[Federal Register Volume 67, Number 148 (Thursday, August 1, 2002)]
[Rules and Regulations]
[Pages 49862-49864]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-19349]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[TD 9012]
RIN 1545-AX75


Clarification of Entity Classification Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final regulations under section 7701 
that address the Federal tax classification of a business entity wholly 
owned by a

[[Page 49863]]

foreign government and that also provide that a nonbank entity wholly 
owned by a foreign bank cannot be disregarded as an entity separate 
from its owner (disregarded entity) for purposes of applying the 
special rules applicable to banks under the Internal Revenue Code. This 
document also contains final regulations providing that a partnership 
can be a controlled commercial entity for purposes of section 
892(a)(2)(B) and reissues certain section 892 temporary regulations 
with references to the final regulations.

DATES: Effective Date: These regulations are effective August 1, 2002.
    Applicability Dates: The regulations that address the Federal tax 
classification of business entities wholly owned by a foreign 
government under Sec. 301.7701-2 apply on or after January 14, 2002, to 
such business entities regardless of any prior entity classification, 
and the regulations that address the definition of the term entity for 
purposes of section 892(a)(2)(B) apply on or after January 14, 2002. 
The regulations relating to a nonbank entity that is wholly owned by a 
foreign bank apply to taxable years beginning after January 12, 2001.

FOR FURTHER INFORMATION CONTACT: Camille B. Evans at (202) 622-3870 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR parts 1 and 301. On 
January 12, 2001, the IRS and the Treasury Department issued a notice 
of proposed rulemaking (REG-101739-00), published in the Federal 
Register (66 FR 2854), to amend the existing elective business entity 
classification regime under section 7701 known as the check-the-box 
regulations, and to amend the existing temporary rules providing for 
the income of entities owned by foreign governments as described under 
section 892. No public hearing was requested or held. Written comments 
responding to the notice of proposed rulemaking were received. After 
consideration of all the comments, the proposed regulations are adopted 
as revised by this Treasury decision. The revisions are discussed 
below.

Explanation and Summary of Comments

    On December 18, 1996, the IRS and Treasury published the elective 
Federal tax classification regime under section 7701 known as the 
check-the-box regulations, 61 FR 66584. On January 12, 2001, the IRS 
and Treasury issued a notice of proposed rulemaking (REG-101739-00) 
that proposed to amend the Procedure and Administration Regulations (26 
CFR Part 301) to address the Federal tax classification of an entity 
wholly owned by a foreign government (as defined in Sec. 1.892-2T) and 
to address the Federal tax treatment to a foreign bank of income and 
assets and liabilities of an otherwise disregarded nonbank entity that 
it owns. As noted in the preamble to the notice of proposed rulemaking, 
the purpose of the proposed regulations was to ensure parity between 
the treatment of entities wholly owned by State governments and 
entities wholly owned by foreign governments, as well as to ensure 
parity between the treatment of nonbank subsidiaries owned by U.S. 
banks and the treatment of nonbank subsidiaries owned by foreign banks 
engaged in a U.S. banking business. The January 12, 2001, notice of 
proposed rulemaking also proposed to provide that a partnership can be 
a controlled commercial entity under section 892.

A. Sec. 301.7701-2(b)(6)

    A commentator suggested that the rule in the proposed regulations 
that a business entity wholly owned by a foreign government (as defined 
in Sec. 1.892-2T) is a per se corporation should be limited to those 
entities directly owned by the foreign government. As indicated above, 
the proposed regulations were issued because the IRS and Treasury 
believe that it is appropriate to treat controlled entities owned by 
foreign governments similarly to controlled entities owned by State 
governments. The per se rule relating to controlled entities owned by 
State governments is not limited to those entities directly owned by a 
State government. Thus, except for minor changes to language, the final 
regulations retain the proposed rule that a business entity wholly 
owned by a foreign government, like a business entity wholly owned by a 
State government, will be treated as a per se corporation.

B. Sec. 301.7701-2(c)(2)(ii)

    Two comments were received on the proposed regulation that provides 
that foreign banks, like domestic banks, would be precluded from 
treating their wholly owned nonbank subsidiaries as disregarded 
entities for purposes of the special rules of the Internal Revenue Code 
(Code) applicable to banks. Both comments asked for guidance on the 
phrase ``special rules of the Internal Revenue Code applicable to 
banks'' and the circumstances under which the regulation would apply to 
entities owned by foreign banks.
    As noted above, the regulations are intended to ensure parity of 
treatment between domestic banks and foreign banks engaged in a U.S. 
trade or business by providing that neither domestic banks as defined 
in section 581 nor foreign banks as defined in section 585(a)(2)(B) 
(without regard to the second sentence thereof) may apply the special 
rules applicable to banks to their nonbank subsidiaries. A foreign bank 
is described in section 585(a)(2)(B) only when it is engaged in a U.S. 
trade or business that meets the requirements of section 581 but for 
the fact the bank is a foreign corporation. Accordingly, a foreign bank 
will be subject to the provisions of these final regulations only if 
the foreign bank is engaged in a U.S. trade or business that meets the 
requirements of section 581 but for the fact that the bank is a foreign 
corporation. The reference to ``special rules applicable to banks'' 
includes not only provisions of the Code but also regulations and other 
published guidance under the Code.
    One of these comments specifically requested clarification on how 
Sec. 301.7701-2(c)(2)(ii) would affect a foreign bank's treatment of 
its disregarded entity for purposes of applying the fixed ratio 
election in the interest allocation rules under Sec. 1.882-5(c)(4). 
Because under Sec. 1.882-5 a foreign bank that meets the definition of 
section 585(a)(2)(B) does not distinguish between its banking and 
nonbanking activities for purposes of taking assets, liabilities and 
interest expense into account in the interest allocation formula, the 
IRS and Treasury do not believe the regulations under Sec. 1.882-5 are 
appropriately considered ``special rules applicable to banks'' for 
purposes of the Sec. 301.7701-2(c)(2)(ii) regulations. Accordingly, the 
final regulations clarify that a foreign bank that is defined in 
section 585(a)(2)(B) is entitled to use the 93 percent fixed ratio 
under Sec. 1.882-5 for the assets, liabilities and interest expense of 
a nonbank subsidiary that otherwise is treated as a disregarded entity 
for federal income tax purposes. Similarly, in calculating the amount 
of excess interest that may be treated as interest expense paid or 
accrued on deposits under Sec. 1.884-4(a)(2)(iii), a foreign bank 
defined in section 585(a)(2)(B) is entitled to take into account its 
combined banking and nonbanking U.S. assets (as defined in Sec. 1.884-
1(d)), including the assets of a nonbank subsidiary that is otherwise 
treated as a disregarded entity for federal income tax purposes.
    A similar analysis applies to the rules under Secs. 1.864-4(c)(5), 
1.864-5, and 1.864-6, which relate to the

[[Page 49864]]

determination of the effectively connected income of a banking, 
financing or similar business. Because those rules apply to both 
section 585(a)(2)(B) banks and to foreign corporations that are not 
regulated as banks but otherwise engage in financial services 
activities (See Inverworld v. Commissioner, T.C. Memo. 1996-301, 
supplemented by T.C. Memo 1997-226), the final regulations clarify that 
these rules are not considered ``special rules applicable to banks.''

Effective Dates

    The regulations that address the Federal tax classification of 
business entities wholly owned by a foreign government under 
Sec. 301.7701-2 apply on or after January 14, 2002, to such business 
entities regardless of any prior entity classification, and the 
regulations that address the definition of the term entity for purposes 
of section 892(a)(2)(B) apply on or after January 14, 2002. The 
regulations relating to a nonbank entity that is wholly owned by a 
foreign bank apply to taxable years beginning after January 12, 2001.

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) and the Regulatory Flexibility Act (5 U.S.C. chapter 
6) do not apply to these regulations. Therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Code, the notice of proposed rulemaking preceding these regulations 
was submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small businesses.

Drafting Information

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

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

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

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 301 are amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for part 1 is amended by removing the 
entry for ``Sections 1.892-1T through 1.892-7T'' and adding the 
following entries in numerical order:

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

    Section 1.892-1T also issued under 26 U.S.C. 892(c).
    Section 1.892-2T also issued under 26 U.S.C. 892(c).
    Section 1.892-3T also issued under 26 U.S.C. 892(c).
    Section 1.892-4T also issued under 26 U.S.C. 892(c).
    Section 1.892-5 also issued under 26 U.S.C. 892(c).
    Section 1.892-5T also issued under 26 U.S.C. 892(c).
    Section 1.892-6T also issued under 26 U.S.C. 892(c).
    Section 1.892-7T also issued under 26 U.S.C. 892(c). * * *

    2. Section 1.892-5 is added to read as follows:


Sec. 1.892-5  Controlled commercial entity.

    (a) through (a)(2) [Reserved]. For further information, see 
Sec. 1.892-5T(a) through (a)(2).
    (3) For purposes of section 892(a)(2)(B), the term entity means and 
includes a corporation, a partnership, a trust (including a pension 
trust described in Sec. 1.892-2T(c)) and an estate.
    (4) Effective date. This section applies on or after January 14, 
2002. See Sec. 1.892-5T(a) for the rules that apply before January 14, 
2002.
    (b) through (d) [Reserved]. For further information, see 
Secs. 1.892-5T(b) through (d).

    3. Section 1.892-5T is amended by:
    1. Removing the concluding text immediately following paragraph 
(a)(2).
    2. Adding paragraph (a)(3).
    The addition reads as follows:


Sec. 1.892-5T  Controlled commercial entity (temporary regulations).

    (a) * * *
    (3) [Reserved]. For further information, see Sec. 1.892-5(a)(3).
* * * * *

PART 301--PROCEDURE AND ADMINISTRATION

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

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


    5. Section 301.7701-2 is amended by:
    1. Revising paragraphs (b)(6) and (c)(2)(ii).
    2. Revising the first sentence of paragraph (e).
    The revisions read as follows:


Sec. 301.7701-2  Business entities; definitions.

* * * * *
    (b) * * *
    (6) A business entity wholly owned by a State or any political 
subdivision thereof, or a business entity wholly owned by a foreign 
government or any other entity described in Sec. 1.892-2T;
* * * * *
    (c) * * *
    (2) * * *
    (ii) Special rule for certain business entities. If the single 
owner of a business entity is a bank (as defined in section 581, or, in 
the case of a foreign bank, as defined in section 585(a)(2)(B) without 
regard to the second sentence thereof), then the special rules 
applicable to banks under the Internal Revenue Code will continue to 
apply to the single owner as if the wholly owned entity were a separate 
entity. For this purpose, the special rules applicable to banks under 
the Internal Revenue Code do not include the rules under sections 
864(c), 882(c), and 884.
* * * * *
    (e) Effective date. Except as otherwise provided in this paragraph 
(e), the rules of this section apply as of January 1, 1997, except that 
paragraph (b)(6) applies on or after January 14, 2002, to a business 
entity wholly owned by a foreign government regardless of any prior 
entity classification, and paragraph (c)(2)(ii) of this section applies 
to taxable years beginning after January 12, 2001. * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: July 25, 2002.
Pamela F. Olson,
Acting Assistant Secretary of the Treasury.
[FR Doc. 02-19349 Filed 7-31-02; 8:45 am]
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