[Federal Register Volume 68, Number 8 (Monday, January 13, 2003)]
[Rules and Regulations]
[Pages 1534-1537]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-646]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9035]
RIN 1545-AX99


Constructive Transfers and Transfers of Property to a Third Party 
on Behalf of a Spouse

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations 
relating to the tax treatment of redemptions, during marriage or 
incident to divorce, of stock in a corporation owned by a spouse or 
former spouse.

DATES: Effective Date: These regulations are effective January 13, 
2003.
    Applicability Date: These regulations are applicable to redemptions 
of stock on or after January 13, 2003 that are pursuant to instruments 
in effect after January 13, 2003. These regulations are also applicable 
to redemptions before January 13, 2003 or that are pursuant to 
instruments in effect before January 13, 2003 if the spouses or former 
spouses execute a written agreement on or after August 3, 2001, that 
satisfies the requirements of Sec.  1.1041-2(c)(1) or (2).

FOR FURTHER INFORMATION CONTACT: Edward C. Schwartz at (202) 622-4960 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1751. Responses to this collection of information 
are required for certain taxpayers to redeem stock in a corporation and 
utilize the special rule in Sec.  1.1041-2(c) of these regulations.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent/recordkeeper varies from 
20 minutes to one hour, depending on individual circumstances, with an 
estimated average of 30 minutes.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On August 3, 2001, the IRS and Treasury Department published in the 
Federal Register a notice of proposed rulemaking under section 1041 
relating to certain redemptions, during marriage or incident to 
divorce, of stock in a corporation owned by a spouse or former spouse 
(REG-107151-00)(2001-2 C.B. 370)[66 FR 40659]). Written and electronic 
comments were solicited, and a public hearing was scheduled for 
December 14, 2001. Several comments were received and are discussed 
below. Because no requests to speak were timely received, the public 
hearing was cancelled. After consideration of all comments received, 
the proposed regulations under section 1041 are adopted as revised by 
this Treasury decision.

Explanation and Summary of Comments

1. Special Rules in Cases of Written Agreements Between the Spouses

    The proposed regulations provided generally that if a corporation 
redeemed stock owned by a transferor spouse and the redemption resulted 
in a constructive distribution to the nontransferor spouse under 
applicable tax law, then the redemption would be taxable to the 
nontransferor spouse as if the nontransferor spouse had actually 
received the redemption proceeds. The proposed regulations contained a 
special rule in Sec.  1.1041-2(c) allowing the spouses the option of 
treating the redemption as resulting in a constructive distribution to 
the nontransferor spouse, and therefore taxable to the nontransferor 
spouse, even if the redemption would not result in a constructive 
distribution to the nontransferor spouse under applicable tax law. The 
proposed regulations provided that the spouses could elect the special 
rule by providing in the divorce or separation instrument, or other 
written agreement, that the spouses must file their Federal income tax 
returns in a manner that reflects that the transferor spouse 
transferred the redeemed stock to the nontransferor spouse in exchange 
for the redemption proceeds and the corporation redeemed the stock from 
the nontransferor spouse in exchange for the redemption proceeds. The 
proposed regulations also provided that the special rule would be 
effective for written agreements executed on or after August 3, 2001, 
that met these requirements.
    Commentators expressed concern that the proposed regulations 
contained no provision addressing the situation where the redemption 
results in a constructive distribution to the nontransferor spouse 
under applicable tax law, but the spouses nevertheless would like to 
agree that the redemption will be treated as a redemption distribution 
to the transferor spouse. They suggested that the final regulations 
expand the special rule in Sec.  1.1041-2(c) to allow the spouses to 
agree in the divorce or separation instrument, or other valid written 
agreement, that the redemption will be taxable to the transferor spouse 
notwithstanding that the redemption might otherwise result in a 
constructive distribution to the nontransferor spouse under applicable 
tax law.
    The IRS and Treasury Department believe that this suggestion is 
consistent with the policy of section 1041 and its legislative history, 
which is to provide flexibility to spouses and former spouses 
concerning the structuring of their property transfers during marriage 
and incident to divorce. Accordingly, this suggestion has been adopted 
in Sec.  1.1041-2(c) of the final regulations. New Example 2 in Sec.  
1.1041-2(d) illustrates the application of this new special rule.
    The manner of electing the special rule also has been modified 
somewhat in the final regulations. Under the final regulations, the 
spouses can elect the special rule by expressly providing, in a divorce 
or separation instrument or other valid written agreement, that 
expressly supersedes any other instrument or agreement concerning the 
purchase, sale, redemption, or other disposition of the stock that is 
the subject of the redemption, their mutual intent concerning whether 
the redemption should be treated as a redemption distribution to the 
transferor spouse or to the nontransferor spouse. The IRS and Treasury 
Department will treat a divorce or separation instrument or other valid 
written agreement executed on or after August 3, 2001, and before May 
13, 2003 that meets the

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requirements of the special rule of the proposed regulations as also 
meeting the requirements of the special rule in paragraph (c)(2) of the 
final regulations.

2. Constructive Distribution Standard

    Some commentators also expressed concern that taxpayers and divorce 
practitioners may not be aware of the situations in which a redemption 
of stock owned by the transferor spouse could result in a constructive 
distribution to the nontransferor spouse under applicable tax law. They 
therefore suggested that the final regulations either provide that the 
redemption will be treated as a redemption distribution to the 
transferor spouse regardless of applicable tax law, unless the spouses 
provide otherwise in a written agreement and file their federal income 
tax returns accordingly, or provide specific definitions and examples 
of situations in which a redemption would result in a constructive 
distribution to the nontransferor spouse under applicable tax law.
    The IRS and Treasury Department continue to believe that the 
approach in the proposed regulations is appropriate. Under existing tax 
law, a redemption of stock owned by one shareholder may result in a 
constructive distribution to another shareholder if such nonredeeming 
shareholder has a primary and unconditional obligation to purchase the 
redeeming shareholder's stock. See Rev. Rul. 69-608 (1969-2 C.B. 42), 
Wall v. United States, 164 F.2d 462 (4th Cir. 1947), and Sullivan v. 
United States, 363 F.2d 724 (8th Cir. 1966). This ``primary and 
unconditional obligation'' standard applies to all redemptions, 
including those involving stock of closely held corporations by spouses 
or former spouses. A rule that provides that a redemption of stock 
owned by the transferor spouse will always be treated as a redemption 
distribution to the transferor spouse would be inconsistent with this 
established law. Furthermore, if taxpayers and divorce practitioners 
are uncertain about the application of the ``primary and unconditional 
obligation'' standard, they may take advantage of the special rules of 
Sec.  1.1041-2(c), which permit spouses to avoid any question of 
whether a redemption results in a constructive distribution to the 
nontransferor spouse under applicable tax law relating to the primary 
and unconditional obligation standard by providing in a written 
agreement which spouse will bear the tax consequences of the 
redemption.

3. Withdrawal of Sec.  1.1041-1T(c), Q&A-9

    Section 1.1041-1T(c), Q&A-9, of the temporary Income Tax 
Regulations provides that there are three situations in which a 
transfer of property to a third party on behalf of a spouse or former 
spouse will qualify under section 1041 (provided all other requirements 
of that section are met): (1) if such transfer is required by the 
divorce or separation instrument; (2) if the transfer is pursuant to a 
written request of the other spouse; and (3) where the transferor 
spouse receives a written consent or ratification from the 
nontransferor spouse. Under Q&A-9, a transfer of property made to a 
third party on behalf of a spouse is treated first as a deemed transfer 
of the property made directly to the nontransferor spouse in a transfer 
to which section 1041 applies, and then as a deemed transfer of the 
property from the nontransferor spouse to the third party in a 
transaction to which section 1041 does not apply.
    Two commentators recommended that Q&A-9 be withdrawn. They 
suggested that retaining that provision would lead to confusion since 
it would apply to all transfers of property other than stock 
redemptions while this final regulation would apply only to stock 
redemptions. Another commentator advocated replacing existing Q&A-9 
with a single standard applicable to all transfers of property to third 
parties under which the tax consequences of the transfer would follow 
the transfer's form unless the spouses agreed in writing otherwise.
    The ``on behalf of'' standard has not led to the same confusion and 
litigation outside the area of stock redemptions because, in such 
cases, it does not conflict with any other standard of tax law. See, 
e.g., Ingham v. United States, 167 F.3d 1240 (9th Cir. 1999). In 
addition, as discussed above, a single standard applicable to all 
transfers of property to third parties under which the tax consequences 
of the transfer would follow the transfer's form would be inconsistent 
with the primary and unconditional obligation standard applicable to 
stock redemptions under existing tax law. Consequently, the IRS and 
Treasury Department continue to believe that the final regulations 
should be limited to stock redemptions and that Q&A-9 should not be 
withdrawn.

4. Use of IRS Form To Designate Intent

    One commentator proposed that the final regulations include a 
requirement that the spouses or former spouses attach a form to their 
Federal income tax returns showing which spouse or former spouse has 
the tax consequences of the redemption. After careful consideration, 
the IRS and Treasury Department have concluded that requiring spouses, 
and particularly spouses who have divorced or are divorcing, to 
complete and file an additional form in order to obtain the result of 
the special rules would unnecessarily increase the administrative 
burden on taxpayers and on the IRS. The divorce or separation 
instrument, or other valid written agreement of the spouses, provides 
adequate evidence of the spouses' intent regarding which spouse has the 
tax consequences of the redemption.

5. Legal Guardians and/or Executors of Estates of Spouses

    One commentator suggested that the final regulations provide 
specific authority for a legal guardian of a spouse or former spouse or 
the executor of a spouse's or former spouse's estate to elect the 
application of one of the special rules of Sec.  1.1041-2(c). However, 
a legal guardian, custodian, or executor of an estate that has the 
general authority to act on behalf of a spouse or former spouse (or his 
or her estate) for federal income tax purposes needs no additional or 
special authority to elect one of the special rules under Sec.  1.1041-
2(c). Accordingly, this suggestion has not been adopted.

6. Other Changes

    In an effort to improve the clarity of the final regulations, the 
order of the two paragraphs in Sec.  1.1041-2(a) has been reversed and 
conforming changes have been made in the remainder of the final 
regulations. Also, the final regulations remove the provision of the 
proposed regulations that would have limited their application to 
transactions in which both spouses or former spouses own stock 
immediately before or after the redemption. On further reflection, the 
IRS and Treasury Department believe it is appropriate to apply the 
regulations to all stock redemptions, regardless of whether both 
spouses own stock of the corporation before or after the redemption.

7. Effective Date

    One comment was received suggesting that the effective date 
provision of the final regulations be changed to include all stock 
redemptions that were pending on the day the proposed regulations were 
issued (August 2, 2001) and to include all cases involving stock 
redemptions at issue on that date at any level of audit, review, 
appeal, or collection by the IRS or before the Tax Court or any other

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federal court. It was argued that this proposal would be consistent 
with the current state of the law and would resolve numerous cases 
involving taxpayers and the IRS. Adopting this suggestion would have 
the effect of making the application of the final regulations 
retroactive. Apart from the special rules of Sec.  1.1041-2(c), which 
are based upon the stated intent of the spouses, the IRS and Treasury 
do not believe it is appropriate to apply the final regulations 
retroactively. Therefore, the final regulations do not adopt this 
suggestion.

Special Analysis

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

Drafting Information

    The principal author of these regulations is Edward C. Schwartz of 
the Office of the Associate Chief Counsel (Income Tax and Accounting). 
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 602

    Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

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

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

    Par. 2. In Sec.  1.1041-1T, paragraph (c) is amended by adding a 
sentence at the end of A-9 to read as follows:


Sec.  1.1041-1T  Treatment of transfers of property between spouses or 
incident to divorce (temporary).

* * * * *
    (c) * * *
    A-9: * * * This A-9 shall not apply to transfers to which Sec.  
1.1041-2 applies.
* * * * *

    Par. 3. Section 1.1041-2 is added to read as follows:


Sec.  1.1041-2  Redemptions of stock.

    (a) In general--(1) Redemptions of stock not resulting in 
constructive distributions. Notwithstanding Q&A-9 of Sec.  1.1041-
1T(c), if a corporation redeems stock owned by a spouse or former 
spouse (transferor spouse), and the transferor spouse's receipt of 
property in respect of such redeemed stock is not treated, under 
applicable tax law, as resulting in a constructive distribution to the 
other spouse or former spouse (nontransferor spouse), then the form of 
the stock redemption shall be respected for Federal income tax 
purposes. Therefore, the transferor spouse will be treated as having 
received a distribution from the corporation in redemption of stock.
    (2) Redemptions of stock resulting in constructive distributions. 
Notwithstanding Q&A-9 of Sec.  1.1041-1T(c), if a corporation redeems 
stock owned by a transferor spouse, and the transferor spouse's receipt 
of property in respect of such redeemed stock is treated, under 
applicable tax law, as resulting in a constructive distribution to the 
nontransferor spouse, then the redeemed stock shall be deemed first to 
be transferred by the transferor spouse to the nontransferor spouse and 
then to be transferred by the nontransferor spouse to the redeeming 
corporation. Any property actually received by the transferor spouse 
from the redeeming corporation in respect of the redeemed stock shall 
be deemed first to be transferred by the corporation to the 
nontransferor spouse in redemption of such spouse's stock and then to 
be transferred by the nontransferor spouse to the transferor spouse.
    (b) Tax consequences--(1) Transfers described in paragraph (a)(1) 
of this section. Section 1041 will not apply to any of the transfers 
described in paragraph (a)(1) of this section. See section 302 for 
rules relating to the tax consequences of certain redemptions; 
redemptions characterized as distributions under section 302(d) will be 
subject to section 301 if received from a Subchapter C corporation or 
section 1368 if received from a Subchapter S corporation.
    (2) Transfers described in paragraph (a)(2) of this section. The 
tax consequences of each deemed transfer described in paragraph (a)(2) 
of this section are determined under applicable provisions of the 
Internal Revenue Code as if the spouses had actually made such 
transfers. Accordingly, section 1041 applies to any deemed transfer of 
the stock and redemption proceeds between the transferor spouse and the 
nontransferor spouse, provided the requirements of section 1041 are 
otherwise satisfied with respect to such deemed transfer. Section 1041, 
however, will not apply to any deemed transfer of stock by the 
nontransferor spouse to the redeeming corporation in exchange for the 
redemption proceeds. See section 302 for rules relating to the tax 
consequences of certain redemptions; redemptions characterized as 
distributions under section 302(d) will be subject to section 301 if 
received from a Subchapter C corporation or section 1368 if received 
from a Subchapter S corporation.
    (c) Special rules in case of agreements between spouses or former 
spouses-- (1) Transferor spouse taxable. Notwithstanding applicable tax 
law, a transferor spouse's receipt of property in respect of the 
redeemed stock shall be treated as a distribution to the transferor 
spouse in redemption of such stock for purposes of paragraph (a)(1) of 
this section, and shall not be treated as resulting in a constructive 
distribution to the nontransferor spouse for purposes of paragraph 
(a)(2) of this section, if a divorce or separation instrument, or a 
valid written agreement between the transferor spouse and the 
nontransferor spouse, expressly provides that--
    (i) Both spouses or former spouses intend for the redemption to be 
treated, for Federal income tax purposes, as a redemption distribution 
to the transferor spouse; and
    (ii) Such instrument or agreement supersedes any other instrument 
or agreement concerning the purchase, sale, redemption, or other 
disposition of the stock that is the subject of the redemption.
    (2) Nontransferor spouse taxable. Notwithstanding applicable tax 
law, a transferor spouse's receipt of property in respect of the 
redeemed stock shall be treated as resulting in a constructive 
distribution to the nontransferor spouse for purposes of paragraph 
(a)(2) of this section, and shall not be treated as a distribution to 
the transferor spouse in redemption of such stock for purposes of 
paragraph (a)(1) of this section, if a divorce or separation 
instrument, or a

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valid written agreement between the transferor spouse and the 
nontransferor spouse, expressly provides that--
    (i) Both spouses or former spouses intend for the redemption to be 
treated, for Federal income tax purposes, as resulting in a 
constructive distribution to the nontransferor spouse; and
    (ii) Such instrument or agreement supersedes any other instrument 
or agreement concerning the purchase, sale, redemption, or other 
disposition of the stock that is the subject of the redemption.
    (3) Execution of agreements. For purposes of this paragraph (c), a 
divorce or separation instrument must be effective, or a valid written 
agreement must be executed by both spouses or former spouses, prior to 
the date on which the transferor spouse (in the case of paragraph 
(c)(1) of this section) or the nontransferor spouse (in the case of 
paragraph (c)(2) of this section) files such spouse's first timely 
filed Federal income tax return for the year that includes the date of 
the stock redemption, but no later than the date such return is due 
(including extensions).
    (d) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1.  Corporation X has 100 shares outstanding. A and B 
each own 50 shares. A and B divorce. The divorce instrument requires 
B to purchase A's shares, and A to sell A's shares to B, in exchange 
for $100x. Corporation X redeems A's shares for $100x. Assume that, 
under applicable tax law, B has a primary and unconditional 
obligation to purchase A's stock, and therefore the stock redemption 
results in a constructive distribution to B. Also assume that the 
special rule of paragraph (c)(1) of this section does not apply. 
Accordingly, under paragraphs (a)(2) and (b)(2) of this section, A 
shall be treated as transferring A's stock of Corporation X to B in 
a transfer to which section 1041 applies (assuming the requirements 
of section 1041 are otherwise satisfied), B shall be treated as 
transferring the Corporation X stock B is deemed to have received 
from A to Corporation X in exchange for $100x in an exchange to 
which section 1041 does not apply and sections 302(d) and 301 apply, 
and B shall be treated as transferring the $100x to A in a transfer 
to which section 1041 applies.
    Example 2.  Assume the same facts as Example 1, except that the 
divorce instrument provides as follows: ``A and B agree that the 
redemption will be treated for Federal income tax purposes as a 
redemption distribution to A.'' The divorce instrument further 
provides that it ``supersedes all other instruments or agreements 
concerning the purchase, sale, redemption, or other disposition of 
the stock that is the subject of the redemption.'' By virtue of the 
special rule of paragraph (c)(1) of this section and under 
paragraphs (a)(1) and (b)(1) of this section, the tax consequences 
of the redemption shall be determined in accordance with its form as 
a redemption of A's shares by Corporation X and shall not be treated 
as resulting in a constructive distribution to B. See section 302.
    Example 3.  Assume the same facts as Example 1, except that the 
divorce instrument requires A to sell A's shares to Corporation X in 
exchange for a note. B guarantees Corporation X's payment of the 
note. Assume that, under applicable tax law, B does not have a 
primary and unconditional obligation to purchase A's stock, and 
therefore the stock redemption does not result in a constructive 
distribution to B. Also assume that the special rule of paragraph 
(c)(2) of this section does not apply. Accordingly, under paragraphs 
(a)(1) and (b)(1) of this section, the tax consequences of the 
redemption shall be determined in accordance with its form as a 
redemption of A's shares by Corporation X. See section 302.
    Example 4.  Assume the same facts as Example 3, except that the 
divorce instrument provides as follows: ``A and B agree the 
redemption shall be treated, for Federal income tax purposes, as 
resulting in a constructive distribution to B.'' The divorce 
instrument further provides that it ``supersedes any other 
instrument or agreement concerning the purchase, sale, redemption, 
or other disposition of the stock that is the subject of the 
redemption.'' By virtue of the special rule of paragraph (c)(2) of 
this section, the redemption is treated as resulting in a 
constructive distribution to B for purposes of paragraph (a)(2) of 
this section. Accordingly, under paragraphs (a)(2) and (b)(2) of 
this section, A shall be treated as transferring A's stock of 
Corporation X to B in a transfer to which section 1041 applies 
(assuming the requirements of section 1041 are otherwise satisfied), 
B shall be treated as transferring the Corporation X stock B is 
deemed to have received from A to Corporation X in exchange for a 
note in an exchange to which section 1041 does not apply and 
sections 302(d) and 301 apply, and B shall be treated as 
transferring the note to A in a transfer to which section 1041 
applies.

    (e) Effective date. Except as otherwise provided in this paragraph, 
this section is applicable to redemptions of stock on or after January 
13, 2003, except for redemptions of stock that are pursuant to 
instruments in effect before January 13, 2003. For redemptions of stock 
before January 13, 2003 and redemptions of stock that are pursuant to 
instruments in effect before January 13, 2003, see Sec.  1.1041-1T(c), 
A-9. However, these regulations will be applicable to redemptions 
described in the preceding sentence of this paragraph (e) if the 
spouses or former spouses execute a written agreement on or after 
August 3, 2001 that satisfies the requirements of one of the special 
rules in paragraph (c) of this section with respect to such redemption. 
A divorce or separation instrument or valid written agreement executed 
on or after August 3, 2001, and before May 13, 2003 that meets the 
requirements of the special rule in Regulations Project REG-107151-00 
published in 2001-2 C.B. 370 (see Sec.  601.601(d)(2) of this chapter) 
will be treated as also meeting the requirements of the special rule in 
paragraph (c)(2) of this section.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 4. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 5. In Sec.  602.101, paragraph (b) is amended by adding an 
entry in numerical order to the table to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
 
                                * * * * *
1.1041-2...................................................    1545-1751
 
                                * * * * *
------------------------------------------------------------------------


David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
    Approved: December 30, 2002.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-646 Filed 1-10-03; 8:45 am]
BILLING CODE 4830-01-P