SERVICE ISSUES VARIOUS CORRECTIONS/CLARIFICATIONS TO EXPENSE ALLOCATION REGULATIONS.

Notice 89-91

The purpose of this notice is to provide taxpayers with information concerning the Service's intention to change, clarify, and correct various provisions of the temporary and proposed regulations under section 864(e) of th Internal Revenue Code of 1986 that were published in the Federal Register as T.D. 8228, on September 14, 1988 (53 Fed. Reg. 35525). In addition, the purpose of this notice is to provide additional information concerning the necessity for filing a written election of allocation method pursuant to section 1.861-9T(f)(3). INTENDED CLARIFICATIONS AND CHANGES 1. Proposed section 1.861-10 provides objective tests relating to the definition of qualified nonrecourse financing and specifically pertaining to the analysis of operating expenses and the determination of excess collateralization. These tests are proposed to be effective for taxable years commencing after December 31, 1989. (See item 1, under the Corrections portion of this notice concerning the erroneous use of December 31, 1988 as the proposed effective date of the rule concerning operating costs.) The Service intends to clarify that any objective tests pertaining to operating expenses and excess collateralization shall not apply to transactions entered into prior to 30 days after the adoption of rules dealing with these issues. However, consistent with the requirements of section 1.861- 8(e)(2)(iv)(A) (as adopted by T.D. 7456 on January 3, 1977), the Service shall continue to require in connection with any transaction entered into after the effective date of that regulation that an adequate return was generated "on or from the property," and that the transaction had economic significance, taking into account, inter alia, collateralization. 2. In the preamble to the regulation, the Service announced that it was considering the adoption of a rule that would require the apportionment of rent in certain leasing transactions. The Service intends to clarify that such a rule would apply prospectively to leases executed after the date that such a rule is adopted. 3. With respect to section 1.861-10T(b)(7)(ii), the Service intends to clarify that, in order for a transaction to fall within the special rule for leveraged leases, the guarantor of the lessor's obligation must be unrelated to both the lessor and the lessee. 4. Also with respect to section 1.861-10T(b)(7)(ii), the preamble to these regulations noted that the decision to permit credit enhancement of a lessor's obligation in a leveraged lease might be reversed in subsequent regulations to be published when the Service completed its study of leasing transactions in general. The Service intends to clarify that any subsequent regulation reversing this decision will apply only to transactions executed after the date of its publication. 5. With respect to section 1.861-10T(b)(8)(i), concerning the definition of an integrated project, the Service intends to clarify that the requirement of geographic contiguity shall not be read to exclude properties that are separated only by roadways, railroads, utilities, or intervening segments of property that are devoted to transportation. The Service further intends to clarify that the requirement of functional relationship is not satisfied merely by showing that two or more properties are used in the same trade or business. Rather, the facts must demonstrate the existence of an economic interrelationship between the contiguous properties. Thus, two contiguous office buildings that are both used in the commercial leasing business by a common owner would not constitute an integrated project unless it is demonstrated that the functions performed in both buildings, and their operation, are economically complementary and interrelated. Conversely, a hotel, office building, and shopping mall that are adjacent could constitute an integrated project if it is demonstrated that the functions performed in each, and their operation, are economically complementary and interrelated. 6. Although stock purchases are excluded from the definition of qualified nonrecourse financing, the Service intends to adopt a rule that would permit stock purchases to qualify in connection with the purchase of stock in a corporation holding a single asset the purchase of which would qualify independently. For example, the purchase of stock of a corporation whose only asset was an office building could qualify for nonrecourse financing. The same would be true in the case of a corporation whose only asset was an integrated project, as described in paragraph 5. 7. With respect to section 1.861-11T(d)(6), the Service intends that the reference to the attribution rules of section 318 should instead be a reference to the constructive ownership rules of section 1563(e). Section 1.1563-3(d) provides tie-breaker rules for any corporation deemed to be owned by two or more persons. In addition to these rules, it may be necessary to issue further guidance concerning the treatment of optionees in a corporation that is not a member of an affiliated group. 8. Section 1.861-12T(j), EXAMPLE 1, indicates that a hypothetical corporate headquarters constitutes an asset without identifiable income yield. The Service intends to clarify that only portions of such a building that are not definitely related to a particular income producing activity shall be considered to constitute an asset without identifiable yield. 9. Section 1.861-9T(g)(2)(iv) provides that the tax book value of assets transferred between affiliated corporations in a deferred intercompany transaction shall be determined without regard to the gain or loss that is deferred. The Service intends to clarify that a similar rule shall apply in connection with an intercompany distribution. See section 1.1502-14. 10. Section 1.861-11T(e)(2)(i) prescribes the treatment of interest expense and interest income on an interaffiliate loan. The Service intends to clarify that rather than including interest income in the same class of gross income from which it was deducted, interest income should match the deduction in terms of its source and its limitation category. 11. Section 1.861-14T(e) enumerates the expenses that are to be allocated and apportioned under the rules of section 1.861-14T. The Service intends to modify section 1.861-14T(e) to include all expenses and deductions that are not definitely related to a particular class of income. Thus, for example, the deduction for charitable contributions allowed by section 170 would be subject to allocation and apportionment under section 1.861-14T. The deduction for charitable contributions is considered to relate to all the members of an affiliated group and not to any subset thereof. CORRECTIONS The Service intends to make the following corrections to the designated provisions of the regulations: 1. With respect to Proposed section 1.861-10(b)(3)(v), the proposed subdivision be numbered "(iv)" instead of "(v)" and that the reference therein to December 31, 1988 should instead be a reference to December 31, 1989. 2. With respect to section 1.861-8T(c)(2), both references to section 1.861-11T(b) should instead be references to section 1.861- 12T(c). 3. Section 1.861-8T(h)(3) and (4) should be deleted. 4. The sixth sentence of section 1.861-9T(a) should read as follows: When money is borrowed for a specific purpose, such borrowing will generally free other funds for other purposes, and it is reasonable under this approach to attribute part of the cost of borrowing to such other purposes. 5. The definition of trade receivable contained in section 1.861-9T(b)(3), to define a trade receivable as any receivable arising out of the sale of property or the performance of services by the taxpayer in lieu of the existing cross reference to section 1.954-2(h). 6. With respect to the example contained in section 1.861- 9T(b)(3), the reference to 88 cents should instead be a reference to 78 cents. 7. With respect to section 1.861-9T(d)(2), the reference to January 1, 1988 should instead be a reference to January 1, 1989. 8. With respect to section 1.861-9T(e)(4), the reference to section 1.904-7(i)(2) should instead be a reference to section 1.904- 5(h)(2)(i). 9. With respect to section 1.861-9T(f)(3)(i), the reference to paragraph (f)(2) should instead be a reference to paragraph (f)(3). 10. With respect to section 1.861-10T(b)(3)(i), the reference to paragraph (b)(3)(ii) should instead be a reference to paragraph (b)(3)(iii). 11. With respect to section 1.861-10T(b)(3)(v), Example (1), the reference to paragraph (b)(2)(iii) should instead be a reference to (b)(2)(iv). 12. With respect to section 1.861-10T(b)(3)(v), Example (2), the fourth sentence of that example should read as follows: Thus, a significant portion of the cash flow is derived from the performance of services not incidental to the occupancy of hotel rooms. 13. With respect to section 1.861-10T(b)(8)(i), the first sentence should read: "A taxpayer's pledge of multiple assets of an integrated project. 14. With respect to section 1.861-10T(b)(8)(iii), the reference to paragraph (b)(6) should instead be a reference to paragraph (b)(12). 15. With respect to section 1.861-10T(b)(10), the reference to paragraph (b)(9)(i) should instead be a reference to (b)(8)(i). 16. With respect to section 1.861-12T(j), Example (1), the first sentence of Step 6 of (4) should read as follows: Since $10,000 of related person interest income received by X constitutes interest received on excess related person indebtedness, $10,000 of X's third party interest expense is allocated to X's debt investment in Y. The last sentence of Step 6 should read as follows: As a result of this direct allocation, the value of X's assets generating foreign source general limitation income are reduced by the principal amount of indebtedness the interest on which is directly allocated to foreign source general limitation income ($62,500), and X's assets generating foreign source passive limitation income are reduced by the principal amount of indebtedness the interest on which is directly allocated to foreign passive income ($37,500). In the table immediately following Step 6, the reference to adjustments for directly allocable interest should be $62,500 and $37,500, instead of $62,250 and $37,750. Thus, the total for foreign general is $302,500 and the total for foreign passive is $92,500. However, the relative percentages are unchanged. 17. With respect to section 1.861-14T(e)(1), the reference to section 1.861-8T(b)(2) should be changed to section 1.861-8(b)(2). 18. With respect to section 1.861-14T(e)(2), the reference to section 1.861-8T(e)(3) should be changed to section 1.861-8(e)(3). 19. With respect to section 1.861-14T(e)(2)(ii), the reference to section 126 of P.L. 98-369 should be changed to section 1216 of P.L. 99-514. EXTENSION OF DEADLINE FOR REQUIRED FILINGS Section 1.861-9T(f)(3) indicates that a controlled foreign corporation shall make an election to use either the asset method or the gross income method in allocating and apportioning its interest expense. The regulation further provides that the election shall be made by filing a written statement described in section 1.964- 1(c)(3)(ii) at the time and in the manner described therein and providing a written notice described in section 1.964-1(c)(3)(iii), except that no such written statement or notice is required to be filed or sent before March 13, 1989. Section 1.861-12T(c)(4)(ii) cross references the rules of section 1.861-9T(f)(3) in connection with an election to reallocate losses in a separate limitation category for dividends received from a noncontrolled section 902 corporation. Upon reconsideration, the Service has determined that the cross- reference to regulations under section 964 should be modified and that the deadline should be extended for the filing of the elections described above. Any reference to a due date in this notice means the due date taking into account extensions. Under section 1.861-9T(f)(3)(iii), the controlling United States shareholder of a controlled foreign corporation is subject to a rule requiring a consistent election of method for all controlled foreign corporations of which the United States shareholder owns a controlling interest. The purpose of the election requirement is to inform the Service of the choice of the majority United States shareholder and to provide a mechanism by which minority shareholders can be informed of the method used by the majority shareholder, as well as to provide a mechanism for selecting a method in the case of a controlled foreign corporation that has no controlling United States shareholder, as in the case of a joint venture between United States shareholders that have elected different methods. In order to facilitate these objectives, the Service has determined that a controlling United States shareholder should attach to its return a statement described in section 1.964-1(c)(3)(ii) indicating which method was employed. No such statement shall be required to be attached to any return due before September 15, 1989. Although such election must be employed consistently, it does not constitute a binding election and may be changed in subsequent years or by amended return. Any taxpayer that fails to file such a statement shall be presumed to have elected the asset method. In the case of any controlled foreign corporation that has a controlling United States shareholder and any minority United States shareholders, the controlling United States shareholder must send to the minority United States shareholders the notice described in section 1.964-1(c)(3)(iii) indicating which method was employed. No such notice shall be required to be sent to a minority shareholder by any controlling United States shareholder that filed its return before September 15, 1989. The minority shareholder must use the method adopted by the controlling United States shareholder with respect to the particular controlled foreign corporation, even if such method would otherwise violate the consistency requirement as applied to the minority shareholder. In the case of any controlled foreign corporation that has no controlling United States shareholder, the controlled foreign corporation shall itself elect a method of allocation and send a notice described in section 1.964-1(c)(3)(iii) to all United States shareholders. (The use of such method will not constitute a violation of the consistency requirement). However, if all United States shareholders have elected the same method with respect to other controlled foreign corporations, that method must be used and no notice is required. The election to reallocate losses under section 1.861- 12T(c)(4)(ii) should be made by filing a statement with the taxpayer's return. With respect to taxable years ending on or before the publication of this notice, such a statement should be filed with the next return due after the publication of this notice and should state the year in which the election is made. However, no such statement shall be required to be attached to a return due before September 15, 1989. Any election filed on or before March 13, 1989 pursuant to the regulations under section 964 shall continue to be valid notwithstanding the changes announced by this notice. Except as otherwise indicated, the effective date of the intended clarifications, changes, and corrections contained in this document shall be the same as the effective date of the relevant provisions of the temporary regulations. This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied on to the same extent as a revenue ruling or revenue procedure. DRAFTING INFORMATION The principal author of this notice is David Merrick of the Office of Associate Chief Counsel (International). For further information regarding this notice, call Mr. Merrick at (202) 566-6276 (not a toll-free call), or write to CC:INTL:Br4, Room 5537, Internal Revenue Service, 1111 Constitution Ave., NW, Washington, DC 20224.