[Federal Register Volume 64, Number 228 (Monday, November 29, 1999)]
[Proposed Rules]
[Pages 66591-66595]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-30505]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 301

[REG-110385-99]
RIN-1545-AX39


Changes in Entity Classification: Special Rule for Certain 
Foreign Eligible Entities

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations addressing certain 
transactions that occur within a specified period of time before or 
after a change in entity classification. The proposed regulations 
prevent, in limited circumstances, the use of changes in entity 
classification to alter a taxpayer's Federal tax consequences. Under 
these regulations, a change in classification by a foreign eligible 
entity that was originally classified as an association taxable as a 
corporation (and, but for this regulation, would be classified as an 
entity disregarded as an entity separate from its owner) will be 
invalidated in certain limited circumstances. This document also 
contains a notice of public hearing on these proposed regulations.

DATES: Written comments must be received by February 28, 2000. Requests 
to speak (with outlines of oral comments) at the public hearing 
scheduled for January 31, 2000, must be submitted by January 10, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-110385-99), room 
5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. In the alternative, submissions may be hand 
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R 
(REG-110385-99), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington, DC. Alternatively, taxpayers may 
submit comments electronically via the Internet by selecting the ``Tax 
Regs'' option of the IRS Home Page, or by submitting comments directly 
to the IRS Internet site at: http://www.irs.ustreas.gov/prod/tax__regs/
regslist.html. The public hearing will be held in room 2615, Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Mark D. 
Harris, (202) 622-3860 (not a toll-free number); concerning submissions 
and the hearing, LaNita VanDyke, (202) 622-7180 (not a toll-free 
number).

SUPPLEMENTARY INFORMATION:

Background

    This document proposes to amend the current Procedure and 
Administration Regulations (26 CFR Part 301) relating to the 
classification of entities for Federal tax purposes. On December 18, 
1996, the IRS and the Treasury Department published final regulations 
(61 FR 66584) relating to the classification of business organizations 
under section 7701. The regulations (the check-the-box regulations) 
replaced the increasingly formalistic entity classification rules with 
a simpler, elective regime. The new rules were

[[Page 66592]]

designed to ease administrative burdens for taxpayers and the 
government. They were not, however, intended to change the application 
of substantive Internal Revenue Code (Code) provisions.
    In the preamble to the check-the-box regulations, the IRS and 
Treasury expressed concern about potential improper uses of the check-
the-box regulations involving partnerships:

    [I]n light of the increased flexibility under an elective regime 
for the creation of organizations classified as partnerships, 
Treasury and the IRS will continue to monitor carefully the uses of 
partnerships in the international context and will take appropriate 
action when partnerships are used to achieve results that are 
inconsistent with the policies and rules of particular Code 
provisions or of U.S. tax treaties.

    On October 28, 1997, the IRS and Treasury issued a notice of 
proposed rulemaking (62 FR 55768) under section 7701. These regulations 
specify the tax consequences resulting from an election to change the 
Federal tax classification of an eligible entity (the conversion 
regulations). The conversion regulations also provide that the tax 
consequences of an elective change in the classification of an entity 
for Federal tax purposes are determined under all relevant provisions 
of the Code and general principles of tax law, including the step 
transaction doctrine. Those final regulations are issued elsewhere in 
this issue of the Federal Register.
    As indicated in the preamble to the check-the-box regulations, the 
IRS and Treasury have been monitoring the manner in which taxpayers 
have used the check-the-box regulations since their enactment. The 
focus has been to determine whether taxpayers use the regulations in a 
manner inconsistent with the application of any Code provisions, and, 
if so, what, if any, action is appropriate. The preamble to the check-
the-box regulations cited the use of partnerships as a primary concern. 
However, it has become apparent to the IRS and Treasury that taxpayers 
may attempt to use entities that are disregarded as entities separate 
from their owners (disregarded entities), in addition to partnerships, 
to achieve results, in relation to certain transactions, that are 
inconsistent with the policies and rules of particular Code sections or 
tax treaties. These regulations are intended to address inappropriate 
Federal tax consequences that would otherwise result from certain of 
these transactions under a number of international provisions of the 
Code. These provisions include the rules governing source of income 
under sections 861 through 865, foreign tax credit limitation 
categories under section 904, the disposition of ownership interests 
under Subpart F (sections 951 through 964), and outbound transfers 
under section 367 (in this last case, leading to a different result 
than that outlined in the example in the preamble to the section 367(a) 
regulations (63 FR 33550)).
    The IRS and Treasury considered several responses to these 
transactions and determined that a special rule completely revoking the 
entity's classification as a disregarded entity was the most equitable 
and administrable approach. Of the responses considered, the IRS and 
Treasury believe that this approach also gives the greatest certainty 
to all parties involved in the transactions covered by this rule.

Explanation of Provisions

    This special rule is limited in scope. It only applies to 
``extraordinary transactions'' (such as sales of a part or whole 
interest) that occur within a period commencing one day before and 
ending 12 months after the date that a foreign eligible entity changed 
its classification to disregarded entity status, provided that the 
entity had been classified as an association taxable as a corporation 
within the 12-month period prior to the extraordinary transaction. The 
rule also applies to certain ``shelf'' entities that might be used in 
an attempt to circumvent the 12-month rule. In these cases, the entity 
would not be treated as a disregarded entity, and instead would be 
classified as an association taxable as a corporation for all purposes. 
The regulations provide rules specifying from what date this 
classification as an association taxable as a corporation will be 
applicable. Examples of these provisions are included in the 
regulations.
    This special rule will not apply to an extraordinary transaction if 
a taxpayer establishes to the satisfaction of the Commissioner that the 
classification as a disregarded entity does not materially alter the 
Federal tax consequences of the extraordinary transaction.
    The IRS and Treasury do not intend that this regulation will 
invalidate an entity classification election in the absence of a 
separate extraordinary transaction, even though the deemed consequences 
of such election under the conversion regulations may constitute an 
extraordinary transaction. In the preamble to the conversion 
regulations, however, the IRS and Treasury requested comments on the 
appropriate tax consequences of an entity classification election made 
by a foreign eligible entity that is not relevant for Federal tax 
purposes (e.g., with respect to the basis of property or earnings and 
profits of the entity). No comments have been received. The IRS and 
Treasury continue to study and solicit comments on this important issue 
and are considering whether, in certain circumstances, the election, 
combined with another event whereby the entity becomes relevant, should 
be considered to be inappropriate and, therefore, invalid under these 
regulations.
    If an entity made a classification election pursuant to 
Sec. 301.7701-3(c) to be disregarded, and that election was considered 
a change in classification, that entity would normally be subject to 
the 60-month limitation on elections under Sec. 301.7701-3(c)(1)(iv). 
However, if that classification election under Sec. 301.7701-3(c) is 
invalid under this regulation, then the election to be a disregarded 
entity shall not constitute an election for all Federal tax purposes, 
including the limitation on elections under Sec. 301.7701-3(c)(1)(iv).
    These regulations do not prevent the Commissioner from applying all 
applicable common law doctrines to any extraordinary transaction to 
which this rule applies, in any administrative or judicial proceeding 
(and create no inference as to the treatment of such transactions 
occurring prior to the effective date of these regulations). 
Conversely, the Commissioner may also provide administrative relief 
from these regulations by published guidance.
    The IRS and Treasury will continue to monitor potentially improper 
uses of the check-the-box regulations involving partnerships and 
disregarded entities, and will take appropriate action when such uses 
achieve results that are inconsistent with the policies and rules of 
particular Code provisions or of U.S. tax treaties.
    This special rule does not apply to the transactions described in 
the proposed regulations on hybrid branch transactions published in the 
Federal Register on July 13, 1999 (64 FR 37727), issued pursuant to 
Notice 98-35 (1998-27 IRB 35). These proposed regulations apply only to 
dispositions of interests in disregarded entities in extraordinary 
transactions.
    The IRS and Treasury request comments with respect to the special 
rule contained herein. In particular, the IRS and Treasury request 
comments on the specific types of transactions which should be excluded 
from the application of the special rule. When this proposed regulation 
is finalized, the IRS and Treasury intend to issue guidance that will 
identify specific transactions that will be excluded from the 
application of this special rule.

[[Page 66593]]

Grandfathered Foreign Per Se Entities

    The check-the-box regulations allowed for certain corporations 
under Sec. 301.7701-2(b)(8)(i) to be treated as partnerships if certain 
conditions enumerated in Sec. 301.7701-2(d)(1) were satisfied. However, 
upon the occurrence of certain events, such an entity's ``grandfathered 
status'' could be terminated. See Sec. 301.7701-2(d)(3)(i). The IRS and 
Treasury are concerned that taxpayers have been trafficking in these 
types of entities. Accordingly, these proposed regulations would add a 
new provision to Sec. 301.7701-2(d)(3)(i) which terminates an entity's 
``grandfather status'' when one or more persons, who were not owners of 
the entity as of November 29, 1999, become owners of 50 percent or more 
of the interests in the entity.

Relevance

    The check-the-box regulations provide a special rule when the 
Federal tax classification of a foreign eligible entity is no longer 
relevant. The rule states that if the classification of a foreign 
eligible entity which was previously relevant for Federal tax purposes 
ceases to be relevant for sixty consecutive months, the entity's 
classification will initially be determined under the default 
classification when the classification of the foreign eligible entity 
again becomes relevant (hereinafter 60-month rule). Several 
practitioners have requested guidance on whether the act of filing an 
entity classification election (Form 8832, Entity Classification 
Election) causes an entity to be relevant for purposes of the 60-month 
rule. Practitioners also have requested clarification regarding whether 
a newly formed foreign eligible entity, that has never been relevant, 
is subject to the 60-month rule.
    These proposed regulations provide that if a foreign eligible 
entity files an entity classification election, it is considered 
relevant on the effective date of the election for purposes of the 60-
month rule. However, if the foreign eligible entity is otherwise not 
relevant within the meaning of Sec. 301.7701-3(d)(1)(i), then for 
purposes of applying the 60-month rule the entity will be considered to 
be not relevant on the day after the date the entity classification 
election was effective.
    The preamble to the conversion regulations stated that a foreign 
eligible entity that is not relevant has a Federal tax classification. 
The proposed regulations clarify that such an entity is subject to the 
60-month rule. However, the proposed regulations provide an exception 
for a foreign eligible entity that was never relevant (within the 
meaning of Sec. 301.7701-3(d)(1)) during its existence. Such entity's 
classification will initially be determined pursuant to the provisions 
of Sec. 301.7701-3(b)(2) when the entity first becomes relevant.

Proposed Effective Date

    Except as otherwise specified, these regulations are proposed to 
apply as of the date final regulations are published in the Federal 
Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It 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 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury request comments on the clarity of the 
proposed regulation and how it may be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for January 31, 2000, beginning 
at 10 a.m., in room 2615, Internal Revenue Building, 1111 Constitution 
Avenue NW., Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the Internal Revenue Building lobby more 
than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit timely written comments and an outline of the topics to be 
discussed and the time to be devoted to each topic by (preferably a 
signed original and eight (8) copies) January 10, 2000. However, 
comments not to be presented at the hearing must be submitted by 
February 28, 2000.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Mark D. Harris, Office 
of Associate Chief Counsel (International). However, other personnel 
from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 301 is proposed to be amended as follows:

PART 301--PROCEDURE AND ADMINISTRATION

    Par. 1. The authority citation for part 301 continues to read in 
part as follows:

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

    Par. 2. Section 301.7701-2 is amended by:
    1. Removing the language ``or'' at the end of paragraph 
(d)(3)(i)(B).
    2. Removing the period at the end of paragraph (d)(3)(i)(C) and 
adding ``; or'' in its place.
    3. Adding paragraph (d)(3)(i)(D).
    4. Adding a sentence at the end of paragraph (e).
    The additions read as follows:


Sec. 301.7701-2  Business entities; definitions.

* * * * *
    (d) * * *
    (3) * * *
    (i) * * *
    (D) The date any person or persons, who were not owners of the 
entity as of November 29, 1999, own in the aggregate a 50 percent or 
greater interest in the entity.
* * * * *
    (e) Effective date. * * * However, paragraph (d)(3)(i)(D) of this 
section applies on or after the date final regulations are published in 
the Federal Register.
    Par. 3. Section 301.7701-3 is amended as follows:
    1. The text of paragraph (d)(1) following the paragraph heading is

[[Page 66594]]

redesignated as paragraph (d)(1)(i), and a paragraph heading is added 
for paragraph (d)(1)(i).
    2. Paragraph (d)(1)(ii) is added.
    3. Paragraph (d)(2) is revised.
    4. Paragraphs (d)(3) and (d)(4) are added.
    5. Paragraph (h) is redesignated as paragraph (i).
    6. A new paragraph (h) is added.
    The revision and addition reads as follows:


Sec. 301.7701-3  Classification of certain business entities.

* * * * *
    (d) Special rules for foreign eligible entities--(1) Definition of 
relevance--(i) General rule. * * *
    (ii) Deemed relevance--(A) General rule. For purposes of this 
section, except as provided in paragraph (d)(1)(ii)(B) of this section, 
a foreign eligible entity that files Form 8832 (Entity Classification 
Election) shall be deemed to be relevant only on the date the entity 
classification election is effective.
    (B) Exception. If a foreign eligible entity is relevant within the 
meaning of paragraph (d)(1)(i) of this section, then the rule in 
paragraph (d)(1)(ii)(A) of this section shall not apply.
    (2) Entities that were never relevant. If a foreign eligible 
entity's Federal tax classification has never been relevant (as defined 
in paragraph (d)(1) of this section), then the entity's classification 
will initially be determined pursuant to the provisions of paragraph 
(b)(2) of this section when the entity first becomes relevant (as 
defined in paragraph (d)(1)(i) of this section).
    (3) Special rule when classification is no longer relevant. If the 
classification of a foreign eligible entity is not relevant for sixty 
consecutive months, the entity's classification will initially be 
determined under the default classification when the classification of 
the foreign eligible entity becomes relevant. The date that the 
classification of a foreign entity is not relevant is the date an event 
occurs that causes the classification to no longer be relevant, or, if 
no event occurs in a taxable year that causes the classification to be 
relevant, then the date is the first day of that taxable year.
    (4) Effective date. Paragraphs (d)(1)(ii), (d)(2), and (d)(3) of 
this section apply on or after the date final regulations are published 
in the Federal Register.
* * * * *
    (h) Special rule when foreign entities that are disregarded as 
entities separate from their owner are used in an extraordinary 
transaction--(1) General rule--(i) When an eligible entity becomes 
disregarded as an entity separate from its owner. Notwithstanding any 
other provision of this section, a foreign eligible entity classified 
as an entity that is disregarded as an entity separate from its owner, 
will instead be classified as an association taxable as a corporation, 
if--
    (A) A 10-percent or greater interest in the foreign eligible entity 
is sold, exchanged, transferred or otherwise disposed of in one or more 
transactions (collectively, extraordinary transactions) that occur (or 
are treated as occurring) in the period commencing one day before and 
ending 12 months after the effective date of that foreign eligible 
entity's change in classification to an entity that is disregarded as 
an entity separate from its owner; and
    (B) The foreign eligible entity was previously classified as an 
association taxable as a corporation at any time within the 12-month 
period prior to the date of the commencement of the extraordinary 
transaction.
    (ii) Period of reclassification. If paragraph (h)(1)(i) of this 
section applies, the foreign eligible entity shall be treated as an 
association taxable as a corporation (and no intervening Federal tax 
classification will be valid) from and including the date that the 
foreign eligible entity ceased to be classified as an association 
taxable as a corporation.
    (2) Shelf entities--(i) Acquisition of assets from another entity. 
A foreign eligible entity, classified as an entity that is disregarded 
as an entity separate from its owner, will instead be classified as an 
association taxable as a corporation, if--
    (A) It acquires the assets of one or more foreign business entities 
(which were classified as associations taxable as corporations at any 
time within the 12-month period prior to the date of the commencement 
of the extraordinary transaction) in a transaction or series of related 
transactions in which gain or loss is not recognized (for Federal tax 
purposes), in whole or in part (acquisition transaction);
    (B) After the acquisition transaction (or transactions), the 
acquired assets comprise more than 80 percent of the value of the 
assets of the entity that is disregarded as an entity separate from its 
owner; and
    (C) Such entity is subsequently involved in an extraordinary 
transaction within 12 months of the date on which the acquisition 
transaction (or the last of such transactions) is completed.
    (ii) Calculation of value of entities. For purposes of calculating 
the ratio of assets under paragraph (h)(2)(i)(B) of this section, cash 
and marketable securities of an entity shall not be included to the 
extent that the cash and marketable securities exceed the reasonable 
needs of that entity's business.
    (iii) Period of reclassification. If paragraph (h)(2)(i) of this 
section applies, the foreign eligible entity shall be treated as an 
association taxable as a corporation from and including the date of the 
acquisition transaction, or, if the acquisition transaction involves a 
series of related transactions, the date of the last of such 
transactions.
    (3) Exception. The rules in paragraphs (h)(1) and (2) of this 
section will not apply to an extraordinary transaction if a taxpayer 
establishes to the satisfaction of the Commissioner that the 
classification as an entity that is disregarded as an entity separate 
from its owner does not materially alter the Federal tax consequences 
of the extraordinary transaction. The Commissioner may also provide 
exceptions to paragraphs (h)(1) and (2) of this section by published 
guidance (see Sec. 601.601(d)(2) of this chapter).
    (4) Examples. The following examples illustrate the rules of this 
paragraph (h). These examples assume that all foreign entities (FC) are 
eligible entities that are classified as associations taxable as 
corporations, and all U.S. entities (P) are corporations, unless 
otherwise specified. The examples are as follows:

    Example 1. (i) Facts. P owns 100 percent of FC1. P plans to sell 
FC1. An entity classification election under paragraph (c) of this 
section is made for FC1 such that FC1 is now classified as an entity 
disregarded as an entity separate from its owner (P). P sells FC1 to 
an unrelated third party within 12 months of the effective date of 
the entity classification election.
    (ii) Result. The sale of FC1, an entity that is disregarded as 
an entity separate from its owner which was previously classified as 
an association taxable as a corporation, is an extraordinary 
transaction, and because it occurred within 12 months of the 
effective date of the entity classification election, it is subject 
to the rule of paragraph (h)(1) of this section. Under paragraph 
(h)(1) of this section, the entity classification election to treat 
FC1 as an entity that is disregarded as an entity separate from its 
owner is invalid, and FC1 remains classified as an association 
taxable as a corporation as if there had been no election to be 
disregarded as an entity separate from its owner. Therefore, P is 
taxed as if it sold the stock of FC1, and not the assets of FC1.
    Example 2. (i) Facts. The facts are the same as Example 1, 
except that an entity classification election is not made for FC1. P 
wishes to avoid the result in Example 1, and not be subject to 
paragraph (h)(1) of this section. P had formed FC2 two years before 
the date of the extraordinary transaction. At that time, P had 
elected for FC2 to be treated as an entity that is disregarded as an 
entity separate from P. Since that time, FC2 has

[[Page 66595]]

conducted no business activities and has held no assets. P causes 
FC1 to merge into FC2 (under foreign law), with FC2 surviving, in a 
transaction in which gain or loss is not recognized for Federal tax 
purposes. On the same day, P sells FC2 to an unrelated third party.
    (ii) Result. The sale of FC2 is an extraordinary transaction. 
Furthermore, despite the fact that FC2 was formed two years before 
the date of the extraordinary transaction, paragraph (h)(2) of this 
section treats FC2 as an association taxable as a corporation. This 
is because more than 80 percent of FC2's post-merger assets were 
acquired from FC1. Thus, the extraordinary transaction is subject to 
the rule of paragraph (h)(2) of this section, and has the same 
result as Example 1.

    (5) Effective date. This paragraph (h) applies on or after the date 
final regulations are published in the Federal Register.
* * * * *
C.O. Rossotti,
Commissioner of Internal Revenue.
[FR Doc. 99-30505 Filed 11-26-99; 8:45 am]
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