States donee can demonstrate to the 
satisfaction of the Commissioner that all beneficial owners (within the 
meaning of Sec. 1.1441-1(c)(6)) of the partnership are United States 
citizens or residents or domestic corporations.
    (3) Contribution to capital of corporate United States donee. 
Paragraph (a) of this section does not apply to the extent a United 
States donee that is a corporation can establish that the purported 
gift or bequest was treated for United States tax purposes as a 
contribution to the capital of the United States donee to which section 
118 applies.
    (4) Charitable transfers. Paragraph (a) of this section does not 
apply if either--
    (i) The United States donee is described in section 170(c); or
    (ii) The transferor has received a ruling or determination letter, 
which has been neither revoked nor modified, from the Internal Revenue 
Service recognizing its exempt status under section 501(c)(3), and the 
transferor made the transfer pursuant to an exempt

[[Page 43279]]

purpose for which the transferor was created or organized. For purposes 
of the preceding sentence, a ruling or determination letter recognizing 
exemption may not be relied upon if there is a material change, 
inconsistent with exemption, in the character, the purpose, or the 
method of operation of the organization.
    (c) Certain transfers from trusts to which a partnership or foreign 
corporation has made a gratuitous transfer--(1) Generally treated as 
distribution from partnership or foreign corporation. Except as 
provided in paragraphs (c)(2) and (3) of this section, if a United 
States donee receives a gratuitous transfer (within the meaning of 
Sec. 1.671-2T(e)(2)) from a trust (or portion of a trust) to which a 
partnership or foreign corporation has made a gratuitous transfer, the 
United States donee must treat the transfer as a purported gift or 
bequest from the partnership or foreign corporation that is subject to 
the rules of paragraph (a) of this section (including the exceptions in 
paragraphs (b) and (f) of this section). This paragraph (c) applies 
without regard to who is treated as the grantor of the trust (or 
portion thereof) under Sec. 1.671-2T(e)(4).
    (2) Alternative rule. Except as provided in paragraph (c)(3) of 
this section, if the United States tax computed under the rules of 
paragraphs (a) and (c)(1) of this section does not exceed the United 
States tax that would be due if the United States donee treated the 
transfer as a distribution from the trust (or portion thereof), 
paragraph (c)(1) of this section does not apply and the United States 
donee must treat the transfer as a distribution from the trust (or 
portion thereof) that is subject to the rules of subparts A through D 
(section 641 and following), part I, subchapter J, chapter 1 of the 
Internal Revenue Code. For purposes of paragraph (f) of this section, 
the transfer is treated as a purported gift or bequest from the 
partnership or foreign corporation that made the gratuitous transfer to 
the trust (or portion thereof).
    (3) Exception. Neither paragraph (c)(1) of this section nor 
paragraph (c)(2) of this section applies to the extent the United 
States donee can demonstrate to the satisfaction of the Commissioner 
that the transfer represents an amount that is, or has been, taken into 
account for United States tax purposes by a United States citizen or 
resident or a domestic corporation. A transfer will be deemed to be 
made first out of amounts that have not been taken into account for 
United States tax purposes by a United States citizen or resident or a 
domestic corporation, unless the United States donee can demonstrate to 
the satisfaction of the Commissioner that another ordering rule is more 
appropriate.
    (d) Definition of purported gift or bequest--(1) In general. 
Subject to the provisions of paragraphs (d)(2) and (3) of this section, 
a purported gift or bequest for purposes of this section is any 
transfer of property by a partnership or foreign corporation other than 
a transfer for fair market value (within the meaning of Sec. 1.671-
2T(e)(2)(ii)) to a person who is not a partner in the partnership or a 
shareholder of the foreign corporation (or to a person who is a partner 
in the partnership or a shareholder of a foreign corporation, if the 
amount transferred is inconsistent with the partner's interest in the 
partnership or the shareholder's interest in the corporation, as the 
case may be). For purposes of this section, the term property includes 
cash.
    (2) Transfers for less than fair market value--(i) Excess treated 
as purported gift or bequest. Except as provided in paragraph 
(d)(2)(ii) of this section, if a transfer described in paragraph (d)(1) 
of this section is for less than fair market value, the excess of the 
fair market value of the property transferred over the value of the 
property received, services rendered, or the right to use property is 
treated as a purported gift or bequest.
    (ii) Exception for transfers to unrelated parties. No portion of a 
transfer described in paragraph (d)(1) of this section will be treated 
as a purported gift or bequest for purposes of this section if the 
United States donee can demonstrate to the satisfaction of the 
Commissioner that the United States donee is not related to a partner 
or shareholder of the transferor within the meaning of Sec. 1.643(h)-
1(e) or does not have another relationship with a partner or 
shareholder of the transferor that establishes a reasonable basis for 
concluding that the transferor would make a gratuitous transfer to the 
United States donee.
    (e) Prohibition against affirmative use of recharacterization by 
taxpayers. A taxpayer may not use the rules of this section if a 
principal purpose for using such rules is the avoidance of any tax 
imposed by the Internal Revenue Code. Thus, with respect to such 
taxpayer, the Commissioner may depart from the rules of this section 
and recharacterize (for all purposes of the Internal Revenue Code) the 
transfer in accordance with its form or its economic substance.
    (f) Transfers not in excess of $10,000. This section does not apply 
if, during the taxable year of the United States donee, the aggregate 
amount of purported gifts or bequests that is transferred to such 
United States donee directly or indirectly from all partnerships or 
foreign corporations that are related (within the meaning of section 
643(i)) does not exceed $10,000. The aggregate amount must include 
gifts or bequests from persons that the United States donee knows or 
has reason to know are related to the partnership or foreign 
corporation (within the meaning of section 643(i)).
    (g) Examples. The following examples illustrate the rules of this 
section. In each example, the amount that is transferred exceeds 
$10,000. The examples are as follows:

    Example 1. Distribution from foreign corporation. FC is a 
foreign corporation that is wholly owned by A, a nonresident alien 
who is resident in Country C. FC makes a gratuitous transfer of 
property directly to A's daughter, B, who is a resident alien. Under 
paragraph (a)(2) of this section, B generally must treat the 
transfer as a dividend from FC to the extent of FC's earnings and 
profits and as an amount received in excess of basis thereafter. If 
FC is a passive foreign investment company, B must treat the amount 
received as a distribution under section 1291. B will be treated as 
having the same holding period as A. However, under paragraph 
(b)(1)(ii) of this section, if B can establish to the satisfaction 
of the Commissioner that, for purposes of the tax laws of Country C, 
A treated (and reported, if applicable) the transfer as a 
distribution to himself and a subsequent gift to B, B may treat the 
transfer as a gift (provided B timely complied with the reporting 
requirements of section 6039F, if applicable).
    Example 2. Distribution of corpus from trust to which foreign 
corporation made gratuitous transfer. FC is a foreign corporation 
that is wholly owned by A, a nonresident alien who is resident in 
Country C. FC makes a gratuitous transfer to a foreign trust, FT, 
that has no other assets. FT immediately makes a gratuitous transfer 
in the same amount to A's daughter, B, who is a resident alien. 
Under paragraph (c)(1) of this section, B must treat the transfer as 
a transfer from FC that is subject to the rules of paragraph (a)(2) 
of this section. Under paragraph (a)(2) of this section, B must 
treat the transfer as a dividend from FC unless she can establish to 
the satisfaction of the Commissioner that, for purposes of the tax 
laws of Country C, A treated (and reported, if applicable) the 
transfer as a distribution to himself and a subsequent gift to B and 
that B timely complied with the reporting requirements of section 
6039F, if applicable. The alternative rule in paragraph (c)(2) of 
this section would not apply as long as the United States tax 
computed under the rules of paragraph (a)(2) of this section is 
equal to or greater than the United States tax that would be due if 
the transfer were treated as a distribution from FT.
    Example 3. Accumulation distribution from trust to which foreign 
corporation made gratuitous transfer. FC is a foreign corporation 
that is wholly owned by A, a nonresident alien. FC is not a passive 
foreign

[[Page 43280]]

investment company (as defined in section 1297). FC makes a 
gratuitous transfer of 100X to a foreign trust, FT, on January 1, 
2001. FT has no other assets on January 1, 2001. Several years 
later, FT makes a gratuitous transfer of 1000X to A's daughter, B, 
who is a United States resident. Assume that the section 668 
interest charge on accumulation distributions will apply if the 
transfer is treated as a distribution from FT. Under the alternative 
rule of paragraph (c)(2) of this section, B must treat the transfer 
as an accumulation distribution from FT, because the resulting 
United States tax liability is greater than the United States tax 
that would be due if the transfer were treated as a transfer from FC 
that is subject to the rules of paragraph (a) of this section.
    Example 4. Transfer from trust that is treated as owned by 
United States citizen. Assume the same facts as in Example 3, except 
that A is a United States citizen. Assume that A treats and reports 
the transfer to FT as a constructive distribution to himself, 
followed by a gratuitous transfer to FT, and that A is properly 
treated as the grantor of FT within the meaning of Sec. 1.671-2T(e). 
A is treated as the owner of FT under section 679 and, as required 
by section 671 and the regulations thereunder, A includes all of 
FT's items of income, deductions, and credit in computing his 
taxable income and credits. Neither paragraph (c)(1) nor paragraph 
(c)(2) of this section is applicable, because the exception in 
paragraph (c)(3) of this section applies.
    Example 5. Transfer for less than fair market value. FC is a 
foreign corporation that is wholly owned by A, a nonresident alien. 
On January 15, 2001, FC transfers property directly to A's daughter, 
B, a resident alien, in exchange for 90X. The Commissioner later 
determines that the fair market value of the property at the time of 
the transfer was 100X. Under paragraph (d)(2)(i) of this section, 
10X will be treated as a purported gift to B on January 15, 2001.

    (h) Effective date. The rules of this section are generally 
applicable to any transfer after August 10, 1999, by a partnership or 
foreign corporation, or by a trust to which a partnership or foreign 
corporation makes a gratuitous transfer after August 10, 1999.


1.672(f)-5   Special rules.

    (a) Transfers by certain beneficiaries to foreign grantor--(1) In 
general. If, but for section 672(f)(5), a foreign person would be 
treated as the owner of any portion of a trust, any United States 
beneficiary of the trust is treated as the grantor of a portion of the 
trust to the extent the United States beneficiary directly or 
indirectly made transfers of property to such foreign person (without 
regard to whether the United States beneficiary was a United States 
beneficiary at the time of any transfer) in excess of transfers to the 
United States beneficiary from the foreign person. The rule of this 
paragraph (a) does not apply to the extent the United States 
beneficiary can demonstrate to the satisfaction of the Commissioner 
that the transfer by the United States beneficiary to the foreign 
person was wholly unrelated to any transaction involving the trust. For 
purposes of this paragraph (a), the term property includes cash, and a 
transfer of property does not include a transfer that is not a 
gratuitous transfer (within the meaning of Sec. 1.671-2T(e)(2)). In 
addition, a gift is not taken into account to the extent such gift 
would not be characterized as a taxable gift under section 2503(b). For 
a definition of United States beneficiary, see section 679.
    (2) Examples. The following examples illustrate the rules of this 
section:

    Example 1. A, a nonresident alien, contributes property to FC, a 
foreign corporation that is wholly owned by A. FC creates a foreign 
trust, FT, for the benefit of A and A's children. FT is revocable by 
FC without the approval or consent of any other person. FC funds FT 
with the property received from A. A and A's family move to the 
United States. Under paragraph (a)(1) of this section, A is treated 
as a grantor of FT. (A may also be treated as an owner of FT under 
section 679(a)(4).)
    Example 2. B, a United States citizen, makes a gratuitous 
transfer of $1 million to B's uncle, C, a nonresident alien. C 
creates a foreign trust, FT, for the benefit of B and B's children. 
FT is revocable by C without the approval or consent of any other 
person. C funds FT with the property received from B. Under 
paragraph (a)(1) of this section, B is treated as a grantor of FT. 
(B also would be treated as an owner of FT as a result of section 
679.)

    (b) Entity characterization. Entities generally are characterized 
under United States tax principles for purposes of Secs. 1.672(f)-1 
through 1.672(f)-5. See Secs. 301.7701-1 through 301.7701-4 of this 
chapter. However, solely for purposes of Sec. 1.672(f)-4, a transferor 
that is a wholly owned business entity is treated as a corporation, 
separate from its single owner.
    (c) Effective date. The rules in paragraph (a) of this section are 
applicable to transfers to trusts on or after August 10, 1999. The 
rules in paragraph (b) of this section are applicable August 10, 1999.
John M. Dalrymple,
Acting Deputy Commissioner of Internal Revenue.

    Approved: July 23, 1999.
Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 99-19928 Filed 8-5-99; 2:09 pm]
BILLING CODE 4830-01-P