Internal Revenue Bulletin 1998-16 (PDF rendition): IRS Announcements

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.

INCOME TAX
T.D. 8765, page 11.
Final regulations under section 985 of the Code relate to ad-
justments required when a qualified business unit (QBU) that
used the profit and loss method of accounting (P&L) in a
post-1986 year begins to use the dollar approximate sepa-
rate transaction method of accounting (DASTM) and adjust-
ments required when a QBU that used DASTM begins using
P&L.
T.D. 8766, page 17.
REG–104062–97, page 20.
Final, temporary, and proposed regulations under section
1502 of the Code relate to limitations on the use of certain
tax credits and related attributes by corporations filing con-
solidated income tax returns. A public hearing on the pro-
posed regulations will be held on May 7, 1998.
T.D. 8767, page 4.
REG–104537–97, page 21.
Final, temporary, and proposed regulations under section
954 of the Code relate to the treatment under subpart F of
certain payments involving branches of a controlled foreign
corporation (CFC) that are treated as separate entities for
foreign tax purposes or partnerships in which CFCs are
partners. A public hearing on the proposed regulations will
be held on July 15, 1998.
EXEMPT ORGANIZATIONS
Announcement 98–29, page 48.
A list is given of organizations now classified as private foun-
dations.
ADMINISTRATIVE
REG–208299–90, page 26.
Proposed regulations under sections 482 and 864 of the
Code relate to rules for the allocation among controlled tax-
payers and sourcing of income, deductions, gains and
losses from a global dealing operation; rules applying these
allocation and sourcing rules to foreign currency transac-
tions and to foreign corporations engaged in a U.S. trade or
business; and rules concerning the mark-to-market treat-
ment resulting from hedging activities of a global dealing op-
eration. A public hearing will be held on July 9, 1998.
Internal Revenue
bbuulllleettiinn
Bulletin No. 1998–16
April 20, 1998
HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.
Department of the Treasury
Internal Revenue Service
Finding Lists begin on page 52.

Mission of the Service
The purpose of the Internal Revenue Service is to collect
the proper amount of tax revenue at the least cost; serve
the public by continually improving the quality of our prod-
ucts and services; and perform in a manner warranting
the highest degree of public confidence in our integrity, effi-
ciency, and fairness.
2
Statement of Principles
of Internal Revenue
Tax Administration
The function of the Internal Revenue Service is to adminis-
ter the Internal Revenue Code. Tax policy for raising revenue
is determined by Congress.
With this in mind, it is the duty of the Service to carry out that
policy by correctly applying the laws enacted by Congress;
to determine the reasonable meaning of various Code provi-
sions in light of the Congressional purpose in enacting them;
and to perform this work in a fair and impartial manner, with
neither a government nor a taxpayer point of view.
At the heart of administration is interpretation of the Code. It
is the responsibility of each person in the Service, charged
with the duty of interpreting the law, to try to find the true
meaning of the statutory provision and not to adopt a
strained construction in the belief that he or she is “protect-
ing the revenue.” The revenue is properly protected only
when we ascertain and apply the true meaning of the statute.
The Service also has the responsibility of applying and
administering the law in a reasonable, practical manner.
Issues should only be raised by examining officers when
they have merit, never arbitrarily or for trading purposes.
At the same time, the examining officer should never hesi-
tate to raise a meritorious issue. It is also important that
care be exercised not to raise an issue or to ask a court to
adopt a position inconsistent with an established Service
position.
Administration should be both reasonable and vigorous. It
should be conducted with as little delay as possible and
with great courtesy and considerateness. It should never
try to overreach, and should be reasonable within the
bounds of law and sound administration. It should, howev-
er, be vigorous in requiring compliance with law and it
should be relentless in its attack on unreal tax devices and
fraud.

The Internal Revenue Bulletin is the authoritative instrument
of the Commissioner of Internal Revenue for announcing offi-
cial rulings and procedures of the Internal Revenue Service
and for publishing Treasury Decisions, Executive Orders, Tax
Conventions, legislation, court decisions, and other items of
general interest. It is published weekly and may be obtained
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dated semiannually into Cumulative Bulletins, which are sold
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It is the policy of the Service to publish in the Bulletin all sub-
stantive rulings necessary to promote a uniform application
of the tax laws, including all rulings that supersede, revoke,
modify, or amend any of those previously published in the
Bulletin. All published rulings apply retroactively unless other-
wise indicated. Procedures relating solely to matters of in-
ternal management are not published; however, statements
of internal practices and procedures that affect the rights
and duties of taxpayers are published.
Revenue rulings represent the conclusions of the Service on
the application of the law to the pivotal facts stated in the
revenue ruling. In those based on positions taken in rulings
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identifying details and information of a confidential nature
are deleted to prevent unwarranted invasions of privacy and
to comply with statutory requirements.
Rulings and procedures reported in the Bulletin do not have
the force and effect of Treasury Department Regulations,
but they may be used as precedents. Unpublished rulings
will not be relied on, used, or cited as precedents by Service
personnel in the disposition of other cases. In applying pub-
lished rulings and procedures, the effect of subsequent leg-
islation, regulations, court decisions, rulings, and proce-
dures must be considered, and Service personnel and oth-
ers concerned are cautioned against reaching the same con-
clusions in other cases unless the facts and circumstances
are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—1986 Code.
This part includes rulings and decisions based on provisions
of the Internal Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows: Subpart A,
Tax Conventions, and Subpart B, Legislation and Related
Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to
these subjects are contained in the other Parts and Sub-
parts. Also included in this part are Bank Secrecy Act Admin-
istrative Rulings. Bank Secrecy Act Administrative Rulings
are issued by the Department of the Treasury’s Office of the
Assistant Secretary (Enforcement).
Part IV.—Items of General Interest.
With the exception of the Notice of Proposed Rulemaking
and the disbarment and suspension list included in this part,
none of these announcements are consolidated in the Cumu-
lative Bulletins.
The first Bulletin for each month includes a cumulative index
for the matters published during the preceding months.
These monthly indexes are cumulated on a semiannual basis
and are published in the first Bulletin of the succeeding semi-
annual period, respectively.
3
Introduction
The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

Section 954.—Foreign Base
Company Income
26 CFR 1.954–9T: Hybrid branches (temporary).
T.D. 8767
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 301
Guidance Under Subpart F
Relating to Partnerships and
Branches
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Temporary and final regula-
tions.
SUMMARY: This document contains
regulations relating to the treatment under
subpart F of certain payments involving
branches of a controlled foreign corpora-
tion (CFC) that are treated as separate en-
tities for foreign tax purposes or partner-
ships in which CFCs are partners. These
regulations are necessary to provide guid-
ance on transactions relating to such enti-
ties. These regulations will affect United
States shareholders of controlled foreign
corporations. The text of these temporary
regulations also serves as the text of the
proposed regulations published in
REG–104537–97, page 21 of this Bul-
letin.
DATES: Effective date: These regula-
tions are effective March 23, 1998.
Applicability date:For dates of applic-
ability see §§1.904–5T(o), 1.954–1T(c)-
(1)(i)(E), 1.954–2T(a)(5)(iii) and
(a)(6)(ii), 1.954–9T(d) and 301.7701–
3T(f) of these regulations.
FOR FURTHER INFORMATION CON-
TACT: Valerie Mark, (202) 622-3840
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
I.In general
In these temporary regulations and in
proposed regulations published in
REG–104537–97, the Treasury and IRS
set forth a framework for dealing with is-
sues posed by the use of certain entities
that are regarded as fiscally transparent
for purposes of U.S. tax law, with regard
to the application of subpart F of the In-
ternal Revenue Code.
Subpart F was enacted by Congress to
limit the deferral of U.S. taxation of cer-
tain income earned outside the United
States by foreign corporations controlled
by U.S. persons. Limited deferral was re-
tained after the enactment of subpart F to
protect the competitiveness of controlled
foreign corporations (CFCs) doing busi-
ness overseas. See S. Rep. No. 1881,
87th Cong., 2d Sess. 78–80 (1962). This
limited deferral furthers the objective of
allowing a CFC engaged in an active
business, and located in a foreign country
for appropriate economic reasons, to
compete in a similar tax environment with
non-U.S. owned corporations located in
the same country.
Conversely, one of the purposes of sub-
part F is to prevent CFCs from converting
active income that is not easily moveable
and is earned in a jurisdiction in which a
business is located for non-tax reasons,
into passive, easily moveable income that
is shifted to a lower tax jurisdiction pri-
marily for tax avoidance. Moreover,
when subpart F was first enacted it was
realized that related person transactions
can be easily manipulated to reduce both
United States and foreign taxes. Conse-
quently, in enacting subpart F, Congress
provided that transactions of CFCs that
involve related persons generally give rise
to subpart F income with certain enumer-
ated exceptions.
Hybrid branches, which, by definition,
are not regarded as fiscally transparent
under foreign law, are particularly well
suited to the type of tax avoidance de-
scribed above. In light of the recent pro-
liferation of hybrid branches, Treasury
and the IRS believe that it is appropriate
to consider the issues related to transac-
tions involving hybrid branches, or other
hybrid entities, under subpart F.
The use of partnerships that are fiscally
transparent for U.S. tax purposes raises
additional issues in the context of subpart
F that are similar to those raised in
connection with hybrid branches. Such
partnerships may or may not be fiscally
transparent under foreign law. (Other fis-
cally-transparent entities, such as grantor
trusts, will be the subject of guidance is-
sued in conjunction with the finalization
of regulations under section 672(f).)
The entity classification regulations of
§§301.7701–1 through 301.7701–3 (the
check-the-box regulations) make entity
classification generally elective, in part so
that taxpayers can choose a tax status that
is consistent with their business objec-
tives. This administrative provision was
not intended to change substantive law.
Particularly in the international area, the
ability to more easily achieve fiscal trans-
parency can lead to inappropriate results
under certain substantive international
provisions of the Code. Thus, the Trea-
sury and the IRS believe that it is neces-
sary to provide additional guidance re-
garding the use of hybrid entities in the
international context. See preamble to
TD 8697, 61 Fed. Reg. 66585 (December
18, 1996).
II. Hybrid Branches
As announced in Notice 98–11 (1998–
6 I.R.B. 13), the Treasury and the IRS un-
derstand that certain taxpayers are using
arrangements involving hybrid branches
to circumvent the purposes of subpart F
(sections 951 through 964 of the Code).
These arrangements generally involve the
use of deductible payments to reduce the
taxable income of a CFC under foreign
law, thereby reducing that CFC’s foreign
tax and, also under foreign law, the corre-
sponding creation in another entity of
low-taxed, passive income of the type to
which subpart F was intended to apply.
Because of the structure of these arrange-
ments, however, taxpayers take the posi-
tion that this income is not taxed under
subpart F. Treasury and the IRS have
concluded that use of these hybrid branch
arrangements is contrary to the policies
and rules of subpart F.
U.S. international tax policy seeks to
balance the objective of neutrality of taxa-
tion between domestic and foreign busi-
ness enterprises (seeking neither to en-
courage nor to discourage one over the
other), while keeping U.S. business com-
petitive. Subpart F strongly reflects and
enforces that balance, while the arrange-
ments described above involving hybrid
branches upset that balance.
April 20, 199841998–16 I.R.B.
Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Explanation of Provisions
Under these temporary regulations, hy-
brid branch payments, as defined in the
regulations, between a CFC and its hybrid
branch, or between hybrid branches of the
CFC may give rise to subpart F income.
When certain conditions are present, the
non-subpart F income of the CFC, in the
amount of the hybrid branch payment, is
recharacterized as subpart F income of the
CFC. Those conditions include that: the
hybrid branch payment reduces the for-
eign tax of the payor; the hybrid branch
payment would have been foreign per-
sonal holding company income if made
between separate CFCs; and there is a dis-
parity between the effective rate of tax on
the payment in the hands of the payee and
the hypothetical rate of tax that would
have applied if the income had been taxed
in the hands of the payor. Treasury and
the IRS are considering applying similar
principles with respect to the foreign base
company services income rules of section
954(e). Comments are requested on this
issue. Any regulations promulgated on
this issue will be prospective.
Policies underlying subpart F would
also be avoided in certain non-hybrid
branch transactions that do not reduce the
tax of the payor. Treasury and the IRS in-
vite comments on the extent to which
rules should be provided to address such
transactions. Any regulations promul-
gated on this issue will be prospective.
Comments are also requested regarding
the application of these rules to dividend
and other equity distributions.
The temporary regulations make clear
that the CFC and the hybrid branch, or the
hybrid branches, are treated as separate
corporations only to recharacterize non-
subpart F income as subpart F income in
the amount of the hybrid branch payment,
and to apply the tax disparity rule of
§1.954–9T(a)(5)(iv). For all other pur-
poses (e.g., for purposes of the earnings
and profits limitation of section 952), a
CFC and its hybrid branch, or hybrid
branches, are not treated as separate cor-
porations.
The temporary regulations provide that
the amount recharacterized as subpart F
income is the gross amount of the hybrid
branch payment limited by the amount of
the CFC’s earnings and profits attribut-
able to non-subpart F income. This
amount is the excess of current earnings
and profits over subpart F income, deter-
mined after the application of the rules of
sections 954(b) and 952(c) and before the
application of these temporary regula-
tions. To the extent that the full amount
required to be recharacterized under this
provision cannot be recharacterized be-
cause it exceeds earnings and profits at-
tributable to non-subpart F income, there
is no requirement to carry such amounts
back or forward to another year.
For purposes of determining the
amount of taxes deemed paid under sec-
tion 960, the amount of non-subpart F in-
come recharacterized as subpart F income
is treated as attributable to income in sep-
arate foreign tax credit baskets in propor-
tion to the ratio of non-subpart F income
in each basket to the total amount of non-
subpart F income of the CFC for the tax-
able year.
The temporary regulations provide
that, under certain circumstances, the
recharacterization rules will also apply to
a CFC’s proportionate share of any hybrid
branch payment made between a partner-
ship in which the CFC is a partner and a
hybrid branch of the partnership, or be-
tween hybrid branches of such a partner-
ship. When the partnership is treated as
fiscally transparent by the CFC’s taxing
jurisdiction, the recharacterization rules
are applied by treating the hybrid branch
payment as if it had been made directly
between the CFC and the hybrid branch,
or as though the hybrid branches of the
partnership had been hybrid branches of
the CFC, as applicable. If the partnership
is treated as a separate entity by the CFC’s
taxing jurisdiction, the recharacterization
rules are applied to the partnership as if it
were a CFC. Comments are requested on
whether the rule for such non-fiscally
transparent partnerships should be relaxed
in the case of small ownership interests.
The temporary regulations provide that
income will not be recharacterized unless
there is a disparity between the effective
rate at which the hybrid branch payment
is taxed to the payee and a hypothetical
tax rate that measures the tax savings to
the payor from the deductible payment.
This provision is similar to the rule in
§1.954–3(b), and adopts the same per-
centage tests as contained in that provi-
sion. The regulations also provide a spe-
cial high tax exception applicable to the
hybrid branch payment that is similar to
the one contained in section 954(b)(4).
Comments are invited on whether the
rules of §1.954–9T could cause inappro-
priate multiple recharacterizations where
the hybrid branch payments are made
through a series of related hybrid entities.
The temporary regulations provide that
if these provisions affect an entity that has
elected under §301.7701–3(c) to be
treated as an entity disregarded as sepa-
rate from its owner, such an entity may
elect to be classified as a corporation, pro-
vided it fulfills certain requirements,
notwithstanding the sixty-month limita-
tion in that section.
III. Related Provisions
These temporary regulations provide
rules, contained in §1.954–1T(c)(1)(i)(B),
to prevent expenses, including related
person interest expense which would nor-
mally be allocable under section
954(b)(5) to subpart F income of a CFC,
from being allocated to a payment from
which the expense arises. The allocation
limit applies: (i) to the extent such pay-
ment is included in the subpart F income
of the CFC; (ii) if the expense arises from
any payment by the CFC to a hybrid part-
nership in which the CFC is a partner; and
(iii) if the payment reduces foreign tax
and there is a significant disparity in tax
rates between the payor and payee juris-
dictions.
These temporary regulations also ad-
dress the application of the related person
exceptions to the foreign personal holding
company income rules in the context of
partnership distributive shares and trans-
actions involving hybrid branches. Under
section 954(c)(3), foreign personal hold-
ing company income does not include
certain interest, dividends, rents and roy-
alties received from related corporations.
These exceptions apply, in the case of in-
terest and dividends, when the related
corporate payor is organized in the coun-
try in which the CFC is organized and
uses a substantial part of its assets in a
trade or business in that country and, in
the case of rents and royalties, when the
rent or royalty payment is made for the
use or privilege of using property within
the CFC’s country of incorporation.
The rules regarding the application of
the related person exceptions with respect
to a CFC partner’s distributive share of
1998–16 I.R.B.5April 20, 1998

partnership income are part of the broader
set of rules addressing distributive share
issues in the context of subpart F con-
tained in the proposed regulations pub-
lished in REG–104537–97. Certain rules
relating to the related person exception
with respect to a CFC partner’s distribu-
tive share of partnership income, and cer-
tain rules relating to the related person ex-
ception with respect to hybrid branches,
however, are included in these temporary
regulations because they address a fact
pattern similar to the one to which the hy-
brid branch payment rules apply. No in-
ference is intended as to the treatment
under existing law of such arrangements
in relation to the related party exceptions.
Under these rules, if the partnership re-
ceives an item of income that reduces the
income tax of the payor, the related per-
son exceptions of section 954(c)(3) apply
to exclude the income from the foreign
personal holding company income of the
CFC partner only where: the exception
would have applied if the CFC earned the
income directly (testing relatedness and
country of incorporation at the CFC part-
ner level); and either the partnership is or-
ganized and operates in the CFC’s coun-
try of incorporation, the partnership is
treated as fiscally transparent in the
CFC’s countries of incorporation and op-
eration, or there is no significant disparity
between the effective rate of tax imposed
on the income and the rate of tax that
would be imposed on the income if
earned directly by the CFC partner.
The rules applying the related person
exceptions with respect to hybrid
branches address transactions illustrated
in the first example of Notice 98–11
(1998–6 I.R.B. 13). These rules apply to
payments by a CFC to a hybrid branch of
a related CFC. Under these rules, the re-
lated person exceptions will apply to ex-
clude the payments from the foreign per-
sonal holding company income of the
recipient CFC only if the payment would
have qualified for the exception if the hy-
brid branch had been a separate CFC in-
corporated in the jurisdiction in which the
payment is subject to tax (other than a
withholding tax).
IV. Effective Date.
These regulations are effective March
23, 1998. For dates of applicability see
§§1.904–5T(o), 1.954–1T(c)(1)(i)(E),
1.954–2T(a)(5)(iii) and (6)(iii), 1.954–
9T(d) and 301.7701–3T(f) of these regu-
lations.
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in Executive Order
12866. Therefore, a regulatory assess-
ment is not required. It has also been de-
termined that section 553(b) of the Ad-
ministrative Procedures Act (5 U.S.C.
chapter 5) does not apply to these regula-
tions and, because the regulation does 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 Internal
Revenue Code, these temporary regula-
tions will be submitted to the Chief Coun-
sel for Advocacy of the Small Business
Administration for comment on their im-
pact on small business.
Drafting Information
The principal author of these regula-
tions is Valerie Mark, of the Office of the
Associate Chief Counsel (International).
Other personnel from the IRS and Trea-
sury Department also participated in the
development of these regulations.
* * * * *
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 301
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
26 CFR part 1 continues to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. In §1.904–5, paragraph (o) is
amended by adding a sentence at the end
to read as follows:
§1.904–5 Look-through rules as applied
to controlled foreign corporations and
other entities.
* * * * *
(o) * * * Paragraph (k)(1) of this sec-
tion does not apply on or after March 23,
1998. For rules applicable on or after
March 23, 1998, see §1.904–5T(k)(1).
Par. 3. §1.904–5T is added to read as
follows:
§1.904–5T Look-through rules as
applied to controlled foreign
corporations and other entities
(temporary).
(a) through (j) [Reserved]. For further
guidance, see §1.904–5(a) through (j).
(k) Ordering rules—(1) In general.In-
come received or accrued by a related
person to which the look-through rules
apply is characterized before amounts in-
cluded from, or paid or distributed by, that
person and received or accrued by a re-
lated person. For purposes of determin-
ing the character of income received or
accrued by a person from a related person
if the payor or another related person also
receives or accrues income from the re-
cipient and the look-through rules apply
to the income in all cases, the rules of
paragraph (k)(2) of this section apply.
Notwithstanding any other provision of
this section, the principles of §1.954–
1T(c)(1)(i) will apply to any expense sub-
ject to that subparagraph.
(k)(2) through (n) [Reserved]. For fur-
ther guidance, see §1.904–5(k)(2) through
(n).
(o) Effective date.Section 1.904–
5T(k)(1) applies on or after March 23,
1998. For rules prior to March 23, 1998,
see §1.904–5(k)(1).
Par. 4. Section 1.954–0(b) is amended
by revising the paragraph heading and the
entry for §1.954–0(b) in the list to read as
follows:
§1.954–0 Introduction.
* * * * *
(b) Outline of §§1.954–0, 1.954–1 and
1.954–2.
§1.954–0 Introduction.
* * * * *
(b) Outline of §§1.954–0, 1.954–1, and
1.954–2.
* * * * *
Par. 5. Section 1.954–1 is amended by
adding a new paragraph (c)(1)(iv) to read
as follows:
§1.954–1 Foreign base company income.
* * * * *
April 20, 199861998–16 I.R.B.

(c) * * *
(1) * * *
(iv) Effective date.Paragraph (c)(1)(i)
of this section does not apply to all
amounts paid or accrued on or after
March 23, 1998, except for amounts paid
or accrued pursuant to arrangements en-
tered into before March 23, 1998, and not
substantially modified (including, for ex-
ample, by expansion of the arrangement
(whether by exercise of an option or oth-
erwise) such as by an increase in the
amount of or term of any borrowing, leas-
ing or licensing constituting the arrange-
ment, changes in direct or indirect control
of any entity that is a party to the arrange-
ment, or any similar measure which mate-
rially increases the tax benefit of the
arrangement) on or after March 23, 1998.
For rules applicable on or after March 23,
1998, see §1.954–1T(c)(1)(i).
Par. 6. Section 1.954–1T is added to
read as follows:
§1.954–1T Foreign base company
income (temporary).
(a) through (c)(1)(i) [Reserved]. For
further guidance, see §1.954–1(a) through
(c)(1).
(c)(1)(i) Deductions against gross for-
eign base company income—(A) In gen-
eral.[Reserved]. For further guidance,
see §1.954–1(c)(1)(i).
(B) Special rule for deductible pay-
ments to certain non-fiscally transparent
entities.Notwithstanding any other pro-
vision of this section, except as provided
in paragraph (c)(1)(i)(C) of this section,
an expense (including a distributive share
of any expense) that would otherwise be
allocable under section 954(b)(5) against
the subpart F income of a controlled for-
eign corporation shall not be allocated
against subpart F income of the controlled
foreign corporation resulting from the
payment giving rise to the expense if—
(1) Such expense arises from a pay-
ment between the controlled foreign cor-
poration and a partnership in which the
controlled foreign corporation is a partner
and the partnership is not regarded as fis-
cally transparent, as defined in §1.954–
9T(a)(7), by any country in which the
controlled foreign corporation does busi-
ness or has substantial assets; and
(2) The payment from which the ex-
pense arises would have met the foreign
tax reduction test of §1.954–9T(a)(3) and
the tax disparity test of §1.954–
9T(a)(5)(iv) if those provisions had been
applicable to the payment.
(C) Limitations.Paragraph (c)(1)(i)(B)
shall not apply to the extent that the con-
trolled foreign corporation partner has no
income against which to allocate the ex-
pense, other than its distributive share of a
payment described in paragraph (c)(1)-
(i)(B) of this section. Similarly, to the ex-
tent an expense described in paragraph
(c)(1)(i)(B) of this section exceeds the
controlled foreign corporation partner’s
distributive share of the payment from
which the expense arises, such excess
amount of the expense may reduce sub-
part F income (other than such payment)
to which it is properly allocable or appor-
tionable under section 954(b)(5).
(D) Example.The following example
illustrates the application of paragraph
(c)(1)(i)(B) and (C) of this section:
Example.CFC, a controlled foreign corporation
in Country A, is a 70 percent partner in partnership
P, located in Country B. Country A’s tax laws do not
classify P as a fiscally transparent entity. The rate of
tax in country B is 15 percent of the tax rate in coun-
try A. P loans $100 to CFC at a market rate of inter-
est. In year 1, CFC pays P $10 of interest on the
loan. The interest payment would have caused the
recharacterization rules of §1.954–9T to apply if the
payment were made between the entities described
in §1.954–9T(a)(2). CFC’s distributive share of P’s
interest income is $7, which is foreign personal
holding company income to CFC under section
954(c). Under paragraph (c)(1)(i)(B) of this section,
$7 of the $10 interest expense may not be allocated
against any of CFC’s subpart F income. However,
to the extent the remaining $3 of interest expense is
properly allocable to subpart F income of CFC other
than its distributive share of P’s interest income, this
expense may offset such other subpart F income.
(E) Effective date.Paragraph (c)(1)-
(i)(B), (C) and (D) of this section shall
apply to all amounts paid or accrued on or
after March 23, 1998, except for amounts
paid or accrued pursuant to arrangements
entered into before March 23, 1998, and
not substantially modified (including, for
example, by expansion of the arrange-
ment (whether by exercise of an option or
otherwise) such as by an increase in the
amount of or term of any borrowing, leas-
ing or licensing constituting the arrange-
ment, changes in direct or indirect control
of any entity that is a party to the arrange-
ment, or any similar measure which mate-
rially increases the tax benefit of the
arrangement) on or after March 23, 1998.
For rules applicable to amounts paid or
accrued pursuant to arrangements entered
into before March 23, 1998, see §1.954–1.
(c)(1)(ii) through (f) [Reserved]. For
further guidance, see §1.954–1(c)(1)(ii)
through (f).
Par. 7. Section 1.954–2T is added to
read as follows:
§1.954–2T Foreign personal holding
company income (temporary).
(a)(1) through (4) [Reserved]. For fur-
ther guidance, see §1.954–2(a) through (4).
(5) Special rules applicable to distribu-
tive share of partnership income—(i) Ap-
plication of related person exceptions
where payment reduces foreign tax of
payor.If a partnership receives an item of
income that reduced the foreign income
tax of the payor (determined under the
principles of §1.954–9T(a)(3)), to deter-
mine the extent to which a controlled for-
eign corporation’s distributive share of
such item of income is foreign personal
holding company income, the exceptions
contained in section 954(c)(3) shall apply
only if—
(A)(1) Any such exception would have
applied to exclude the income from for-
eign personal holding company income if
the controlled foreign corporation had
earned the income directly (determined
by testing, with reference to such con-
trolled foreign corporation, whether an
entity is a related person, within the
meaning of section 954(d)(3), or is orga-
nized under the laws of, or uses property
in, the foreign country in which the con-
trolled foreign corporation is created or
organized); and
(2) The distributive share of such in-
come is not in respect of a payment made
by the controlled foreign corporation to
the partnership; and
(B)(1) The partnership is created or or-
ganized, and uses a substantial part of its
assets in a trade or business in the country
under the laws of which the controlled
foreign corporation is created or orga-
nized (determined under the principles of
§1.954–2(b)(4));
(2) The partnership is regarded as fis-
cally transparent, as defined in §1.954–
9T(a)(7), by all countries under the laws
of which the controlled foreign corpora-
tion is created or organized or has sub-
stantial assets; or
(3) The income is taxed in the year
when earned at an effective rate of tax
1998–16 I.R.B.7April 20, 1998

(determined under the principles of
§1.954–1(d)(2)) that is not less than 90
percent of, and not more than five percent-
age points less than, the effective rate of
tax that would have applied to such in-
come under the laws of the country in
which the controlled foreign corporation is
created or organized if such income were
earned directly by the controlled foreign
corporation partner from local sources.
(ii) Certain other exceptions applicable
to foreign personal holding company in-
come. [Reserved].
(iii) Effective date.Paragraph (a)(5)(i)
of this section shall apply to all amounts
paid or accrued on or after March 23,
1998, except for amounts paid or accrued
pursuant to arrangements entered into be-
fore March 23, 1998, and not substan-
tially modified (including, for example,
by expansion of the arrangement (whether
by exercise of an option or otherwise)
such as by an increase in the amount of or
term of any borrowing, leasing or licens-
ing constituting the arrangement, changes
in direct or indirect control of any entity
that is a party to the arrangement, or any
similar measure which materially in-
creases the tax benefit of the arrange-
ment) on or after March 23, 1998.
(6) Special rules applicable to excep-
tions from foreign personal holding com-
pany income treatment in circumstances
involving hybrid branches—(i) In gen-
eral.In the case of a payment between a
controlled foreign corporation (or its hy-
brid branch, as defined in §1.954–9T(a)-
(6)) and the hybrid branch of a related
controlled foreign corporation, the excep-
tions contained in section 954(c)(3) shall
apply only if the payment would have
qualified for the exception if the payor
were a separate controlled foreign corpo-
ration created or organized in the jurisdic-
tion where foreign tax is reduced and the
payee were a separate controlled foreign
corporation created or organized under
the laws of the jurisdiction in which the
payment is subject to tax (other than a
withholding tax).
(ii) Exception where no tax reduction
or tax disparity.Paragraph (a)(6)(i) of
this section shall not apply unless the pay-
ment would have met the foreign tax re-
duction test of §1.954–9T(a)(3) and the
tax disparity test of §1.954–9T(a)(5)(iv) if
those provisions had been applicable to
the payment.
(iii) Effective date.The rules of this
section shall apply to all amounts paid or
accrued on or after January 16, 1998, ex-
cept for amounts paid or accrued pursuant
to arrangements entered into before Janu-
ary 16, 1998, and not substantially modi-
fied (including, for example, by expan-
sion of the arrangement (whether by
exercise of an option or otherwise) such
as by an increase in the amount of or term
of any borrowing, leasing or licensing
constituting the arrangement, changes in
direct or indirect control of any entity that
is a party to the arrangement, or any simi-
lar measure which materially increases
the tax benefit of the arrangement) on or
after January 16, 1998.
(b) through (h) [Reserved]. For further
guidance, see §1.954–2(b) through (h).
Par. 8. Section 1.954–9T is added to
read as follows:
§1.954–9T Hybrid branches
(temporary).
(a) Subpart F income arising from cer-
tain payments involving hybrid
branches—(1) Payment causing foreign
tax reduction gives rise to additional sub-
part F income.The non-subpart F in-
come of the controlled foreign corpora-
tion will be recharacterized as subpart F
income, to the extent provided in para-
graph (a)(5) of this section, if—
(i) A hybrid branch payment, as defined
in paragraph (a)(6) of this section, is
made between the entities described in
paragraph (a)(2) of this section;
(ii) The hybrid branch payment reduces
foreign tax, as determined under para-
graph (a)(3) of this section; and
(iii) The hybrid branch payment is
treated as falling within a category of for-
eign personal holding company income
under the rules of paragraph (a)(4) of this
section.
(2) Hybrid branch payment between
certain entities—(i) In general.Para-
graph (a)(1) of this section shall apply to
hybrid branch payments between—
(A) A controlled foreign corporation
and its hybrid branch;
(B) Hybrid branches of a controlled
foreign corporation;
(C) A partnership in which a controlled
foreign corporation is a partner (either di-
rectly or through one or more branches or
other partnerships) and a hybrid branch of
the partnership; or
(D) Hybrid branches of a partnership in
which a controlled foreign corporation is
a partner (either directly or through one or
more branches or other partnerships).
(ii) Hybrid branch payment involving
partnership—(A) Fiscally transparent
partnership.To the extent of the con-
trolled foreign corporation’s proportion-
ate share of a hybrid branch payment, the
rules of paragraphs (a)(3), (4) and (5) of
this section shall be applied by treating
the hybrid branch payment between the
partnership and the hybrid branch as if it
were made directly between the con-
trolled foreign corporation and the hybrid
branch, or as if the hybrid branches of the
partnership were hybrid branches of the
controlled foreign corporation, if the hy-
brid branch payment is made between—
(1) A fiscally transparent partnership in
which a controlled foreign corporation is
a partner (either directly or through one or
more branches or other fiscally transpar-
ent partnerships) and the partnership’s hy-
brid branch; or
(2) Hybrid branches of a fiscally trans-
parent partnership in which a controlled
foreign corporation is a partner (either di-
rectly or through one or more branches or
other fiscally transparent partnerships).
(B) Non-fiscally transparent partner-
ship.To the extent of the controlled for-
eign corporation’s proportionate share of
a hybrid branch payment, the rules of
paragraphs (a)(3) and (4) and (a)(5)(iv) of
this section shall be applied to the non-fis-
cally transparent partnership as if it were
the controlled foreign corporation, if the
hybrid branch payment is made be-
tween—
(1) A non-fiscally transparent partner-
ship in which a controlled foreign corpo-
ration is a partner (either directly or
through one or more branches or other
partnerships) and the partnership’s hybrid
branch; or
(2) Hybrid branches of a non-fiscally
transparent partnership in which a con-
trolled foreign corporation is a partner (ei-
ther directly or through one or more
branches or other partnerships).
(C) Examples.The following examples
illustrate the application of this paragraph
(a)(2)(ii).
Example 1. CFC, a controlled foreign corpora-
tion in Country A, is a 90 percent partner in partner-
ship P, which is treated as fiscally transparent under
the laws of Country A. P has a hybrid branch, BR,
April 20, 199881998–16 I.R.B.

in Country B. P makes an interest payment of $100
to BR. Under Country A law, CFC’s 90 percent
share of the payment reduces CFC’s Country A in-
come tax. Under paragraph (a)(2)(ii)(A) of this sec-
tion, the recharacterization rules of this section are
applied by treating the payment as if made by CFC
to BR. Ninety dollars of CFC’s non-subpart F in-
come, to the extent available, and subject to the
earnings and profits and tax rate limitations of
§1.954–9T(a)(5), is recharacterized as subpart F in-
come.
Example 2. CFC, a controlled foreign corpora-
tion in Country A, is a 90 percent partner in partner-
ship P, which is treated as fiscally transparent under
the laws of Country A. P has two branches in Coun-
try B, BR1 and BR2. BR1 is treated as fiscally
transparent under the laws of Country A. BR2 is a
hybrid branch. BR1 makes an interest payment of
$100 to BR2. Under paragraph (a)(2)(ii)(A) of this
section, the payment by BR1, the fiscally transpar-
ent branch, is treated as a payment by P, and the
deemed payment by P, a fiscally transparent partner-
ship, is treated as made by CFC. Under Country A
law, CFC’s 90 percent share of BR1’s payment re-
duces CFC’s Country A income tax. Ninety dollars
of CFC’s non-subpart F income, to the extent avail-
able, and subject to the earnings and profits and tax
rate limitations of §1.954–9T(a)(5), is recharacter-
ized as subpart F income.
(3) Application when payment reduces
foreign tax.For purposes of paragraph
(a)(1) of this section, a hybrid branch pay-
ment reduces foreign tax when the foreign
tax imposed on the income of the payor or
any owner of the payor is less than the for-
eign tax that would have been imposed on
such income had the hybrid branch pay-
ment not been made, or the hybrid branch
payment creates or increases a loss or
deficit or other tax attribute which may be
carried back or forward to reduce the for-
eign income tax of the payor or any owner
in another year (determined by taking into
account any refund of such tax made to
the payor, payee or any other person).
(4) Hybrid branch payment that is in-
cluded within a category of foreign per-
sonal holding company income—(i) In
general.For purposes of paragraph (a)(1)
of this section, whether the hybrid branch
payment is treated as income included
within a category of foreign personal
holding company income is determined
by treating a hybrid branch that is either
the payor or recipient of the hybrid branch
payment as a separate wholly-owned sub-
sidiary corporation of the controlled for-
eign corporation that is incorporated in
the jurisdiction under the laws of which
such hybrid branch is created, organized
for foreign law purposes, or has substan-
tial assets. Thus, the hybrid branch pay-
ment will be treated as included within a
category of foreign personal holding com-
pany income if, taking into account any
specific exceptions for that category, the
payment would be included within a cate-
gory of foreign personal holding company
income if the branch or branches were
treated as separately incorporated for U.S.
tax purposes.
(ii) Extent to which controlled foreign
corporation and hybrid branches treated
as separate entities.For purposes other
than the determination under paragraph
(a)(4)(i) of this section, a controlled for-
eign corporation and its hybrid branch, a
partnership and its hybrid branch, or hy-
brid branches shall not be treated as sepa-
rate entities. Thus, for example, if a con-
trolled foreign corporation, including all
of its hybrid branches, has an overall
deficit in earnings and profits to which
section 952(c) applies, the limitation of
such section on the amount includible in
the subpart F income of such corporation
will apply. Similarly, for purposes of ap-
plying the de minimis and full inclusion
rules of section 954(b)(3), a controlled
foreign corporation and its hybrid branch,
or hybrid branches shall not be treated as
separate corporations. Further, a hybrid
branch payment that would reduce for-
eign personal holding company income
under section 954(b)(5) if made between
two separate entities will not create an ex-
pense if made between a controlled for-
eign corporation and its hybrid branch, a
partnership and its hybrid branch, or hy-
brid branches.
(5) Recharacterization of income at-
tributable to current earnings and profits
as subpart F income—(i) General rule.
Non-subpart F income of a controlled for-
eign corporation in an amount equal to the
excess of earnings and profits of the con-
trolled foreign corporation for the taxable
year over subpart F income, as defined in
section 952(a), will be recharacterized as
subpart F income under paragraph (a)(1)
of this section only to the extent provided
under paragraphs (a)(5)(ii) through (vi) of
this section.
(ii) Subpart F income.For purposes of
determining the excess of current earn-
ings and profits over subpart F income
under paragraph (a)(1) of this section, the
amount of subpart F income is determined
before the application of the rules of this
section but after the application of the
rules of sections 952(c) and 954(b). Fur-
ther, such amount is determined by treat-
ing the controlled foreign corporation and
all of its hybrid branches as a single cor-
poration.
(iii) Recharacterization limited to gross
amount of hybrid branch payment—(A)
In general.The amount recharacterized
as subpart F income under paragraph
(a)(1) of this section is limited to the
amount of the hybrid branch payment.
(B) Exception for duplicative pay-
ments.[Reserved].
(iv) Tax disparity rule—(A) In general.
Paragraph (a)(1) of this section will apply
only if the hybrid branch payment falls
within the tax disparity rule. The hybrid
branch payment falls within the tax dis-
parity rule if it is taxed in the year when
earned at an effective rate of tax that is
less than 90 percent of, and at least 5 per-
centage points less than, the hypothetical
effective rate of tax imposed on the hy-
brid branch payment, as determined under
paragraph (a)(5)(iv)(B) of this section.
(B) Hypothetical effective rate of tax—
(1) In general.The hypothetical effective
rate of tax imposed on the hybrid branch
payment is—
(i) For the taxable year of the payor in
which the hybrid branch payment is
made, the amount of income taxes that
would have been paid or accrued by the
payor if the hybrid branch payment had
not been made, less the amount of income
taxes paid or accrued by the payor; di-
vided by
(ii) The amount of the hybrid branch
payment.
(2) Hypothetical effective rate of tax
when hybrid branch payment causes or
increases loss or deficit.If the hybrid
branch payment causes or increases a loss
or deficit of the payor for foreign tax pur-
poses, and such loss or deficit can be car-
ried forward or back, the hypothetical ef-
fective rate of tax imposed on the hybrid
branch payment is the effective rate of tax
that would be imposed on the taxable in-
come of the payor for the year in which
the foreign law payment is made if the
payor’s taxable income were equal to the
amount of the hybrid branch payment.
(C) Examples.The application of this
paragraph (a)(5)(iv) is illustrated by the
following examples.
Example 1. In 1998, CFC organized in Country
A had net income of $60 from manufacturing for
1998–16 I.R.B.9April 20, 1998

Country A tax purposes. It also had a branch (BR) in
Country B. BR is a hybrid entity under paragraph
(a)(1) of this section. CFC made a payment of $40
to BR, which was a hybrid branch payment under
paragraph (a)(6) of this section, and was treated by
CFC as a deductible payment for Country A tax pur-
poses. CFC paid $30 of Country A taxes in 1998. It
would have paid $50 of Country A taxes without the
deductible payment. Country A did not impose any
withholding tax on the $40 payment to BR. Country
B also did not impose a tax on the $40 received by
BR. Therefore, the effective rate of tax on that pay-
ment is 0%. Furthermore, the hypothetical effective
rate of tax on the $40 hybrid branch payment is 50%
($50-$30/$40). The effective rate of tax (0%) is less
than 90% of, and more than 5 percentage points less
than, this hypothetical rate of tax of 50%. As a re-
sult, the $40 hybrid branch payment falls within the
tax disparity rule of this paragraph (a)(5)(iv).
Example 2. Assume the same facts as in Example
1,except that CFC has a loss of $100 for the year for
Country A tax purposes. Under Country A law, CFC
can carry the loss forward for use in subsequent
years. CFC paid no Country A taxes in 1998. The
rate of tax in Country A is graduated from 20% to
50%. If the $40 hybrid branch payment were the
only item of taxable income of CFC, Country A
would have imposed tax at an effective rate of 30%.
The effective rate of tax (0%) is less than 90 percent
of, and more than 5 percentage points less than, the
hypothetical effective rate of tax (30%) imposed on
the hybrid branch payment. As a result, the $40 hy-
brid branch payment falls within the tax disparity
rule of this paragraph (a)(5)(iv).
Example 3.Assume the same facts as in Example
1,except that Country B imposes tax on the $40 hy-
brid payment to BR at an effective rate of 50%. The
effective rate of 50% is equal to the hypothetical ef-
fective rate of tax. As a result, the hybrid branch
payment does not fall within the tax disparity rule of
this paragraph (a)(5)(iv) and, thus, the recharacteri-
zation rules of paragraph (a)(1) of this section do not
apply. See also the special high tax exception of
paragraph (a)(5)(v) of this section.
(v) Special high tax exception—(A) In
general.Paragraph (a)(1) of this section
shall not apply if the non-subpart F income
recharacterized as subpart F income under
this section was subject to foreign income
taxes imposed by a foreign country or
countries at an effective rate that is greater
than 90 percent of the maximum rate of tax
specified in section 11 for the taxable year
of the controlled foreign corporation.
(B) Effective rate of tax.The effective
rate of tax imposed on the net amount of
the hybrid branch payment is determined
under the principles of §1.954–1(d)(2)
and (3). See paragraph (c) of this section
for the application of section 960 to
amounts recharacterized as subpart F in-
come under this section.
(vi) No carryback or carryforward of
amounts in excess of current year earn-
ings and profits limitation.To the extent
that some or all of the amount required to
be recharacterized under this section is
not recharacterized as subpart F income
because the hybrid branch payment ex-
ceeds the amount that can be recharacter-
ized, as determined under paragraph
(a)(5)(i) of this section, this excess shall
not be carried back or forward to another
year.
(6) Definitions.For purposes of this
section—
Entitymeans any person that is treated
by the United States or any jurisdiction as
other than an individual.
Hybrid branchmeans an entity that—
(i) Has a single owner (including own-
ership through branches) that is either a
controlled foreign corporation or a part-
nership in which a controlled foreign cor-
poration is a partner (either directly or in-
directly through one or more branches or
partnerships);
(ii) Is treated as fiscally transparent by
the United States; and
(iii) Is treated as non-fiscally transpar-
ent by the country in which the payor en-
tity, any owner of a fiscally-transparent
payor entity, the controlled foreign corpo-
ration, or any intermediary partnership is
created, organized or has substantial as-
sets.
Hybrid branch paymentmeans the
gross amount of any payment (including
any accrual) which, under the tax laws of
any foreign jurisdiction to which the
payor is subject, is regarded as a payment
between two separate entities but which,
under U.S. income tax principles, is not
income to the recipient because it is be-
tween two parts of a single entity.
(7) Fiscally transparent and non-fis-
cally transparent.For purposes of this
section an entity shall be treated as fis-
cally transparent with respect to an inter-
est holder of the entity, if such interest
holder is required, under the laws of any
jurisdiction to which it is subject, to take
into account separately, on a current basis,
such interest holder’s share of all items
which, if separately taken into account by
such interest holder, would result in an in-
come tax liability for the interest holder in
such jurisdiction different from that
which would result if the interest holder
did not take the share of such items into
account separately. A non-fiscally trans-
parent entity is an entity that is not fis-
cally transparent under this paragraph
(a)(7).
(b) Election to change classification—
(1) In general.If a hybrid branch subject
to the provisions of paragraph (a) of this
section is an entity that has made an elec-
tion under §301.7701–3(c)(1) of this chap-
ter to be disregarded as an entity separate
from its owner, such entity may elect to
change its classification to that of an asso-
ciation taxable as a corporation, under the
procedures described in §301.7701–3(c) of
this chapter, without regard to the limita-
tion of §301.7701–3T(c)(1)(iv) of this
chapter, but only if such election is made
on or before the last day of the first taxable
year beginning on or after January 1, 1998.
An election made pursuant to this para-
graph (b)(1) is effective as of the first day
of such taxable year. The 75 day limitation
on retroactivity in §301.7701–3(c)(1)(iii)
of this chapter does not apply.
(2) Limitation.An entity can elect to
change its classification under the provi-
sions of this paragraph only one time.
(c) Application of section 960.For pur-
poses of determining the amount of taxes
deemed paid under section 960, the
amount of non-subpart F income rechar-
acterized as subpart F income under this
section shall be treated as attributable to
income in separate categories, as defined
in §1.904–5(a)(1), in proportion to the
ratio of non-subpart F income in each
such category to the total amount of non-
subpart F income of the controlled foreign
corporation for the taxable year.
(d) Effective dates—(1) Hybrid
branches of controlled foreign corpora-
tions.With respect to hybrid branch pay-
ments described in paragraph (a)(2)(i)(A)
and (B) of this section, the rules of this
section shall apply to all amounts paid or
accrued on or after January 16, 1998, ex-
cept for amounts paid or accrued pursuant
to arrangements entered into before Janu-
ary 16, 1998, and not substantially modi-
fied (including, for example, by expan-
sion of the arrangement (whether by
exercise of an option or otherwise) such
as by an increase in the amount of or term
of any borrowing, leasing or licensing
constituting the arrangement, changes in
direct or indirect control of any entity that
is a party to the arrangement, or any simi-
lar measure which materially increases
the tax benefit of the arrangement) on or
after January 16, 1998.
April 20, 1998101998–16 I.R.B.

(2) Hybrid branches of partnerships in
which controlled foreign corporations are
partners. With respect to hybrid branch
payments described in paragraph (a)(2)-
(i)(C) and (D) of this section, the rules of
this section shall apply to all amounts
paid or accrued on or after March 23,
1998, except for amounts paid or accrued
pursuant to arrangements entered into be-
fore March 23, 1998, and not substan-
tially modified (including, for example,
by expansion of the arrangement (whether
by exercise of an option or otherwise)
such as by an increase in the amount of or
term of any borrowing, leasing or licens-
ing constituting the arrangement, changes
in direct or indirect control of any entity
that is a party to the arrangement, or any
similar measure which materially in-
creases the tax benefit of the arrange-
ment) on or after March 23, 1998.
PART 301—PROCEDURE AND
ADMINISTRATION
Par. 9. The authority citation for 26
CFR part 301 continue to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Par. 10. In §301.7701–3, paragraph
(f)(1) is amended by adding a sentence at
the end to read as follows:
§301.7701–3. Classification of certain
business entities.
* * * * *
(f)(1) * * * Paragraphs (a), (c)(1)(iv)
and (f) of this section do not apply on or
after March 23, 1998. For rules applica-
ble on or after March 23, 1998, see
§301.7701–3T(a), (c)(1)(iv) and (f).
Par. 11. Section 301.7701–3T is added
to read as follows:
§301.7701–3T Classification of certain
business entities (temporary).
(a) In general.A business entity that is
not classified as corporation under
§301.7701–2(b)(1), (3), (4), (5), (6), (7),
or (8) (an eligible entity) can elect its clas-
sification for federal tax purposes as pro-
vided in this section. An eligible entity
with at least two members can elect to be
classified as either an association (and
thus a corporation under §301.7701–
2(b)(2)) or a partnership, and an eligible
entity with a single owner can elect to be
classified as an association or to be disre-
garded as an entity separate from its
owner. Paragraph (b) of this section pro-
vides a default classification for an eligi-
ble entity that does not make an election.
Thus, elections are necessary only when
an eligible entity chooses to be classified
initially as other than the default classifi-
cation or when an eligible entity chooses
to change its classification. An entity
whose classification is determined under
the default classification retains that clas-
sification (regardless of any changes in
the members’ liability that occurs at any
time during the time that the entity’s clas-
sification is relevant as defined in para-
graph (d) of this section) until the entity
makes an election to change that classifi-
cation under paragraph (c)(1) of this sec-
tion. Paragraph (c) of this section pro-
vides rules for making express elections.
Paragraph (d) provides special rules for
foreign eligible entities. Paragraph (e) of
this section provides special rules for
classifying entities resulting from partner-
ship terminations and divisions under sec-
tion 708(b). Paragraph (f) of this section
sets forth the effective date of this section
and a special rule relating to prior periods.
An entity that has elected to be disre-
garded as an entity separate from its
owner may nevertheless be treated as a
corporation for the limited purposes of
§1.954–9T(a)(4)(i) of this chapter.
(b) through (c)(1)(iii) [Reserved]. For
further guidance, see §301.7701–3(b)
through (c)(1)(iii).
(c)(1)(iv) Limitation.If an eligible en-
tity makes an election under paragraph
(c)(1)(i) of this section to change its clas-
sification (other than an election made by
an existing entity to change its classifica-
tion as of the effective date of this sec-
tion), the entity cannot change its classifi-
cation by election again during the sixty
months succeeding the effective date of
the election. However, the Commissioner
may permit the entity to change its classi-
fication by election within the sixty
months if more than fifty percent of the
ownership interests in the entity as of the
effective date of the subsequent election
are owned by person that did not own any
interests in the entity on the filing date or
on the effective date of the entity’s prior
election. See §1.954–9T(b) of this chap-
ter, for circumstances under which certain
eligible entities may make an election to
change their classification within the
sixty-month period.
(c)(1)(v) through (e) [Reserved]. For
further guidance, see §301.7701–3(c)-
(1)(v) through (e).
(f) Effective date.Section 301.7701–
3T(a) and (c)(1)(iv) applies on or after
March 23, 1998. For rules prior to March
23, 1998, see §301.7701–3(a) and
(c)(1)(iv).
Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
Donald C. Lubick,
Assistant Secretary of
the Treasury.
(Filed by the Office of the Federal Register on
March 23, 1998, 12:58 p.m., and published in the
issue of the Federal Register for March 26, 1998, 63
F.R. 14613)
Section 985.—Functional
Currency
26 CFR 1.985–1: Functional currency.
T.D. 8765
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
Change From Dollar
Approximate Separate
Transactions Method of
Accounting (DASTM) to the
Profit and Loss Method of
Accounting/Change From the
Profit and Loss Method to
DASTM
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final Regulations.
SUMMARY: This document contains
final Income Tax Regulations relating to
adjustments required when a qualified
business unit (QBU) that used the profit
and loss method of accounting (P&L) in a
post-1986 year begins to use the dollar
approximate separate transaction method
of accounting (DASTM) and adjustments
required when a QBU that used DASTM
begins using P&L. The regulations pro-
vide rules for taxpayers to construct an
1998–16 I.R.B.11April 20, 1998

opening dollar balance sheet for the QBU
and require income adjustments in certain
cases.
DATES: These regulations are effective
April 6, 1998.
FOR FURTHER INFORMATION CON-
TACT: Howard Wiener at (202) 622-
3870 (not a toll-free number) of the office
of Chief Counsel (International) within
the Office of Chief Counsel, Internal Rev-
enue Service, 1111 Constitution Avenue,
NW, Washington, DC 20224.
SUPPLEMENTARY INFORMATION:
Background
On January 5, 1993 and July 25, 1994,
the IRS published proposed amendments
to §1.985–7 in the Federal Registerat 58
F.R. 300 (INTL–0045–92) and §1.985–1
in the Federal Registerat 59 F.R. 37733
(INTL–0066–92), respectively. No pub-
lic hearing was held and few comments
were received. After consideration of
these comments, the regulations are
adopted as a Treasury Decision with mod-
ifications as described below.
Explanation of Provisions
I. Proposed Rules for Changing From
P&L to DASTM (§1.985–7)
1. The Proposed Regulations
The proposed regulations under
§1.985–7 set forth transition rules for
QBUs changing from the profit and loss
method of accounting (P&L) to DASTM
in tax years after 1987. Section 1.985–6
provides the translation rules for QBUs
using DASTM in 1987. Generally, when
a QBU changes its functional currency,
two basic issues arise: (1) How should the
QBU translate its balance sheet accounts
into the new functional currency in a way
that preserves any unrecognized currency
gain or loss which accrued in the old
functional currency; and (2) whether in-
come adjustments need to be made to rec-
ognize any currency gain or loss which
accrued in the old functional currency that
cannot be preserved.
Section 1.985–5 provides rules that
generally apply when a QBU changes its
functional currency. Under §1.985–5 bal-
ance sheet accounts are translated using
the spot rate on the last day prior to the
taxable year of change. In addition,
§1.985–5 generally requires recognition
of unrealized exchange gain or loss on in-
struments and other accounts that were
maintained in the functional currency to
which the QBU is changing.
The proposed regulations issued under
§1.985–7 were issued in response to tax-
payer comments that §1.985–5 resulted in
significant distortions when a QBU either
elected or was required to use DASTM.
Applying the spot rate on the last day
prior to the year in which the QBU begins
to use DASTM (the “taxable year of
change”) to translate fixed assets typically
results in a significant loss of basis in dol-
lar terms and does not take into account
certain income and expense distortions
that occur in the period immediately pre-
ceding the taxable year of change.
In response to taxpayers’ comments,
the proposed regulations provide for use
of the translation rules provided under
§1.985–3. These rules generally translate
fixed assets at the historical exchange rate
and other assets and liabilities at the cur-
rent exchange rate. To correct for distor-
tions that would result from applying his-
toric exchange rates for fixed assets while
applying the current year’s spot rate for
other balance sheet accounts, the pro-
posed regulations provide for income ad-
justments in the case of a controlled for-
eign corporation (CFC) and a branch that
reflect amounts that would have been in-
cluded in income under DASTM.
In the case of a CFC, the proposed regu-
lations provide for a shareholder level in-
come adjustment to the extent subpart F
income realized during the period after
1986 until the taxable year of change dif-
fers from subpart F income that would
have been realized if the CFC had used
DASTM throughout this period. In the
case of a branch, the regulations provide
that any difference between the branch’s
local currency equity translated into dol-
lars at the spot exchange rate on the last
day prior to the taxable year of change and
the taxpayer’s dollar basis pool on that day
is included in income over three taxable
years beginning with the taxable year of
change. For purposes of translating the
balance sheet of noncontrolled section 902
corporations, the proposed regulations
apply historic exchange rates for fixed as-
sets. In such case, no shareholder level in-
come adjustments are required.
Recognizing the administrative burden
of making income adjustments for all post-
1986 tax years in the case of a CFC, the
preamble to the proposed regulations re-
quested comments regarding three alterna-
tive transition rules as follows: (1) requir-
ing shareholder level adjustments for the
three-year base period used to determine
the hyperinflationary status of the local
currency, (in which case the general rule of
§1.985–5 would be applied in preparing
the balance sheet for the first year of the
base period); (2) treating a portion of re-
tained earnings as subpart F income based
on an average historical rate of subpart F
income to total earnings and profits, and
(3) using the spot rate on the last day prior
to the taxable year of change to translate
balance sheet items with special rules to
allow historical exchange rates to translate
fixed assets to the extent of unrealized ex-
change loss on paid-in capital.
2. Reasons for change
The IRS is concerned that the approach
of the proposed regulations could create a
significant administrative burden for
shareholders of CFCs. The administrative
burden results from the requirement that
shareholders recompute subpart F income
for all of the CFC’s post 1986 taxable
years. If the functional currency of a CFC
becomes hyperinflationary in a year that
is significantly distant from the CFC’s
first post-1986 taxable year, records sup-
porting the required recomputation may
be unavailable.
Further, the required recomputation
under the proposed regulations is gener-
ally inconsistent with the policy of sec-
tions 986 and 987 that the income of
branches with a functional currency dif-
ferent than that of the taxpayer and the
earnings and profits of foreign corpora-
tions be computed under a profit and loss
method, except in the case of hyperinfla-
tion. See S. Rep. No. 99–313, 99th
Cong., 2d Sess., 454 (1986). The recom-
putation under the proposed regulation
would put the CFC on DASTM for non-
hyperinflationary years. Accordingly, the
rules in the proposed regulations have
been modified as described below.
II. Final Regulations for Changing
From P&L to DASTM (§1.985–7)
1. General Rule
The approach employed in the final
April 20, 1998121998–16 I.R.B.

regulations has the general effect of treat-
ing a QBU as if it had applied §1.985–5
on the last day of the last taxable year
prior to the base period for determining
whether a currency is hyperinflationary
(transition date) and had applied DASTM
during the taxable years beginning after
the transition date until the taxable year of
change (look-back period). This ap-
proach addresses the problems of apply-
ing §1.985–5 in the taxable year of
change for purposes of translating fixed
assets by applying the historical exchange
rate to the extent fixed assets were ac-
quired during the look-back period. As-
sets acquired prior to the look-back period
are translated by applying the spot rate on
the transition date. This approach also
corrects distortions in income and ex-
pense (generally interest income and ex-
pense) that occur during the look-back pe-
riod.
The final regulations respond to tax-
payers’ comments and provide an appro-
priate rule for translating the adjusted
basis of fixed assets into dollars by apply-
ing an exchange rate in effect prior to the
hyperinflationary period. Moreover, this
method more accurately reflects Congres-
sional intent for QBUs to apply the profit
and loss method except in the case of hy-
perinflation. In addition, this approach
decreases the administrative burden of
changing to DASTM.
2. Foreign Corporations
In the case of a foreign corporation
which is either required or elects to use
DASTM, four basic corporate level ad-
justments are required as follows. (1) The
balance sheet is translated by treating the
corporation as if it had changed its func-
tional currency to the dollar for the first
post-transition date taxable year and had
applied the rules of §1.985–5(c) on the
transition date. Assets acquired and lia-
bilities incurred in the functional currency
during the look-back period are translated
by applying the rules of §1.985–3. (2)
The unrealized gain or loss on dollar de-
nominated section 988 transactions as de-
termined on the transition date are treated
as if recognized on that date (and actual
gain or loss recognized on dollar denomi-
nated section 988 transactions during the
look-back period is reversed). (3) The
dollar value of the pre-1987 E&P of the
corporation as stated on the transition date
in the functional currency is translated
into U.S. dollars at the spot rate in effect
on the transition date. (4) The dollar value
of the post-1986 E&P is computed by
translating the post-1986 E&P as stated
on the transition date in the functional
currency at the spot rate on such date and
adding to it the E&P for the years during
the look-back period as computed under
DASTM.
In the case of a CFC, there are three
shareholder level adjustments as follows:
(1) The U.S. shareholders must take into
income exchange gain or loss on the
deemed recognition of the section 988
transactions as determined at the corpo-
rate level to the extent such gain or loss is
subpart F income. (2) The U.S. sharehold-
ers must recognize foreign currency gain
or loss as computed under section 986(c)
as if all previously taxed earnings and
profits were distributed on the transition
date (however, any actual 986(c) gain or
loss recognized during the look-back pe-
riod is reversed). (3) The subpart F in-
come of the CFC is recomputed during
the look-back period under DASTM and
compared to the subpart F income as
computed under the P&L method. The
difference (positive or negative) is taken
into account in the taxable year of change
and spread over four years. Similar rules
apply to United States persons who have
made an election under section 1295 to
treat a passive foreign investment com-
pany as a qualified electing fund. In the
case of other foreign corporations, no
shareholder level income adjustments are
necessary.
4. Branches
In accord with the general approach ar-
ticulated above, the regulations treat a
branch changing to DASTM as applying
the principles of §1.985–5 on the transi-
tion date. Thus, the balance sheet is trans-
lated by treating the branch as if it had
changed its functional currency to the dol-
lar for the first post-transition date taxable
year and had applied the rules of §1.985–
5(c) on the transition date. Unrealized
gain or loss on dollar denominated section
988 transactions as stated on the transition
date are treated as if recognized on that
date (and any actual gain or loss realized
with respect to section 988 transactions
during the look-back period is reversed).
Further, the regulations require that the
taxpayer recognize gain or loss attribut-
able to the branch’s equity pool (as stated
on the transition date) under the principles
of section 987, computed as if the branch
terminated on the transition date. Such
gain or loss is reduced by any section 987
gain and increased by any section 987
loss that was recognized by the taxpayer
with respect to remittances during the
look-back period. Finally, branch income
shall be determined under §1.985–3 for
each look-back year and compared to the
amount that was taken into account for
each year. The sum of the difference
(positive or negative) is taken into ac-
count in the taxable year of change and
spread over four years.
III. Rules for Changing from DASTM to
P&L (§1.985–1)
Under the proposed regulation, a QBU
that has been required or had elected to
use DASTM must change functional cur-
rency to the currency of its economic en-
vironment in a year in which the currency
is no longer hyperinflationary pursuant to
the three-year test under §1.985–1(b).
These rules provide that when a taxpayer
changes from DASTM to the P&L
method of accounting, §1.985–5 shall
apply for purposes of translating a QBU’s
balance sheet and for making certain in-
come adjustments. Because these rules
generally do not create distortions and are
administrable, the final regulations adopt
these regulations as proposed.
IV. Other Changes
Various conforming changes have been
made to §§1.985–1 and 1.985–5 to ac-
count for the addition of §1.985–7. In ad-
dition, the definition of hyperinflation has
been liberalized to provide that for pur-
poses of determining whether a currency
is hyperinflationary for income tax pur-
poses, United States generally accepted
accounting principles will be accepted
provided that the determination is based
on criteria that is substantially similar to
the general rules provided in the regula-
tions, the method of determination is ap-
plied consistently from year to year, and
the same method is applied to all related
persons.
Special Analysis
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in EO 12866.
1998–16 I.R.B.13April 20, 1998

Therefore, a regulatory assessment is not
required. It also has been determined that
section 553(b) of the Administrative Pro-
cedure Act (5 U.S.C. chapter 5) does not
apply to these regulations, and because
the notice of proposed rulemaking pre-
ceding the regulations was issued prior to
March 29, 1996, the Regulatory Flexibil-
ity Act (5 U.S.C. chapter 6) does not
apply. Accordingly, a regulatory flexibil-
ity analysis is not required. Pursuant to
section 7805(f) of the Code, the notice of
proposed rulemaking preceding these reg-
ulations was submitted to the Small Busi-
ness Administration for comment on its
impact on small business.
Drafting Information
The principal author of these regula-
tions is Howard A. Wiener of the Office
of the Associate Chief Counsel (Interna-
tional). Other personnel from the IRS and
Treasury Department also participated in
their development.
* * * * *
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 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.985–1 is amended by:
1. Revising paragraph (b)(2)(ii)(C).
2. Adding a sentence to the end of
paragraph (b)(2)(ii)(D).
3. Adding paragraph (b)(2)(ii)(E).
The additions and revision reads as fol-
lows:
§1.985–1. Functional currency.
* * * * *
(b) * * *
(2) * * *
(ii) * * *
(C) Change in functional currency.If a
QBU is required to change its functional
currency to the dollar under paragraph
(b)(2)(ii)(A) of this section, or chooses or
is required to change its functional cur-
rency to the dollar for any open taxable
year (and all subsequent taxable years)
under §1.985–3(a)(2)(ii), the change is
considered to be made with the consent of
the Commissioner for purposes of
§1.985–4. A QBU changing functional
currency must make adjustments de-
scribed in §1.985–7 if the year of change
(as defined in §1.481–1(a)(1)) begins
after 1987, or the adjustments described
in §1.985–6 if the year of change begins
in 1987. No adjustments under section
481 are required solely because of a
change in functional currency described
in this paragraph (b)(2)(ii)(C).
(D) * * * In making the determination
whether a currency is hyperinflationary,
the determination for purposes of United
States generally accepted accounting
principles may be used for income tax
purposes provided the determination is
based on criteria that is substantially simi-
lar to the rules previously set forth in this
paragraph (b)(2)(ii)(D), the method of de-
termination is applied consistently from
year to year, and the same method is ap-
plied to all related persons as defined in
§1.985–3(e)(2)(vi).
(E) Change in functional currency
when currency ceases to be hyperinfla-
tionary–(1) In general.A QBU that has
been required to use the dollar as its func-
tional currency under paragraph (b)(2) of
this section, or has elected to use the dol-
lar as its functional currency under para-
graph (b)(2)(ii)(B)(2) of this section or
§1.985–2, must change its functional cur-
rency as of the first day of the first taxable
year that follows three consecutive tax-
able years in which the currency of its
economic environment, determined under
paragraph (c)(2) of this section, is not a
hyperinflationary currency. The func-
tional currency of the QBU for such year
shall be determined in accordance with
paragraph (c) of this section. For pur-
poses of §1.985–4, the change is consid-
ered to be made with the consent of the
Commissioner. See §1.985–5 for adjust-
ments that are required upon a change in
functional currency.
(2) Effective Date.This paragraph
(b)(2)(ii)(E) of this section applies to tax-
able years beginning after April 6, 1998.
Par. 3. Section 1.985–5(a) is amended
by adding the following sentence to the
end of the paragraph:
§1.985–5 Adjustments required upon
change in functional currency.
(a) * * *
However, a QBU that changes to the
dollar pursuant to §1.985–1(b)(2) after
1987 shall apply §1.985–7.
* * * * *
Par. 4. Section 1.985–7 is added as
follows:
1.985–7 Adjustments required in
connection with a change to DASTM.
(a) In general. If a QBU begins to use
the dollar approximate separate transac-
tions method of accounting set forth in
§1.985–3 (DASTM) in a taxable year be-
ginning after April 6, 1998, adjustments
shall be made as provided by this section.
For the rules with respect to foreign cor-
porations, see paragraph (b) of this sec-
tion. For the rules with respect to adjust-
ments to the income of United States
shareholders of controlled foreign corpo-
rations, see paragraph (c) of this section.
For the rules with respect to adjustments
relating to QBU branches, see paragraph
(d) of this section. For the effective date
of this section, see paragraph (e). For
purposes of applying this section, the
look-back period shall be the period be-
ginning with the first taxable year after
the transition date and ending on the last
day prior to the taxable year of change.
The term transition date means the later of
the last day of the last taxable year ending
before the base period as defined in
§1.985–1(b)(2)(ii)(D) or the last day of
the taxable year in which the QBU last
applied DASTM. The taxable year of
change shall mean the taxable year of
change as defined in §1.481–1(a)(1). The
application of this paragraph may be illus-
trated by the following examples:
Example 1.A calendar year QBU that has not
previously used DASTM operates in a country in
which the functional currency of the country is hy-
perinflationary as defined under §1.985–1(b)-
(2)(ii)(D) for the QBU’s 1999 tax year. The look-
back period is the period from January 1, 1996
through December 31, 1998, the transition date is
December 31, 1995, and the taxable year of change
is the taxable year beginning January 1, 1999.
Example 2.A QBU that has not previously used
DASTM with a taxable year ending June 30, oper-
ates in a country in which the functional currency of
the country is hyperinflationary for the QBU’s tax
year beginning July 1, 1999 as defined under
§1.985–1(b)(2)(ii)(D)(where the base period is the
thirty-six calendar months immediately preceding
the first day of the current calendar year 1999). The
look-back period is the period from July 1, 1995
through June 30, 1999, the transition date is June 30,
1995, and the taxable year of change is the taxable
year beginning July 1, 1999.
April 20, 1998141998–16 I.R.B.

(b) Adjustments to foreign corpora-
tions—(1) In general.In the case of a
foreign corporation, the corporation shall
make the adjustments set forth in para-
graphs (b)(2) through (4) of this section.
The adjustments shall be made on the first
day of the taxable year of change.
(2) Treatment of certain section 988
transactions—(i) Exchange gain or loss
from section 988 transactions unrealized
as of the transition date.A foreign corpo-
ration shall adjust earnings and profits by
the amount of any unrealized exchange
gain or loss that was attributable to a sec-
tion 988 transaction (as defined in sec-
tions 988(c)(1)(A), (B), and (C)) that was
denominated in terms of (or determined
by reference to) the dollar and was held
by the corporation on the transition date.
Such gain or loss shall be computed as if
recognized on the transition date and shall
be reduced by any gain and increased by
any loss recognized by the corporation
with respect to such transaction during the
look-back period. The amount of such
gain or loss shall be determined without
regard to the limitations of section 988(b)
(i.e., whether any gain or loss would be
realized on the transaction as a whole).
The character and source of such gain or
loss shall be determined under section
988. Proper adjustments shall be made to
account for gain or loss taken into account
by reason of this paragraph (b)(2). See
§1.985–5(f) Example 1, footnote 1.
(ii) Treatment of a section 988 transac-
tion entered into and terminated during
the look-back period. A foreign corpora-
tion shall reduce earnings and profits by
the amount of any gain, and increase
earnings and profits by the amount of any
loss, that was recognized with respect to
any dollar denominated section 988 trans-
actions entered into and terminated during
the look-back period.
(3) Opening balance sheet.The open-
ing balance sheet of a foreign corporation
for the taxable year of change shall be de-
termined as if the corporation had
changed its functional currency to the dol-
lar by applying § 1.985–5(c) on the transi-
tion date and had translated its assets and
liabilities under §1.985–3 during the
look-back period.
(4) Earnings and profits adjust-
ments—(i) Pre-1987 accumulated profits.
The foreign income taxes and accumu-
lated profits or deficits in accumulated
profits of a foreign corporation that are at-
tributable to taxable years beginning be-
fore January 1, 1987, as stated on the tran-
sition date, and that were maintained for
purposes of section 902 in the old func-
tional currency, shall be translated into
dollars at the spot rate in effect on the
transition date. The applicable accumu-
lated profits shall be reduced on a last-in,
first-out basis by the aggregate dollar
amount (translated from functional cur-
rency in accordance with the rules of sec-
tion 989(b)) attributable to earnings and
profits that were distributed (or treated as
distributed) during the look-back period
to the extent such amounts distributed ex-
ceed the earnings and profits calculated
under (b)(4)(ii) or (b)(4)(iii), as applica-
ble. See §1.902–1(b)(2)(ii). Once trans-
lated into dollars, these pre-1987 taxes
and accumulated profits or deficits in ac-
cumulated profits shall (absent a change
in functional currency) remain in dollars
for all federal income tax purposes.
(ii) Post-1986 undistributed earnings
of a CFC.In the case of a controlled for-
eign corporation (within the meaning of
section 957 or section 953(c)(1)(B))-
(CFC) or a foreign corporation subject to
the rules of §1.904–6(a)(2), the corpora-
tion’s post-1986 undistributed earnings in
each separate category as defined in
§1.904–5(a)(1) as of the first day of the
taxable year of change (and prior to ad-
justment under paragraph (c)(1) of this
section) shall equal the sum of—
(A) The corporation’s post-1986
undistributed earnings and profits (or
deficit in earnings and profits) in each
separate category as defined in §1.904–
5(a)(1) as stated on the transition date
translated into dollars at the spot rate in
effect on the transition date; and
(B) The sum of the earnings and prof-
its (or deficit in earnings and profits) in
each separate category determined under
§1.985–3 for each post-transition date
taxable year prior to the taxable year of
change.
Such amount shall be reduced by the ag-
gregate dollar amount (translated from
functional currency in accordance with
the rules of section 989(b)) attributable to
earnings and profits that were distributed
(or treated as distributed) during the look-
back period out of post-1986 earnings and
profits in such separate category. For pur-
poses of applying this paragraph
(b)(4)(ii)(B), the opening balance sheet
for calculating earnings and profits under
§1.985–3 for the first post-transition year
shall be translated into dollars pursuant to
§1.985–5(c).
(iii) Post-1986 undistributed earnings
of other foreign corporations.In the case
of a foreign corporation that is not a CFC
or subject to the rules of §1.904–6(a)(2),
the corporation’s post-1986 undistributed
earnings shall equal the sum of—
(A) The corporation’s post-1986
undistributed earnings (or deficit) on the
transition date translated into dollars at
the spot rate in effect on the transition
date; and
(B) The sum of the earnings and prof-
its (or deficit in earnings and profits) de-
termined under §1.985–3 for each post-
transition date taxable year (or such later
year determined under section 902(c)-
(3)(A)) prior to the taxable year of
change.
Such amount shall be reduced by the ag-
gregate dollar amount (translated from
functional currency in accordance with
the rules of section 989(b)) that was dis-
tributed (or treated as distributed) during
the look-back period out of post-1986
earnings and profits. For purposes of ap-
plying this paragraph (b)(4)(iii)(B), the
opening balance sheet for calculating
earnings and profits under §1.985-3 for
the first post-transition year shall be trans-
lated into dollars pursuant to §1.985–5(c).
(c) United States shareholders of con-
trolled foreign corporations—(1) In gen-
eral.A United States shareholder (within
the meaning of section 951(b) or section
953(c)(1)(B)) of a CFC that changes to
DASTM shall make the adjustments set
forth in paragraphs (c)(2) through (5) of
this section on the first day of the taxable
year of change. Adjustments under this
section shall be taken into account by the
shareholder (or such shareholder’s suc-
cessor in interest) ratably over four tax-
able years beginning with the taxable year
of change. Similar rules shall apply in de-
termining adjustments to income of
United States persons who have made an
election under section 1295 to treat a pas-
sive foreign investment company as a
qualified electing fund.
(2) Treatment under subpart F of in-
come recognized on section 988 transac-
tions.The character of amounts taken
into account under paragraph (b)(2) of
1998–16 I.R.B.15April 20, 1998

this section for purposes of sections 951
through 964, shall be determined on the
transition date and to the extent character-
ized as subpart F income shall be taken
into account in accordance with the rules
of paragraph (c)(1) of this section. Such
amounts shall retain their character for all
federal income tax purposes (including
sections 902, 959, 960, 961, 1248, and
6038).
(3) Recognition of foreign currency
gain or loss on previously taxed earnings
and profits on the transition date.Gain or
loss is recognized under section 986(c) as
if all previously taxed earnings and profits
as determined on the transition date, if
any, were distributed on such date. Such
gain or loss shall be reduced by any for-
eign currency gain and increased by any
foreign currency loss that was recognized
under section 986(c) with respect to dis-
tributions of previously taxed earnings
and profits during the look-back period.
Such amount shall be characterized in ac-
cordance with section 986(c) and taken
into account in accordance with the rules
of paragraph (c)(1) of this section.
(4) Subpart F income adjustment.
Subpart F income in a separate category
shall be determined under §1.985–3 for
each look-back year. For this purpose, the
opening DASTM balance sheet shall be
determined under §1.985–5. The sum of
the difference (positive or negative) be-
tween the amount computed pursuant to
§1.985–3 and amount that was included
in income for each year shall be taken into
account in the taxable year of change pur-
suant to paragraph (c)(1) of this section.
Such amounts shall retain their character
for all federal income tax purposes (in-
cluding sections 902, 959, 960, 961,
1248, and 6038). For rules applicable if
an adjustment under this section results in
a loss for the taxable year in a separate
category, see section 904(f) and the regu-
lations thereunder. The amount of previ-
ously taxed earnings and profits as deter-
mined under section 959(c)(2) shall be
adjusted (positively or negatively) by the
amount taken into account under this
paragraph (c)(4) as of the first day of the
taxable year of change.
(5) Foreign tax credit.A United States
shareholder of a CFC shall compute an
amount of foreign taxes deemed paid
under section 960 with respect to any pos-
itive adjustments determined under para-
graph (c) of this section. The amount of
foreign tax deemed paid shall be com-
puted with reference to the full amount of
the adjustment and to the post-1986
undistributed earnings determined under
paragraph (b)(4)(i) and (ii) of this section
and the post-1986 foreign income taxes of
the CFC on the first day of the taxable
year of change (i.e., without taking into
account earnings and taxes for the taxable
year of change.) For purposes of section
960, the associated taxes in each separate
category shall be allocated pro rata
among, and deemed paid in, the share-
holder’s taxable years in which the in-
come is taken into account. (No adjust-
ment to foreign taxes deemed paid in
prior years is required solely by reason of
a negative adjustment to income under
paragraph (c)(1) of this section.)
(d) QBU branches—(1) In general. In
the case of a QBU branch, the taxpayer
shall make the adjustments set forth in
paragraphs (d)(2) through (d)(4) of this
section. Adjustments under this section
shall be taken into account by the tax-
payer ratably over four taxable years be-
ginning with the taxable year of change.
(2) Treatment of certain section 988
transactions—(i) Exchange gain or loss
from section 988 transactions unrealized
as of the transition date. A QBU branch
shall adjust income by the amount of any
unrealized exchange gain or loss that was
attributable to a section 988 transaction
(as defined in sections 988(c)(1)(A), (B),
and (C)) that was denominated in terms of
(or determined by reference to) the dollar
and was held by the QBU branch on the
transition date. Such gain or loss shall be
computed as if recognized on the transi-
tion date and shall be reduced by any gain
and increased by any loss recognized by
the QBU branch with respect to such
transaction during the look-back period.
The amount of such gain or loss shall be
determined without regard to the limita-
tions of section 988(b) (i.e., whether any
gain or loss would be realized on the
transaction as a whole). The character
and source of such gain or loss shall be
determined under section 988. Proper ad-
justments shall be made to account for
gain or loss taken into account by reason
of this paragraph (d)(2). See §1.985–5(f)
Example 1, footnote 1.
(ii) Treatment of a section 988 transac-
tion entered into and terminated during
the look-back period.A QBU branch
shall reduce income by the amount of any
gain, and increase income by the amount
of any loss, that was recognized with re-
spect to any dollar denominated section
988 transactions entered into and termi-
nated during the look-back period.
(3) Deemed termination income ad-
justment.The taxpayer shall realize gain
or loss attributable to the QBU branch’s
equity pool (as stated on the transition
date) under the principles of section 987,
computed as if the branch terminated on
the transition date. Such amount shall be
reduced by section 987 gain and increased
by section 987 loss that was recognized
by such taxpayer with respect to remit-
tances during the look-back period.
(4) Branch income adjustment.
Branch income in a separate category
shall be determined under §1.985–3 for
each look-back year. For this purpose, the
opening DASTM balance sheet shall be
determined under §1.985–5. The sum of
the difference (positive or negative) be-
tween the amount computed pursuant to
§1.985–3 and amount taken into account
for each year shall be taken into account
in the taxable year of change pursuant to
paragraph (d)(1) of this section. Such
amounts shall retain their character for all
federal income tax purposes.
(5) Opening balance sheet.The open-
ing balance sheet of a QBU branch for the
taxable year of change shall be determined
as if the branch had changed its functional
currency to the dollar by applying
§ 1.985–5(c) on the transition date and had
translated its assets and liabilities under
§1.985–3 during the look-back period.
(e) Effective date.This section is effec-
tive for taxable years beginning after April
6, 1998. However, a taxpayer may choose
to apply this section to all open taxable
years beginning after December 31, 1986,
provided each person, and each QBU
branch of a person, that is related (within
the meaning of §1.985–2(d)(3)) to the tax-
payer also applies this section rules.
Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
Approved February 11, 1998.
Donald C. Lubick,
Assistant Secretary of
the Treasury.
April 20, 1998161998–16 I.R.B.

(Filed by the Office of the Federal Register on
March 4, 1998, 8:45 a.m., and published in the issue
of the Federal Register for March 5, 1998, 63 F.R.
10772)
Section 1.1502–3: Regulations
26 CFR 1.1502–3: Consolidated investment credit.
T.D. 8766
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
Consolidated Returns—
Limitations on the Use of
Certain Credits; Overall
Foreign Loss Accounts
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final and temporary regula-
tions.
SUMMARY: This document contains
temporary amendments to the consoli-
dated return regulations. The temporary
amendments modify the date temporary
regulations apply as published in the Fed-
eral Registeron January 12, 1998, relat-
ing to the use of tax credits of a consoli-
dated group and its members. The
amendments provide guidance to consoli-
dated groups that have a taxable year be-
ginning on or after January 1, 1997, for
which the income tax return is due on or
before March 13, 1998. The text of the
temporary regulations also serves as the
text of REG–104062–97, page 20 of this
Bulletin.
DATES: Effective dates:These amend-
ments are effective March 13, 1998.
Applicability dates:For dates of appli-
cation, see the Effective Datesportion of
the preamble under SUPPLEMENTARY
INFORMATION.
FOR FURTHER INFORMATION CON-
TACT: Roy A. Hirschhorn, (202) 622-
7770.
SUPPLEMENTARY INFORMATION:
Background and Explanation of
Provisions
On January 12, 1998, the IRS and Trea-
sury published in the Federal Register
final, temporary and proposed regulations
(the January 12, 1998, regulations) relat-
ing to limitations on the use of certain tax
credits and related attributes by corpora-
tions filing consolidated income tax re-
turns. In general, the January 12, 1998,
regulations relate to the separate return
limitation year provisions (and certain
consolidated return changes in owner-
ship) for general business credits, alterna-
tive minimum tax credits, foreign tax
credits and overall foreign loss accounts.
The January 12, 1998, regulations were
generally applicable to consolidated re-
turn years beginning on or after January
1, 1997. IRS and Treasury have deter-
mined that the appropriate effective date
of those regulations should be for consoli-
dated return years for which the due date
(without extensions) of the income tax re-
turn is after March 13, 1998. In lieu of
applying this effective date, a consoli-
dated group may choose to apply the ef-
fective date provisions as published in the
January 12, 1998, regulations. Taxpayers
making this choice must apply all of those
effective date provisions for all relevant
years. Thus, such taxpayers may not
choose to apply one provision of the Janu-
ary 12, 1998, regulations and not another.
Effective Dates
The temporary amendments are applic-
able to consolidated return years for
which the due date of the income tax re-
turn (without extensions) is after March
13, 1998. As explained in the Back-
ground portion of this preamble, taxpay-
ers may instead choose to apply the effec-
tive date provisions of the January 12,
1998, regulations (i.e., generally taxable
years beginning on or after January 1,
1997).
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in EO 12866.
Therefore, a regulatory assessment is not
required. It is hereby certified that these
regulations do not have a significant eco-
nomic impact on a substantial number of
small entities. This certification is based
on the fact that these regulations princi-
pally affect corporations filing consoli-
dated federal income tax returns that have
carryover or carryback of credits from
separate return limitation years. Available
data indicates that many consolidated re-
turn filers are large companies (not small
businesses). In addition, the data indi-
cates that an insubstantial number of con-
solidated return filers that are smaller
companies have credit carryovers or carry-
backs, and thus even fewer of these filers
have credit carryovers or carrybacks that
are subject to the separate return limitation
year rules. Therefore, a Regulatory Flexi-
bility Analysis under the Regulatory Flex-
ibility Act (5 U.S.C. chapter 6) is not re-
quired. It has also been determined that
under section 553(d) of the Administrative
Procedure Act (5 U.S.C. chapter 5) these
regulations should be effective immedi-
ately because they involve the applicabil-
ity of regulations that modify the limita-
tions on the use of certain tax attributes for
taxable years beginning on or after Janu-
ary 1, 1997. Pursuant to section 7805(f)
of the Internal Revenue Code, the notice
of proposed rulemaking accompanying
these regulations is being sent to the Small
Business Administration for comment on
their impact on small businesses.
Drafting Information
The principal author of these regula-
tions is Roy A. Hirschhorn of the Office
of Assistant Chief Counsel (Corporate).
Other personnel from the IRS and Trea-
sury participated in their development.
* * * * *
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR part 1 is amended
as follows:
PART 1—INCOME TAXES
Paragraph. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.1502–3 is amended by
revising paragraphs (c)(3), (d)(2) and
(e)(3) to read as follows:
§1.1502–3 Consolidated investment
credit.
* * * * *
(c)* * *
(3) Special effective date.This para-
graph (c) applies to consolidated return
1998–16 I.R.B.17April 20, 1998

years for which the due date of the in-
come tax return (without extensions) is on
or before March 13, 1998. See §1.1502–
3T(c) for the rule that limits the group’s
use of a section 38 credit carryover or car-
ryback from a SRLY for a consolidated re-
turn year for which the due date of the in-
come tax return (without extensions) is
after March 13, 1998. For taxable years
not subject to §1.1502–3T(c), prior law
applies. See §1.1502–3(c) in effect prior
to January 12, 1998 (§1.1502–3(c) as con-
tained in the 26 CFR part 1 edition revised
April 1, 1997) for prior law. See also
§1.1502–3T(c)(4) for an optional effective
date rule (generally making the rules of
this paragraph (c) inapplicable to a consol-
idated return year beginning after Decem-
ber 31, 1996, if the due date of the income
tax return (without extensions) for such
year is on or before March 13, 1998).
(d) Examples.* * *
(2) Example (2)andExample (3)of
this paragraph (d) do not apply to consoli-
dated return years for which the due date
of the income tax return (without exten-
sions) is after March 13, 1998. For con-
solidated return years for which the due
date of the income tax return (without ex-
tensions) is after March 13, 1998, see
§1.1502–3T(d).
(e) * * *
(3) Special effective date.This para-
graph (e) applies only to a consolidated
return change of ownership that occurred
during a consolidated return year for
which the due date of the income tax re-
turn (without extensions) is on or before
March 13, 1998. See §1.1502–3T(c)(4)
for an optional effective date rule (gener-
ally making the rules of this paragraph
(e) inapplicable if the consolidated return
change of ownership occurred on or after
January 1, 1997, and during a consoli-
dated return year for which the due date
of the income tax return (without exten-
sions) is on or before March 13, 1998).
* * * * *
Par. 3. Section 1.1502–3T is amended
by revising paragraphs (c)(3) and (d)(2)
and adding a new paragraph (c)(4) to read
as follows:
§1.1502–3T Consolidated investment
credit (temporary).
* * * * *
(c) * * *
(3) Effective date.This paragraph (c)
applies to consolidated return years for
which the due date of the income tax re-
turn (without extensions) is after March
13, 1998. However, a group does not take
into account a consolidated taxable year
for which the due date of the income tax
return (without extensions) is on or before
March 13, 1998, in determining a mem-
ber’s (or subgroup’s) contributions to the
consolidated section 38(c) limitation
under this paragraph (c). See also
§1.1502–3(c).
(4) Optional effective date of January
1, 1997.In lieu of paragraphs (c)(3) and
(d)(2) of this section and §§1.1502–
3(c)(3), (d)(2) and (e)(3) (relating to the
general business credit), 1.1502–4(f)(3)
and (g)(3), 1.1502–4T(f) and (g)(3) (relat-
ing to the foreign tax credit), 1.1502–9(a)
(the next to last sentence), 1.1502–9T(b)-
(1)(v) (relating to overall foreign losses),
and 1.1502–55T(h)(4)(iii)(C) (relating to
the alternative minimum tax credit), a
consolidated group may apply such para-
graphs as they appear in 1998–10 I.R.B.
23 (see §601.601(d)(2) of this chapter). A
consolidated group making this choice
must apply all such paragraphs for all rel-
evant years.
(d) * * *
(2) This paragraph (d) applies to con-
solidated return years for which the due
date of the income tax return (without ex-
tensions) is after March 13, 1998. See
also §1.1502–3(d) for years for which the
due date of the income tax return (without
extensions) is on or before March 13,
1998.
* * * * *
Par. 4. Section 1.1502–4 is amended by
revising paragraphs (f)(3) and (g)(3) to
read as follows:
§1.1502–4 Consolidated foreign tax
credit.
* * * * *
(f) * * *
(3) Special effective date ending SRLY
limitation.See §1.1502–4T(f) for the rule
that ends the SRLY limitation with re-
spect to foreign tax credits for consoli-
dated return years for which the due date
of the income tax return (without exten-
sions) is after March 13, 1998. See also
§1.1502–3T(c)(4) for an optional effec-
tive date rule (generally making the rules
of this paragraph (f) inapplicable to a con-
solidated return year beginning after De-
cember 31, 1996, if the due date of the in-
come tax return (without extensions) for
such year is on or before March 13, 1998.
(g) * * *
(3) Special effective date for CRCO
limitation.See §1.1502–4T(g)(3) for the
rule that ends the CRCO limitation with
respect to a consolidated return change of
ownership that occurs on or after the first
day of a taxable year for which the due
date of the income tax return (without ex-
tensions) is after March 13, 1998. See
also §1.1502–3T(c)(4) for an optional ef-
fective date rule (generally making the
rules of this paragraph (g) inapplicable if
the consolidated return change of owner-
ship occurred on or after January 1, 1997,
and during a consolidated return year for
which the due date of the income tax re-
turn (without extensions) is on or before
March 13, 1998).
* * * * *
Par. 5. Section 1.1502–4T is amended
by revising paragraphs (f) and (g)(3) to
read as follows:
§1.1502–4T Consolidated foreign tax
credit (temporary).
* * * * *
(f) Limitation on unused foreign tax
carryover or carryback from separate re-
turn limitation years.Section 1.1502–
4(f) does not apply for consolidated return
years for which the due date of the in-
come tax return (without extensions) is
after March 13, 1998. For consolidated
return years for which the due date of the
income tax return (without extensions) is
after March 13, 1998, a group shall in-
clude an unused foreign tax of a member
arising in a SRLY without regard to the
contribution of the member to consoli-
dated tax liability for the consolidated re-
turn year. See also §1.1502–3T(c)(4) for
an optional effective date rule (generally
making the rules of this paragraph (f) ap-
plicable to a consolidated return year be-
ginning after December 31, 1996, if the
due date of the income tax return (without
extensions) for such year is on or before
March 13, 1998).
* * * * *
April 20, 1998181998–16 I.R.B.

(g)(3) Special effective date for CRCO
limitation. Section 1.1502–4(g) applies
only to a consolidated return change of
ownership that occurred during a consoli-
dated return year for which the due date
of the income tax return (without exten-
sions) is on or before March 13, 1998.
See also §1.1502–3T(c)(4) for an optional
effective date rule (generally making the
rules of this paragraph (g)(3) applicable if
the consolidated return change of owner-
ship occurred on or after January 1, 1997,
and during a consolidated return year for
which the due date of the income tax re-
turn (without extensions) is on or before
March 13, 1998).
Par. 6. In §1.1502–9, paragraph (a) is
amended by removing the last sentence
and adding two sentences in its place to
read as follows:
§1.1502–9 Application of overall foreign
loss recapture rules to corporations filing
consolidated returns.
(a) * * * See §1.1502–9T(b)(1)(v) for
the rule that ends the separate return limi-
tation year limitation for consolidated re-
turn years for which the due date of the
income tax return (without extensions) is
after March 13, 1998. See also §1.1502–
3T(c)(4) for an optional effective date
rule (generally making the rules of para-
graphs (b)(1)(iii) and (iv) of this section
inapplicable for a consolidated return year
beginning after December 31, 1996, if the
due date of the income tax return (without
extensions) for such year is on or before
March 13, 1998).
* * * * *
Par. 7. Section 1.1502–9T is amended
by revising paragraph (b)(1)(v) to read as
follows:
§1.1502–9T Application of overall
foreign loss recapture rules to
corporations filing consolidated returns
(temporary).
* * * * *
(b)(1)(v) Special effective date for
SRLY limitation.Sections 1.1502–
9(b)(1)(iii) and (iv) apply only to consoli-
dated return years for which the due date
of the income tax return (without exten-
sions) is on or before March 13, 1998.
For consolidated return years for which
the due date of the income tax return
(without extensions) is after March 13,
1998, the rules of §1.1502–9(b)(1)(ii)
shall apply to overall foreign losses from
separate return years that are separate re-
turn limitation years. For purposes of ap-
plying §1.1502–9(b)(1)(ii) in such years,
the group treats a member with a balance
in an overall foreign loss account from a
separate return limitation year on the first
day of the first consolidated return year
for which the due date of the income tax
return (without extensions) is after March
13, 1998, as a corporation joining the
group on such first day. An overall for-
eign loss that is part of a net operating
loss or net capital loss carryover from a
separate return limitation year of a mem-
ber that is absorbed in a consolidated re-
turn year for which the due date of the in-
come tax return (without extensions) is
after March 13, 1998, shall be added to
the appropriate consolidated overall for-
eign loss account in the year that it is ab-
sorbed. For consolidated return years for
which the due date of the income tax re-
turn (without extensions) is after March
13, 1998, similar principles apply to over-
all foreign losses when there has been a
consolidated return change of ownership
(regardless of when the change of owner-
ship occurred). See also §1.1502–3T(c)-
(4) for an optional effective date rule
(generally making this paragraph
(b)(1)(v) applicable to a consolidated re-
turn year beginning after December 31,
1996, if the due date of the income tax re-
turn (without extensions) for such year is
on or before March 13, 1998).
* * * * *
Par. 8. Section 1.1502–55T is amended
by revising paragraph (h)(4)(iii)(C) to
read as follows:
§1.1502–55T Computation of alternative
minimum tax of consolidated groups
(temporary).
* * * * *
(h)(4) * * *
(iii) * * *
(C) Effective date.This paragraph
(h)(4)(iii) applies to consolidated return
years for which the due date of the in-
come tax return (without extensions) is
after March 13, 1998. However, a group
does not take into account a consolidated
taxable year for which the due date of the
income tax return (without extensions) is
on or before March 13, 1998, in determin-
ing a member’s (or subgroup’s) contribu-
tions to the consolidated section 53(c)
limitation under paragraph (h)(4)(iii) of
this section. See §1.1502–3T(c)(4) for an
optional effective date rule (generally
making this paragraph (h)(4)(iii) applica-
ble to a consolidated return year begin-
ning after December 31, 1996, if the due
date of the income tax return (without ex-
tensions) for such year is on or before
March 13, 1998).
Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
Approved March 9, 1998.
Donald C. Lubick,
Assistant Secretary of
the Treasury.
(Filed by the Office of the Federal Register on
March 13, 1998, at 8:45 a.m., and published in the
Federal Register for March 16, 1998, 63 F.R. 12641)
1998–16 I.R.B.19April 20, 1998

April 20, 1998201998–16 I.R.B.
Notice of Proposed Rulemaking
and Notice of Public Hearing
Consolidated Returns—
Limitations on the Use of
Certain Credits and Related
Tax Attributes
REG–104062–97
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemak-
ing by cross-reference to temporary regu-
lations and notice of public hearing.
SUMMARY: In T.D. 8766 on page 17 of
this Bulletin, the IRS is issuing temporary
regulations that relate to the use of cer-
tain tax credits and losses of a consoli-
dated group and its members. The text of
those temporary regulations also serves as
the text of these proposed regulations.
This document also provides notice of a
public hearing on these proposed regula-
tions.
DATES: Written comments and outlines
of topics to be discussed at the public
hearing scheduled for May 7, 1998, at 10
a.m., must be received by April 13, 1998.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R [REG–104062–97],
room 5226, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. Submissions may be
hand delivered between the hours of 8 a.m.
and 5 p.m. to: CC:DOM:CORP:R
[REG–104005–98], Courier’s Desk, Inter-
nal Revenue Service, 1111 Constitution
Avenue NW, Washington, DC. Alterna-
tively, taxpayers may submit comments
electronically via the Internet by selecting
the “Tax Regs” option on the Home Page
or by submitting comments directly to the
IRS Internet site at: http://www.irs.
ustreas.gov/prod/tax_regs/comments.html.
The public hearing has been scheduled for
May 7, 1998, at 10 a.m., in room 2615, In-
ternal Revenue Building, 1111 Constitu-
tion Avenue NW, Washington DC.
FOR FURTHER INFORMATION CON-
TACT: Concerning the proposed regula-
tions, in general, Roy A. Hirschhorn (202)
622-7770; concerning submissions and
the hearing, Mike Slaughter (202) 622-
7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
T.D. 8766 amends the Income Tax Regu-
lations (26 CFR part 1) relating to section
1502. The temporary regulations provide
rules that relate to the use of certain tax
credits and related tax attributes of a con-
solidated group and its members. The
text of those temporary regulations also
serves as the text of these proposed regu-
lations. The preamble to the temporary
regulations explains the temporary regu-
lations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in EO
12866. Therefore, a regulatory assess-
ment is not required. It is hereby certified
that these regulations do not have a signif-
icant economic impact on a substantial
number of small entities. This certifica-
tion is based on the fact that these regula-
tions principally affect corporations filing
consolidated federal income tax returns
that have carryover or carryback of cred-
its from separate return limitation years.
Available data indicates that many con-
solidated return filers are large companies
(not small businesses). In addition, the
data indicates that an insubstantial num-
ber of consolidated return filers that are
smaller companies have credit carryovers
or carrybacks, and thus even fewer of
these filers have credit carryovers or car-
rybacks that are subject to the separate re-
turn limitation year rules. Therefore, a
Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C.
chapter 6) is not required. Pursuant to
section 7805(f) of the Internal Revenue
Code, this notice of proposed rulemaking
will be submitted to the Chief Counsel for
Advocacy of the Small Business Admin-
istration 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. All comments will be made available
for public inspection and copying.
A public hearing has been scheduled
for May 7, 1998, at 10 a.m., in room
2615. Because of access restrictions, visi-
tors will not be admitted beyond the Inter-
nal 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 who wish to present oral com-
ments at the hearing must submit written
comments and an outline of the topics
(signed original and eight (8) copies) to
be discussed by April 13, 1998.
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 regula-
tions is Roy A. Hirschhorn of the Office
of Assistant Chief Counsel (Corporate).
Other personnel from the IRS and Trea-
sury participated in their development.
* * * * *
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is pro-
posed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
26 CFR part 1 is amended by adding en-
tries in numerical order to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1502–3 also issued under 26
U.S.C. 1502.
Section 1.1502–4 also issued under 26
U.S.C. 1502.
Section 1.1502–9 also issued under 26
U.S.C. 1502. * * *
Section 1.1502–55 also issued under 26
U.S.C. 1502. * * *
Par. 2. Section 1.1502–3, as proposed
to be amended at 63 F.R. 1804, January
Part IV. Items of General Interest

1998–16 I.R.B.21April 20, 1998
12, 1998, is amended by revising para-
graphs (c)(3) and (d)(2) and adding para-
graph (c)(4) to read as follows:
§1.1502–3 Consolidated investment
credit.
* * * * *
(c) * * *
(3) and (4) [The text of proposed para-
graphs (c)(3) and (4) of this section is the
same as the text of §1.1502–3T(c)(3) and
(4) published in T.D. 8766.]
(d) * * *
(2) [The text of proposed paragraph
(d)(2) of this section is the same as the
text of §1.1502–3T(d)(2) published in
T.D. 8766.]
* * * * *
Par. 3. Section 1.1502–4, as proposed to
be amended at 63 F.R. 1804, January 12,
1998, is amended by revising paragraphs
(f)(3) and (g)(3) to read as follows:
§1.1502–4 Consolidated foreign tax
credit.
* * * * *
(f) * * *
(3) [The text of proposed paragraph
(f)(3) of this section is the same as the text
of §1.1502–4T(f)(3) published in T.D.
8766.]
(g) * * *
(3) [The text of proposed paragraph
(g)(3) of this section is the same as the
text of §1.1502–4T and (g)(3) published
in T.D. 8766.]
* * * * *
Par. 4. Section 1.1502–9, as proposed
to be amended at 63 F.R. 1804, January
12, 1998, is amended by revising para-
graph (b)(1)(v) to read as follows:
§1.1502–9 Application of overall foreign
losses recapture rules to corporations
filing consolidated returns.
* * * * *
(b) * * *
(1) * * *
(v) [The text of proposed paragraph
(b)(1)(v) of this section is the same as the
text of §1.1502–9T(b)(1)(v) published in
T.D. 8766.]
* * * * *
Par. 5. Section 1.1502–55, as proposed
to be added at 57 F.R. 62257, December
30, 1992, and amended at 63 F.R. 1804,
January 12, 1998, is further amended by
revising paragraph (h)(4)(iii)(C) to read
as follows as follows:
§1.1502–55 Computation of alternative
minimum tax of consolidated groups.
* * * * *
(h) * * *
(4) * * *
(iii) * * *
(C) [The text of proposed paragraph
(h)(4)(iii)(C) of this section is the same as
the text of §1.1502–55T(h)(4)(iii)(C)
published in T.D. 8766.]
* * * * *
Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on
March 13, 1998, at 8:45 a.m., and published in the
Federal Register for March 16, 1998, 63 F.R. 12717)
Notice of Proposed Rulemaking
and Notice of Public Hearing
Guidance Under Subpart F
Relating to Partnerships and
Branches
REG–104537–97
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemak-
ing, notice of proposed rulemaking by
cross-reference to temporary regulations
and notice of public hearing.
SUMMARY: The IRS and Treasury De-
partment are issuing temporary regula-
tions, published in T.D. 8767, page 4 of
this Bulletin, relating to the treatment
under subpart F of certain branches of a
controlled foreign corporation (CFC) that
are treated as separate entities for foreign
tax purposes . The text of the temporary
regulations also serves as the text of these
proposed regulations. In addition, this
document contains proposed regulations
relating to the treatment of a CFC’s dis-
tributive share of partnership income.
This document also provides notice of a
public hearing on these proposed regula-
tions.
DATES: Written comments must be re-
ceived by June 24, 1998. Outlines of oral
comments to be discussed at the public
hearing scheduled for July 15, 1998, must
be received by June 24, 1998.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (REG–104537–97),
room 5226, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington DC 20044. Submissions may be
hand delivered between the hours of 8
a.m. and 5 p.m. to: CC:DOM:CORP:T:R
(REG–104537–97), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitution
Avenue, NW, Washington DC. Alterna-
tively, taxpayers may submit comments
electronically via the Internet by selecting
the “Tax Regs” option on the IRS Home
Page, or by submitting comments directly
to the IRS Internet site at http://www.irs.
ustreas.gov/prod/tax_regs/comments.html.
The public hearing will be held in room
2615, Internal Revenue Building, 1111
Constitution Avenue NW, Washington,
DC 20224.
FOR FURTHER INFORMATION CON-
TACT: Concerning the regulations, Va-
lerie Mark, (202) 622-3840; concerning
submissions and the hearing, Mike
Slaughter (202) 622-7190 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Background
I. In General
In these proposed regulations, and in
temporary regulations published in T.D.
8767, the Treasury and IRS set forth a
framework for dealing with the issues
posed by the use of certain entities which
are regarded as fiscally transparent for the
purposes of U.S. tax law, with regard to
the application of subpart F of the Internal
Revenue Code.
Subpart F was enacted by Congress to
limit the deferral of U.S. taxation of cer-
tain income earned outside the United
States by foreign corporations controlled
by U.S. persons. Limited deferral was re-
tained after the enactment of subpart F to
protect the competitiveness of controlled
foreign corporations (CFCs) doing busi-
ness overseas. See S. Rep. No. 1881,

April 20, 1998221998–16 I.R.B.
87th Cong., 2d Sess. 78–80 (1962). This
limited deferral furthers the objective of
allowing a CFC engaged in an active
business, and located in a foreign country
for appropriate economic reasons, to
compete in a similar tax environment with
non-U.S. owned corporations located in
the same country.
Conversely, one of the purposes of sub-
part F is to prevent CFCs from converting
active income that is not easily moveable
and is earned in a jurisdiction in which a
business is located for non-tax reasons
into passive, easily moveable income
shifted to a lower tax jurisdiction primar-
ily for tax avoidance. Moreover, when
subpart F was first enacted it was realized
that related person transactions can be
easily manipulated to reduce both United
States and foreign taxes. Consequently,
in enacting subpart F, Congress provided
that transactions of CFCs that involve re-
lated persons generally give rise to sub-
part F income with certain enumerated
exceptions.
Hybrid branches, by definition, are not
regarded as fiscally transparent under for-
eign law. Thus, they are particularly well
suited for the type of tax avoidance de-
scribed above. In light of the recent pro-
liferation of hybrid branches, Treasury
and the IRS believe that it is appropriate
to consider the issues related to transac-
tions involving hybrid branches, or other
hybrid entities, under subpart F.
The use of other organizations that are
fiscally transparent for U.S. tax purposes,
including partnerships, raise additional is-
sues. These entities may or may not be
fiscally transparent under foreign law. In
the context of subpart F, issues similar to
those raised in connection with hybrid
branches are raised in connection with
partnerships. (Other fiscally-transparent
entities, such as grantor trusts, will be the
subject of guidance issued in conjunction
with the finalization of regulations under
section 672(f).)
The entity classification regulations of
§§301.7701–1 through 301.7701–3 (the
check-the-box regulations) make entity
classification generally elective, in part so
that taxpayers can choose a tax status con-
sistent with their business objectives.
This administrative provision, however,
was not intended to change substantive
law. Particularly in the international area,
however, the ability to more easily
achieve fiscal transparency can lead to in-
appropriate results under certain substan-
tive international provisions of the Code.
Thus, the Treasury and the IRS believe
that it is necessary to provide additional
guidance regarding the use of hybrid enti-
ties in the international context. Seepre-
amble to T.D. 8697, 61 Fed. Reg. 66585
(December 18, 1996).
II. Controlled Foreign Corporation’s
Distributive Share of Partnership
Income
In Brown Group, Inc. v. Commissioner,
77 F.3d 217 (8th Cir. 1996), vacating and
remanding 104 T.C. 105 (1995), a Cay-
man Islands partnership with a Cayman
Islands CFC partner earned commission
income from selling footwear purchased
in Brazil on behalf of the CFC’s U.S. par-
ent. This commission income would have
been subpart F income, specifically for-
eign base company sales income under
section 954(d), to the CFC if it had earned
this commission income directly and
under the same circumstances in which
the partnership earned this income. The
Tax Court held that the CFC’s distributive
share of this commission income was sub-
part F income. The Eighth Circuit, vacat-
ing and remanding the Tax Court’s deci-
sion, held that the CFC’s distributive
share of this commission income was not
subpart F income.
In response to the Eighth Circuit’s
opinion, the IRS announced that it in-
tended to issue regulations under subpart
F to confirm its position that whether a
CFC partner’s distributive share of part-
nership income is subpart F income gen-
erally is determined at the CFC partner
level. See Notice 96–39 (1996–2 C.B.
209).
These proposed regulations would ad-
dress the treatment of a CFC partner’s dis-
tributive share of partnership income
under subpart F. These regulations apply
to all categories of subpart F income, not
only to foreign base company sales in-
come, which was at issue in Brown
Group. These regulations would provide
specific rules that apply to determine a
CFC partner’s distributive share of foreign
personal holding company income, for-
eign base company sales income, foreign
base company services income, and earn-
ings invested in United States property.
The approach taken by these proposed
regulations is based on the provisions of
subchapter K and subpart F and the poli-
cies underlying those provisions. The
legislative history of subchapter K indi-
cates that a partnership distributive share
should be characterized by using the ap-
proach that best serves the Code or regu-
lations section at issue. Subpart F limits
deferral of U.S. income tax on common
types of passive income received by
CFCs, as well as on certain other types of
easily moveable income. To allow a CFC
to avoid subpart F treatment for items of
income by the simple expedient of receiv-
ing them as distributive shares of partner-
ship income, rather than directly, is con-
trary to the intent of subpart F.
Explanation of Provisions
Under these proposed regulations, in-
come and deductions would be character-
ized at the partnership level. If any part of
the partnership’s gross income would be
subpart F income if received directly by
partners that are CFCs, it must be sepa-
rately stated under section 702. Com-
ments are requested as to whether this rule
should not apply for ownership levels
under certain thresholds. The regulations
under section 702 also would be clarified
to expressly provide that an item must be
separately stated when, if separately taken
into account by any partner, the separately
stated item would affect the income tax li-
ability of that partner or any other person.
This clarification incorporates in the regu-
lations the position of the IRS. See Rev.
Rul. 86–138 (1986–2 C.B. 84) (holding
that a subsidiary partnership in a multi-
tiered arrangement must separately state
items which, if separately taken into ac-
count by any partner of any partnership in
the multi-tiered arrangement, would affect
the income tax liability of that partner).
The regulations under section 952
would also be clarified to expressly in-
clude within the definition of subpart F
income a CFC’s distributive share of any
item of gross income of a partnership to
the extent the income would have been
subpart F income if received by the CFC
partner directly. The proposed regula-
tions would further provide that, gener-
ally, in determining whether a distributive
share of partnership income is subpart F
income, whether an entity is a related per-
son and whether activity takes place in or
outside the CFC’s country of incorpora-
tion is determined with respect to the CFC

1998–16 I.R.B.23April 20, 1998
partner and not the partnership. Thus, on
the Brown Group facts, the income in
issue would retain its character as com-
mission income from the sale of shoes
purchased in Brazil on behalf of a U.S.
parent for sale in the U.S. It would be de-
termined at the CFC partner level that the
shoes were manufactured and sold for use
outside of the CFC’s country of incorpo-
ration (Cayman Islands), and that the U.S.
parent was a related person with respect
to the CFC. Thus, the income would be
foreign base company sales income.
The proposed and temporary regula-
tions also address the question of whether
a CFC’s distributive share of partnership
income can qualify for the exceptions
from foreign personal holding company
income treatment. Some of these excep-
tions are based on whether the income is
earned in a transaction with a related per-
son that is incorporated, or uses property,
in the CFC’s country of incorporation.
The proposed and temporary regulations
address the application of those excep-
tions. Other exceptions are based on the
activities performed by the CFC in con-
nection with the property through which it
earns the income. The proposed regula-
tions would provide that the exceptions
requiring activity will generally apply if
the exception would have applied to the
income had the partnership itself been a
CFC. This requirement is not met if the
partnership can qualify for the exception
only by taking into account the separate
activities of its partners (e.g., the partner-
ship owns property and the CFC provides
the management services).
These proposed regulations would
amend the rules regarding the application
of the manufacturing exception of
§1.954–3(a)(4). The regulations would
clarify the Service’s current position that,
in general, a controlled foreign corpora-
tion can apply the exception only if it has
performed the manufacturing activities it-
self. Thus, manufacturing activities of a
contract manufacturer will not be taken
into account.
Nevertheless, the manufacturing activi-
ties of a partnership may be taken into ac-
count under the distributive share rules
when the partnership sells the property
that it manufactures. These proposed reg-
ulations would clarify how the manufac-
turing exception of §1.954–3(a)(4) ap-
plies in the context of the distributive
share rules. As previously noted, the gen-
eral rules would provide that income that
could be foreign base company sales in-
come at the CFC partner level is sepa-
rately stated and that determinations as to
relatedness and the relevant country are
made at the partner level. Consistent with
the framework outlined above, these reg-
ulations would allow a CFC’s distributive
share of sales income to be excluded,
under the manufacturing exception of
§1.954–3(a)(4), when the partnership’s
activities with respect to the property it
sells (without regard to the CFC partner’s
activities) would be sufficient to consti-
tute manufacturing.
Treasury and the IRS are considering
applying foreign base company sales in-
come rules in the context of manufactur-
ing branches of partnerships. Comments
are requested as to the appropriate scope
of such rules.
Under the general rule for determining
whether a CFC partner’s distributive
share includes subpart F income, a CFC
partner’s distributive share of partnership
income earned from performing services
for or on behalf of a person that is a re-
lated person with respect to the CFC part-
ner will be foreign base company services
income. These proposed regulations also
would describe how the substantial assis-
tance rule of §1.954–4(b)(1)(iv) applies
when the CFC earns services income
through a partnership. When the partner-
ship is performing services for a person
unrelated to the CFC partner but the CFC
partner provides substantial assistance to
the partnership contributing to the perfor-
mance of those services, the partner and
the partnership would be regarded as
separate entities and the substantial assis-
tance provided from the CFC to the part-
nership would cause the CFC’s distribu-
tive share of the services income to be
treated as foreign base company services
income. Treasury and the IRS are consid-
ering applying similar principles to
branches. Comments are requested on
this issue.
Finally, consistent with Rev. Rul. 90–
112 (1990–2 C.B. 186), the regulations
would provide that, for purposes of section
956, a CFC partner’s investment in U.S.
property includes the U.S. property held by
a partnership to the extent of the CFC’s
ownership interest in the partnership.
Comments are requested on this issue.
III. Hybrid Branches
Temporary regulations, published in
T.D. 8767, amend the Income Tax Regu-
lations (26 CFR part 1) relating to sec-
tions 952 and 954 by adding rules relating
to the treatment under subpart F of certain
branches of a CFC or a partnership in
which a CFC is a partner that are treated
as separate entities for foreign tax pur-
poses. The text of those temporary regu-
lations also serves as the text of the pro-
posed regulations. The preamble to the
temporary regulations explains the rea-
sons for the addition.
IV. Proposed Effective Date
These regulations are proposed to
apply for taxable years of a controlled for-
eign corporation beginning on or after the
date the final regulations are published in
the Federal Register. For prior periods,
the IRS will rely on principles and author-
ities under subpart F and subchapter K to
apply an aggregate approach, including
§1.701–2(e) and (f) of the regulations for
periods for which it is effective.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in Exec-
utive Order 12866. Therefore, a regula-
tory assessment is not required. It has
also been determined that section 553(b)
of the Administrative Procedures Act (5
U.S.C. chapter 5) does not apply to these
regulations, and, because the regulation
does not impose a collection of informa-
tion on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does
not apply. Pursuant to section 7805(f) of
the Code, this notice of proposed rule-
making will be submitted to the Chief
Counsel for Advocacy of the Small Busi-
ness Administration for comment on its
impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, considera-
tion will be given to any written com-
ments (preferably a signed original and
eight (8) copies) that are timely submitted
to the IRS. All comments will be avail-
able for public inspection and copying.
A public hearing has been scheduled
for July 15, 1998, at 10 a.m., in room
2615, Internal Revenue Building, 1111

April 20, 1998241998–16 I.R.B.
Constitution Avenue NW, Washington
DC. Because of access restrictions, visi-
tors will not be admitted beyond the
building lobby more than 15 minutes be-
fore the hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral com-
ments at the hearing must submit written
comments by June 24, 1998, and submit an
outline of topics to be discussed and time
to be devoted to each topic (signed original
and eight (8) copies) by June 24, 1998.
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 regula-
tions is Valerie Mark of the Office of the
Associate Chief Counsel (International),
IRS. However, other personnel from the
IRS and Treasury Department partici-
pated in their development.
* * * * *
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is pro-
posed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
26 CFR part 1 continues to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2 Section §1.702–1 is amended as
follows:
1. Paragraph (a)(8)(ii) is revised.
2. A new paragraph (c)(1)(v) is added.
The addition and revision read as fol-
lows:
§1.702–1 Income and credits of partner.
(a) * * *
(8) * * *
(ii) Each partner must also take into ac-
count separately the partner’s distributive
share of any partnership item which, if
separately taken into account by any part-
ner, would result in an income tax liability
for that partner, or for any other person,
different from that which would result if
that partner did not take the item into ac-
count separately. Thus, if any partner is a
controlled foreign corporation, as defined
in section 957, items of income that
would be gross subpart F income if taken
into account by the controlled foreign cor-
poration must be separately stated for all
partners. Under section 911(a), if any
partner is a bona fide resident of a foreign
country who may exclude from gross in-
come the part of the partner’s distributive
share which qualifies as earned income as
defined in section 911(b), the earned in-
come of the partnership for all partners
must be separately stated. Similarly, all
relevant items of income or deduction of
the partnership must be separately stated
for all partners in determining the applica-
bility of section 183 (relating to activities
not engaged in for profit) and the recom-
putation of tax thereunder for any partner.
* * * * *
(c) * * *
(1) * * *
(v) In determining whether the de min-
imisor full inclusion rules of section
954(b)(3) apply.
* * * * *
Par. 3. In §1.952–1, paragraphs (b)
through (f) are redesignated as paragraphs
(c) through (g), respectively, and a new
paragraph (b) is added to read as follows:
§1.952–1 Subpart F income defined.
* * * * *
(b) Treatment of distributive share of
partnership income—(1) In general.A
controlled foreign corporation’s distribu-
tive share of any item of income of a part-
nership is income that falls within a cate-
gory of subpart F income described in
section 952(a) to the extent the item of in-
come would have been income in such
category if received by the controlled for-
eign corporation directly. For specific
rules regarding the treatment of a distribu-
tive share of partnership income under
certain provisions of subpart F, see
§§1.954–1(g); 1.954–2(a)(5); 1.954–3(a)-
(6); 1.954–4(b)(2)(iii); and 1.954– 6(g).
(2) Example.The application of this
paragraph (b) may be illustrated by the
following example.
Example. CFC, a controlled foreign corporation,
is an 80-percent partner in PRS, a foreign partner-
ship. PRS earns $100 of interest income that is not
export financing interest, as defined in section
954(c)(2)(B), from a person unrelated to CFC. This
interest income would have been foreign personal
holding company income to CFC, under section
954(c), if it had received this income directly. Ac-
cordingly, CFC’s distributive share of this interest
income, $80, is foreign personal holding company
income.
* * * * *
Par. 4. Section 1.954–1 is amended as
follows:
1. Paragraphs (c)(1)(i)(A) through (D)
are redesignated as (c)(1)(i)(A)(1)
through (4), respectively.
2. A new paragraph heading for newly
designated paragraph (c)(1)(i)(A) is
added.
3. New paragraphs (c)(1)(i)(B)
through (E) are added.
4. Paragraph (g) is added.
The additions read as follows:
§1.954–1 Foreign base company income.
* * * * *
(c) * * *
(1) * * *
(i) Deductions against gross foreign
base company income—(A) In general.
* * *
* * * * *
(B) through (E) [The text of the pro-
posed paragraphs (c)(1)(i)(B) through (E)
is the same as the text of §1.954–
1T(c)(1)(i)(B) through (E) published in
T.D. 8767.]
* * * * *
(g) Distributive share of partnership in-
come—(1) Application of related person
and country of organization tests. Unless
otherwise provided, to determine the ex-
tent to which a controlled foreign corpora-
tion’s distributive share of any item of
gross income of a partnership would have
been subpart F income if received by it di-
rectly, under §1.952–1(b), if a provision of
subpart F requires a determination of
whether an entity is a related person,
within the meaning of section 954(d)(3),
or whether an activity occurred within or
outside the country under the laws of
which the controlled foreign corporation is
created or organized, this determination
shall be made by reference to such con-
trolled foreign corporation and not by ref-
erence to the partnership.

1998–16 I.R.B.25April 20, 1998
(2) Example.The application of para-
graph (g)(1) of this section is illustrated
by the following example:
Example.(i) CFC1, a controlled foreign corpora-
tion organized in Country A, is an 80-percent partner
in Partnership, a partnership organized in Country B.
CFC2, a controlled foreign corporation organized in
Country B, owns the remaining 20 percent interest
in Partnership. CFC1 and CFC2 are owned by a
common U.S. parent, USP. CFC2 manufactures
Product A in Country B. Partnership earns sales in-
come from purchasing Product A from CFC2 and
selling it to third parties located in Country B that
are not related persons with respect to CFC1 or
CFC2. For purposes of determining whether
CFC1’s distributive share of Partnership’s sales in-
come is foreign base company sales income under
section 954(d), CFC1 is treated as if it purchased
Product A from CFC2 and sold it to third parties in
Country B. Under section 954(d)(3), CFC2 is a re-
lated person with respect to CFC1. Thus, with re-
spect to CFC1, the sales income is deemed to be de-
rived from the purchase of personal property from a
related person. Because the property purchased is
both manufactured and sold for use outside of Coun-
try A, CFC1’s country of organization, CFC1’s dis-
tributive share of the sales income is foreign base
company sales income.
(ii) For purposes of determining whether CFC2’s
distributive share of Partnership’s sales income is
foreign base company sales income, CFC2 is treated
as if it directly sold Product A to third parties within
Country B. Therefore, Product A is both manufac-
tured and sold for use within CFC2’s country of or-
ganization. Thus, CFC2’s distributive share of Part-
nership’s sales income is not foreign base company
sales income.
Par. 5. In §1.954–2, paragraph (a)(5)
and (a)(6) are added to read as follows:
§1.954–2 Foreign personal holding
company income.
(a) * * *
(5) Special rules applicable to distribu-
tive share of partnership income—(i)
[The text of the proposed paragraph
(a)(5)(i) is the same as the text of §1.954–
2T(a)(5) published in T.D. 8767.]
(ii) Certain other exceptions applicable
to foreign personal holding company in-
come. To determine the extent to which a
controlled foreign corporation’s distribu-
tive share of an item of income of a part-
nership is foreign personal holding com-
pany income, the exceptions contained in
sections 954(c)(2) and §1.954–2(b)(2)
and (6), (e)(1)(ii), (f)(1)(ii), (g)(2)(ii), and
(h)(3)(ii), shall apply only if any such ex-
ception would have applied to exclude the
income from foreign personal holding
company income if the controlled foreign
corporation had earned the income di-
rectly, determined by taking into account
only the activities of, and property owned
by, the partnership and not the separate
activities or property of the controlled for-
eign corporation or any other person.
(iii) [The text of the proposed para-
graph (a)(5)(iii) is the same as the text of
§1.954–2T(a)(5)(iii) published in T.D.
8767.]
(6) Special rules applicable to excep-
tions from foreign personal holding com-
pany income treatment in circumstances
involving hybrid branches—(i) [The text
of the proposed paragraph (a)(6)(i) is the
same as the text of §1.954–2T(a)(6) pub-
lished in T.D. 8767.]
* * * * *
Par. 6. Section 1.954–3 is amended as
follows:
1. The second sentence of paragraph
(a)(4)(i) is revised.
2. The first sentence of paragraph
(a)(4)(ii) is revised.
3. Paragraph (a)(6) is added.
The revisions and addition read as fol-
lows:
§1.954–3 Foreign base company sales
income.
(a) * * *
(4) * * *
(i) * * * A controlled foreign corpora-
tion (selling corporation) will be consid-
ered, for purposes of this paragraph
(a)(4), to have manufactured, produced,
or constructed personal property that it
sells if, as a result of the operations con-
ducted by such selling corporation in con-
nection with the property that it purchased
and sold, the property sold is in effect not
the property that it purchased. * * *
(ii) * * * If, prior to its sale of property
that it has purchased, a selling corporation
substantially transforms the property, the
selling corporation will be treated as hav-
ing manufactured, produced, or con-
structed such property. * * *
* * * * *
(6) Special rule applicable to distribu-
tive share of partnership income—(i) In
general.To determine the extent to which
a controlled foreign corporation’s distrib-
utive share of any item of gross income of
a partnership would have been foreign
base company sales income if received by
it directly, under §1.952–1(b), the prop-
erty sold will be considered to be manu-
factured, produced or constructed by the
controlled foreign corporation within the
meaning of paragraph (a)(4) of this sec-
tion only if the manufacturing exception
of paragraph (a)(4) of this section would
have applied to exclude the income from
foreign base company sales income if the
controlled foreign corporation had earned
the income directly, determined by taking
into account only the activities of, and
property owned by, the partnership and
not the separate activities or property of
the controlled foreign corporation or any
other person.
* * * * *
Par. 7. In §1.954–4, paragraph
(b)(2)(iii) is added to read as follows:
§1.954–4 Foreign base company
services income.
* * * * *
(b) * * *
(2) * * *
(iii) Special rule applicable to distribu-
tive share of partnership income. A con-
trolled foreign corporation’s distributive
share of a partnership’s services income
will be deemed to be derived from ser-
vices performed for or on behalf of a re-
lated person, within the meaning of sec-
tion 954(e)(1)(A), if the partnership is a
related person with respect to the con-
trolled foreign corporation, under section
954(d)(3), and, in connection with the ser-
vices performed by the partnership, the
controlled foreign corporation provided
assistance that would have constituted
substantial assistance contributing to the
performance of such services, under para-
graph (b)(2)(ii) of this section, if fur-
nished to the controlled foreign corpora-
tion by a related person.
* * * * *
Par. 8. Section 1.954–9 is added to
read as follows:
§1.954–9 Hybrid branches.
[The text of this proposed section is the
same as the text of §1.954–9T published
in T.D. 8767.]
Par. 9. In §1.956–2, paragraph (a)(3)
is added to read as follows:

April 20, 1998261998–16 I.R.B.
§1.956–2 Definition of United States
property.
(a) * * *
(3) For purposes of section 956, if a
controlled foreign corporation is a partner
in a partnership that owns property that
would be United States property, within
the meaning of paragraph (a)(1) of this
section, if owned directly by the con-
trolled foreign corporation, the controlled
foreign corporation will be treated as hold-
ing an interest in the property equal to its
ownership interest in the partnership and
such ownership interest will be treated as
an interest in United States property.
* * * * *
PART 301—PROCEDURE AND
ADMINISTRATION
Par. 10. The authority citation for 26
CFR part 301 continues to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Par. 11. Section 301.7701–3 is
amended as follows:
1. Paragraph (a) is amended by adding
a sentence at the end of the paragraph.
2. Paragraph (c)(1)(iv) is amended by
adding a sentence at the end of the para-
graph.
The additions read as follows:
§301.7701–3 Classification of certain
business entities.
(a) [The text of the proposed paragraph
(a) of this section is the same as the text of
§301.7701–3T(a) published in T.D.
8767.]
* * * * *
(c) * * *
(1) * * *
(iv) [The text of the proposed para-
graph (c)(1)(iv) of this section is the same
as the text of §301.7701–3T(c)(1)(iv)
published in T.D. 8767.]
* * * * *
Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on
March 23, 1998, 12:58 p.m., and published in the
issue of the Federal Register for March 26, 1998, 63
F.R. 14669)
Notice of Proposed Rulemaking
and Notice of Public Hearing
Allocation and Sourcing of
Income and Deductions Among
Taxpayers Engaged in a Global
Dealing Operation
REG–208299–90
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
and notice of public hearing.
SUMMARY: This document contains
proposed rules for the allocation among
controlled taxpayers and sourcing of in-
come, deductions, gains and losses from a
global dealing operation; rules applying
these allocation and sourcing rules to for-
eign currency transactions and to foreign
corporations engaged in a U.S. trade or
business; and rules concerning the mark-
to-market treatment resulting from hedg-
ing activities of a global dealing opera-
tion. These proposed rules affect foreign
and domestic persons that are participants
in such operations either directly or indi-
rectly through subsidiaries or partner-
ships. These proposed rules are necessary
to enable participants in a global dealing
operation to determine their arm’s length
contribution to a global dealing operation.
This document also provides notice of a
public hearing on these proposed regula-
tions.
DATES: Written comments must be re-
ceived by June 4, 1998. Outlines of oral
comments to be discussed at the public
hearing scheduled for July 9, 1998, must
be received by June 18, 1998.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (REG–208299–90),
room 5226, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. Submissions may be
hand delivered between the hours of 8
a.m. and 5 p.m. to: CC:DOM:CORP:R
(REG–208299–90), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitution
Avenue, NW, Washington, D.C. Alterna-
tively, taxpayers may submit comments
electronically via the Internet by selecting
the “Tax Regs” option on the IRS Home
Page, or by submitting comments directly
to the IRS Internet site at http://www.irs.
ustreas.gov/prod/tax_regs/comments.html.
The public hearing will be held in room
2615, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC.
FOR FURTHER INFORMATION CON-
TACT: Concerning the regulations in gen-
eral, Ginny Chung of the Office of Asso-
ciate Chief Counsel(International), (202)
622-3870; concerning the mark-to-market
treatment of global dealing operations,
Richard Hoge or JoLynn Ricks of the Of-
fice of Assistant Chief Counsel (Financial
Institutions & Products), (202) 622-3920;
concerning submissions and the hearing,
Michael Slaughter, (202) 622-7190 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained
in this notice of proposed rulemaking have
been submitted to the Office of Manage-
ment and Budget for review in accordance
with the Paperwork Reduction Act of 1995
(44 U.S.C. 3507(d)). Comments on the
collections of information should be sent to
the Office of Management and Budget,
Attn: Desk Officer for the Department of
the Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance offi-
cer, T:FS:FP, Washington, DC 20224.
Comments on the collections of informa-
tion should be received by May 5, 1998.
Comments are specifically requested
concerning:
Whether the proposed collections of in-
formation are necessary for the proper
performance of the functions of the Inter-
nal Revenue Service, including whether
the information will have practical utility;
The accuracy of the estimated burden as-
sociated with the proposed collections of
information (see below);
How the quality, utility, and clarity of the
information to be collected may be en-
hanced;
How the burden of complying with the
proposed collections of information may
be minimized, including through the ap-
plication of automated collection tech-
niques or other forms of information tech-
nology; and

1998–16 I.R.B.27April 20, 1998
Estimates of capital or start-up costs and
costs of operation, maintenance, and pur-
chase of services to provide information.
The collections of information in these
proposed regulations are in §§1.475(g)–
2(b), 1.482–8(b)(3), 1.482–8(c)(3),
1.482–8(d)(3), 1.482–8(e)(5), 1.482–
8(e)(6), and 1.863–3(h). The information
is required to determine an arm’s length
price. The collections of information are
mandatory. The likely recordkeepers are
business or other for-profit institutions.
An agency may not conduct or sponsor,
and a person is not required to respond to,
a collection of information unless the col-
lection of information displays a valid
control number assigned by the Office of
Management and Budget.
Books or records relating to a collec-
tion of information must be retained as
long as their contents may become mater-
ial 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.
Estimated total annual recordkeeping
burden: 20,000 hours. Estimated average
annual burden per recordkeeper is 40
hours. Estimated number of recordkeep-
ers: 500.
Background
In 1990, the IRS issued Announcement
90–106, 1990–38 I.R.B. 29, requesting
comments on how the regulations under
sections 482, 864 and other sections of
the Internal Revenue Code could be im-
proved to address the taxation issues
raised by global trading of financial in-
struments. Section 482 concerns the allo-
cation of income, deductions, credits and
allowances among related parties. Sec-
tion 864 provides rules for determining
the income of a foreign person that is “ef-
fectively connected” with the conduct of a
U.S. trade or business and therefore can
be taxed on a net income basis in the
United States. Provisions under sections
864(c)(2) and (3) provide rules for deter-
mining when U.S. source income is effec-
tively connected income (ECI); section
864(c)(4) provides rules for determining
when foreign source income is ECI.
The rules for determining the source of
income generally are in sections 861, 862,
863 and 865, and the regulations promul-
gated under those sections. Section
1.863–7 provides a special rule for in-
come from notional principal contracts,
under which such income will be treated
as U.S.-source ECI if it arises from the
conduct of a U.S. trade or business under
principles similar to those that apply
under section 864(c)(2). An identical rule
applies for determining U.S. source ECI
under §1.988–4(c) from foreign exchange
gain or loss from certain transactions de-
nominated in a foreign currency.
Because no regulations were issued in
response to the comments that were re-
ceived after Announcement 90–106, there
remain a number of uncertainties regard-
ing the manner in which the existing regu-
lations described above apply to financial
institutions that deal in financial instru-
ments through one or more entities or
trading locations. Many financial institu-
tions have sought to resolve these prob-
lems by negotiating advance pricing
agreements (APAs) with the IRS. In
1994, the IRS published Notice 94–40,
1994–1 C.B. 351, which provided a
generic description of the IRS’s experi-
ence with global dealing operations con-
ducted in a functionally fully integrated
manner. Notice 94–40 specified that it
was not intended to prescribe rules for fu-
ture APAs or for taxpayers that did not
enter into APAs. Moreover, Notice 94–40
provided no guidance of any kind for fi-
nancial institutions that do not conduct
their global dealing operations in a func-
tionally fully integrated manner.
Explanation of Provisions
1. Introduction
This document contains proposed regu-
lations relating to the determination of an
arm’s length allocation of income among
participants engaged in a global dealing
operation. For purposes of these regula-
tions, the terms “global dealing opera-
tion” and “participant” are specifically
defined. The purpose of these regulations
is to provide guidance on applying the
arm’s length principle to transactions be-
tween participants in a global dealing op-
eration. The general rules in the final reg-
ulations under section 482 that provide
the best method rule, comparability
analysis, and the arm’s length range are
generally adopted with some modifica-
tions to conform these principles to the
global dealing environment. In addition,
the proposed regulations contain new
specified methods with respect to global
dealing operations that replace the speci-
fied methods in §§1.482–3 through
1.482–6.
This document also contains proposed
regulations addressing the source of in-
come earned in a global dealing operation
and the circumstances under which such
income is effectively connected to a for-
eign corporation’s U.S. trade or business.
The regulations proposed under section
863 generally source income earned in a
global dealing operation by reference to
the residence of the participant. For these
purposes, residence is defined under sec-
tion 988(a)(3)(B) such that global dealing
income may be sourced between separate
qualified business units (QBUs) of a sin-
gle taxpayer or among separate taxpayers
who are participants, as the case may be.
Exceptions to this general rule are dis-
cussed in further detail below.
Proposed amendments to the regula-
tions under section 864 provide that the
principles of the proposed section 482
regulations may be applied to determine
the amount of income, gain or loss from a
foreign corporation’s global dealing oper-
ation that is effectively connected to a
U.S. trade or business of a participant.
Similar rules apply to foreign currency
transactions that are part of a global deal-
ing operation.
The combination of these allocation,
sourcing, and effectively connected in-
come rules is intended to enable taxpayers
to establish and recognize on an arm’s
length basis the contributions provided by
separate QBUs to a global dealing opera-
tion.
This document also contains proposed
regulations under section 475 to coordi-
nate the accounting rules governing the
timing of income with the allocation,
sourcing, and effectively connected in-
come rules proposed in this document and
discussed above.
2. Explanation of Specific Provisions
A. §1.482–1(a)(1)
Section 1.482–1(a)(1) has been
amended to include expressly transactions
undertaken in the course of a global deal-
ing operation between controlled taxpay-
ers within the scope of transactions cov-
ered by section 482. The purpose of this
amendment is to clarify that the principles
of section 482 apply to evaluate whether
global dealing transactions entered into

April 20, 1998281998–16 I.R.B.
between controlled taxpayers are at arm’s
length.
B. §1.482–(a)—General Requirements
Section 1.482–8(a)(1) lists specified
methods that may be used to determine if
global dealing transactions entered into
between controlled taxpayers are at arm’s
length. The enumerated methods must be
applied in accordance with all of the pro-
visions of §1.482–1, including the best
method rule of §1.482–1(c), the compara-
bility analysis of §1.482–1(d), and the
arm’s length range rule of §1.482–1(e).
The section further requires that any mod-
ifications or supplemental considerations
applicable to a global dealing operation
set forth in §1.482–8(a)(3) be taken into
account when applying any of the transfer
pricing methods. Specific modifications
to the factors for determining comparabil-
ity and the arm’s length range rule are
provided in §1.482–8(a)(3). These modi-
fications and special considerations are
discussed in more detail under their re-
spective headings below.
C. §1.482–8(a)(2)—Definitions
Applicable to a Global Dealing
Operation
Section 1.482–8(a)(2) defines “global
dealing operation,” “participant,” “regular
dealer in securities,” and other terms that
apply for purposes of these regulations.
These definitions supplement the general
definitions provided in §1.482–1(i).
The rules of §1.482–8 apply only to a
global dealing operation. A “global deal-
ing operation” consists of the execution of
customer transactions (including market-
ing, sales, pricing and risk management
activities) in a particular financial product
or line of financial products, in multiple
tax jurisdictions and/or through multiple
participants. The taking of proprietary po-
sitions is not included within the definition
of a global dealing operation unless the
proprietary positions are entered into by a
regular dealer in securities in connection
with its activities as such a dealer. Thus, a
hedge fund that does not have customers
is not covered by these regulations. Posi-
tions held in inventory by a regular dealer
in securities, however, are covered by
these regulations even if the positions are
unhedged because the dealer is taking a
view as to future market changes.
Similarly, lending activities are not in-
cluded within the definition of a global
dealing operation. However, if a person
makes a market in, by buying and selling,
asset-backed securities, the income from
that activity may be covered by these reg-
ulations, regardless of whether the dealer
was a party to the loans backing the secu-
rities. Therefore, income earned from
such lending activities or from securities
held for investment is not income from a
global dealing operation and is not gov-
erned by this section. A security may be
held for investment for purposes of this
section even though it is not identified as
held for investment under section 475.
Activities unrelated to the conduct of a
global dealing operation are not covered
by these regulations, even if they are ac-
counted for on a mark-to-market basis.
Accordingly, income from proprietary
trading that is not undertaken in connec-
tion with a global dealing operation, and
other financial transactions that are not
entered into in a dealing capacity are not
covered by these proposed regulations.
The regulations require that participants
engaged in dealing and nondealing activi-
ties and/or multiple dealing activities seg-
regate income and expense attributable to
each separate dealing operation so that the
best method may be used to evaluate
whether controlled transactions entered
into in connection with a particular deal-
ing activity are priced at arm’s length.
The regulations also require that taxpay-
ers segregate their dealer activities from
their lending, proprietary trading or other
investment activities not entered into in
connection with a global dealing opera-
tion. Comments are solicited on whether
the proposed regulations issued under
section 475 in this notice of proposed
rulemaking are sufficient to facilitate
identification of the amount of income
that should be subject to allocation under
the global dealing regulations.
The term “participant” is defined as a
controlled taxpayer that is either a regular
dealer in securities within the meaning of
§1.482–8(a)(2)(iii), or a member of a
group of controlled taxpayers which in-
cludes a regular dealer in securities, so
long as that member conducts one or
more activities related to the activities of
such dealer. For these purposes, such re-
lated activities are the marketing, sales,
pricing, and risk management activities
necessary to the definition of a global
dealing operation. Additionally, broker-
ing is a related activity that may give rise
to participant status. Related activities do
not include credit analysis, accounting
services, back office services, or the pro-
vision of a guarantee of one or more
transactions entered into by a regular
dealer in securities or other participant.
This definition is significant because the
transfer pricing methods contained in this
section can only be used by participants,
and only to evaluate whether compensa-
tion attributable to a regular dealer in se-
curities or a marketing, sales, pricing, risk
management or brokering function is at
arm’s length. Whether the compensation
paid for other functions performed in the
course of a global dealing operation (in-
cluding certain services and development
of intangibles) is at arm’s length is deter-
mined under the appropriate section 482
regulations applicable to those transac-
tions.
The definition of a global dealing oper-
ation does not require that the global deal-
ing operation be conducted around the
world or on a twenty-four hour basis.
These regulations will apply if the con-
trolled taxpayers, or QBUs of a single
taxpayer, operate in the aggregate in more
than one tax jurisdiction. It is not neces-
sary, however, for the participants to con-
duct the global dealing operation in more
than one tax jurisdiction. For example, a
participant that is resident in one tax juris-
diction may conduct its participant activi-
ties in the global dealing operation
through a trade or business in another ju-
risdiction that is the same jurisdiction
where the dealer activity of a separate
controlled taxpayer takes place. In this
situation, the rules of this section apply to
determine the allocation of income, gain
or loss between the two controlled tax-
payers even if all of the income, gain or
loss is allocable within the same tax juris-
diction.
The term “regular dealer in securities”
is specifically defined in this regulation
consistently with the definition of a regu-
lar dealer under §1.954–2(a)(4)(iv).
Under these proposed regulations, a
dealer in physical securities or currencies
is a regular dealer in securities if it regu-
larly and actively offers to, and in fact
does, purchase securities or currencies
from and sell securities or currencies to
customers who are not controlled taxpay-
ers in the ordinary course of a trade or

business. In addition, a dealer in deriva-
tives is a regular dealer in securities if it
regularly and actively offers to, and in
fact does, enter into, assume, offset, as-
sign or otherwise terminate positions in
securities with customers who are not
controlled entities in the ordinary course
of a trade or business. The IRS solicits
comments on whether these regulations
should be extended to cover dealers in
commodities and/or persons trading for
their own account that are not dealers.
D. Best Method and Comparability
Consistent with the general principles
of section 482, the best method rule ap-
plies to evaluate the most appropriate
method for determining whether the con-
trolled transactions are priced at arm’s
length. New specified methods which re-
place the specified methods of §§1.482–2
through 1.482–6 for a global dealing op-
eration are set forth in §§1.482–8(b)
through 1.482–8(f). The comparable
profits method of §1.482–5 has been ex-
cluded as a specified method for a global
dealing operation because of the high
variability in profits from company to
company and year to year due to differ-
ences in business strategies and fluctua-
tions in the financial markets.
The proposed regulations do not apply
specific methods to certain trading mod-
els, such as those commonly referred to in
the financial services industry as “separate
enterprise,” “natural home,” “centralized
product management,” or “integrated trad-
ing.” Rather, the proposed regulations
adopt the best method rule of §1.482–1(c)
to determine the most appropriate transfer
pricing methodology, taking into account
all of the facts and circumstances of a par-
ticular taxpayer’s trading structure. Con-
sistent with the best method rule, there is
no priority of methods.
Application of the best method rule
will depend on the structure and organiza-
tion of the individual taxpayer’s global
dealing operation and the nature of the
transaction at issue. Where a taxpayer is
engaged in more than one global dealing
operation, it will be necessary to segre-
gate each activity and determine on a
transaction-by-transaction basis within
each activity which method provides the
most reliable measure of an arm’s length
price. It may be appropriate to apply the
same method to multiple transactions of
the same type within a single business ac-
tivity entered into as part of a global deal-
ing operation. For example, if a taxpayer
operates its global dealing activity in no-
tional principal contracts differently than
its foreign exchange trading activity, then
the income from notional principal con-
tracts may be allocated using a different
methodology than the income from for-
eign exchange trading. Moreover, the
best method rule may require that differ-
ent methods be used to determine whether
different controlled transactions are
priced at arm’s length even within the
same product line. For example, one
method may be the most appropriate to
determine if a controlled transaction be-
tween a global dealing operation and an-
other business activity is at arm’s length,
while a different method may be the most
appropriate to determine if the allocation
of income and expenses among partici-
pants in a global dealing operation is at
arm’s length.
Section 1.482–8(a)(3) reiterates that
the principle of comparability in §1.482–
1(d) applies to transactions entered into
by a global dealing operation. The com-
parability factors provided in §1.482–
8(a)(3) (functional analysis, risk, and eco-
nomic conditions), however, must be ap-
plied in place of the comparability factors
discussed in §1.482–1(d)(3). The compa-
rability factors for contractual terms in
§1.482–8(a)(3) supplement the compara-
bility factors for contractual terms in
§1.482–1(d)(3)(ii). The comparability
factors in this section have been included
to provide guidance on the factors that
may be most relevant in assessing compa-
rability in the context of a global dealing
operation.
E. Arm’s Length Range
In determining the arm’s length range,
§1.482–1(e) will apply except as modi-
fied by these proposed regulations. In de-
termining the reliability of an arm’s
length range, the IRS believes that it is
necessary to consider the fact that the
market for financial products is highly
volatile and participants in a global deal-
ing operation frequently earn only thin
profit margins. The reliability of using a
statistical range in establishing a compa-
rable price of a financial product in a
global dealing operation is based on facts
and circumstances. In a global dealing
operation, close proximity in time be-
tween a controlled transaction and an un-
controlled transaction may be a relevant
factor in determining the reliability of the
uncontrolled transaction as a measure of
the arm’s length price. The relevant time
period will depend on the price volatility
of the particular product.
The district director may, notwithstand-
ing §1.482–1(e)(1), adjust a taxpayer’s re-
sults under a method applied on a transac-
tion-by-transaction basis if a valid
statistical analysis demonstrates that the
taxpayer’s controlled prices, when ana-
lyzed on an aggregate basis, provide re-
sults that are not arm’s length. See
§1.482–1(f)(2)(iv). This may occur, for
example, when there is a pattern of prices
in controlled transactions that are higher
or lower than the prices of comparable
uncontrolled transactions.
Comments are solicited on the types of
analyses and factors that may be relevant
for pricing controlled financial transac-
tions in a global dealing operation. Sec-
tion 1.482–1(e) continues to apply in its
entirety to transactions among partici-
pants that are common to businesses other
than a global dealing operation. In this
regard, the existing rules continue to
apply to pricing of certain services from a
participant to a regular dealer in securities
other than services that give rise to partic-
ipant status.
F. Comparable Uncontrolled Financial
Transaction Method
The comparable uncontrolled financial
transaction (CUFT) method is set forth in
§1.482–8(b). The CUFT method evalu-
ates whether controlled transactions sat-
isfy the arm’s length standard by compar-
ing the price of a controlled financial
transaction with the price of a comparable
uncontrolled financial transaction. Simi-
larity in the contractual terms and risks
assumed in entering into the financial
transaction are the most important compa-
rability factors under this method.
Ordinarily, in global dealing opera-
tions, proprietary pricing models are used
to calculate a financial product’s price
based upon market data, such as interest
rates, currency rates, and market risks.
The regulations contemplate that indirect
evidence of the price of a CUFT may be
derived from a proprietary pricing model
if the data used in the model is widely and
routinely used in the ordinary course of
the taxpayer’s business to price uncon-
trolled transactions, and adjustments are
1998–16 I.R.B.29April 20, 1998

made to the amount charged to reflect dif-
ferences in the factors that affect the price
to which uncontrolled taxpayers would
agree. In addition, the proprietary pricing
model must be used in the same manner
to price transactions with controlled and
uncontrolled parties. If a taxpayer uses its
internal pricing model as evidence of a
CUFT, it must, upon request, furnish the
pricing model to the district director in
order to substantiate its use.
G. Gross Margin Method
The gross margin method is set forth in
§1.482–8(c) and should be considered in
situations where a taxpayer performs only
a routine marketing or sales function as
part of a global dealing operation. Fre-
quently, taxpayers that perform the sales
function in these circumstances partici-
pate in the dealing of a variety of, rather
than solely identical, financial products.
In such a case, the variety of financial
products sold within a relevant time pe-
riod may limit the availability of compa-
rable uncontrolled financial transactions.
Where the taxpayer has performed a simi-
lar function for a variety of products,
however, the gross margin method can be
used to determine if controlled transac-
tions are priced at arm’s length by refer-
ence to the amount earned by the taxpayer
for performing similar functions with re-
spect to uncontrolled transactions.
The gross margin method determines if
the gross profit realized on sales of finan-
cial products acquired from controlled
parties is at arm’s length by comparing
that profit to the gross profit earned on
uncontrolled transactions. Since compa-
rability under this method depends on the
similarity of functions performed and
risks assumed, adjustments must be made
for differences between the functions per-
formed in the disposition of financial
products acquired in controlled transac-
tions and the functions performed in the
disposition of financial products acquired
in uncontrolled transactions. Although
close product similarity will tend to im-
prove the reliability of the gross margin
method, the reliability of this method is
not as dependent on product similarity as
the CUFT method.
Participants in a global dealing opera-
tion may act simply as brokers, or they
may participate in structuring complex
products. As the role of the participant
exceeds the brokerage function, it be-
comes more difficult to find comparable
functions because the contributions made
in structuring one complex financial prod-
uct are not likely to be comparable to the
contributions made in structuring a differ-
ent complex financial product. Accord-
ingly, the regulations provide that the reli-
ability of this method is decreased where
a participant is substantially involved in
developing a financial product or in tai-
loring the product to the unique require-
ments of a customer prior to resale.
H. Gross Markup Method
Like the gross margin method, the
gross markup method set forth in §1.482–
8(d) should generally be considered in sit-
uations where a taxpayer performs only a
routine marketing or sales function as part
of a global dealing operation, and, as is
often the case, handles a variety of finan-
cial products within a relevant time pe-
riod. The gross markup method is gener-
ally appropriate in cases where the
taxpayer performs a routine sales function
in buying a financial product from an un-
controlled party and reselling or transfer-
ring the product to a controlled party.
The gross markup method determines if
the gross profit earned on the purchase of
financial products from uncontrolled par-
ties and sold to controlled taxpayers is at
arm’s length by comparing that profit to
the gross profit earned on uncontrolled
transactions. Like the gross margin
method, comparability under this method
depends on the similarity of the functions
performed and risks assumed in the con-
trolled and uncontrolled transactions. Ac-
cordingly, adjustments should be made for
differences between the functions per-
formed in the sale or transfer of financial
products to controlled parties, and the
functions performed with respect to the
sale or transfer of financial products to un-
controlled parties. Although close product
similarity will tend to improve the reliabil-
ity of the gross markup method, the relia-
bility of this method is not as dependent on
product similarity as the CUFT method.
As in the gross margin method, the reg-
ulations provide that the reliability of this
method generally is decreased where a
participant is substantially involved in de-
veloping a financial product or in tailor-
ing the product to the unique require-
ments of a customer prior to resale.
I. Profit Split Methods
New profit split methods are proposed
for global dealing participants under
§1.482–8(e). Global dealing by its nature
involves a certain degree of integration
among the participants in the global deal-
ing operation. The structure of some
global dealing operations may make it
difficult to apply a traditional transac-
tional method to determine if income is
allocated among participants on an arm’s
length basis. Two profit split methods,
the total profit split method and the resid-
ual profit split method, have been in-
cluded as specified methods for determin-
ing if global dealing income is allocated
at arm’s length.
Profit split methods may be used to
evaluate if the allocation of operating
profit from a global dealing operation
compensates the participants at arm’s
length for their contribution by evaluating
if the allocation is one which uncontrolled
parties would agree to. Accordingly, the
reliability of this method is dependent
upon clear identification of the respective
contributions of each participant to the
global dealing operation.
In general, the profit split methods
must be based on objective market
benchmarks that provide a high degree of
reliability, i.e., comparable arrangements
between unrelated parties that allocate
profits in the same manner and on the
same basis. Even if such comparable un-
controlled transactions are not available,
however, the taxpayer may be able to
demonstrate that a total profit split pro-
vides arm’s length results that reflect the
economic value of the contribution of
each participant, by reference to other ob-
jective factors that provide reliability due
to their arm’s length nature. For exam-
ple, an allocation of income based on
trader bonuses may be reliable, under the
particular facts and circumstances of a
given case, if the taxpayer can demon-
strate that such bonuses are based on the
value added by the individual traders. By
contrast, an allocation based on head-
count or gross expenses may be unreli-
able, because the respective participants
might, for example, have large differ-
ences in efficiency or cost control prac-
tices, which would tend to make such
factors poor reflections of the economic
value of the functions contributed by
each participant.
April 20, 1998301998–16 I.R.B.

The proposed regulations define gross
profit as gross income earned by the
global dealing operation. Operating ex-
penses are those not applicable to the de-
termination of gross income earned by the
global dealing operation. The operating
expenses are global expenses of the
global dealing operation and are sub-
tracted from gross profit to determine the
operating profit. Taxpayers may need to
allocate operating expenses that relate to
more than one global dealing activity.
The regulations state that in appropriate
circumstances a multi-factor formula may
be used to determine whether an alloca-
tion is at arm’s length. Use of a multi-fac-
tor formula is permitted so long as the for-
mula allocates the operating profit or loss
based upon the factors that uncontrolled
taxpayers would consider. The regula-
tions do not prescribe specific factors to
be used in the formula since the appropri-
ateness of any one factor will depend on
all the facts and circumstances associated
with the global dealing operation. How-
ever, the regulations require that the
multi-factor formula take into account all
of the functions performed and risks as-
sumed by a participant, and attribute the
appropriate amount of income or loss to
each function. The IRS also solicits com-
ments concerning which factors may be
appropriate (for example, initial net pre-
sent value of derivatives contracts) and
the circumstances under which specific
factors may be appropriately applied.
The purpose of the factors is to mea-
sure the relative value contributed by each
participant. Thus, adjustments must be
made for any circumstances other than the
relative value contributed by a participant
that influence the amount of a factor so
that the factor does not allocate income to
a participant based on circumstances that
are not relevant to the value of the func-
tion or activity being measured. For ex-
ample, if trader compensation is used to
allocate income among participants, and
the traders in two different jurisdictions
would be paid different amounts (for ex-
ample, due to cost of living differences)
to contribute the same value, adjustments
should be made for the difference so that
the factors accurately measure the value
contributed by the trading function. The
IRS solicits comments regarding the types
of adjustments that should be made, how
to make such adjustments, and the need
for further guidance on this point.
The total profit split method entails a
one step process whereby the operating
profit is allocated among the participants
based on their relative contributions to the
profitability of the global dealing opera-
tion. No distinction is made between rou-
tine and nonroutine contributions. The
total profit split method may be useful to
allocate income earned by a highly inte-
grated global dealing operation where all
routine and nonroutine dealer functions
are performed by each participant in each
location. Accordingly, total profit or loss
of the global dealing operation may be al-
located among various jurisdictions based
on the relative performance of equivalent
functions in each jurisdiction.
The residual profit split method entails
a two step process. In the first step, the
routine functions are compensated with a
market return based upon the best transfer
pricing method applicable to that transac-
tion. Routine functions may include, but
are not limited to, functions that would
not give rise to participant status and
which should be evaluated under
§§1.482–3 through 1.482–6. After com-
pensating the routine functions, the re-
maining operating profit (the “residual
profit”) is allocated among the partici-
pants based upon their respective nonrou-
tine contributions.
It should be noted that, while in appro-
priate cases a profit split method may be
used to determine if a participant is com-
pensated at arm’s length, use of the profit
split method does not change the contrac-
tual relationship between participants, nor
does it affect the character of intercom-
pany payments. For example, if a con-
trolled taxpayer provides solely trading
services to a global dealing operation in a
particular jurisdiction, any payment it re-
ceives as compensation for services re-
tains its character as payment for services
and, under the regulations, is not con-
verted into a pro rata share of each item of
gross income earned by the global dealing
operation.
J. Unspecified Methods
Consistent with the principles underly-
ing the best method rule, the regulations
provide the option to use an unspecified
method if it is determined to be the best
method. The IRS solicits comments on
the extent to which the variety of methods
on which specific guidance has been pro-
vided is adequate.
Guidance on the use of a comparable
profits method has specifically not been
included as a specified method in the pro-
posed regulations because use of that
method depends on the existence of
arrangements between uncontrolled tax-
payers that perform comparable functions
and assume comparable risks. Global
dealing frequently involves the use of
unique intangibles such as trader know-
how. Additionally, anticipated profit is
often influenced by the amount of risk a
participant is willing to bear. Accord-
ingly, the IRS believes it is unlikely that
the comparability of these important func-
tions can be measured and adjusted for
accurately in a global dealing operation.
K. Source of Global Dealing Income
Under current final regulations in
§1.863–7(a), all of the income attributable
to a notional principal contract is sourced
by reference to the taxpayer’s residence.
Exceptions are provided for effectively
connected notional principal contract in-
come, and for income earned by a foreign
QBU of a U.S. resident taxpayer if the no-
tional principal contract is properly re-
flected on the books of the foreign QBU.
Attribution of all of the income from a no-
tional principal contract to a single loca-
tion has generally been referred to as the
“all or nothing” rule. The current final
regulations do not provide for multi-loca-
tion sourcing of notional principal con-
tract income among the QBUs that have
participated in the acquisition or risk
management of a notional principal con-
tract and therefore do not recognize that
significant activities, including structur-
ing or risk managing derivatives, often
occur through QBUs in more than one ju-
risdiction.
Recognizing the need for multi-loca-
tion sourcing of income earned in a global
dealing operation, the proposed regula-
tions provide a new rule under §1.863–3
which sources income from a global deal-
ing operation in the same manner as the
income would be allocated under §1.482–
8 if each QBU were a separate entity.
However, the rules must be applied differ-
ently to take into account the economic
differences between acting through a sin-
gle legal entity and through separate legal
entities.
Accordingly, income from a single
transaction may be split-sourced to more
than one location, so long as the alloca-
1998–16 I.R.B.31April 20, 1998

tion methodology satisfies the arm’s
length standard. The all or nothing rule of
§1.863–7(a) continues to apply to no-
tional principal contract income attribut-
able to activities not related to a global
dealing operation. Corresponding
changes have been made in proposed
§1.988–4(h) to exclude exchange gain or
loss derived in the conduct of a global
dealing operation from the general source
rules in §1.988–4(b) and (c).
These special source rules apply only
with respect to participants that perform a
dealing, marketing, sales, pricing, risk
management or brokering function.
Moreover, these rules do not apply to in-
come, such as fees for services, for which
a specific source rule is provided in sec-
tion 861, 862 or 865 of the Code. Accord-
ingly, if a controlled taxpayer provides
back office services, the amount and
source of an intercompany payment for
such services is determined under existing
transfer pricing and sourcing rules applic-
able to those services without regard to
whether the controlled taxpayer is also a
participant in a global dealing operation.
If an entity directly bears the risk as-
sumed by the global dealing operation, it
should be compensated for that function.
In providing, however, that the source
(and effectively connected status) of
global dealing income is determined by
reference to where the dealing, marketing,
sales, pricing, risk management or broker-
ing function that gave rise to the income
occurred, the regulations effectively pro-
vide that compensation for risk bearing
should be sourced by reference to where
the capital is employed by traders, mar-
keters and salespeople, rather than the
residence of the capital provider. This
principle applies where a taxpayer di-
rectly bears risk arising from the conduct
of a global dealing operation, such as
when it acts as a counterparty without
performing other global dealing func-
tions. A special rule provides that the ac-
tivities of a dependent agent may give rise
to participant status through a deemed
QBU that performs its participant func-
tions in the same location where the de-
pendent agent performs its participant
functions. The deemed QBU may be cre-
ated without regard to the books and
records requirement of §1.989–1(b).
As indicated, accounting, back office,
credit analysis, and general supervision
and policy control functions do not give
rise to participant status in a global deal-
ing operation but are services that should
be remunerated and sourced separately
under existing rules. This principle also
applies where a taxpayer bears risk indi-
rectly, such as through the extension of a
guarantee. Accordingly, the sourcing rule
of §1.863–3(h) does not apply to interest,
dividend, or guarantee fee income re-
ceived by an owner or guarantor of a
global dealing operation that is conducted
by another controlled taxpayer. The
source of interest, dividend and guarantee
fee income, substitute interest and substi-
tute dividend payments sourced under
§§1.861–2(a)(7) and 1.861–3(a)(6), and
other income sourced by section 861, 862
or 865 continues to be governed by the
source rules applicable to those transac-
tions.
The proposed regulations provide, con-
sistent with U.S. tax principles, that an
agreement between two QBUs of a single
taxpayer does not give rise to a transac-
tion because a taxpayer cannot enter into
nor profit from a “transaction” with itself.
See, e.g., §1.446–3(c)(1). The IRS be-
lieves, however, that these agreements be-
tween QBUs of a single taxpayer may
provide evidence of how income from the
taxpayer’s transactions with third parties
should be allocated among QBUs. It is a
common practice for taxpayers to allocate
income or loss from transactions with
third parties among QBUs for internal
control and risk management purposes.
Accordingly, the proposed regulations
specifically provide that such allocations
may be used to source income to the same
extent and in the same manner as they
may be used to allocate income between
related persons. Conversely, such trans-
actions may not be used to the extent they
do not provide an arm’s length result.
L. Determination of Global Dealing
Income Effectively Connected with a
U.S. Business
After determining the source of in-
come, it is necessary to determine the ex-
tent to which such income is ECI. Under
current law, the general rule is that all of
the income, gain or loss from a global
dealing operation is effectively connected
with a U.S. trade or business if the U.S.
trade or business materially participates in
the acquisition of the asset that gives rise
to the income, gain or loss, or property is
held for use in the active conduct of a
U.S. trade or business, or the business ac-
tivities conducted by the U.S. trade or
business are a material factor in the real-
ization of income, gain or loss. As noted
above, the current final regulations do not
permit the attribution of income, gain or
loss from a global dealing operation that
is allocated and sourced to a U.S. trade or
business under §1.863–3(h) shall be ef-
fectively connected. In this regard, an
asset used in a global dealing operation is
treated as an asset used in a U.S. trade or
business to the extent that an allocation is
made to a U.S. QBU. Similarly, the U.S.
trade or business is also treated as a mate-
rial factor in the realization of income,
gain or loss for which an allocation is
made to a U.S. QBU. A special rule for
U.S. source interest and dividend income,
including substitute interest and substitute
dividends, earned by a foreign banking or
similar financial institution in a global
dealing operation treats such income as
attributable to a U.S. trade or business to
the extent such income would be sourced
to the United States under §1.863–3(h).
Any foreign source income allocated to
the United States under the principles of
§1.863–3(h) is also treated as attributable
to the U.S. trade or business.
The proposed regulations also limit an
entity’s effectively connected income
from a global dealing operation to that
portion of an item of income, gain or loss
that would be sourced to the U.S. trade or
business if the rules of §1.863–3(h) were
to apply. These rules are intended to en-
sure that income for which a specific
source rule is provided in section 861,
862 or 865 does not produce effectively
connected income unless it was earned
through functions performed by a U.S.
QBU of the taxpayer.
With respect to notional principal con-
tract income and foreign exchange gain or
loss, proposed §§1.863–3(h) and 1.988–
4(h) also provide that such income, gain
or loss is effectively connected with the
conduct of a U.S. trade or business to the
extent that it is sourced to the United
States under §1.863–3(h).
In certain circumstances, the global
dealing activities of an entity acting as the
agent of a foreign taxpayer in the United
States may cause the foreign taxpayer to
be engaged in a U.S. trade or business.
April 20, 1998321998–16 I.R.B.

Any income effectively connected with
the U.S. trade or business must be re-
ported by the foreign corporation on a
timely filed U.S. tax return in order for
the foreign corporation to be eligible for
deductions and credits attributable to such
income. See §1.882–4. In addition, the
agent must also report any income earned
in its capacity as agent on its own tax re-
turn. The provisions governing the time
and manner for foreign corporations to
make elections under §§1.882–5 and
1.884–1 remain in force as promulgated.
Under current rules, these formalities
must be observed even if all of the global
dealing income would be allocated be-
tween a U.S. corporation and a foreign
corporation’s U.S. trade or business. The
IRS believes that these requirements are
justified because of potential differences
that might occur with respect to the real-
ization of losses and between actual divi-
dend remittances of a U.S. corporation
and deemed dividend remittances under
the branch profits tax. The IRS, however,
solicits comments regarding whether
these filing requirements can be simpli-
fied, taking into consideration the policies
underlying the filing requirements of
§1.882–4.
The Business Profits article contained
in U.S. income tax treaties requires the
United States to attribute to a permanent
establishment that portion of the income
earned by the entity from transactions
with third parties that the permanent es-
tablishment might be expected to earn if it
were an independent enterprise. Because
the proposed regulations contained in this
document allocate global trading income
among permanent establishments under
the arm’s length principle of the Associ-
ated Enterprises article of U.S. income tax
treaties, such rules are consistent with our
obligations under the Business Profits ar-
ticle. Accordingly, a proposed rule under
section 894 provides that, if a taxpayer is
engaged in a global dealing operation
through a U.S. permanent establishment,
the proposed regulations will apply to de-
termine the income attributable to that
U.S. permanent establishment under the
applicable U.S. income tax treaty.
M. Relationship to Other Regulations
The allocation rules contained herein
do not apply to the allocation of interest
expense. As discussed in the preamble to
§1.882–5 (T.D. 8658, 1996–1 C.B. 161,
162, 61 F.R. 9326, March 5, 1996), the
rules contained in §1.882–5 are the exclu-
sive rules for allocating interest expense,
including under U.S. income tax treaties.
Proposed regulations have been issued
under sections 882 and 884 (INTL–0054–
95, 1996–1 C.B. 844, 61 F.R. 9377,
March 5, 1996) for purposes of allocating
interest expense and determining the U.S.
assets and/or liabilities reflected on the
books of a foreign corporation’s U.S.
trade or business that are attributable to its
activities as a dealer under section 475.
The proposed regulations (and similar
final regulations) under section 884 ad-
dress the treatment of assets which give
rise to both effectively connected and
non-effectively connected income. Those
rules thus address a situation analogous to
the split-sourcing situation addressed in
these proposed regulations. The IRS an-
ticipates issuing proposed regulations
under section 861 that provide a similar
rule for purposes of allocating interest ex-
pense of a U.S. corporation that has assets
that give rise to split-sourced income.
Comments are solicited on the compati-
bility of the proposed regulations con-
tained in this document with the princi-
ples of the proposed regulations that
address a foreign corporation’s allocation
of interest expense, including its compu-
tation of U.S. assets included in step 1 of
the §1.882–5 formula and component lia-
bilities included in steps 2 and 3 of the
§1.882–5 formula.
The IRS believes that the transfer pric-
ing compliance issues associated with a
global dealing operation are substantially
similar to those raised by related party
transactions generally. The IRS also be-
lieves that the existing regulations under
section 6662 adequately address these is-
sues. Accordingly, amendments have not
been proposed to the regulations under
section 6662. Section 6662 may not in
certain circumstances, however, apply to
the computation of effectively connected
income in accordance with proposed reg-
ulations under section 475, 863, 864 or
988 contained in this document. The IRS
will propose regulations under section
6038C regarding the information report-
ing and recordkeeping requirements ap-
plicable to foreign corporations engaged
in a global dealing operation. It is antici-
pated that these regulations will coordi-
nate the application of sections 6662 and
6038C where necessary.
No inference should be drawn from the
examples in these proposed regulations
concerning the treatment or significance
of liquidity and creditworthiness or the ef-
fect of such items on the valuation of a se-
curity. The purpose of the proposed regu-
lations under section 482 is not to provide
guidance on the valuation of a security,
but rather to determine whether the prices
of controlled transactions satisfy the
arm’s length standard. Section 475 and
the regulations thereunder continue to
govern exclusively the valuation of secu-
rities.
N. Section 475
A dealer in securities as defined in sec-
tion 475 is generally required to mark its
securities to market. Securities are ex-
empt from mark-to-market accounting if
the securities are held for investment or
not held for sale to customers and are
properly identified on the taxpayer’s
books and records. Additionally, securi-
ties that hedge positions that are not sub-
ject to mark-to-market accounting are ex-
empt from mark-to-market accounting if
they are properly identified.
Under the current regulations, a tax-
payer may not take into account an agree-
ment between separate business units
within the same entity that transfers risk
management responsibility from a non-
dealing business unit to a dealing business
unit. Moreover, such an agreement may
not be used to allocate income, expense,
gain or loss between activities that are ac-
counted for on a mark-to-market basis
and activities that are accounted for on a
non-mark-to-market basis. In contrast,
the regulations proposed in this document
under sections 482, 863, 864, 894, and
988 allow a taxpayer to take into account
records of internal transfers when allocat-
ing global dealing income earned from
third parties for purposes of determining
source and effectively connected income.
This may cause a mismatch in the timing
of income, expense, gain, or loss.
For example, if a taxpayer’s lending
desk enters into a third-party transaction
that exposes the lending desk to currency
or interest rate risk, the lending desk may
transfer responsibility for managing the
risk for that particular transaction to an-
other business activity that can manage
1998–16 I.R.B.33April 20, 1998

the risk more efficiently (e.g., the desk
that deals in currency or interest rate de-
rivatives). The dealing desk then, in the
ordinary course of its business, may enter
into a transaction such as a swap with a
third party to hedge the aggregate risk of
the dealing desk and, indirectly, the risk
incurred by the lending desk with respect
to the original transaction. Where, as is
generally the case, the dealing desk has a
large volume of transactions, it is not pos-
sible as a practical matter to associate the
aggregate hedge with the risk of the lend-
ing desk. Since the transactions entered
into by the dealing desk must generally be
marked to market, the third-party transac-
tion that hedges the aggregate risk of the
dealing desk (which includes the risk
transferred from the lending desk) must
generally also be marked. To the extent
that a portion of the income, expense,
gain, or loss from the aggregate hedging
transaction is allocated to the lending
desk under the proposed global dealing
regulations, the potential timing mis-
match described above will occur if the
lending desk accounts for its positions on
a non-mark-to-market basis. This mis-
match could occur because the portion of
the income, expense, gain, or loss from
the hedging transaction, although allo-
cated to the lending desk for sourcing and
effectively connected income purposes,
will be accounted for on a mark-to-market
basis under the dealing desk’s method of
accounting. Entirely exempting the ag-
gregate hedging transaction from mark-
to-market accounting does not adequately
solve this problem, because it results in
the portion of the income, expense, gain
or loss from the aggregate hedging trans-
action that is allocated to the dealing desk
being accounted for on other than a mark-
to-market method.
As the example shows, respecting
records of internal transfers for purposes
of sourcing without respecting these same
records for purposes of timing could pro-
duce unpredictable and arbitrary results.
Accordingly, the proposed regulations
permit participants in a global dealing op-
eration to respect records of internal
transfers in applying the timing rules of
section 475. Because the need to recon-
cile sourcing and timing exists only in the
context of a cross-border operation, the
proposed regulations have a limited
scope. In particular, for the proposed reg-
ulations to apply, income of the global
dealing desk must be subject to allocation
among two or more jurisdictions or be
sourced to two or more jurisdictions.
The purpose of the proposed regula-
tions under section 475 is to coordinate
section 475 with the proposed global
dealing regulations and to facilitate iden-
tification of the amount of income, ex-
pense, gain or loss from third party trans-
actions that is subject to mark-to-market
accounting. This rule is not intended to
allow a shifting of income inconsistent
with the arm’s length standard.
Under the proposed section 475 regula-
tions, an interdesk agreement or “risk
transfer agreement” (RTA) includes a
transfer of responsibility for risk manage-
ment between a business unit that is hedg-
ing some of its risk (the hedging QBU)
and another business unit of the same tax-
payer that uses mark-to-market account-
ing (the marking QBU). If the marking
QBU, the hedging QBU, and the RTA sat-
isfy certain requirements, the RTA is
taken into account for purposes of deter-
mining the timing of income allocated by
the proposed global dealing regulations to
the separate business units of a taxpayer.
The proposed amendments to the sec-
tion 475 regulations require that the mark-
ing QBU must be a dealer within the
meaning of proposed §1.482–8(a)(2)(iii)
and that its income must be allocated to at
least two jurisdictions under proposed
§1.482–8 or sourced to at least two juris-
dictions under proposed §1.863–3(h).
Additionally, the RTA qualifies only if the
marking QBU would mark its side of the
RTA to market under section 475 if the
transaction were with an unrelated third
party. Thus, if the marking QBU were to
identify the RTA as a hedge of a position
that is not subject to mark-to-market ac-
counting (such as debt issued by the
marking QBU), the RTA would not qual-
ify. The IRS requests comments on
whether the marking QBU should ever be
able to exempt its position in the RTA
from mark-to-market treatment and ac-
count for its position in the RTA.
The proposed amendments to the sec-
tion 475 regulations are intended to ad-
dress situations where the hedging QBU
transfers responsibility for the manage-
ment of risk arising from a transaction
with a third party. Accordingly, the pro-
posed regulations require that the hedging
QBU’s position in the RTA would be a
hedge within the meaning of §1.1221–
2(b) if the transaction were entered into
with an unrelated entity. The IRS solicits
comments on whether this requirement is
broad enough to address the business
needs of entities engaged in global deal-
ing and nondealing activities. Comments
that suggest broadening the requirement
(e.g., to include risk reduction with re-
spect to capital assets) should address
how such a regime could be coordinated
with other relevant rules (e.g., the straddle
rules). Additionally, if a taxpayer sug-
gests changes to the section 475 rules pro-
posed in this notice, the IRS requests ad-
ditional comments addressing whether or
not corresponding changes should be
made to §1.1221–2(d).
The proposed regulations also require
that the RTA be recorded on the books
and records of the QBU no later than the
time the RTA is effective. RTAs that are
not timely recorded do not qualify under
the proposed regulations. Additionally,
the RTA must be accounted for in a man-
ner that is consistent with the QBU’s
usual accounting practices.
If all of the requirements of the pro-
posed regulations are satisfied, then for
purposes of determining the timing of in-
come, expense, gain, or loss allocated to a
QBU under the global dealing regula-
tions, the marking QBU and the hedging
QBU account for their respective posi-
tions in the RTA as if the position were
entered into with an unrelated third party.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in Exec-
utive Order 12866. Therefore, a regula-
tory impact analysis is not required. It is
hereby certified that these regulations do
not have a significant economic impact on
a substantial number of small entities.
This certification is based upon the fact
that these regulations affect entities who
participate in cross-border global dealing
of stocks and securities. These regula-
tions affect the source of income and allo-
cation of income, deductions, credits, and
allowances among such entities. The pri-
mary participants who engage in cross-
border global dealing activities are large
regulated commercial banks and broker-
age firms, and investment banks. Accord-
April 20, 1998341998–16 I.R.B.

ingly, the IRS does not believe that a sub-
stantial number of small entities engage in
cross-border global dealing activities cov-
ered by these regulation. Therefore, a
Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C.
Chapter 6) is not required. Pursuant to
section 7805(f) of the Code, this notice of
proposed rulemaking will be submitted to
the Chief Counsel for Advocacy of the
Small Business Administration for com-
ment on their impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, considera-
tion will be given to any written com-
ments that are submitted timely to the IRS
(a signed original and eight (8) copies).
All comments will be available for public
inspection and copying.
A public hearing has been scheduled
for July 9, 1998, at 10 a.m. in room 2615,
Internal Revenue Building, 1111 Consti-
tution Avenue NW, Washington, DC. Be-
cause of access restrictions, visitors will
not be admitted beyond the Internal Rev-
enue Building lobby more than 15 min-
utes before the hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral com-
ments at the hearing must submit written
comments by June 4, 1998, and submit an
outline of the topics to be discussed and
the time to be devoted to each topic by
June 18, 1998.
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.
Proposed Effective Date
These regulations are proposed to be
effective for taxable years beginning after
the date final regulations are published in
the Federal Register.
Drafting Information
The principal authors of these regula-
tions are Ginny Chung of the Office of
Associate Chief Counsel (International)
and Richard Hoge of the Office of Assis-
tant Chief Counsel (Financial Institutions
& Products). However, other personnel
from the IRS and Treasury Department
participated in their development.
* * * * *
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is pro-
posed to be amended as follows:
Part 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding entries in nu-
merical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
§1.475(g)–2 also issued under 26
U.S.C. 475. * * *
§1.482–8 also issued under 26 U.S.C.
482. * * *
Section 1.863–3(h) also issued under
26 U.S.C. 863 and 26 U.S.C. 865(j). * * *
Section 1.988–4(h) also issued under
26 U.S.C. 863 and 26 U.S.C. 988. * * *
Par. 2. Section 1.475(g)–2 is added as
follows:
§1.475(g)–2 Risk transfer agreements in
a global dealing operation.
(a) In general. This section provides
computational rules to coordinate the ap-
plication of section 475 and §1.446–4
with rules for allocation and sourcing
under the global dealing regulations. If
the requirements in paragraph (c) of this
section are met, a risk transfer agreement
(RTA) (as defined in paragraph (b) of this
section) is accounted for under the rules
of paragraph (d) of this section.
(b) Definition of risk transfer agree-
ment.For purposes of this section, a risk
transfer agreement (RTA) is a transfer of
risk between two qualified business units
(QBUs) (as defined in §1.989(a)–1(b)) of
the same taxpayer such that—
(1) The transfer is consistent with the
business practices and risk management
policies of each QBU;
(2) The transfer is evidenced in each
QBU’s books and records;
(3) Each QBU records the RTA on its
books and records at a time no later than
the time the RTA is effective; and
(4) Except to the extent required by
paragraph (b)(3) of this section, the entry
in the books and records of each QBU is
consistent with that QBU’s normal ac-
counting practices.
(c) Requirements for application of oper-
ational rule—(1) The position in the RTA
of one QBU (the hedging QBU) would
qualify as a hedging transaction (within the
meaning of §1.1221–2(b)) with respect to
that QBU if—
(i) The RTA were a transaction entered
into with an unrelated party; and
(ii) For purposes of determining whether
the hedging QBU’s position satisfies the
risk reduction requirement in §1.1221–
2(b), the only risks taken into account are
the risks of the hedging QBU (that is, the
risks that would be taken into account if the
hedging QBU were a separate corporation
that had made a separate-entity election
under §1.1221–2(d)(2));
(2) The other QBU (the marking QBU)
is a regular dealer in securities (within the
meaning of §1.482–8(a)(2)(iii));
(3) The marking QBU would mark to
market its position in the RTA under section
475 if the RTA were a transaction entered
into with an unrelated party; and
(4) Income of the marking QBU is sub-
ject to allocation under §1.482–8 to two or
more jurisdictions or is sourced under
§1.863–3(h) to two or more jurisdictions.
(d) Operational rule.If the requirements
in paragraph (c) of this section are met,
each QBU that is a party to a RTA (as de-
fined in paragraph (b) of this section) takes
its position in the RTA into account as if
that QBU had entered into the RTA with an
unrelated party. Thus, the marking QBU
marks its position to market, and the hedg-
ing QBU accounts for its position under
§1.446–4. Because this section only effects
coordination with the allocation and sourc-
ing rules, it does not affect factors such as
the determination of the amount of interest
expense that is incurred by either QBU and
that is subject to allocation and apportion-
ment under section 864(e) or 882(c).
Par. 3. Section 1.482–0 is amended as
follows:
1. The introductory text is revised.
2. The section heading and entries for
§1.482–8 are redesignated as the section
heading and entries for §1.482–9.
3. A new section heading and entries for
§1.482–8 are added.
The addition and revision read as fol-
lows:
§1.482–0 Outline of regulations under
section 482.
This section contains major captions
for §§1.482–1 through 1.482–9.
1998–16 I.R.B.35April 20, 1998

* * * * *
§1.482–8 Allocation of income earned in
a global dealing operation.
(a) General requirements and defini-
tions.
(1) In general.
(2) Definitions.
(i)Global dealing operation.
(ii) Participant.
(iii) Regular dealer in securities.
(iv) Security.
(3) Factors for determining comparabil-
ity for a global dealing operation.
(i)Functional analysis.
(ii) Contractual terms.
(iii) Risk.
(iv) Economic conditions.
(4) Arm’s length range.
(i)General rule.
(ii) Reliability.
(iii) Authority to make adjustments.
(5) Examples.
(b) Comparable uncontrolled financial
transaction method.
(1) General rule.
(2) Comparability and reliability.
(i)In general.
(ii) Adjustments for differences between
controlled and uncontrolled transac-
tions.
(iii) Data and assumptions.
(3) Indirect evidence of the price of a
comparable uncontrolled financial
transaction.
(i)In general.
(ii)Public exchanges or quotation
media.
(iii)Limitation on use of public ex-
changes or quotation media.
(4) Arm’s length range.
(5) Examples.
(c) Gross margin method.
(1) General rule.
(2) Determination of an arm’s length
price.
(i)In general.
(ii) Applicable resale price.
(iii) Appropriate gross profit.
(3) Comparability.
(i)In general.
(ii) Adjustments for differences between
controlled and uncontrolled transac-
tions.
(iii) Reliability.
(iv) Data and assumptions.
(A) n general.
(B) Consistency in accounting.
(4) Arm’s length range.
(5) Example.
(d) Gross markup method.
(1) General rule.
(2) Determination of an arm’s length
price.
(i)In general.
(ii) Appropriate gross profit.
(3) Comparability and reliability.
(i)In general.
(ii) Adjustments for differences between
controlled and uncontrolled transac-
tions.
(iii) Reliability.
(iv) Data and assumptions.
(A) In general.
(B) Consistency in accounting.
(4) Arm’s length range.
(e) Profit split method.
(1) General rule.
(2) Appropriate share of profit and loss.
(i)In general.
(ii)Adjustment of factors to measure
contribution clearly.
(3) Definitions.
(4) Application.
(5) Total profit split.
(i)In general.
(ii) Comparability.
(iii) Reliability.
(iv) Data and assumptions.
(A) In general.
(B) Consistency in accounting.
(6) Residual profit split.
(i)In general.
(ii) Allocate income to routine contribu-
tions.
(iii) Allocate residual profit.
(iv) Comparability.
(v) Reliability.
(vi) Data and assumptions.
(A) General rule.
(B) Consistency in accounting.
(7) Arm’s length range.
(8) Examples.
(f)Unspecified methods.
(g) Source rule for qualified business
units.
Par. 4. Section 1.482–1 is amended as
follows:
1. In paragraph (a)(1), remove the last
sentence and add two new sentences in its
place.
2. Revise paragraph (b)(2)(i).
3. In paragraph (c)(1), revise the last
sentence.
4. In paragraph (d)(3)(v), revise the
last sentence.
5. In paragraph (i), revise the introduc-
tory text.
The additions and revisions read as fol-
lows:
§1.482–1 Allocation of income and
deductions among taxpayers.
(a) In general—(1) Purpose and scope.
* * * Section 1.482–8 elaborates on the
rules that apply to controlled entities en-
gaged in a global securities dealing opera-
tion. Finally, §1.482–9 provides exam-
ples illustrating the application of the best
method rule.
* * * * *
(b) * * *
(2) * * *
(i) Methods.Sections 1.482–2 through
1.482–6 and §1.482–8 provide specific
methods to be used to evaluate whether
transactions between or among members
of the controlled group satisfy the arm’s
length standard, and if they do not, to de-
termine the arm’s length result.
(c) Best method rule—(1) In general.
* * * See §1.482–9 for examples of the
application of the best method rule.
* * * * *
(d) * * *
(3) * * *
(v) Property or services.* * * For
guidance concerning the specific compa-
rability considerations applicable to trans-
fers of tangible and intangible property,
see §§1.482–3 through 1.482–6 and
§1.482–8; see also §1.482–3(f), dealing
with the coordination of the intangible
and tangible property rules.
* * * * *
(i) Definitions. The definitions set
forth in paragraphs (i)(1) through (10) of
this section apply to §§1.482–1 through
1.482–9.
* * * * *
Par. 5. Section 1.482–2 is amended as
follows:
1. In paragraph (a)(3)(iv), revise the
first sentence.
2. Revise paragraph (d).
The revisions read as follows:
§1.482–2 Determination of taxable
income in specific situations.
(a) * * *
April 20, 1998361998–16 I.R.B.

(3) * * *
(iv) Fourth, section 482 and paragraphs
(b) through (d) of this section and
§§1.482–3 through 1.482–8, if applicable,
may be applied by the district director to
make any appropriate allocations, other
than an interest rate adjustment, to reflect
an arm’s length transaction based upon
the principal amount of the loan or ad-
vance and the interest rate as adjusted
under paragraph (a)(3)(i), (ii), or (iii) of
this section. * * *
* * * * *
(d) Transfer of property.For rules gov-
erning allocations under section 482 to re-
flect an arm’s length consideration for
controlled transactions involving the
transfer of property, see §§1.482–3
through 1.482–6 and §1.482–8.
§1.482–8 [Redesignated as §1.482–9]
Par. 6. Section 1.482–8 is redesignated
as §1.482–9 and a new §1.482–8 is added
to read as follows:
§1.482–8 Allocation of income earned in
a global securities dealing operation.
(a) General requirements and defini-
tions—(1) In general.Where two or
more controlled taxpayers are participants
in a global dealing operation, the alloca-
tion of income, gains, losses, deductions,
credits and allowances (referred to herein
as income and deductions) from the
global dealing operation is determined
under this section. The arm’s length allo-
cation of income and deductions related
to a global dealing operation must be de-
termined under one of the methods listed
in paragraphs (b) through (f) of this sec-
tion. Each of the methods must be ap-
plied in accordance with all of the provi-
sions of §1.482–1, including the best
method rule of §1.482–1(c), the compara-
bility analysis of §1.482–1(d), and the
arm’s length range of §1.482–1(e), as
those sections are supplemented or modi-
fied in paragraphs (a)(3) and (a)(4) of this
section. The available methods are—
(i) The comparable uncontrolled finan-
cial transaction method, described in
paragraph (b) of this section;
(ii) The gross margin method, de-
scribed in paragraph (c) of this section;
(iii) The gross markup method, de-
scribed in paragraph (d) of this section;
(iv) The profit split method, described
in paragraph (e) of this section; and
(v) Unspecified methods, described in
paragraph (f) of this section.
(2) Definitions—(i) Global dealing op-
eration.A global dealing operation con-
sists of the execution of customer transac-
tions, including marketing, sales, pricing
and risk management activities, in a par-
ticular financial product or line of finan-
cial products, in multiple tax jurisdictions
and/or through multiple participants, as
defined in paragraph (a)(2)(ii) of this sec-
tion. The taking of proprietary positions
is not included within the definition of a
global dealing operation unless the pro-
prietary positions are entered into by a
regular dealer in securities in its capacity
as such a dealer under paragraph
(a)(2)(iii) of this section. Lending activi-
ties are not included within the definition
of a global dealing operation. Therefore,
income earned from such lending activi-
ties or from securities held for investment
is not income from a global dealing oper-
ation and is not governed by this section.
A global dealing operation may consist of
several different business activities en-
gaged in by participants. Whether a sepa-
rate business activity is a global dealing
operation shall be determined with re-
spect to each type of financial product en-
tered on the taxpayer’s books and records.
(ii) Participant—(A) A participant is a
controlled taxpayer, as defined in §1.482–
1(i)(5), that is—
(1) A regular dealer in securities as de-
fined in paragraph (a)(2)(iii) of this sec-
tion; or
(2) A member of a group of controlled
taxpayers which includes a regular dealer
in securities, but only if that member con-
ducts one or more activities related to the
activities of such dealer.
(B) For purposes of paragraph (a)(2)-
(ii)(A)(2) of this section, such related ac-
tivities are marketing, sales, pricing, risk
management or brokering activities. Such
related activities do not include credit
analysis, accounting services, back office
services, general supervision and control
over the policies of the controlled taxpayer,
or the provision of a guarantee of one or
more transactions entered into by a regular
dealer in securities or other participant.
(iii) Regular dealer in securities.For
purposes of this section, a regular dealer
in securities is a taxpayer that—
(A) Regularly and actively offers to,
and in fact does, purchase securities from
and sell securities to customers who are
not controlled taxpayers in the ordinary
course of a trade or business; or
(B) Regularly and actively offers to,
and in fact does, enter into, assume, off-
set, assign or otherwise terminate posi-
tions in securities with customers who are
not controlled entities in the ordinary
course of a trade or business.
(iv) Security.For purposes of this sec-
tion, a security is a security as defined in
section 475(c)(2) or foreign currency.
(3) Factors for determining compara-
bility for a global dealing operation. The
comparability factors set out in this para-
graph (a)(3) must be applied in place of
the comparability factors described in
§1.482–1(d)(3) for purposes of evaluating
a global dealing operation.
(i) Functional analysis.In lieu of the
list set forth in §1.482–1(d)(3)(i)(A)
through (H), functions that may need to
be accounted for in determining the com-
parability of two transactions are—
(A) Product research and development;
(B) Marketing;
(C) Pricing;
(D) Brokering; and
(E) Risk management.
(ii) Contractual terms.In addition to
the terms set forth in §1.482–1(d)(3)(ii)-
(A), and subject to §1.482–1(d)(3)(ii)(B),
significant contractual terms for financial
products transactions include—
(A) Sales or purchase volume;
(B) Rights to modify or transfer the
contract;
(C) Contingencies to which the con-
tract is subject or that are embedded in the
contract;
(D) Length of the contract;
(E) Settlement date;
(F) Place of settlement (or delivery);
(G) Notional principal amount;
(H) Specified indices;
(I) The currency or currencies in which
the contract is denominated;
(J) Choice of law and jurisdiction gov-
erning the contract to the extent chosen by
the parties; and
(K) Dispute resolution, including bind-
ing arbitration.
(iii) Risk.In lieu of the list set forth in
§1.482–1(d)(3), significant risks that
could affect the prices or profitability in-
clude—
1998–16 I.R.B.37April 20, 1998

(A) Market risks, including the volatil-
ity of the price of the underlying property;
(B) Liquidity risks, including the fact
that the property (or the hedges of the
property) trades in a thinly traded market;
(C) Hedging risks;
(D) Creditworthiness of the counter-
party; and
(E) Country and transfer risk.
(iv) Economic conditions.In lieu of
the list set forth in §1.482–1(d)(3)(iv)(A)
through (H), significant economic condi-
tions that could affect the prices or prof-
itability include—
(A) The similarity of geographic mar-
kets;
(B) The relative size and sophistication
of the markets;
(C) The alternatives reasonably avail-
able to the buyer and seller;
(D) The volatility of the market; and
(E) The time the particular transaction
is entered into.
(4) Arm’s length range— (i) General
rule.Except as modified in this para-
graph (a)(4), §1.482–1(e) will apply to
determine the arm’s length range of trans-
actions entered into by a global dealing
operation as defined in paragraph (a)(2)(i)
of this section. In determining the arm’s
length range, whether the participant is a
buyer or seller is a relevant factor.
(ii) Reliability. In determining the reli-
ability of an arm’s length range, it is nec-
essary to consider the fact that the market
for financial products is highly volatile
and participants in a global dealing opera-
tion frequently earn only thin profit mar-
gins. The reliability of using a statistical
range in establishing a comparable price
of a financial product in a global dealing
operation is based on facts and circum-
stances. In a global dealing operation,
close proximity in time between a con-
trolled transaction and an uncontrolled
transaction may be a relevant factor in de-
termining the reliability of the uncon-
trolled transaction as a measure of the
arm’s length price. The relevant time pe-
riod will depend on the price volatility of
the particular product.
(iii) Authority to make adjustments.
The district director may, notwithstanding
§1.482–1(e)(1), adjust a taxpayer’s results
under a method applied on a transaction
by transaction basis if a valid statistical
analysis demonstrates that the taxpayer’s
controlled prices, when analyzed on an
aggregate basis, provide results that are
not arm’s length. See §1.482–1(f)(2)(iv).
This may occur, for example, when there
is a pattern of prices in controlled transac-
tions that are higher or lower than the
prices of comparable uncontrolled trans-
actions.
(5) Examples.The following examples
illustrate the principles of this paragraph
(a).
Example 1. Identification of participants.(i) B
is a foreign bank that acts as a market maker in for-
eign currency in country X, the country of which it
is a resident. C, a country Y resident corporation, D,
a country Z resident corporation, and USFX, a U.S.
resident corporation are all members of a controlled
group of taxpayers with B, and each acts as a market
maker in foreign currency. In addition to market-
making activities conducted in their respective
countries, C, D, and USFX each employ marketers
and traders, who also perform risk management with
respect to their foreign currency operations. In a
typical business day, B, C, D, and USFX each enter
into several hundred spot and forward contracts to
purchase and sell Deutsche marks (DM) with unre-
lated third parties on the interbank market. In the or-
dinary course of business, B, C, D, and USFX also
enter into contracts to purchase and sell DM with
each other.
(ii) Under §1.482–8(a)(2)(iii), B, C, D, and
USFX are each regular dealers in securities because
they each regularly and actively offer to, and in fact
do, purchase and sell currencies to customers who
are not controlled taxpayers, in the ordinary course
of their trade or business. Consequently, each con-
trolled taxpayer is also a participant. Together, B, C,
D, and USFX conduct a global dealing operation
within the meaning of §1.482–8(a)(2)(i) because
they execute customer transactions in multiple tax
jurisdictions. Accordingly, the controlled transac-
tions between B, C, D, and USFX are evaluated
under the rules of §1.482–8.
Example 2. Identification of participants.(i)
The facts are the same as in Example 1, except that
USFX is the only member of the group of controlled
taxpayers that buys from and sells foreign currency
to customers. C performs marketing and pricing ac-
tivities with respect to the controlled group’s foreign
currency operation. D performs accounting and
back office services for B, C, and USFX, but does
not perform any marketing, sales, pricing, risk man-
agement or brokering activities with respect to the
controlled group’s foreign currency operation. B
provides guarantees for all transactions entered into
by USFX.
(ii) Under §1.482–8(a)(2)(iii), USFX is a regular
dealer in securities and therefore is a participant. C
also is a participant because it performs activities re-
lated to USFX’s foreign currency dealing activities.
USFX’s and C’s controlled transactions relating to
their DM activities are evaluated under §1.482–8. D
is not a participant in a global dealing operation be-
cause its accounting and back office services are not
related activities within the meaning of §1.482–
8(a)(2)(ii)(B). B also is not a participant in a global
dealing operation because its guarantee function is
not a related activity within the meaning of §1.482–
8(a)(2)(ii)(B). Accordingly, the determination of
whether transactions between B and D and other
members of the controlled group are at arm’s length
is not determined under §1.482–8.
Example 3. Scope of a global dealing operation.
(i) C, a U.S. resident commercial bank, conducts a
banking business in the United States and in coun-
tries X and Y through foreign branches. C regularly
and actively offers to, and in fact does, purchase
from and sell foreign currency to customers who are
not controlled taxpayers in the ordinary course of its
trade or business in the United States and countries
X and Y. In all the same jurisdictions, C also regu-
larly and actively offers to, and in fact does, enter
into, assume, offset, assign, or otherwise terminate
positions in interest rate and cross-currency swaps
with customers who are not controlled taxpayers. In
addition, C regularly makes loans to customers
through its U.S. and foreign branches. C regularly
sells these loans to a financial institution that
repackages the loans into securities.
(ii) C is a regular dealer in securities within the
meaning of §1.482–8(a)(2)(ii) because it purchases
and sells foreign currency and enters into interest
rate and cross-currency swaps with customers. Be-
cause C conducts these activities through U.S. and
foreign branches, these activities constitute a global
dealing operation within the meaning of §1.482–
8(a)(2)(i). The income, expense, gain or loss from
C’s global dealing operation is sourced under
§§1.863–3(h) and 1.988–4(h). Under §1.482–
8(a)(2)(i), C’s lending activities are not, however,
part of a global dealing operation.
Example 4. Dissimilar products.The facts are
the same as in Example 1, but B, C, D, and USFX
also act as a market maker in Malaysian ringgit-U.S.
dollar cross-currency options in the United States
and countries X, Y, and Z. The ringgit is not widely
traded throughout the world and is considered a
thinly traded currency. The functional analysis re-
quired by §1.482–8(a)(3)(i) shows that the develop-
ment, marketing, pricing, and risk management of
ringgit-U.S. dollar cross-currency option contracts
are different than that of other foreign currency con-
tracts, including option contracts. Moreover, the
contractual terms, risks, and economic conditions of
ringgit-U.S. dollar cross-currency option contracts
differ considerably from that of other foreign cur-
rency contracts, including option contracts. See
§1.482–8(a)(3)(ii) through (iv). Accordingly, the
ringgit-U.S. dollar cross-currency option contracts
are not comparable to contracts in other foreign cur-
rencies.
Example 5. Relevant time period. (i) USFX is a
U.S. resident corporation that is a regular dealer in
securities acting as a market maker in foreign cur-
rency by buying from and selling currencies to cus-
tomers. C performs marketing and pricing activities
with respect to USFX’s foreign currency operation.
Trading in Deutsche marks (DM) is conducted be-
tween 10:00 a.m. and 10:30 a.m. and between 10:45
a.m. and 11:00 a.m. under the following circum-
stances.
10:00 a.m. 1.827DM: $1 Uncontrolled Transaction
10:04 a.m. 1.827DM: $1 Controlled Transaction
10:06 a.m. 1.826DM: $1 Uncontrolled Transaction
10:08 a.m. 1.825DM: $1 Uncontrolled Transaction
10:10 a.m. 1.827DM: $1 Controlled Transaction
10:12 a.m. 1.824DM: $1 Uncontrolled Transaction
10:15 a.m. 1.825DM: $1 Uncontrolled Transaction
April 20, 1998381998–16 I.R.B.

10:18 a.m. 1.826DM: $1 Controlled Transaction
10:20 a.m. 1.824DM: $1 Uncontrolled Transaction
10:23 a.m. 1.825DM: $1 Uncontrolled Transaction
10:25 a.m. 1.825DM: $1 Uncontrolled Transaction
10:27 a.m. 1.827DM: $1 Controlled Transaction
10:30 a.m. 1.824DM: $1 Uncontrolled Transaction
10:45 a.m. 1.822DM: $1 Uncontrolled Transaction
10:50 a.m. 1.821DM: $1 Uncontrolled Transaction
10:55 a.m. 1.822DM: $1 Uncontrolled Transaction
11:00 a.m. 1.819DM: $1 Uncontrolled Transaction
(ii) USFX and C are participants in a global deal-
ing operation under §1.482–8(a)(2)(i). Therefore,
USFX determines its arm’s length price for its con-
trolled DM contracts under §1.482–8(a)(4). Under
§1.482–8(a)(4), the relevant arm’s length range for
setting the prices of USFX’s controlled DM transac-
tions occurs between 10:00 a.m. and 10:30 a.m. Be-
cause USFX has no controlled transactions between
10:45 a.m. and 11:00 a.m., and the price movement
during this later time period continued to decrease,
the 10:45 a.m. to 11:00 a.m. time period is not part
of the relevant arm’s length range for pricing
USFX’s controlled transactions.
(b) Comparable uncontrolled financial
transaction method—(1) General rule.
The comparable uncontrolled financial
transaction (CUFT) method evaluates
whether the amount charged in a con-
trolled financial transaction is arm’s
length by reference to the amount charged
in a comparable uncontrolled financial
transaction.
(2) Comparability and reliability—(i)
In general.The provisions of §1.482–
1(d), as modified by paragraph (a)(3) of
this section, apply in determining whether
a controlled financial transaction is com-
parable to a particular uncontrolled finan-
cial transaction. All of the relevant fac-
tors in paragraph (a)(3) of this section
must be considered in determining the
comparability of the two financial trans-
actions. Comparability under this method
depends on close similarity with respect
to these factors, or adjustments to account
for any differences. Accordingly, unless
the controlled taxpayer can demonstrate
that the relevant aspects of the controlled
and uncontrolled financial transactions
are comparable, the reliability of the re-
sults as a measure of an arm’s length price
is substantially reduced.
(ii) Adjustments for differences be-
tween controlled and uncontrolled trans-
actions. If there are differences between
controlled and uncontrolled transactions
that would affect price, adjustments
should be made to the price of the uncon-
trolled transaction according to the com-
parability provisions of §1.482–1(d)(2)
and paragraph (a)(3) of this section.
(iii) Data and assumptions.The relia-
bility of the results derived from the
CUFT method is affected by the com-
pleteness and accuracy of the data used
and the reliability of the assumptions
made to apply the method. See §1.482–
1(c)(2)(ii). In the case of a global dealing
operation in which the CUFT is set
through the use of indirect evidence, par-
ticipants generally must establish data
from a public exchange or quotation
media contemporaneously to the time of
the transaction, retain records of such
data, and upon request furnish to the dis-
trict director any pricing model used to
establish indirect evidence of a CUFT, in
order for this method to be a reliable
means of evaluating the arm’s length na-
ture of the controlled transactions.
(3) Indirect evidence of the price of a
comparable uncontrolled financial trans-
action—(i) In general.The price of a
CUFT may be derived from data from
public exchanges or quotation media if
the following requirements are met—
(A) The data is widely and routinely
used in the ordinary course of business in
the industry to negotiate prices for uncon-
trolled sales;
(B) The data derived from public ex-
changes or quotation media is used to set
prices in the controlled transaction in the
same way it is used for uncontrolled
transactions of the taxpayer, or the same
way it is used by uncontrolled taxpayers;
and
(C) The amount charged in the con-
trolled transaction is adjusted to reflect
differences in quantity, contractual terms,
counterparties, and other factors that af-
fect the price to which uncontrolled tax-
payers would agree.
(ii) Public exchanges or quotation
media.For purposes of paragraph
(b)(3)(i) of this section, an established fi-
nancial market, as defined in §1.1092(d)–
1(b), qualifies as a public exchange or a
quotation media.
(iii) Limitation on use of data from
public exchanges or quotation media.
Use of data from public exchanges or
quotation media is not appropriate under
extraordinary market conditions. For ex-
ample, under circumstances where the
trading or transfer of a particular coun-
try’s currency has been suspended or
blocked by another country, causing sig-
nificant instability in the prices of foreign
currency contracts in the suspended or
blocked currency, the prices listed on a
quotation medium may not reflect a reli-
able measure of an arm’s length result.
(4) Arm’s length range. See
§1.482–1(e)(2) and paragraph (a)(4) of
this section for the determination of an
arm’s length range.
(5) Examples. The following examples
illustrate the principles of this paragraph
(b).
Example 1. Comparable uncontrolled financial
transactions.(i) B is a foreign bank resident in
country X that acts as a market maker in foreign cur-
rency in country X. C, a country Y resident corpora-
tion, D, a country Z resident corporation, and USFX,
a U.S. resident corporation are all members of a con-
trolled group of taxpayers with B, and each acts as a
market maker in foreign currency. In addition to
market marking activities conducted in their respec-
tive countries, C, D, and USFX each employ mar-
keters and traders, who also perform risk manage-
ment with respect to their foreign currency
operations. In a typical business day, B, C, D, and
USFX each enter into several hundred spot and for-
ward contracts to purchase and sell Deutsche marks
(DM) with unrelated third parties on the interbank
market. In the ordinary course of business, B, C, D,
and USFX also each enter into contracts to purchase
and sell DM with each other. On a typical day, no
more than 10% of USFX’s DM trades are with con-
trolled taxpayers. USFX’s DM-denominated spot
and forward contracts do not vary in their terms, ex-
cept as to the volume of DM purchased or sold. The
differences in volume of DM purchased and sold by
USFX do not affect the pricing of the DM. USFX
maintains contemporaneous records of its trades, ac-
counted for by type of trade and counterparty. The
daily volume of USFX’s DM-denominated spot and
forward contracts consistently provides USFX with
third party transactions that are contemporaneous
with the transactions between controlled taxpayers.
(ii) Under §1.482-–8(a)(2)(iii), B, C, D, and
USFX each are regular dealers in securities because
they each regularly and actively offer to, and in fact
do, purchase and sell currencies to customers who
are not controlled taxpayers, in the ordinary course
of their trade or business. Consequently, each con-
trolled taxpayer is also a participant. Together, B, C,
D, and USFX conduct a global dealing operation
within the meaning of §1.482–8(a)(2)(i) because
they execute customer transactions in multiple tax
jurisdictions. To determine the comparability of
USFX’s controlled and uncontrolled DM-denomi-
nated spot and forward transactions, the factors in
§1.482–8(a)(3) must be considered. USFX per-
forms the same functions with respect to controlled
and uncontrolled DM-denominated spot and for-
ward transactions. See §1.482–8(a)(3)(i). In evalu-
ating the contractual terms under §1.482–8(a)(3)(ii),
it is determined that the volume of DM transactions
varies, but these variances do not affect the pricing
of USFX’s uncontrolled DM transactions. Taking
into account the risk factors of §1.482–8(a)(3)(iii),
USFX’s risk associated with both the controlled and
uncontrolled DM transactions does not vary in any
material respect. In applying the significant factors
1998–16 I.R.B.39April 20, 1998

for evaluating the economic conditions under
§1.482–8(a)(3)(iv), USFX has sufficient third party
DM transactions to establish comparable economic
conditions for evaluating an arm’s length price. Ac-
cordingly, USFX’s uncontrolled transactions are
comparable to its controlled transactions in DM spot
and forward contracts.
Example 2. Lack of comparable uncontrolled fi-
nancial transactions.The facts are the same as in
Example 1, except that USFX trades Italian lira
(lira) instead of DM. USFX enters into few uncon-
trolled and controlled lira-denominated forward
contracts each day. The daily volume of USFX’s
lira forward purchases and sales does not provide
USFX with sufficient third party transactions to es-
tablish that uncontrolled transactions are sufficiently
contemporaneous with controlled transactions to be
comparable within the meaning of §1.482–8(a)(3).
In applying the comparability factors of §1.482–
8(a)(3), and of paragraph (a)(3)(iv) of this section in
particular, USFX’s controlled and uncontrolled lira
forward purchases and sales are not entered into
under comparable economic conditions. Accord-
ingly, USFX’s uncontrolled transactions in lira for-
ward contracts are not comparable to its controlled
lira forward transactions.
Example 3. Indirect evidence of the price of a
comparable uncontrolled financial transaction.(i)
The facts are the same as in Example 2, except that
USFX uses a computer quotation system (CQS) that
is an interdealer market, as described in §1.1092(d)–
1(b)(2), to set its price on lira forward contracts with
controlled and uncontrolled taxpayers. Other finan-
cial institutions also use CQS to set their prices on
lira forward contracts. CQS is an established finan-
cial market within the meaning of §1.1092(d)–1(b).
(ii) Because CQS is an established financial mar-
ket, it is a public exchange or quotation media
within the meaning of §1.482–8(b)(3)(i). Because
other financial institutions use prices from CQS in
the same manner as USFX, prices derived from CQS
are deemed to be widely and routinely used in the
ordinary course of business in the industry to negoti-
ate prices for uncontrolled sales. See §1.482–8(b)-
(3)(i)(A) and (B). If USFX adjusts the price quoted
by CQS under the criteria specified in §1.482–8(b)-
(2)(ii)(A)(3), the controlled price derived by USFX
from CQS qualifies as indirect evidence of the price
of a comparable uncontrolled financial transaction.
Example 4. Indirect evidence of the price of a
comparable uncontrolled financial transaction—in-
ternal pricing models. (i) T is a U.S. resident corpo-
ration that acts as a market maker in U.S. dollar-de-
nominated notional principal contracts. T’s
marketers and traders work together to sell notional
principal contracts (NPCs), primarily to T’s North
and South American customers. T typically earns 4
basis points at the inception of each standard 3 year
U.S. dollar-denominated interest rate swap that is
entered into with an unrelated, financially sophisti-
cated, creditworthy counterparty. TS, T’s wholly
owned U.K. subsidiary, also acts as a market maker
in U.S. dollar-denominated NPCs, employing sev-
eral traders and marketers who initiate contracts pri-
marily with European customers. On occasion, for
various business reasons, TS enters into a U.S. dol-
lar-denominated NPC with T. The U.S. dollar-de-
nominated NPCs that T enters into with unrelated
parties are comparable in all material respects to the
transactions that T enters into with TS. TS prices all
transactions with T using the same pricing models
that TS uses to price transactions with third parties.
The pricing models analyze relevant data, such as
interest rates and volatilities, derived from public
exchanges. TS records the data that were used to de-
termine the price of each transaction at the time the
transaction was entered into. Because the price pro-
duced by the pricing models is a mid-market price,
TS adjusts the price so that it receives the same 4
basis point spread on its transactions with T that it
would earn on comparable transactions with compa-
rable counterparties during the same relevant time
period.
(ii) Under §1.482–8(a)(2), T and TS are partici-
pants in a global dealing operation that deals in U.S.
dollar-denominated NPCs. Because the prices pro-
duced by TS’s pricing model are derived from infor-
mation on public exchanges and TS uses the same
pricing model to set prices for controlled and uncon-
trolled transactions, the requirements of §1.482–
8(b)(3)(i)(A) and (B) are met. Because the U.S. dol-
lar-denominated NPCs that T enters into with cus-
tomers (uncontrolled transactions) are comparable
to the transactions between T and TS within the
meaning of §1.482–8(a)(3) and TS earns 4 basis
points at inception of its uncontrolled transactions
that are comparable to its controlled transactions, TS
has also satisfied the requirements of §1.482–
8(b)(3)(i)(C). Accordingly, the price produced by
TS’s pricing model constitutes indirect evidence of
the price of a comparable uncontrolled financial
transaction.
(c) Gross margin method—(1) General
rule.The gross margin method evaluates
whether the amount allocated to a partici-
pant in a global dealing operation is arm’s
length by reference to the gross profit
margin realized on the sale of financial
products in comparable uncontrolled
transactions. The gross margin method
may be used to establish an arm’s length
price for a transaction where a participant
resells a financial product to an unrelated
party that the participant purchased from
a related party. The gross margin method
may apply to transactions involving the
purchase and resale of debt and equity in-
struments. The method may also be used
to evaluate whether a participant has re-
ceived an arm’s length commission for its
activities in a global dealing operation
when the participant has not taken title to
a security or has not become a party to a
derivative financial product. To meet the
arm’s length standard, the gross profit
margin on controlled transactions should
be similar to that of comparable uncon-
trolled transactions.
(2) Determination of an arm’s length
price—(i) In general.The gross margin
method measures an arm’s length price by
subtracting the appropriate gross profit
from the applicable resale price for the fi-
nancial product involved in the controlled
transaction under review.
(ii) Applicable resale price.The applic-
able resale price is equal to either the price
at which the financial product involved is
sold in an uncontrolled sale or the price at
which contemporaneous resales of the
same product are made. If the product
purchased in the controlled sale is resold
to one or more related parties in a series of
controlled sales before being resold in an
uncontrolled sale, the applicable resale
price is the price at which the product is
resold to an uncontrolled party, or the
price at which contemporaneous resales of
the same product are made. In such case,
the determination of the appropriate gross
profit will take into account the functions
of all members of the controlled group
participating in the series of controlled
sales and final uncontrolled resales, as
well as any other relevant factors de-
scribed in paragraph (a)(3) of this section.
(iii) Appropriate gross profit. The ap-
propriate gross profit is computed by mul-
tiplying the applicable resale price by the
gross profit margin, expressed as a per-
centage of total revenue derived from
sales, earned in comparable uncontrolled
transactions.
(3) Comparability and reliability—(i)
In general.The provisions of §1.482–
1(d), as modified by paragraph (a)(3) of
this section, apply in determining whether
a controlled transaction is comparable to a
particular uncontrolled transaction. All of
the factors described in paragraph (a)(3)
of this section must be considered in de-
termining the comparability of two finan-
cial products transactions, including the
functions performed. The gross margin
method considers whether a participant
has earned a sufficient gross profit margin
on the resale of a financial product (or
line of products) given the functions per-
formed by the participant. A reseller’s
gross profit margin provides compensa-
tion for performing resale functions re-
lated to the product or products under re-
view, including an operating profit in
return for the reseller’s investment of cap-
ital and the assumption of risks. Accord-
ingly, where a participant does not take
title, or does not become a party to a fi-
nancial product, the reseller’s return to
capital and assumption of risk are addi-
tional factors that must be considered in
determining an appropriate gross profit
April 20, 1998401998–16 I.R.B.

margin. An appropriate gross profit mar-
gin primarily should be derived from
comparable uncontrolled purchases and
resales of the reseller involved in the con-
trolled sale. This is because similar char-
acteristics are more likely to be found
among different resales of a financial
product or products made by the same re-
seller than among sales made by other re-
sellers. In the absence of comparable un-
controlled transactions involving the
same reseller, an appropriate gross profit
margin may be derived from comparable
uncontrolled transactions of other re-
sellers.
(ii) Adjustments for differences be-
tween controlled and uncontrolled trans-
actions. If there are material differences
between controlled and uncontrolled
transactions that would affect the gross
profit margin, adjustments should be
made to the gross profit margin earned in
the uncontrolled transaction according to
the comparability provisions of §1.482–
1(d)(2) and paragraph (a)(3) of this sec-
tion. For this purpose, consideration of
operating expenses associated with func-
tions performed and risks assumed may
be necessary because differences in func-
tions performed are often reflected in op-
erating expenses. The effect of a differ-
ence in functions performed on gross
profit, however, is not necessarily equal
to the difference in the amount of related
operating expenses.
(iii) Reliability. In order for the gross
margin method to be considered a reliable
measure of an arm’s length price, the
gross profit should ordinarily represent an
amount that would allow the participant
who resells the product to recover its ex-
penses (whether directly related to selling
the product or more generally related to
maintaining its operations) and to earn a
profit commensurate with the functions it
performed. The gross margin method
may be a reliable means of establishing an
arm’s length price where there is a pur-
chase and resale of a financial product
and the participant who resells the prop-
erty does not substantially participate in
developing a product or in tailoring the
product to the unique requirements of a
customer prior to the resale.
(iv) Data and assumptions—(A) In
general. The reliability of the results de-
rived from the gross margin method is af-
fected by the completeness and accuracy
of the data used and the reliability of the
assumptions made to apply the method.
See §1.482–1(c)(2)(ii). A participant may
establish the gross margin by comparing
the bid and offer prices on a public ex-
change or quotation media. In such case,
the prices must be contemporaneous to
the controlled transaction, and the partici-
pant must retain records of such data.
(B) Consistency in accounting.The de-
gree of consistency in accounting prac-
tices between the controlled transaction
and the uncontrolled transactions may af-
fect the reliability of the gross margin
method. For example, differences as be-
tween controlled and uncontrolled trans-
actions in the method used to value simi-
lar financial products (including methods
of accounting, methods of estimation, and
the timing for changes of such methods)
could affect the gross profit. The ability
to make reliable adjustments for such dif-
ferences could affect the reliability of the
results.
(4)Arm’s length range.See §1.482–
1(e)(2) and paragraph (a)(4) of this sec-
tion for the determination of an arm’s
length range.
(5) Example. The following example
illustrates the principles of this paragraph
(c).
Example 1. Gross margin method. (i) T is a U.S.
resident financial institution that acts as a market
maker in debt and equity instruments issued by U.S.
corporations. Most of T’s sales are to U.S.-based
customers. TS, T’s U.K. subsidiary, acts as a market
maker in debt and equity instruments issued by Eu-
ropean corporations and conducts most of its busi-
ness with European-based customers. On occasion,
however, a customer of TS wishes to purchase a se-
curity that is either held by or more readily accessi-
ble to T. To facilitate this transaction, T sells the se-
curity it owns or acquires to TS, who then promptly
sells it to the customer. T and TS generally derive
the majority of their profit on the difference between
the price at which they purchase and the price at
which they sell securities (the bid/offer spread). On
average, TS’s gross profit margin on its purchases
and sales of securities from unrelated persons is 2%.
Applying the comparability factors specified in
§1.482–8(a)(3), T’s purchases and sales with unre-
lated persons are comparable to the purchases and
sales between T and TS.
(ii) Under §1.482–8(a)(2), T and TS are partici-
pants in a global dealing operation that deals in debt
and equity securities. Since T’s related purchases
and sales are comparable to its unrelated purchases
and sales, if TS’s gross profit margin on purchases
and sales of comparable securities from unrelated
persons is 2%, TS should also typically earn a 2%
gross profit on the securities it purchases from T.
Thus, when TS resells for $100 a security that it pur-
chased from T, the arm’s length price at which TS
would have purchased the security from T would
normally be $98 ($100 sales price minus (2% gross
profit margin 3$100)).
(d) Gross markup method—(1) Gen-
eral rule.The gross markup method eval-
uates whether the amount allocated to a
participant in a global dealing operation is
arm’s length by reference to the gross
profit markup realized in comparable un-
controlled transactions. The gross
markup method may be used to establish
an arm’s length price for a transaction
where a participant purchases a financial
product from an unrelated party that the
participant sells to a related party. This
method may apply to transactions involv-
ing the purchase and resale of debt and
equity instruments. The method may also
be used to evaluate whether a participant
has received an arm’s length commission
for its role in a global dealing operation
when the participant has not taken title to
a security or has not become a party to a
derivative financial product. To meet the
arm’s length standard, the gross profit
markup on controlled transactions should
be similar to that of comparable uncon-
trolled transactions.
(2) Determination of an arm’s length
price—(i) In general.The gross markup
method measures an arm’s length price by
adding the appropriate gross profit to the
participant’s cost or anticipated cost, of
purchasing, holding, or structuring the fi-
nancial product involved in the controlled
transaction under review (or in the case of
a derivative financial product, the initial
net present value, measured by the antici-
pated cost of purchasing, holding, or
structuring the product).
(ii) Appropriate gross profit.The ap-
propriate gross profit is computed by mul-
tiplying the participant’s cost or antici-
pated cost of purchasing, holding, or
structuring a transaction by the gross
profit markup, expressed as a percentage
of cost, earned in comparable uncon-
trolled transactions.
(3) Comparability and reliability—(i)
In general.The provisions of §1.482–
1(d), as modified by paragraph (a)(3) of
this section, apply in determining whether
a controlled transaction is comparable to a
particular uncontrolled transaction. All of
the factors described in paragraph (a)(3)
of this section must be considered in de-
termining the comparability of two finan-
cial products transactions, including the
1998–16 I.R.B.41April 20, 1998

functions performed. The gross markup
method considers whether a participant
has earned a sufficient gross markup on
the sale of a financial product, or line of
products, given the functions it has per-
formed. A participant’s gross profit
markup provides compensation for pur-
chasing, hedging, and transactional struc-
turing functions related to the transaction
under review, including an operating
profit in return for the investment of capi-
tal and the assumption of risks. Accord-
ingly, where a participant does not take
title, or does not become a party to a fi-
nancial product, the reseller’s return to
capital and assumption of risk are addi-
tional factors that must be considered in
determining the gross profit markup. An
appropriate gross profit markup primarily
should be derived from comparable un-
controlled purchases and sales of the par-
ticipant involved in the controlled sale.
This is because similar characteristics are
more likely to be found among different
sales of property made by the same partic-
ipant than among sales made by other re-
sellers. In the absence of comparable un-
controlled transactions involving the
same participant, an appropriate gross
profit markup may be derived from com-
parable uncontrolled transactions of other
parties whether or not such parties are
members of the same controlled group.
(ii) Adjustments for differences be-
tween controlled and uncontrolled trans-
actions. If there are material differences
between controlled and uncontrolled
transactions that would affect the gross
profit markup, adjustments should be
made to the gross profit markup earned in
the uncontrolled transaction according to
the comparability provisions of
§1.482–1(d)(2) and paragraph (a)(3) of
this section. For this purpose, considera-
tion of operating expenses associated with
the functions performed and risks as-
sumed may be necessary, because differ-
ences in functions performed are often re-
flected in operating expenses. The effect
of a difference in functions on gross
profit, however, is not necessarily equal
to the difference in the amount of related
operating expenses.
(iii) Reliability.In order for the gross
markup method to be considered a reli-
able measure of an arm’s length price, the
gross profit should ordinarily represent an
amount that would allow the participant
who purchases the product to recover its
expenses (whether directly related to sell-
ing the product or more generally related
to maintaining its operations) and to earn
a profit commensurate with the functions
it performed. As with the gross margin
method, the gross markup method may be
a reliable means of establishing an arm’s
length price where there is a purchase and
resale of a financial product and the par-
ticipant who resells the property does not
substantially participate in developing a
product or in tailoring the product to the
unique requirements of a customer prior
to the resale.
(iv) Data and assumptions—(A) In
general.The reliability of the results de-
rived from the gross markup method is af-
fected by the completeness and accuracy
of the data used and the reliability of the
assumptions made to apply the method.
See §1.482–1(c)(2)(ii). A participant may
establish the gross markup by comparing
the bid and offer prices on a public ex-
change or quotation media. In such case,
the prices must be contemporaneous with
the controlled transaction, and the partici-
pant must retain records of such data.
(B) Consistency in accounting.The de-
gree of consistency in accounting prac-
tices between the controlled transaction
and the uncontrolled transactions may af-
fect the reliability of the gross markup
method. For example, differences as be-
tween controlled and uncontrolled trans-
actions in the method used to value simi-
lar financial products (including methods
in accounting, methods of estimation, and
the timing for changes of such methods)
could affect the gross profit. The ability
to make reliable adjustments for such dif-
ferences could affect the reliability of the
results.
(4) Arm’s length range.See §1.482–
1(e)(2) and paragraph (a)(4) of this sec-
tion for the determination of an arm’s
length range.
(e) Profit split method—(1) General
rule.The profit split method evaluates
whether the allocation of the combined
operating profit or loss of a global dealing
operation to one or more participants is at
arm’s length by reference to the relative
value of each participant’s contribution to
that combined operating profit or loss.
The combined operating profit or loss
must be derived from the most narrowly
identifiable business activity of the partic-
ipants for which data is available that in-
cludes the controlled transactions (rele-
vant business activity).
(2) Appropriate share of profit and
loss—(i) In general.The relative value of
each participant’s contribution to the
global dealing activity must be deter-
mined in a manner that reflects the func-
tions performed, risks assumed, and re-
sources employed by each participant in
the activity, consistent with the compara-
bility provisions of §1.482–1(d), as modi-
fied by paragraph (a)(3) of this section.
Such an allocation is intended to corre-
spond to the division of profit or loss that
would result from an arrangement be-
tween uncontrolled taxpayers, each per-
forming functions similar to those of the
various controlled taxpayers engaged in
the relevant business activity. The rela-
tive value of the contributions of each
participant in the global dealing operation
should be measured in a manner that most
reliably reflects each contribution made to
the global dealing operation and each par-
ticipant’s role in that contribution. In ap-
propriate cases, the participants may find
that a multi-factor formula most reliably
measures the relative value of the contri-
butions to the profitability of the global
dealing operation. The profit allocated to
any particular participant using a profit
split method is not necessarily limited to
the total operating profit from the global
dealing operation. For example, in a
given year, one participant may earn a
profit while another participant incurs a
loss, so long as the arrangement is compa-
rable to an arrangement to which two un-
controlled parties would agree. In addi-
tion, it may not be assumed that the
combined operating profit or loss from
the relevant business activity should be
shared equally or in any other arbitrary
proportion. The specific method must be
determined under paragraph (e)(4) of this
section.
(ii) Adjustment of factors to measure
contribution clearly.In order to reliably
measure the value of a participant’s contri-
bution, the factors, for example, those used
in a multi-factor formula, must be ex-
pressed in units of measure that reliably
quantify the relative contribution of the
participant. If the data or information is
influenced by factors other than the value
of the contribution, adjustments must be
made for such differences so that the fac-
April 20, 1998421998–16 I.R.B.

tors used in the formula only measure the
relative value of each participant’s
contribution. For example, if trader com-
pensation is used as a factor to measure the
value added by the participants’ trading ex-
pertise, adjustments must be made for vari-
ances in compensation paid to traders due
solely to differences in the cost of living.
(3) Definitions. The definitions in this
paragraph (e)(3) apply for purposes of ap-
plying the profit split methods in this
paragraph (e).
Gross profitis gross income earned by
the global dealing operation.
Operating expensesincludes all ex-
penses not included in the computation of
gross profit, except for interest, foreign
income taxes as defined in §1.901–2(a),
domestic income taxes, and any expenses
not related to the global dealing activity
that is evaluated under the profit split
method. With respect to interest expense,
see section 864(e) and the regulations
thereunder and §1.882–5.
Operating profit or lossis gross profit
less operating expenses, and includes all
income, expense, gain, loss, credits or al-
lowances attributable to each global deal-
ing activity that is evaluated under the
profit split method. It does not include in-
come, expense, gain, loss, credits or al-
lowances from activities that are not eval-
uated under the profit split method, nor
does it include extraordinary gains or
losses that do not relate to the continuing
global dealing activities of the participant.
(4) Application.Profit or loss shall be
allocated under the profit split method
using either the total profit split, de-
scribed in paragraph (e)(5) of this section,
or the residual profit split, described in
paragraph (e)(6) of this section.
(5) Total profit split—(i) In general.
The total profit split derives the percent-
age of the combined operating profit of
the participants in a global dealing opera-
tion allocable to a participant in the global
dealing operation by evaluating whether
uncontrolled taxpayers who perform simi-
lar functions, assume similar risks, and
employ similar resources would allocate
their combined operating profits in the
same manner.
(ii) Comparability.The total profit
split evaluates the manner by which com-
parable uncontrolled taxpayers divide the
combined operating profit of a particular
global dealing activity. The degree of
comparability between the controlled and
uncontrolled taxpayers is determined by
applying the comparability standards of
§1.482–1(d), as modified by paragraph
(a)(3) of this section. In particular, the
functional analysis required by §1.482–
1(d)(3)(i) and paragraph (a)(3)(i) of this
section is essential to determine whether
two situations are comparable. Neverthe-
less, in certain cases, no comparable ven-
tures between uncontrolled taxpayers may
exist. In this situation, it is necessary to
analyze the remaining factors set forth in
paragraph (a)(3) of this section that could
affect the division of operating profits be-
tween parties. If there are differences be-
tween the controlled and uncontrolled
taxpayers that would materially affect the
division of operating profit, adjustments
must be made according to the provisions
of §1.482–1(d)(2) and paragraph (a)(3) of
this section.
(iii) Reliability.As indicated in
§1.482–1(c)(2)(i), as the degree of com-
parability between the controlled and un-
controlled transactions increases, the reli-
ability of a total profit split also increases.
In a global dealing operation, however,
the absence of external market bench-
marks (for example, joint ventures be-
tween uncontrolled taxpayers) on which
to base the allocation of operating profits
does not preclude use of this method if the
allocation of the operating profit takes
into account the relative contribution of
each participant. The reliability of this
method is increased to the extent that the
allocation has economic significance for
purposes other than tax (for example, sat-
isfying regulatory standards and report-
ing, or determining bonuses paid to man-
agement or traders). The reliability of the
analysis under this method may also be
enhanced by the fact that all parties to the
controlled transaction are evaluated under
this method. The reliability of the results,
however, of an analysis based on informa-
tion from all parties to a transaction is af-
fected by the reliability of the data and as-
sumptions pertaining to each party to the
controlled transaction. Thus, if the data
and assumptions are significantly more
reliable with respect to one of the parties
than with respect to the others, a different
method, focusing solely on the results of
that party, may yield more reliable results.
(iv) Data and assumptions—(A) In
general.The reliability of the results de-
rived from the total profit split method is
affected by the quality of the data used
and the assumptions used to apply the
method. See §1.482–1(c)(2)(ii). The reli-
ability of the allocation of income, ex-
pense, or other attributes between the par-
ticipants’ relevant business activities and
the participants’ other activities will affect
the reliability of the determination of the
combined operating profit and its alloca-
tion among the participants. If it is not
possible to allocate income, expense, or
other attributes directly based on factual
relationships, a reasonable allocation for-
mula may be used. To the extent direct al-
locations are not made, the reliability of
the results derived from application of this
method is reduced relative to the results of
a method that requires fewer allocations of
income, expense, and other attributes.
Similarly, the reliability of the results de-
rived from application of this method is
affected by the extent to which it is possi-
ble to apply the method to the participants’
financial data that is related solely to the
controlled transactions. For example, if
the relevant business activity is entering
into interest rate swaps with both con-
trolled and uncontrolled taxpayers, it may
not be possible to apply the method solely
to financial data related to the controlled
transactions. In such case, the reliability
of the results derived from application of
this method will be reduced.
(B) Consistency in accounting. The de-
gree of consistency between the con-
trolled and uncontrolled taxpayers in ac-
counting practices that materially affect
the items that determine the amount and
allocation of operating profit affects the
reliability of the result. Thus, for exam-
ple, if differences in financial product val-
uation or in cost allocation practices
would materially affect operating profit,
the ability to make reliable adjustments
for such differences would affect the reli-
ability of the results.
(6) Residual profit split—(i) In general.
The residual profit split allocates the com-
bined operating profit or loss between
participants following the two-step
process set forth in paragraphs (e)(6)(ii)
and (iii) of this section.
(ii) Allocate income to routine contri-
butions.The first step allocates operating
income to each participant to provide an
arm’s length return for its routine contri-
butions to the global dealing operation.
1998–16 I.R.B.43April 20, 1998

Routine contributions are contributions of
the same or similar kind as those made by
uncontrolled taxpayers involved in simi-
lar business activities for which it is pos-
sible to identify market returns. Routine
contributions ordinarily include contribu-
tions of tangible property, services, and
intangibles that are generally owned or
performed by uncontrolled taxpayers en-
gaged in similar activities. For example,
transactions processing and credit analy-
sis are typically routine contributions. In
addition, a participant that guarantees
obligations of or otherwise provides
credit support to another controlled tax-
payer in a global dealing operation is re-
garded as making a routine contribution.
A functional analysis is required to iden-
tify the routine contributions according to
the functions performed, risks assumed,
and resources employed by each of the
participants. Market returns for the rou-
tine contributions should be determined
by reference to the returns achieved by
uncontrolled taxpayers engaged in similar
activities, consistent with the methods de-
scribed in §§1.482–2 through 1.482–4
and this §1.482–8.
(iii) Allocate residual profit. The allo-
cation of income to the participant’s rou-
tine contributions will not reflect profits
attributable to each participant’s valuable
nonroutine contributions to the global
dealing operation. Thus, in cases where
valuable nonroutine contributions are pre-
sent, there normally will be an unallo-
cated residual profit after the allocation of
income described in paragraph (e)(6)(ii)
of this section. Under this second step,
the residual profit generally should be di-
vided among the participants based upon
the relative value of each of their nonrou-
tine contributions. Nonroutine contribu-
tions are contributions so integral to the
global dealing operation that it is impossi-
ble to segregate them from the operation
and find a separate market return for the
contribution. Pricing and risk managing
financial products almost invariably in-
volve nonroutine contributions. Simi-
larly, product development and informa-
tion technology are generally nonroutine
contributions. Marketing may be a non-
routine contribution if the marketer sub-
stantially participates in developing a
product or in tailoring the product to the
unique requirements of a customer. The
relative value of the nonroutine contribu-
tions of each participant in the global
dealing operation should be measured in a
manner that most reliably reflects each
nonroutine contribution made to the
global dealing operation and each partici-
pant’s role in the nonroutine contribu-
tions.
(iv) Comparability. The first step of
the residual profit split relies on external
market benchmarks of profitability. Thus,
the comparability considerations that are
relevant for the first step of the residual
profit split are those that are relevant for
the methods that are used to determine
market returns for routine contributions.
In the second step of the residual profit
split, however, it may not be possible to
rely as heavily on external market bench-
marks. Nevertheless, in order to divide
the residual profits of a global dealing op-
eration in accordance with each partici-
pant’s nonroutine contributions, it is nec-
essary to apply the comparability
standards of §1.482–1(d), as modified by
paragraph (a)(3) of this section. In partic-
ular, the functional analysis required by
§1.482–1(d)(3)(i) and paragraph (a)(3)(i)
of this section is essential to determine
whether two situations are comparable.
Nevertheless, in certain cases, no compa-
rable ventures between uncontrolled tax-
payers may exist. In this situation, it is
necessary to analyze the remaining fac-
tors set forth in paragraph (a)(3) of this
section that could affect the division of
operating profits between parties. If there
are differences between the controlled
and uncontrolled taxpayers that would
materially affect the division of operating
profit, adjustments must be made accord-
ing to the provisions of §1.482–1(d)(2)
and paragraph (a)(3) of this section.
(v) Reliability.As indicated in §1.482–
1(c)(2)(i), as the degree of comparability
between the controlled and uncontrolled
transactions increases, the reliability of a
residual profit split also increases. In a
global dealing operation, however, the ab-
sence of external market benchmarks (for
example, joint ventures between uncon-
trolled taxpayers) on which to base the al-
location of operating profits does not pre-
clude use of this method if the allocation
of the residual profit takes into account
the relative contribution of each partici-
pant. The reliability of this method is in-
creased to the extent that the allocation
has economic significance for purposes
other than tax (for example, satisfying
regulatory standards and reporting, or de-
termining bonuses paid to management or
traders). The reliability of the analysis
under this method may also be enhanced
by the fact that all parties to the controlled
transaction are evaluated under this
method. The reliability of the results,
however, of an analysis based on informa-
tion from all parties to a transaction is af-
fected by the reliability of the data and as-
sumptions pertaining to each party to the
controlled transaction. Thus, if the data
and assumptions are significantly more
reliable with respect to one of the parties
than with respect to the others, a different
method, focusing solely on the results of
that party, may yield more reliable results.
(vi) Data and assumptions—(A) Gen-
eral rule.The reliability of the results de-
rived from the residual profit split is mea-
sured under the standards set forth in
paragraph (e)(5)(iv)(A) of this section.
(B) Consistency in accounting.The de-
gree of accounting consistency between
controlled and uncontrolled taxpayers is
measured under the standards set forth in
paragraph (e)(5)(iv)(B) of this section.
(7) Arm’s length range. See §1.482–
1(e)(2) and paragraph (a)(4) of this sec-
tion for the determination of an arm’s
length range.
(8) Examples.The following exam-
ples illustrate the principles of this para-
graph (e).
Example 1. Total profit split.(i) P, a U.S. corpora-
tion, establishes a separate U.S. subsidiary (USsub)
to conduct a global dealing operation in over-the-
counter derivatives. USsub in turn establishes sub-
sidiaries incorporated and doing business in the
U.K. (UKsub) and Japan (Jsub). USsub, UKsub,
and Jsub each employ marketers and traders who
work closely together to design and sell derivative
products to meet the particular needs of customers.
Each also employs personnel who process and con-
firm trades, reconcile trade tickets and provide on-
going administrative support (back office services)
for the global dealing operation. The global dealing
operation maintains a single common book for each
type of risk, and the book is maintained where the
head trader for that type of risk is located. Thus, no-
tional principal contracts denominated in North and
South American currencies are booked in USsub,
notional principal contracts denominated in Euro-
pean currencies are booked in UKsub, and notional
principal contracts denominated in Japanese yen are
booked in Jsub. However, each of the affiliates has
authorized a trader located in each of the other affili-
ates to risk manage its books during periods when
the booking location is closed. This grant of author-
ity is necessary because marketers, regardless of
their location, are expected to sell all of the group’s
April 20, 1998441998–16 I.R.B.

products, and need to receive pricing information
with respect to products during their clients’ busi-
ness hours, even if the booking location is closed.
Moreover, P is known for making a substantial
amount of its profits from trading activities, and fre-
quently does not hedge the positions arising from its
customer transactions in an attempt to profit from
market changes. As a result, the traders in “off-
hours” locations must have a substantial amount of
trading authority in order to react to market changes.
(ii) Under §1.482–8(a)(2), USsub, UKsub and
Jsub are participants in a global dealing operation in
over-the-counter derivatives. P determines that the
total profit split method is the best method to allo-
cate an arm’s length amount of income to each par-
ticipant. P allocates the operating profit from the
global dealing operation between USsub, UKsub
and Jsub on the basis of the relative compensation
paid to marketers and traders in each location. In
making the allocation, P adjusts the compensation
amounts to account for factors unrelated to job per-
formance, such as the higher cost of living in certain
jurisdictions. Because the traders receive signifi-
cantly greater compensation than marketers in order
to account for their greater contribution to the profits
of the global dealing operation, P need not make ad-
ditional adjustments or weight the compensation of
the traders more heavily in allocating the operating
profit between the affiliates. For rules concerning
the source of income allocated to Ussub, Uksub and
Jsub (and any U.S. trade or business of the partici-
pants), see §1.863–3(h).
Example 2. Total profit split.The facts are the
same as in Example 1, except that the labor market
in Japan is such that traders paid by Jsub are paid the
same as marketers paid by Jsub at the same seniority
level, even though the traders contribute substan-
tially more to the profitability of the global dealing
operation. As a result, the allocation method used
by P is unlikely to compensate the functions pro-
vided by each affiliate so as to be a reliable measure
of an arm’s length result under §§1.482–8(e)(2) and
1.482–1(c)(1), unless P weights the compensation of
traders more heavily than the compensation of mar-
keters or develops another method of measuring the
contribution of traders to the profitability of the
global dealing operation.
Example 3. Total profit split. The facts are the
same as in Example 2, except that, in P’s annual re-
port to shareholders, P divides its operating profit
from customer business into “dealing profit” and
“trading profit.” Because both marketers and traders
are involved in the dealing function, P divides the
“dealing profit” between the affiliates on the basis of
the relative compensation of marketers and traders.
However, because only the traders contribute to the
trading profit, P divides the trading profit between
the affiliates on the basis of the relative compensa-
tion only of the traders. In making that allocation, P
must adjust the compensation of traders in Jsub in
order to account for factors not related to job perfor-
mance.
Example 4. Total profit split.The facts are the
same as in Example 1, except that P is required by
its regulators to hedge its customer positions as
much as possible and therefore does not earn any
“trading profit.” As a result, the marketing intangi-
bles, such as customer relationships, are relatively
more important than the intangibles used by traders.
Accordingly, P must weight the compensation of
marketers more heavily than the compensation of
traders in order to take into account accurately the
contribution each function makes to the profitability
of the business.
Example 5. Residual profit split. (i) P is a U.S.
corporation that engages in a global dealing opera-
tion in foreign currency options directly and through
controlled taxpayers that are incorporated and oper-
ate in the United Kingdom (UKsub) and Japan
(Jsub). Each controlled taxpayer is a participant in a
global dealing operation. Each participant employs
marketers and traders who work closely together to
design and sell foreign currency options that meet
the particular needs of customers. Each participant
also employs salespeople who sell foreign currency
options with standardized terms and conditions, as
well as other financial products offered by the con-
trolled group. The traders in each location risk man-
age a common book of transactions during the rele-
vant business hours of each location. P has a AAA
credit rating and is the legal counterparty to all third
party transactions. The traders in each location have
discretion to execute contracts in the name of P.
UKsub employs personnel who process and confirm
trades, reconcile trade tickets, and provide ongoing
administrative support (back office services) for all
the participants in the global dealing operation. The
global dealing operation has generated $192 of oper-
ating profit for the period.
(ii) After analyzing the foreign currency options
business, P has determined that the residual profit
split method is the best method to allocate the oper-
ating profit of the global dealing operation and to
determine an arm’s length amount of compensation
allocable to each participant in the global dealing
operation.
(iii) The first step of the residual profit split
method (§1.482–8(e)(6)(ii)) requires P to identify
the routine contributions performed by each partici-
pant. P determines that the functions performed by
the salespeople are routine. P determines that the
arm’s length compensation for salespeople is $3, $4,
and $5 in the United States, the United Kingdom,
and Japan, respectively. Thus, P allocates $3, $4,
and $5 to P, UKsub, and Jsub, respectively.
(iv) Although the back office function would not
give rise to participant status, in the context of a
residual profit split allocation, the back office func-
tion is relevant for purposes of receiving remunera-
tion for routine contributions to a global dealing
operation. P determines that an arm’s length com-
pensation for the back office is $20. Since the back
office services constitute routine contributions, $20
of income is allocated to UKsub under step 1 of the
residual profit split method. In addition, P deter-
mines that the comparable arm’s length compensa-
tion for the risk to which P is subject as counterparty
is $40. Accordingly, $40 is allocated to P as com-
pensation for acting as counterparty to the transac-
tions entered into in P’s name by Jsub and UKsub.
(v) The second step of the residual profit split
method (§1.482–8(e)(6)(iii)) requires that the resid-
ual profit be allocated to participants according to
the relative value of their nonroutine contributions.
Under P’s transfer pricing method, P allocates the
residual profit of $120 ($192 gross income minus
$12 salesperson commissions minus $20 payment
for back office services minus $40 compensation for
the routine contribution of acting as counterparty)
using a multi-factor formula that reflects the relative
value of the nonroutine contributions. Applying the
comparability factors set out in §1.482–8(a)(3), P al-
locates 40% of the residual profit to UKsub, 35% of
the residual profit to P, and the remaining 25% of
residual profit to Jsub. Accordingly, under step 2,
$48 is allocated to UKsub, $42 is allocated to P, and
$30 is allocated to Jsub. See § 1.863–3(h) for the
source of income allocated to P with respect to its
counterparty function.
(f) Unspecified methods. Methods not
specified in paragraphs (b),(c),(d), or (e)
of this section may be used to evaluate
whether the amount charged in a con-
trolled transaction is at arm’s length. Any
method used under this paragraph (f)
must be applied in accordance with the
provisions of §1.482–1 as modified by
paragraph (a)(3) of this section.
(g) Source rule for qualified business
units. See §1.863–3(h) for application of
the rules of this section for purposes of
determining the source of income, gain or
loss from a global dealing operation
among qualified business units (as de-
fined in section 989(c) and §§1.863–
3(h)(3)(iv) and 1.989(a)–1).
Par. 7. Section 1.863–3 is amended as
follows:
1. Paragraph (h) is redesignated as
paragraph (i).
2. A new paragraph (h) is added.
The addition reads as follows:
§1.863–3 Allocation and apportionment
of income from certain sales of inventory.
* * * * *
(h) Income from a global dealing oper-
ation—(1) Purpose and scope.This para-
graph (h) provides rules for sourcing in-
come, gain and loss from a global dealing
operation that, under the rules of §1.482–
8, is earned by or allocated to a controlled
taxpayer qualifying as a participant in a
global dealing operation under §1.482–
8(a)(2)(ii). This paragraph (h) does not
apply to income earned by or allocated to
a controlled taxpayer qualifying as a par-
ticipant in a global dealing operation that
is specifically sourced under sections 861,
862 or 865, or to substitute payments
earned by a participant in a global dealing
operation that are sourced under §1.861–
2(a)(7) or §1.861–3(a)(6).
(2) In general.The source of any in-
come, gain or loss to which this section
applies shall be determined by reference
to the residence of the participant. For
purposes of this paragraph (h), the resi-
1998–16 I.R.B.45April 20, 1998

dence of a participant shall be determined
under section 988(a)(3)(B).
(3) Qualified business units as partici-
pants in global dealing operations—(i)
In general.Except as otherwise provided
in this paragraph (h), where a single con-
trolled taxpayer conducts a global dealing
operation through one or more qualified
business units (QBUs), as defined in sec-
tion 989(a) and §1.989(a)–1, the source of
income, gain or loss generated by the
global dealing operation and earned by or
allocated to the controlled taxpayer shall
be determined by applying the rules of
§1.482–8 as if each QBU that performs
activities of a regular dealer in securities
as defined in §1.482–8(a)(2)(ii)(A) or the
related activities described in §1.482–
8(a)(2)(ii)(B) were a separate controlled
taxpayer qualifying as a participant in the
global dealing operation within the mean-
ing of §1.482–8(a)(2)(ii). Accordingly,
the amount of income sourced in the
United States and outside of the United
States shall be determined by treating the
QBU as a participant in the global dealing
operation, allocating income to each par-
ticipant under §1.482–8, as modified by
paragraph (h)(3)(ii) of this section, and
sourcing the income to the United States
or outside of the United States under
§1.863–3(h)(2).
(ii) Economic effects of a single legal
entity.In applying the principles of
§1.482–8, the taxpayer shall take into ac-
count the economic effects of conducting
a global dealing operation through a sin-
gle entity instead of multiple legal enti-
ties. For example, since the entire capital
of a corporation supports all of the en-
tity’s transactions, regardless of where
those transactions may be booked, the
payment of a guarantee fee within the en-
tity is inappropriate and will be disre-
garded.
(iii) Treatment of interbranch and in-
terdesk amounts.An agreement among
QBUs of the same taxpayer to allocate in-
come, gain or loss from transactions with
third parties is not a transaction because a
taxpayer cannot enter into a contract with
itself. For purposes of this paragraph
(h)(3), however, such an agreement, in-
cluding a risk transfer agreement (as de-
fined in §1.475(g)–2(b)) may be used to
determine the source of global dealing in-
come from transactions with third parties
in the same manner and to the same extent
that transactions between controlled tax-
payers in a global dealing operation may
be used to allocate income, gain or loss
from the global dealing operation under
the rules of §1.482–8.
(iv) Deemed QBU. For purposes of
this paragraph (h)(3), a QBU shall include
a U.S. trade or business that is deemed to
exist because of the activities of a depen-
dent agent in the United States, without
regard to the books and records require-
ment of §1.989(a)–1(b).
(v) Examples. The following exam-
ples illustrate this paragraph (h)(3).
Example 1. Use of comparable uncontrolled fi-
nancial transactions method to source global deal-
ing income between branches.(i) F is a foreign
bank that acts as a market maker in foreign currency
through branch offices in London, New York, and
Tokyo. In a typical business day, the foreign ex-
change desk in F’s U.S. branch (USFX) enters into
several hundred spot and forward contracts on the
interbank market to purchase and sell Deutsche
marks (DM) with unrelated third parties. Each of
F’s branches, including USFX, employs both mar-
keters and traders for their foreign currency dealing.
In addition, USFX occasionally transfers risk with
respect to its third party DM contracts to F’s London
and Tokyo branches. These interbranch transfers are
entered into in the same manner as trades with unre-
lated third parties. On a typical day, risk manage-
ment responsibility for no more than 10% of
USFX’s DM trades are transferred interbranch. F
records these transfers by making notations on the
books of each branch that is a party to the transfers.
The accounting procedures are nearly identical to
those followed when a branch enters into an offset-
ting hedge with a third party. USFX maintains con-
temporaneous records of its interbranch transfers
and third party transactions, separated according to
type of trade and counterparty. Moreover, the vol-
ume of USFX’s DM spot purchases and sales each
day consistently provides USFX with third party
transactions that are contemporaneous with the
transfers between the branches.
(ii) As provided in paragraph (h)(3)(i) of this sec-
tion, USFX and F’s other branches that trade DM are
participants in a global dealing operation. Accord-
ingly, the principles of §1.482–8 apply in determin-
ing the source of income earned by F’s qualified
business units that are participants in a global deal-
ing operation. Applying the comparability factors in
§1.482–8(a)(3) shows that USFX’s interbranch
transfers and uncontrolled DM-denominated spot
and forward contracts have no material differences.
Because USFX sells DM in uncontrolled transac-
tions and transfers risk management responsibility
for DM-denominated contracts, and the uncontrolled
transactions and interbranch transfers are consis-
tently entered into contemporaneously, the inter-
branch transfers provide a reliable measure of an
arm’s length allocation of third party income from
F’s global dealing operation in DM-denominated
contracts. This allocation of third party income is
treated as U.S. source in accordance with
§§1.863–3(h) and 1.988–4(h) and accordingly will
be treated as income effectively connected with F’s
U.S. trade or business under §1.864–4.
Example 2. Residual profit split between
branches.(i) F is a bank organized in country X that
has a AAA credit rating and engages in a global
dealing operation in foreign currency options
through branch offices in London, New York, and
Tokyo. F has dedicated marketers and traders in
each branch who work closely together to design
and sell foreign currency options that meet the par-
ticular needs of customers. Each branch also em-
ploys general salespeople who sell standardized for-
eign currency options, as well as other financial
products and foreign currency offered by F. F’s
traders work from a common book of transactions
that is risk managed at each branch during local
business hours. Accordingly, all three branches
share the responsibility for risk managing the book
of products. Personnel in the home office of F
process and confirm trades, reconcile trade tickets,
and provide ongoing administrative support (back
office services) for the other branches. The global
dealing operation has generated $223 of operating
profit for the period.
(ii) Under §1.863–3(h), F applies §1.482–8 to al-
locate global dealing income among its branches,
because F’s London, New York, and Tokyo branches
are treated as participants in a global dealing opera-
tion that deals in foreign currency options under
§1.482–8(a)(2). After analyzing the foreign cur-
rency options business, F has determined that the
residual profit split method is the best method to de-
termine an arm’s length amount of compensation al-
locable to each participant in the global dealing op-
eration.
(iii) Under the first step of the residual profit split
method (§1.482–8(e)(6)(ii)), F identifies and com-
pensates the routine contributions performed by
each participant. F determines that an arm’s length
compensation for general salespeople is $3, $4, and
$5 in New York, London, and Tokyo, respectively,
and that the home office incurred $11 of expenses in
providing the back office services. Since F’s capital
legally supports all of the obligations of the
branches, no amount is allocated to the home office
of F for the provision of capital.
(iv) The second step of the residual profit split
method (§1.482–8(e)(6)(iii)) requires that the resid-
ual profit be allocated to participants according to
their nonroutine contributions. F determines that a
multi-factor formula best reflects these contribu-
tions. After a detailed functional analysis, and ap-
plying the comparability factors in §1.482–8(a)(3),
40% of the residual profit is allocated to the London
branch, 35% to the New York branch, and the re-
maining 25% to the Tokyo branch. Thus, the resid-
ual profit of $200 ($223 operating profit minus $12
general salesperson commissions minus $11 back
office allocation) is allocated $80 to London (40%
allocation x $200), $70 to New York (35% x $200)
and $50 to Tokyo (25% x $200).
Example 3. Residual profit split—deemed
branches.(i) P, a U.K. corporation, conducts a
global dealing operation in notional principal con-
tracts, directly and through a U.S. subsidiary
(USsub) and a Japanese subsidiary (Jsub). P is the
counterparty to all transactions entered into with
third parties. P, USsub, and Jsub each employ mar-
keters and traders who work closely together to de-
sign and sell derivative products to meet the particu-
April 20, 1998461998–16 I.R.B.

lar needs of customers. USsub also employs person-
nel who process and confirm trades, reconcile trade
tickets and provide ongoing administrative support
(back office services) for the global dealing opera-
tion. The global dealing operation maintains a sin-
gle common book for each type of risk, and the book
is maintained where the head trader for that type of
risk is located. However, P, USsub, and Jsub have
authorized a trader located in each of the other affili-
ates to risk manage its books during periods when
the primary trading location is closed. This grant of
authority is necessary because marketers, regardless
of their location, are expected to sell all of the
group’s products, and need to receive pricing infor-
mation with respect to products during their clients’
business hours, even if the booking location is
closed. The global dealing operation has generated
$180 of operating profit for the period.
(ii) Because employees of USsub have authority
to enter into contracts in the name of P, P is treated
as being engaged in a trade or business in the United
States through a deemed QBU. §1.863–3(h)(3)(iv).
Similarly, under U.S. principles, P would be treated
as being engaged in business in Japan through a
QBU. Under §1.482–8(a)(2), P, USsub, and Jsub are
participants in the global dealing operation relating
to notional principal contracts. Additionally, under
§1.863–3(h)(3), the U.S. and Japanese QBUs are
treated as participants in a global dealing operation
for purposes of sourcing the income from that opera-
tion. Under §1.863–3(h), P applies the methods in
§1.482–8 to determine the source of income allo-
cated to the U.S. and non-U.S. QBUs of P.
(iii) After analyzing the notional principal con-
tract business, P has concluded that the residual
profit split method is the best method to allocate in-
come under §1.482–8 and to source income under
§1.863–3(h).
(iv) Under the first step of the residual profit split
method (§1.482–8(e)(6)(ii)), P identifies and com-
pensates the routine contributions performed by
each participant. Although the back office function
does not give rise to participant status, in the context
of a residual profit split allocation, the back office
function is relevant for purposes of receiving remu-
neration for a routine contribution to a global deal-
ing operation. P determines that an arm’s length
compensation for the back office is $20. Since the
back office services constitute a routine contribu-
tion, $20 of income is allocated to USsub under step
1 of the residual profit split method. Similarly, as
the arm’s length compensation for the risk to which
P is subject as counterparty is $40, $40 is allocated
to P as compensation for acting as counterparty.
(v) The second step of the residual profit split
method (§1.482–8(e)(6)(iii)) requires that the resid-
ual profit be allocated to participants according to
the relative value of their nonroutine contributions.
Under P’s transfer pricing method, P allocates the
residual profit of $120 ($180 gross income minus
$20 for back office services minus $40 compensa-
tion for the routine contribution of acting as counter-
party) using a multi-factor formula that reflects the
relative value of the nonroutine contributions. Ap-
plying the comparability factors set out in §1.482–
8(a)(3), P allocates 40% of the residual profit to P,
35% of the residual profit to USsub, and the remain-
ing 25% of residual profit to Jsub. Accordingly,
under step 2, $48 is allocated to P, $42 is allocated to
USsub, and $30 is allocated to Jsub. Under §1.863–
3(h), the amounts allocated under the residual profit
split is sourced according to the residence of each
participant to which it is allocated.
(vi) Because the $40 allocated to P consists of
compensation for the use of capital, the allocation is
sourced according to where the capital is employed.
Accordingly, the $40 is sourced 35% to P’s deemed
QBU in the United States under §1.863–3(h)(3)(iv)
and 65% to non-U.S. sources.
* * * * *
Par. 8. Section 1.863–7(a)(1) is
amended by revising the second sentence
to read as follows:
§1.863–7 Allocation of income
attributable to certain notional principal
contracts under section 863(a).
(a) Scope—(1) Introduction.* * * This
section does not apply to income from a
section 988 transaction (as defined in sec-
tion 988(c) and §1.988–1(a)), or to income
from a global dealing operation (as de-
fined in §1.482–8(a)(2)(i)) that is sourced
under the rules of §1.863–3(h). * * *
* * * * *
Par. 9. Section 1.864–4 is amended as
follows:
1. Paragraphs (c)(2)(iv), (c)(2)(v),
(c)(3)(ii), and (c)(5)(vi)(a) and (b) are re-
designated as (c)(2)(v), (c)(2)(vi),
(c)(3)(iii), and (c)(5)(vi)(b) and (c), re-
spectively.
2. New paragraphs (c)(2)(iv),
(c)(3)(ii), and (c)(5)(vi)(a) are added.
The additions read as follows:
§1.864–4 U.S. source income effectively
connected with U.S. business.
* * * * *
(c) * * *
(2) * * *
(iv) Special rule relating to a global
dealing operation.An asset used in a
global dealing operation, as defined in
§1.482–8(a)(2)(i), will be treated as an
asset used in a U.S. trade or business only
if and to the extent that the U.S. trade or
business is a participant in the global
dealing operation under §1.863–3(h)(3),
and income, gain or loss produced by the
asset is U.S. source under §1.863–3(h) or
would be treated as U.S. source if
§1.863–3(h) were to apply to such
amounts.
* * * * *
(3) * * *
(ii) Special rule relating to a global
dealing operation.A U.S. trade or busi-
ness shall be treated as a material factor in
the realization of income, gain or loss de-
rived in a global dealing operation, as de-
fined in §1.482–8(a)(2)(i), only if and to
the extent that the U.S. trade or business
is a participant in the global dealing oper-
ation under §1.863–3(h)(3), and income,
gain or loss realized by the U.S. trade or
business is U.S. source under §1.863–3(h)
or would be treated as U.S. source if
§1.863–3(h) were to apply to such
amounts.
* * * * *
(5) * * *
(vi) * * *
(a) Certain income earned by a global
dealing operation.Notwithstanding para-
graph (c)(5)(ii) of this section, U.S. source
interest, including substitute interest as de-
fined in §1.861–2(a)(7), and dividend in-
come, including substitute dividends as
defined in §1.861–3(a)(6), derived by a
participant in a global dealing operation,
as defined in §1.482–8(a)(2)(i), shall be
treated as attributable to the foreign corpo-
ration’s U.S. trade or business, only if and
to the extent that the income would be
treated as U.S. source if §1.863–3(h) were
to apply to such amounts.
Par. 10. Section 1.864–6 is amended as
follows:
1. Paragraph (b)(2)(ii)(d)(3) and
(b)(3)(ii)(c) are added.
2. Paragraph (b)(3)(i) is revised by
adding a new sentence after the last sen-
tence.
The additions and revision read as fol-
lows:
§1.864–6 Income, gain or loss
attributable to an office or other fixed
place of business in the United States.
* * * * *
(b) * * *
(2) * * *
(ii) * * *
(d) * * *
(3) Certain income earned by a global
dealing operation.Notwithstanding para-
graphs (b)(2)(ii)(a) or (b) of this section,
foreign source interest, including substi-
tute interest as defined in §1.861–2(a)(7),
or dividend income, including substitute
dividends as defined in §1.861–3(a)(6),
derived by a participant in a global deal-
1998–16 I.R.B.47April 20, 1998

ing operation, as defined in §1.482–
8(a)(2)(i) shall be treated as attributable to
the foreign corporation’s U.S. trade or
business only if and to the extent that the
income would be treated as U.S. source if
§1.863–3(h) were to apply to such
amounts. * * *
(3) * * *
(i) * * * Notwithstanding paragraphs
(b)(3)(i)(1) and (2) of this section, an of-
fice or other fixed place of business of a
nonresident alien individual or a foreign
corporation which is located in the United
States and which is a participant in a
global dealing operation, as defined in
§1.482–8(a)(2)(i), shall be considered to
be a material factor in the realization of
foreign source income, gain or loss, only
if and to the extent that such income, gain
or loss would be treated as U.S. source if
§1.863–3(h) were to apply to such
amounts.
(ii) * * *
(c) Property sales in a global dealing
operation.Notwithstanding paragraphs
(b)(3)(ii)(a) or (b) of this section, per-
sonal property described in section
1221(1) and sold in the active conduct of
a taxpayer’s global dealing operation, as
defined in §1.482–8(a)(2)(i), shall be pre-
sumed to have been sold for use, con-
sumption, or disposition outside of the
United States only if and to the extent that
the income, gain or loss to which the sale
gives rise would be sourced outside of the
United States if §1.863–3(h) were to
apply to such amounts.
Par. 11. Section 1.894–1 is amended as
follows:
1. Paragraph (d) is redesignated as
paragraph (e).
2. New paragraph (d) is added.
The addition reads as follows:
§1.894–1 Income affected by treaty.
* * * * *
(d) Income from a global dealing oper-
ation.If a taxpayer that is engaged in a
global dealing operation, as defined in
§1.482–8(a)(2)(i), has a permanent estab-
lishment in the United States under the
principles of an applicable U.S. income
tax treaty, the principles of §1.863–3(h),
§1.864–4(c)(2)(iv), §1.864–4(c)(3)(ii),
§1.864–4(c)(5)(vi)(a) or §1.864–
6(b)(2)(ii)(d)(3) shall apply for purposes
of determining the income attributable to
that U.S. permanent establishment.
* * * * *
Par. 12. Section 1.988–4 is amended as
follows:
1. Paragraph (h) is redesignated as
paragraph (i).
2. A new paragraph (h) is added.
The addition and revision read as fol-
lows:
§1.988–4 Source of gain or loss realized
on a section 988 transfer.
* * * * *
(h) Exchange gain or loss from a
global dealing operation. Notwithstand-
ing the provisions of this section, ex-
change gain or loss derived by a partici-
pant in a global dealing operation, as
defined in §1.482–8(a)(2)(i), shall be
sourced under the rules set forth in
§1.863–3(h).
* * * * *
Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on
March 2, 1998, at 1:50 p.m., and published in the
issue of the Federal Register for March 6, 1998, 63
F.R. 11177)
Foundations Status of Certain
Organizations
Announcement 98–29
The following organizations have
failed to establish or have been unable to
maintain their status as public charities or
as operating foundations. Accordingly,
grantors and contributors may not, after
this date, rely on previous rulings or des-
ignations in the Cumulative List of Orga-
nizations (Publication 78), or on the pre-
sumption arising from the filing of notices
under section 508(b) of the Code. This
listing does notindicate that the organiza-
tions have lost their status as organiza-
tions described in section 501(c)(3), eligi-
ble to receive deductible contributions.
Former Public Charities.The following
organizations (which have been treated as
organizations that are not private founda-
tions described in section 509(a) of the
Code) are now classified as private foun-
dations:
Ahepa Ypsilanti Chapter No. 118
Foundation, Toledo, OH
American Friends of the Institute of
Talmudic Studies, Inc., Lakewood, NJ
Apex Capital, Inc., Cleveland, OH
Baton Rouge Rehab Community Homes,
Bossier City, LA
Boston Foundation, Leavenworth, KS
Bright Light Corp., Atlanta, GA
California Compact Inc., Phoenix, AZ
Childrens Educational Project, Inc., New
York, NY
Childrens Trust Fund of Northeast
Florida, Inc., Pensacola, FL
Childrens Wildlife Preserve, Tucson, AZ
Chips of New Jersey Inc., Caldwell, NJ
Christian Foreign Missions Inc., Phoenix,
AZ
Christian Haitian American Community
Services, Inc., Miami, FL
Christian Health Institute and Wellness
Center, Inc., Bloomfield, NJ
Christian Lighthome Network Inc.,
Tallahassee, FL
Coleman Community Foundation,
Coleman, OK
College Attain Inc., Royal Palm Beach,
FL
College Hispanic Council Inc., Miami,
FL
Community Language Institute, San
Rafael, CA
Comstock Foundation, Phoenix, AZ
Concerned Americans for Cultural
Change, Southfield, MI
Concerned Citizens Against Drugs,
Painesville, OH
Conference of Community Health
Centers, Inc., Cincinnati, OH
Congregations Allied for Community
Improvement, Saint Louis, MO
Council for Marriage Preservation &
Divorce Resolution, Inc., Fort
Lauderdale, FL
Counseling and Enrichment Center Inc.,
Columbus, GA
Coventry People Enhancing a Child’s
Environment, Incorporated, Cleveland
Hts, OH
Creating Opportunities for Parent
Empowerment Coalition, Washington,
DC
Creative Directions of Acadiana Inc.,
Scott, LA
Creative Learning and Child Care,
Severn, MD
Crescendo, The Tampa Bay Womyns
Chorus, Inc., Tampa, FL
Criminal Justice Policy Foundation,
Boston, MA
April 20, 1998481998–16 I.R.B.

Crisis Pregnancy Center of Jefferson
County, Mount Vernon, IL
Cultural Crossovers, Inc., New York, NY
Deedco Gardens Inc., Miami, FL
Dream Maker Charitable Trust, Bethany,
OK
Emerald Isle Immigration Center Inc.,
Pompano Beach, FL
Emergency Assistance Program, West
Branch, MI
Emet Services Incorporated,
Philadelphia, PA
Englewood Hispanic Association Inc.,
Englewood, NJ
Englewood Social Services, Chicago, IL
Enterprise Developmental, Bethesda, MD
Environmental Communications,
Phoenix, AZ
Everlasting Tape Ministry and Caption
Service, Vancouver, WA
Florida Section American Water
Resources Association Inc., Boynton
Beach, FL
Floyd County Token Club Inc., New
Albany, IN
Floyd County Youth Services Coalition
Inc., New Albany, IN
Flyt Gymnastics Team Association,
Chicago, IL
Focus Inc., Columbia, TN
Focus Children Center LTD,
Albuquerque, NM
Fort Worth Educational Council Inc., Fort
Worth, TX
Foundation for Tropical Research and
Exploration, Chicago, IL
Foundation Lighthouse Inc., Lincoln, NE
Foundation of America, Salt Lake City,
UT
Foundation on Aging, Merriam, KS
Foundation To Save Our Childrens
Environment, Tulsa, OK
The Francesa Ronnie Primus Foundation
Inc., W. Hempstead, NY
Good News Foundation of Central NY,
Inc., Utica, NY
Greater Houston Sports Association Inc.,
Houston, TX
Greater Indianapolis Track Club Inc.,
Indianapolis, IN
Greater Kansas City Football Coaches
Association, Blue Springs, MO
Greater Louisville Council on Sexual
Health and Addiction Inc., Louisville,
KY
Greater Melbourne Soccer Association
Inc., Palm Bay, FL
Greater Piedmont Foundation Inc.,
Greensboro, NC
Greater St. Louis Construction Workforce
Coalition, St. Louis, MO
Greene County Fair Housing Advisory
Board, Xenia, OH
Greene County Landmarks Foundation
Inc., Bloomfield, IN
Greensboro Homeless Workers Inc.,
Snow Camp, NC
Greenville Theatre Arts Center Inc.,
Greenville, NC
Greenwood Foundation Inc., Tulsa, OK
Hatpeth Terrace Health Center, Franklin,
TN
Health and Education Services, Inc.,
Beverly, MA
Home of Hope Inc., Jacksonville, FL
Homebound Elderly Rehabilitative
Opportunities Foundation, Dover, DE
Homeless Assistance Organization,
Inkster, MI
Horizon Community Residence,
Houston, TX
Horry County Air Rescue Inc., Myrtle
Beach, SC
Horses for the Handicapped Inc.,
Hollywood, FL
Hospice Care of Carroll County Inc.,
Carrollton, GA
Hospice Foundation of Cross Timbers
Inc., Abilene, TX
Hospice of Cheat River Inc., Saint
George, WV
Hospice of Mercy Foundation, Mexia, TX
Innovative Human Services Corporation,
Southfield, MI
Institute for Educational Research for
African American Male Study, New
Orleans, LA
Italian Village and Cultural Center
Incorporated, Torrance, CA
Jewish Outreach Center Inc., Richardson,
TX
Jim Burkeholder Family Learning Center
Inc., Lubbock, TX
Kendall County Community Health
Center Inc., Boerne, TX
Kenosis Inc., New Orleans, LA
Kensington Court Inc., Norfolk, VA
Kincaid Community Composting, Inc.,
Marietta, GA
The Kings College Foundation, Inc.,
Albany, NY
Last Chance for Life Inc., Oklahoma
City, OK
Latch Key Center of Memphis, Memphis,
TN
Lathrup Village Historical Society Inc.,
Lathrup Village, MI
Latin American Association of North
Carolina-LAANC, Raleigh, NC
Latin-American Ethnic Foundation,
Shawnee, KS
Latino Civil Rights Task Force,
Washington, DC
Lewis Group Home Inc., Canton, OH
Liberian After War Relief Fund Inc.,
Alexandria, VA
Liberty Air Museum Inc., Elyria, OH
Liberty Place Inc., Garden City, KS
Libros Para Ninos, St. Paul, MN
Licking Arc Apartments Inc., Newark,
OH
Life Athletes Inc., Chatham, NJ
Living Water Evangelistic Association,
Irmo, SC
Livingston Council for Accessible
Housing Inc., West Orange, NJ
Longmont High School Education
Foundation Inc., Longmont, CO
Longwood Babe Ruth Baseball League of
Seminole County Inc., Longwood, FL
Loramie Watershed Association Inc., Fort
Loramie, OH
Lord Berkeley Conservation Trust,
Moncks Corner, SC
Lords Table of Indian River County Inc.,
Sebastian, FL
Melville House, Inc., Roslyn, NY
Metropolitan Entertainment, Sterling
Heights, MI
Montezuma County Hospital District
Foundation, Inc., Cortez, CO
Montgomery County Animal Alliance
Inc., Kensington, MD
Montgomery County School Safety
Committee, Inc., Rockville, MD
National Smokejumpers Association,
Missoula, MT
National Soccer Foundation,
Miamisburg, OH
National South Asian AIDS Organization,
River Forest, IL
Native American Alliance of Ohio,
Thornville, OH
Native American Expressions Inc., Fort
Pierre, SD
Navajo School Alumni Association,
Altus, OK
Naval Home Memorial Windows
Committee, Inc., Gulfport, MS
Nawake Conference & Retreat Center,
Inc., Newport, AR
Nebraska Environment Education,
Wahoo, NE
1998–16 I.R.B.49April 20, 1998

Nebraska Health-Fitness Coalition for
Youth, Lincoln, NE
Nebraska Homeless Veterans Shelters
Programs, Inc., Lincoln, NE
Nebraska Law Enforcement Intelligence
Network, Plattsmouth, NE
Neighborhood Rehabilitation Center,
Inc., Arlington, TX
New York Retinal Research Foundation,
Inc., New York, NY
Northeastern Lumber Manufacturers
Institute, Cumberland Center, ME
Oak Lawn Community House Inc.,
Dallas, TX
Oakland County Express, Farmington
Hills, MI
Ocean Kids, Inc., New York, NY
Ocala Youth Baseball Association Inc.,
Ocala, FL
Operation Shelter Inc., Grosse Pointe
Park, MI
Orange-Calhoun-Allendale-Bamberg
Community Development Corporation,
Bamberg, SC
P.A.B. Alumni, Chicago, IL
Pam Foundation Inc., Tampa, FL
P.C. Development Corporation, Port
Clinton, OH
The Penobscot Center for Marine Studies
Inc., West Buxton, ME
Pineywoods Art League of East Texas,
Jasper, TX
Polish American Club, Columbus, OH
Ponca Hills Preservation Association
Inc., Omaha, NE
Porcine Interest Group Inc., Columbus,
OH
Port Aransas Council for the Arts Inc.,
Port Aransas, TX
Producciones Flor De Cahillo Inc., Rio
Piedras, PR
Professional Female Politicians,
Greensboro, NC
Professional Sports Linkage Inc.,
Minneapolis, MN
Rabun County Interagency Coalition,
Dillard, GA
Racquetball 96 Inc., Atlanta, GA
Ragged Mountain Wolf Rescue Fund
Inc., Marble, CO
Rainbow Falls Corporation, Wichita
Falls, TX
Rainbow Promise Ministries, Denver,
CO
Rampart Range Motorcycle Management
Committee, Inc., Englewood, CO
Randolph Advocates for the
Developmentally Disabled, Asheboro,
NC
Rangers Youth Athletic Organization Inc.
In Texas, El Paso, TX
Raton Rodeo Association, Raton, NM
R Center Inc., Houston, TX
Regional Environmental Monitoring
Association, Inc., Beaver Falls, PA
Relationship Enhancement Foundation,
Tucson, AZ
Remember My Name Committee,
Lansing, MI
Renaissance Club Inc., Arlington, VA
Renewable Resources Fellowship LTD,
Peoria, IL
Rennebaum Foundation for the Arts,
Middlesboro, KY
Research Center for Experimental
Theatre—RECET, Philadelphia, PA
Research Fund Inc., Laytonsville, MD
Resident Advisory Board of Southward
Village Annex, Inc., Ft. Myers, FL
Resident Council of Pecan Grove,
Paragould, AR
Residing in Group Housing Together—
RIGHT, Washington, DC
Resource for Christian Leadership, Inc.,
Charleston, SC
Restaurants United To Serve the
Homeless, Inc., Ponte Vedra Beach, FL
Restoration Ministries Inc., Philadelphia,
PA
Restorers-Teachers and Friends, Chicago,
IL
Return to Life House Inc., Red Bank, NJ
Robert Chesley Foundation, Inc., Los
Angeles, CA
Rotary Club of Big Rapids Foundation,
Big Rapids, MI
Rotary Foundation of South Miami, Inc.,
Miami, FL
Routt County Sheriffs Reserve Inc.,
Steamboat Springs, CO
Royal Mohammed Ali Pasha Foundation,
Washington, DC
RPFD & ND Inc., Jackson, MS
Ruby Life Memorial Scholarship
Corporation, Corinth, MS
Rubys Daycare Center Inc., Jackson,
MS
Running Creek Counseling Service,
Franktown, CO
Rural Affordable Housing Inc., Tempe,
AZ
Rural Enterprise Adaptation Program,
Cedar Rapids, IA
Rural Opportunities Corporation,
Carrboro, NC
Sada-Sewa Foundation Inc., Baldwin,
NY
Save the C S S Alabama Committee,
Mobile, AL
Save West Virginia Jobs, Inc., Fairmont,
WV
SEED Ministries Inc., Somerville, TX
SELF Inc., Peoria, IL
Ship 364, Inc., Virginia Beach, VA
Southern Indiana Family Education, Inc.,
Columbus, IN
Supernal Initiatives Inc., Lexington, KY
The Terezin Foundation, Inc., New York,
NY
Triway Athletic Booster Club, Wooster,
OH
If an organization listed above submits
information that warrants the renewal of its
classification as a public charity or as a pri-
vate operating foundation, the Internal
Revenue Service will issue a ruling or de-
termination letter with the revised classifi-
cation as to foundation status. Grantors and
contributors may thereafter rely upon such
ruling or determination letter as provided
in section 1.509(a)–7 of the Income Tax
Regulations. It is not the practice of the
Service to announce such revised classifi-
cation of foundation status in the Internal
Revenue Bulletin.
April 20, 1998501998–16 I.R.B.

1998–16 I.R.B.51April 20, 1998
Revenue rulings and revenue procedures
(hereinafter referred to as “rulings”) that
have an effect on previous rulings use the
following defined terms to describe the
effect:
Amplified describes a situation where
no change is being made in a prior pub-
lished position, but the prior position is
being extended to apply to a variation of
the fact situation set forth therein. Thus,
if an earlier ruling held that a principle
applied to A, and the new ruling holds
that the same principle also applies to B,
the earlier ruling is amplified. (Compare
with modified, below).
Clarified is used in those instances
where the language in a prior ruling is
being made clear because the language
has caused, or may cause, some confu-
sion. It is not used where a position in a
prior ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously
published ruling and points out an essen-
tial difference between them.
Modified is used where the substance
of a previously published position is
being changed. Thus, if a prior ruling
held that a principle applied to A but not
to B, and the new ruling holds that it ap-
plies to both A and B, the prior ruling is
modified because it corrects a published
position. (Compare with amplified and
clarified, above).
Obsoleted describes a previously pub-
lished ruling that is not considered deter-
minative with respect to future transac-
tions. This term is most commonly used
in a ruling that lists previously published
rulings that are obsoleted because of
changes in law or regulations. A ruling
may also be obsoleted because the sub-
stance has been included in regulations
subsequently adopted.
Revoked describes situations where the
position in the previously published rul-
ing is not correct and the correct position
is being stated in the new ruling.
Superseded describes a situation where
the new ruling does nothing more than
restate the substance and situation of a
previously published ruling (or rulings).
Thus, the term is used to republish under
the 1986 Code and regulations the same
position published under the 1939 Code
and regulations. The term is also used
when it is desired to republish in a single
ruling a series of situations, names, etc.,
that were previously published over a pe-
riod of time in separate rulings. If the
new ruling does more than restate the
substance of a prior ruling, a combination
of terms is used. For example, modified
and superseded describes a situation
where the substance of a previously pub-
lished ruling is being changed in part and
is continued without change in part and it
is desired to restate the valid portion of
the previously published ruling in a new
ruling that is self contained. In this case
the previously published ruling is first
modified and then, as modified, is super-
seded.
Supplemented is used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and
that list is expanded by adding further
names in subsequent rulings. After the
original ruling has been supplemented
several times, a new ruling may be pub-
lished that includes the list in the original
ruling and the additions, and supersedes
all prior rulings in the series.
Suspended is used in rare situations to
show that the previous published rulings
will not be applied pending some future
action such as the issuance of new or
amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.
Abbreviations
The following abbreviations in current use and for-
merly used will appear in material published in the
Bulletin.
A—Individual.
Acq.—Acquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank.
B.T.A.—Board of Tax Appeals.
C.—Individual.
C.B.—Cumulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Cooperative.
Ct.D.—Court Decision.
CY—County.
D—Decedent.
DC—Dummy Corporation.
DE—Donee.
Del. Order—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Employer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduciary.
FC—Foreign Country.
FICA—Federal Insurance Contribution Act.
FISC—Foreign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Federal Unemployment Tax Act.
FX—Foreign Corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grantee.
GP—General Partner.
GR—Grantor.
IC—Insurance Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited Partner.
LR—Lessor.
M—Minor.
Nonacq.—Nonacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Personal Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Partnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Real Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsidiary.
S.P.R.—Statements of Procedral Rules.
Stat.—Statutes at Large.
T—Target Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Transferee.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpayer.
TR—Trust.
TT—Trustee.
U.S.C.—United States Code.
X—Corporation.
Y—Corporation.
Z—Corporation.
Definition of Terms

April 20, 1998521998–16 I.R.B.
1
A cumulative list of all revenue rulings, revenue
procedures, Treasury decisions, etc., published in
Internal Revenue Bulletins 1997–27 through
1997–52 will be found in Internal Revenue Bulletin
1998–1, dated January 5, 1998.
Numerical Finding List
1
Bulletins 1998–1 through 1998–15
Announcements:
98–1, 1998–2 I.R.B. 38
98–2, 1998–2 I.R.B.38
98–3, 1998–2 I.R.B.38
98–4, 1998–4 I.R.B.31
98–5, 1998–5 I.R.B. 25
98–6, 1998–5 I.R.B. 25
98–7, 1998–5 I.R.B. 26
98–8, 1998–6 I.R.B. 96
98–9, 1998–7 I.R.B. 35
98–10, 1998–7 I.R.B. 35
98–11, 1998–8 I.R.B. 42
98–12, 1998–8 I.R.B. 43
98–13, 1998–8 I.R.B. 43
98–14, 1998–8 I.R.B. 44
98–15, 1998–10 I.R.B.36
98–16, 1998–9 I.R.B. 17
98–17, 1998–9 I.R.B. 16
98–18, 1998–10 I.R.B.44
98–19, 1998–10 I.R.B.44
98–20, 1998–11 I.R.B. 25
98–21, 1998–11 I.R.B. 26
98–22, 1998–12 I.R.B. 33
98–23, 1998–12 I.R.B. 34
98–24, 1998–12 I.R.B. 35
98–25, 1998–13 I.R.B.43
98–26, 1998–14 I.R.B. 28
98–27, 1998–15 I.R.B. 30
98–28, 1998–15 I.R.B. 30
Notices:
98–1, 1998–3 I.R.B. 42
98–2, 1998–2 I.R.B. 22
98–3, 1998–3 I.R.B. 48
98–4, 1998–2 I.R.B. 25
98–5, 1998–3 I.B.R.49
98–6, 1998–3 I.R.B. 52
98–7, 1998–3 I.R.B. 54
98–8, 1998–4 I.R.B. 6
98–9, 1998–4 I.R.B. 8
98–10, 1998–6 I.R.B.9
98–11, 1998–6 I.R.B. 18
98–12, 1998–5 I.R.B.12
98–13, 1998–6 I.R.B.19
98–14, 1998–8 I.R.B. 27
98–15, 1998–9 I.R.B. 8
98–16, 1998–15 I.R.B. 12
98–17, 1998–11 I.R.B. 6
98–18, 1998–12 I.R.B. 11
98–19, 1998–13 I.R.B.24
98–20, 1998–13 I.R.B.25
98–21, 1998–15 I.R.B. 14
Proposed Regulations:
PS–158–86, 1998–11 I.R.B. 13
REG–100841–97, 1998–8 I.R.B. 30
REG–102144–98, 1998–15 I.R.B.25
REG–102894–97, 1998–3 I.R.B. 59
REG–104062–97, 1998–10 I.R.B. 34
REG–104691–97, 1998–11 I.R.B. 13
REG–105163–97, 1998–8 I.R.B. 31
REG–109333–97, 1998–9 I.R.B. 9
REG–109704–97, 1998–3 I.R.B. 60
REG–110965–97, 1998–13 I.R.B. 42
REG–115795–97, 1998–8 I.R.B.33
REG–119449–97, 1998–10 I.R.B. 35
Proposed Regulations—Continued
REG–120200–97, 1998–12 I.R.B. 32
REG–120882–97, 1998–14 I.R.B. 25
REG–121755–97, 1998–9 I.R.B. 13
REG–209276–87, 1998–11 I.R.B. 18
REG–209322–82, 1998–15 I.R.B. 26
REG–209373–81, 1998–14 I.R.B. 26
REG–209463–82, 1998–4 I.R.B. 27
REG–209476–82, 1998–8 I.R.B. 36
REG–209484–87, 1998–8 I.R.B.40
REG–209485–86, 1998–11 I.R.B. 21
REG–209807–95, 1998–8 I.R.B. 40
REG–251502–96, 1998–9 I.R.B. 14
Revenue Procedures:
98–1, 1998–1 I.R.B. 7
98–2, 1998–1 I.R.B. 74
98–3, 1998–1 I.R.B. 100
98–4, 1998–1 I.R.B. 113
98–5, 1998–1 I.R.B. 155
98–6, 1998–1 I.R.B. 183
98–7, 1998–1 I.R.B. 222
98–8, 1998–1 I.R.B. 225
98–9, 1998–3 I.R.B. 56
98–10, 1998–2 I.R.B. 35
98–11, 1998–4 I.R.B.9
98–12, 1998–4 I.R.B. 18
98–13, 1998–4 I.R.B. 21
98–14, 1998–4 I.R.B. 22
98–15, 1998–4 I.R.B. 25
98–16, 1998–5 I.R.B. 19
98–17, 1998–5 I.R.B. 21
98–18, 1998–6 I.R.B. 20
98–19, 1998–7 I.R.B. 30
98–20, 1998–7 I.R.B. 32
98–21, 1998–8 I.R.B. 27
98–22, 1998–12 I.R.B. 11
98–23, 1998–10 I.R.B. 30
98–24, 1998–10 I.R.B. 31
98–25, 1998–11 I.R.B. 7
98–26, 1998–13 I.R.B.26
98–27, 1998–15 I.R.B.15
98–28, 1998–15 I.R.B.14
98–29, 1998–15 I.R.B. 22
Revenue Rulings:
98–1, 1998–2 I.R.B. 5
98–2, 1998–2 I.R.B. 15
98–3, 1998–2 I.R.B. 4
98–4, 1998–2 I.R.B. 18
98–5, 1998–2 I.R.B. 20
98–6, 1998–4 I.R.B. 4
98–7, 1998–6 I.R.B.6
98–8, 1998–7 I.R.B. 24
98–9, 1998–6 I.R.B. 5
98–10, 1998–10 I.R.B. 11
98–11, 1998–10 I.R.B. 13
98–12, 1998–10 I.R.B. 5
98–13, 1998–11 I.R.B. 4
98–14, 1998–11 I.R.B. 4
98–15, 1998–12 I.R.B. 6
98–16, 1998–13 I.R.B. 18
98–17, 1998–13 I.R.B. 21
98–18, 1998–14 I.R.B. 22
98–19, 1998–15 I.R.B. 5
98–20, 1998–15 I.R.B. 8
Treasury Decisions:
8740, 1998–3 I.R.B. 4
Treasury Decisions—Continued
8741, 1998–3 I.R.B. 6
8742, 1998–5 I.R.B.4
8743, 1998–7 I.R.B. 26
8744, 1998–7 I.R.B. 20
8745, 1998–7 I.R.B. 15
8746, 1998–7 I.R.B. 4
8747, 1998–7 I.R.B. 18
8748, 1998–8 I.R.B. 24
8749, 1998–7 I.R.B. 16
8750, 1998–8 I.R.B. 4
8751, 1998–10 I.R.B. 23
8752, 1998–9 I.R.B. 4
8753, 1998–9 I.R.B. 6
8754, 1998–10 I.R.B. 15
8755, 1998–10 I.R.B. 21
8756, 1998–12 I.R.B.4
8757, 1998–13 I.R.B.4
8758, 1998–13 I.R.B. 15
8759, 1998–13 I.R.B. 19
8760, 1998–14 I.R.B. 4
8761, 1998–14 I.R.B. 13
8762, 1998–14 I.R.B. 15
8763, 1998–15 I.R.B. 5
8764, 1998–15 I.R.B. 9

1998–16 I.R.B.53April 20, 1998
Finding List of Current Action on
Previously Published Items
1
Bulletins 1998–1 through 1998–15
Revenue Procedures:
91–59
Updated and superseded by
98–25, 1998–11 I.R.B. 7
94–16
Modified and superseded by
98–22, 1998–12 I.R.B. 11
93–62
Modified and superseded by
98–22, 1998–12 I.R.B. 11
95–35
95–35A
Superseded by
98–19, 1998–7 I.R.B. 30
96–29
Modified and superseded by
98–22, 1998–12 I.R.B. 11
97–1
Superseded by
98–1, 1998–1 I.R.B. 7
97–2
Superseded by
98–2, 1998–1 I.R.B. 74
97–3
Superseded by
98–3, 1998–1 I.R.B. 100
97–4
Superseded by
98–4, 1998–1 I.R.B. 113
97–5
Superseded by
98–5, 1998–1 I.R.B. 155
97–6
Superseded by
98–6, 1998–1 I.R.B. 183
97–7
Superseded by
98–7, 1998–1 I.R.B. 222
97–8
Superseded by
98–8, 1998–1 I.R.B. 225
97–21
Superseded by
98–2, 1998–1 I.R.B. 74
97–26
Obsoleted by
98–28, 1998–15 I.R.B. 14
97–53
Superseded by
98–3, 1998–1 I.R.B. 100
Revenue Rulings:
75–17
Supplemented and superseded by
98–5, 1998–2 I.R.B. 20
92–19
Supplemented in part by
98–2, 1998–2 I.R.B. 15
1
A cumulative finding list for previously published
items mentioned in Internal Revenue Bulletins
1997–27 through 1997–52 will be found in Internal
Revenue Bulletin 1998–1, dated January 5, 1998.

April 20, 1998541998–16 I.R.B.
Notes

INTERNAL REVENUE BULLETIN
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on a yearly subscription basis by the Superintendent of Documents. Current subscribers are notified by the Superintendent of
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The contents of this weekly Bulletin are consolidated semiannually into a permanent, indexed, Cumulative Bulletin. These are
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ly Bulletin are notified when copies of the Cumulative Bulletin are available. Certain issues of Cumulative Bulletins are out of print
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INTERNAL REVENUE BULLETIN
If you have comments concerning the format or production of the Internal Revenue Bulletin or suggestions for improving it, we
would be pleased to hear from you. You can e-mail us your suggestions or comments through the IRS Internet Home Page
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