IRS Proposes New Rules On Deductions For Foreign Deferred Compensation Plans.

The Service has released proposed regulations (EE-14-81) under section 404A relating to the limitations on deductions and adjustments to earnings and profits (or accumulated profits) regarding certain foreign deferred compensation plans. These new proposed regs supersede proposed regulations published on April 8, 1985.

There are several significant differences between the new proposed regulations and those published in 1985. For instance, old proposed section 1.404A-1(e) provided that earnings and profits (or accumulated profits) may be reduced by an employer's payments to a funded foreign deferred compensation plan that are not deductible under section 404(a), even when an election under section 404A has not been made. However, after reexamining the congressional intent underlying section 404A, the Service now believes that the position reflected in the old regs is inconsistent with the purposes of section 404A. Therefore, new proposed section 1.404A-1(a) states that section 404A provides the exclusive means by which an employer may reduce E&P for deferred compensation in situations other than those in which a reduction of E&P is permitted under section 404.

The new proposed regulations also modify the rules for elections under section 404A and other accounting method changes. Old proposed section 1.404A-2(b)(5) required section 404A elections to be made no later than the due date for filing the U.S. tax return for a U.S. taxpayer's tax year. For a qualified foreign plan maintained by a foreign corporation, the regs have been modified to conform the filing requirements to the general rules applicable to tax accounting elections on behalf of foreign corporations under section 964. For example, under the new regs, a section 404A election need not be made before the U.S. shareholder's tax liability is affected by the E&P of the foreign corporation. Such an effect on the U.S. shareholder's tax liability may occur as a result of a dividend distribution, an income inclusion under section 951(a), a section 1248 transaction, a section 864(e) basis adjustment by E&P, or an inclusion in income of the earnings of a qualified electing fund under section 1293(a)(1).

The 1985 proposed regulations provided that for "protective" or "Method (2)" elections to be effective, taxpayers had to file amended returns no later than 90 days after the final regs were published. In response to numerous comments calling the 90-day period inadequate, the Service has extended the deadlines for perfecting retroactive elections and making or perfecting certain other elections to 365 days after the publication of final regulations.

New proposed section 1.404A-7 provides rules for making, perfecting, and revoking retroactive effective date elections, as well as retroactive plan-by-plan elections for qualified foreign plans maintained by foreign subsidiaries and for qualified funded plans maintained by foreign branches. Taxpayers have 365 days after publication of the final regs to decide whether to perfect or revoke retroactive elections or to make, revoke, or reelect in intervals of six or more years, effective for tax years in the open period (as defined in new section 1.404A-7(g)(6)) and continuing after tax years beginning after December 31, 1979. Taxpayers must file amended returns and attach statements in order to perfect a retroactive election and to conform all items to the treatment consistent with election or revocation. If the amended returns and statements are not timely filed, the retroactive elections will be deemed revoked.

Other changes in the new proposed regulations include the addition of a safe-harbor provision for the 90-percent requirement of section 404A(e)(2); revision of the rules affecting termination indemnity plans; modification of the rules for qualified funded plans; and changes in the rules for qualified reserve plans. In addition, the Service says it is considering, and invites suggestions on, whether simplified or alternative methods of determining E&P reductions under section 404A might be appropriate for foreign corporations that are not controlled.

The Service has scheduled a public hearing on the proposed regulations for October 5, 1993, beginning at 10:00 a.m. in room 2615, Internal Revenue Service Building, 1111 Constitution Ave., N.W., Washington. Requests to speak at the hearing and outlines of oral comments are due by September 14. Written comments on the proposals must be received by July 6. Written comments, requests to speak, and outlines of oral comments should be sent to Internal Revenue Service, PO Box 7604, Ben Franklin Station, Attention: CC:CORP:T:R (EE-14-81), Room 5228, Washington, DC 20044.

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[4830-01]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

[EE-14-81]

RIN 1545-AD81

AGENCY: Internal Revenue Service, Treasury.

ACTION: Withdrawal of previous proposed rules and notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations relating to the limitations on deductions and adjustments to earnings and profits (or accumulated profits) with respect to certain foreign deferred compensation plans. These new proposed regulations reflect changes to the applicable law made by the Act of December 28, 1980, as amended by the Technical Corrections Act of 1982, by the Tax Reform Act of 1986, and by the Technical and Miscellaneous Revenue Act of 1988. The new proposed regulations will affect employers (and shareholders of employers) that provide deferred compensation directly or indirectly to foreign employees and will provide the public and Internal Revenue Service personnel with the guidance needed to comply with section 404A of the Internal Revenue Code of 1986. These new proposed regulations supersede the prior proposed regulations published in the Federal Register on April 8, 1985 (50 FR 13821).

DATES: Written comments must be received by [INSERT DATE THAT IS 60 DAYS AFTER THE DATE OF PUBLICATION OF THESE PROPOSED REGULATIONS IN THE FEDERAL REGISTER]. Requests to speak (with outlines of oral comments) at a public hearing scheduled for October 5, 1993, at 10:00 a.m., must be received by September 14, 1993. See notice of hearing published elsewhere in this issue of the Federal Register.

ADDRESSES: Send comments, requests to appear at the public hearing, and outlines of comments to be presented to: Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Attention: CC:CORP:T:R (EE-14-81), Room 5228, Washington, D.C. 20044.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Elizabeth A. Purcell, Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations) at (202) 622- 6080 (not a toll-free number). Concerning the hearing, Carol Savage, Regulations Unit, at (202) 622-8452 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

STATUTORY AUTHORITY.

This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under sections 404A and 7805(a) of the Internal Revenue Code (Code).

PAPERWORK REDUCTION ACT.

The collection of information requirement contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)). Comments on the collection of information should be sent to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503, with copies to the Internal Revenue Service, Attention: IRS Reports Clearance Officer T:FP, Washington, D.C. 20224.

The collection of information requirement in these regulations is in sections 1.404A-5, 1.404A-6 and 1.404A-7. This information is required by the Internal Revenue Service to determine accurately the correct deductions and reductions in earnings and profits for foreign deferred compensation. The likely respondents are businesses or other for-profit institutions.

These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents may require greater or less time, depending on their particular circumstances. The estimated total annual reporting burden is 633,200 hours. The estimated annual reporting burden per respondent varies from 5 hours to 1,000 hours, depending on individual circumstances, with an estimated average of 506 hours. The estimated number of respondents is 1,250. The estimated annual frequency: once. Background.

On April 8, 1985, the Internal Revenue Service published in the Federal Register proposed amendments to the Income Tax Regulations under section 404A of the Internal Revenue Code of 1954 (now 1986) (50 FR 13821). Comments were requested and received, and a public hearing was held on September 20, 1985. After consideration of the comments received, the Service has determined that, rather than promulgate final regulations, it is more appropriate to withdraw the original proposed regulations and propose new regulations. This determination is based on a number of factors, including the number of significant substantive changes made to the prior proposed rules, changes to the underlying statute and other relevant Code provisions, and a need to reorganize the regulations. For a general discussion of section 404A and description of the prior proposed regulations, see the preamble to the prior proposed regulations published in the Federal Register on April 8, 1985.

The significant differences (or, where appropriate, the significant similarities) between these new proposed regulations and the prior proposed regulations are discussed, section by section, in the remainder of this preamble. Prior proposed section 1.404A-1 remains new proposed section 1.404A-1. However, the rules found in section 1.404A-2 of the prior proposed regulations are now incorporated in new proposed sections 1.404A-6 and 1.404A-7. Prior proposed sections 1.404A-3, 1.404A-4, 1.404A-5 and 1.404A-6 are redesignated sections 1.404A-2, 1.404A-3, 1.404A-4 and 1.404A-5, respectively.

SECTION 1.404A-1: GENERAL RULES CONCERNING DEDUCTIONS AND ADJUSTMENTS

90-PERCENT TEST

As a condition to electing treatment as a qualified foreign plan, section 404A(e)(2) requires that 90 percent or more of the amounts taken into account for a taxable year under the plan be attributable to services performed by nonresident aliens, the compensation for which is not subject to United States federal income tax. Prior proposed section 1.404A-1(c) provided that, in determining whether the 90-percent test is satisfied, accrued benefits may be calculated under any reasonable method. It also provided that the rules for calculating the present value of accrued benefits at normal retirement age (except for the actuarial assumption safe harbor) under section 1.416-1 (concerning the determination whether a retirement plan is top-heavy) are presumed to be reasonable for this purpose.

Many commentators suggested that these rules for calculating accrued benefits for purposes of the 90-percent test are extremely burdensome and disproportionately expensive. They also suggested that the calculations require a degree of precision and accuracy that in many cases is unwarranted by the circumstances (i.e., where very few plan participants are United States citizens or residents and little compensation of the plan participants is subject to United States federal income tax). To give taxpayers in those cases a less burdensome and less expensive means of demonstrating compliance with the 90-percent requirement, a safe harbor provision has been provided in paragraph (c)(2) of new proposed section 1.404A-1. It provides that the 90-percent requirement of section 1.404A-1(a)(3) will be deemed satisfied with respect to a plan if the participants' benefits under the plan increase generally in proportion to their compensation taken into account under the plan, and the sum of (1) the compensation of United States citizens and residents taken into account under the plan, and (2) any other compensation subject to United States federal income tax taken into account under the plan, does not exceed five percent of all compensation taken into account under the plan for the plan year. This safe harbor provision does not apply, however, if the Commissioner determines that a significant purpose of the plan is to provide benefits not otherwise eligible for tax benefits under the Internal Revenue Code for participants who are United States citizens or residents. An example is provided in new proposed section 1.404A-1(c)(4) to illustrate the application of this safe harbor provision.

TERMINATION INDEMNITY PLANS

Many commentators suggested that the regulations be revised to provide specifically that certain termination indemnity plans are considered deferred compensation plans for purposes of section 404A. The laws of many countries require employers to maintain termination indemnity plans to pay termination benefits. Some of these termination indemnities are payable solely upon involuntary discharge (other than by reason of mandatory retirement) and thus may be viewed as dismissal wage plans under United States tax principles. However, other termination indemnity plans are akin to deferred compensation plans. For example, one commentator noted that, in one European country, employers are required by law to provide severance benefits equal to one month's pay (final pay) for each year of service. These benefits are fully vested and payable upon all events of termination, including retirement.

Because the provisions of termination indemnity plans may vary widely, paragraph (iii) of the definition of deferred compensation in paragraph (e) of new proposed section 1.404A-1 provides guidelines for determining whether such a plan provides deferred compensation. A termination indemnity plan is considered to provide deferred compensation if: (1) a major purpose of the plan is to provide for the payment of retirement benefits, (2) it has a benefit formula providing for payment based at least in part upon length of service, (3) it provides for the payment of benefits to employees (or their beneficiaries) after the employee's retirement, death or other termination of employment, and (4) it meets such other requirements as may be prescribed by the Commissioner with respect to termination indemnity plans. An example is provided under the definition of deferred compensation in paragraph (e) of new proposed section 1.404A-1 to illustrate this provision. Any plan that meets these requirements is treated as providing deferred compensation, whether or not it is called a termination indemnity plan.

EQUIVALENT OF A TRUST

Section 404A(b)(5)(A) provides that, in order for a contribution to be taken into account in the case of a qualified funded plan, it must be paid to a trust or the "equivalent of a trust". The reference to the equivalent of a trust recognizes that, in some foreign countries, the common law concept of a trust does not exist. Thus, in those countries, the arrangement used to fund deferred compensation benefits for purposes of section 404A(b)(5)(A) must be functionally equivalent to a trust. The essential function of a trust in the context of a United States deferred compensation plan is to provide an entity separate from an employer through which deferred compensation benefits may be secured and liabilities funded. The four elements necessary to accomplish this function are provided in the definition of "equivalent of a trust" in paragraph (e) of new proposed section 1.404A-1. These elements have been revised to allow an employer some latitude to insulate corpus and income from the claims of an employer's creditors, and to remove the concept of legal and beneficial ownership. Finally, the concept of fiduciary duty has been replaced with legally enforceable duty.

Some commentators urged the Service to endorse as the equivalent of a trust the so-called "Security Contract" or "Security Concept" developed in Germany. As explained by those commentators, the Security Contract combines a book reserve commitment by an employer with a pledge and guaranty. First, an employer establishes a book reserve for its pension liabilities for which it receives a tax deduction under German law. It then establishes a wholly-owned subsidiary to which it transfers assets to fund its pension liabilities. As such, the corpus and income of the subsidiary are separately identifiable from an employer's general assets. This arrangement, without more, would not satisfy the requirements of the equivalent of a trust because the assets held by the subsidiary are not protected from the claims of an employer's creditors in the event of bankruptcy or receivership. Under the Security Contract concept, however, the subsidiary also pledges its assets irrevocably to a custodian who then gives a guaranty to the employees to pay the benefits up to the assets pledged to the custodian in the event an employer declares bankruptcy or goes into receivership. The custodian's guaranty is intended to place a prior lien on the assets pledged and protect them from the claims of an employer's creditors in the event of bankruptcy or receivership.

As one commentator asserted, however, it is unclear under German law that the arrangement provides such protection. According to that commentator, in the event of bankruptcy or receivership, the German Pension Guaranty Corporation is required by law to settle an employer's book reserve commitment. The Pension Guaranty Corporation then becomes a non-privileged creditor in the bankruptcy process and exercises any rights the employees have under the plan. As a non- privileged creditor, the Pension Guaranty Corporation is not entitled to all the assets pledged to the custodian, but is limited to a percentage of employer assets that is consistent with its general bankruptcy quota. Thus, it appears that the subsidiary's assets may be subject to the claims of an employer's creditors before all claims of the Pension Guaranty Corporation, exercising the rights of the employees under the plan, are settled.

Until the Service is satisfied that the corpus and income of the subsidiary are to be used to satisfy the claims of the employees and their beneficiaries (or those exercising their rights under the plan) before those of an employer's creditors, the Service cannot endorse this arrangement as the equivalent of a trust.

EXCLUSIVE MEANS FOR DEDUCTION OR REDUCTION IN EARNINGS AND PROFITS

For foreign plans that fail to satisfy the requirements of section 404A, section 404 governs deductions for deferred compensation expense. For plans that are not qualified under section 401, section 404(a)(5) generally provides that the employer's deduction for contributions is delayed until amounts attributable to the employer's contribution are includible in the plan participant's gross income. In addition, under section 404(a)(5), deductions are denied altogether unless separate accounts are maintained for each participant. The Service took this position with respect to a foreign plan in Private Letter Ruling 7904042 (Oct. 25, 1978), available in the Freedom of Information Reading Room, Room 1569, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. This position is reflected, in part, in paragraph (a) of new proposed section 1.404A-1.

Prior proposed section 1.404A-1(e) provided that earnings and profits (or accumulated profits) may be reduced with respect to payments by an employer to a funded foreign deferred compensation plan that are not deductible under section 404(a) even where an election under section 404A has not been made. Upon reexamination of the Congressional intent underlying the enactment of section 404A, however, the Service now believes that the position reflected in the prior proposed regulations is inconsistent with the purposes of section 404A (and the limitations thereunder). Thus, in accordance with the Secretary's section 404A(h) authority to prescribe regulations necessary to carry out the purposes of section 404A, paragraph (a) of new proposed section 1.404A-1 provides that section 404A provides the exclusive means by which an employer may reduce earnings and profits for deferred compensation in situations other than those in which a reduction of earnings and profits is permitted under section 404. See also the discussion below of the relevance of sections 61, 671 through 679, and 1001 in this context.

REQUEST FOR COMMENTS CONCERNING FOREIGN CORPORATIONS THAT ARE NOT CONTROLLED

The Service is considering whether simplified or alternative methods of determining allowable earnings and profits reductions under section 404A might be appropriate for foreign corporations that are not controlled. Suggestions are invited on this matter. Section 1.404A-2: Rules for qualified funded plans.

SUBSTANTIALITY OF PAYMENTS TO TRUST

A commentator suggested that the focus of the flush language of paragraph (b) of prior proposed section 1.404A-3 (requiring a trust to have "substantiality") should be on the substantiality of payments to a trust (or the equivalent of a trust) rather than on the substantiality of a trust (or the equivalent of a trust), because the determination with respect to the latter can be made under the standards set forth in prior proposed section 1.404A-1(g)(9). Accordingly, new proposed section 1.404A-2(b)(2)(i) provides that employer contributions must have substance. For example, contributions may not be made in the form of a promissory note. This also means that the contributions must be accumulated in the trust (or the equivalent of a trust) in order to be distributed as benefits under a deferred compensation plan. Whether contributions are being accumulated in the trust (or the equivalent of a trust) to be distributed as benefits will depend on the facts and circumstances. The example in paragraph (b)(5) of new proposed section 1.404A-2 reflects this change.

EXCLUSIVE BENEFIT RULE

Section 404A(b)(5)(A) provides that, in the case of a qualified funded plan, a contribution is taken into account only if it is paid to a trust (or the equivalent of a trust) that meets the requirements of section 401(a)(2). Section 401(a)(2) provides generally that it must be impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be used for, or diverted to, purposes other than the exclusive benefit of the employees or their beneficiaries. Thus, in effect, section 404A(b)(5)(A) reemphasizes, with regard to qualified funded plans, the general rule found in section 404A(e) that any "qualified foreign plan" must be for the exclusive benefit of an employer's employees or their beneficiaries. (As stated in the Senate Finance Committee Report, "[f]irst, the plan must be for the exclusive benefit of an employer's employees or their beneficiaries." S. Rep. No. 1039, 96th Cong., 2d Sess. 13 (1980).)

To reflect this emphasis, new proposed section 1.404A-2(b)(2) provides that one important factor that is taken into account in determining whether a trust has or has not been operated in a manner consistent with the exclusive benefit rule is whether it has not or has been involved in a transaction that would be described in section 4975(c)(1) if the plan were the type of plan subject to those rules. For example, a loan from the trust to an employer, on any terms, ordinarily would be a circumstance that strongly suggests noncompliance with section 404A(b)(5)(A). Similarly, a sale, exchange, or lease of any property between the trust and an employer would generally violate this provision. These rules, as set forth in new proposed section 1.404A-2(b)(2), apply prospectively.

CONTRIBUTIONS DEEMED MADE BEFORE PAYMENT

Paragraph (c) of new proposed section 1.404A-2 clarifies the circumstances under which a payment made after the last day of an employer's taxable year is deemed to have been made on that last day.

FREQUENCY OF ACTUARIAL VALUATIONS

The new proposed regulations generally continue the requirement in the prior proposed regulations that an actuarial valuation be made no less frequently than once every three years for a qualified funded plan. However, for interim years, they require a reasonable actuarial determination to be made of whether the full funding limit in section 1.404A-5(c)(2) applies to the plan, and provide that the Commissioner may require an actuarial valuation in interim years under appropriate circumstances. It is anticipated that the Commissioner will not exercise this authority except in situations similar to those described in section 1.412(c)(9)-1(d) of the proposed regulations.

SHAREHOLDER-LEVEL CONSEQUENCES

A sentence in paragraph (d)(1) of prior proposed section 1.404A- 3 provided that, where a foreign corporation maintained a qualified funded plan, the deductible amount was taken into account for the shareholder's taxable year in which or with which an employer's taxable year ended. This sentence has been deleted because section 404A does not govern the time at which adjustments to earnings and profits of a foreign employer corporation for a particular year are taken into account at the shareholder level. Section 1.404A-3: Rules for qualified reserve plans.

The new proposed regulations have modified in several ways the guidance on the calculation of the amount that may be taken into account under a qualified reserve plan. First, the presentation has been changed in order to parallel the components of net periodic pension cost used in Statement of Financial Accounting Standards No. 87 "Employer's Accounting for Pensions" (1985), available from the Financial Accounting Standards Board, 401 Merritt 7, Norwalk, CT 06856. Thus, the amount taken into account for a year is based on the sum of a type of "service cost", "interest cost" and the amortization of the increase or decrease in the reserve from other sources. As part of this change, the steps for determining the actuarial gain or loss have been made explicit. In addition, as discussed below, certain increases or decreases in the reserve that were subject to amortization under the old proposed regulations are now included in the reasonable addition to the reserve.

TEN-YEAR AMORTIZATION

Section 404A(c)(4) provides for the spreading over ten years of certain increases and decreases in reserves on account of various events including a catch-all category of "such other factors as may be prescribed by regulations". The Senate Finance Committee Report includes two suggestions of possible items that could be included in this category: "adjustments in the reserve resulting from changes in levels of compensation on which benefits depend or the vesting in one year of a benefit which was accrued in a prior year." S. Rep. No. 1039, 96th Cong. 2d. Sess. 14 (1980).

Some commentators criticized the rule in paragraph (d) of prior proposed section 1.404A-4 providing for the amortization of changes in the reserve arising from these two sources. They suggested that the ten-year amortization requirement for increases or decreases to the reserve on account of changes in the level of compensation upon which plan benefits depend, and for vesting of benefits accrued in prior years, was unnecessary because those items are ongoing costs of the plan that are specifically contemplated by the plan and will arise periodically as each participant's circumstances dictate. Thus, those increases or decreases can be expected to occur regularly in the aggregate and will not create the "bunching" that section 404A(c)(4) was designed to avoid.

The new proposed regulations respond to commentators' concerns by incorporating certain increases in the reserve (as described below) into the definition of the reasonable addition to a reserve, subject to an anti-abuse rule. The effect of this change is to allow immediate recognition, rather than ten-year amortization, of these changes. Under normal circumstances this immediate recognition will not result in significant bunching of income or deductions. Further, to the extent bunching occurs, abuse potential is limited because the bunching is the result of a deferral of deductions rather than the recognition of these items. Finally, as discussed below, for taxable years beginning after December 31, 1986, the indirect foreign tax credit is determined using post-1986 earnings and profits (i.e., aggregated for all post-1986 years). Use of a multi-year earnings and profits pool diminishes the effect of bunching on the foreign tax credit.

The increases in reserve that are now included in the reasonable addition to the reserve are those increases that result from expected changes in compensation and from the increase in vesting for employees whose liabilities were included in the reserve as of the beginning of the year. Thus, for example, the reasonable addition to the reserve may reflect an expected increase in compensation of five percent and expected changes in the vesting percentage in the current year for all employees in the reserve as of the beginning of the year. By contrast, any increase in reserve that results from compensation changes that are greater than expected or from the inclusion of newly-vested employees who were not included in the prior year's reserve are categorized as actuarial losses subject to ten-year amortization.

SECTION 1.404A-4: UNITED STATES AND FOREIGN LAW LIMITATIONS ON

SECTION 404A(d) LIMITATION - POOLING OF EARNINGS AND PROFITS

Section 404A(d)(3) provides that, in determining the earnings and profits (and accumulated profits) of any foreign corporation with respect to a qualified foreign plan, the amount determined under section 404A with respect to any plan for any taxable year must not exceed the amount allowed as a deduction under the appropriate foreign law for such taxable year. As the legislative history makes clear, this limitation was imposed in response to "the possibilities for distortion of a taxpayer's indirect foreign tax credit which are presented by the present annual system for determining the amount of the foreign taxes paid by a subsidiary which are attributable to dividends paid to U.S. shareholders." S. Rep. No. 1039, 96th Cong., 2d Sess. 15 (1980). The legislative history further makes clear that "[t]his potential for distortion might be eliminated if the indirect credit were computed with reference to the subsidiary's accumulated foreign taxes and undistributed accumulated profits for all years." Id.

Section 1202(a) of the Tax Reform Act of 1986 amended section 902 to provide for computation of the indirect foreign tax credit by pooling all post-1986 earnings and profits and all post-1986 creditable foreign taxes. These amendments to section 902 prevent the distortion at which section 404A(d)(3) was aimed. Section 1012(b)(4) of the Technical and Miscellaneous Revenue Act of 1988 added specific regulatory authority to section 404A(d)(3) (retroactive to enactment of the Tax Reform Act of 1986), to take this change in the law into account. Accordingly, pursuant to that grant of regulatory authority, new proposed section 1.404A-4 provides that, for taxable years beginning after December 31, 1986, the reduction of earnings and profits of a foreign corporation with respect to a qualified foreign plan is determined without regard to the tax deduction under foreign law for that year. This new rule allows any amount that is disallowed for a year (because the foreign tax deduction for that year is greater than the amount allowed under section 404A(b) or (c)) to be carried forward to a future year, in which it may increase the amount allowable under section 404A.

SECTION 404A(d) LIMITATION

Section 404A(d)(1) provides that the annual amount allowable under section 404A "shall equal" the lesser of the cumulative United States amount or the cumulative foreign amount, reduced by the aggregate amount. Prior proposed section 1.404A-5(a) provided that the annual amount allowable "shall not exceed" these cumulative amounts. The new proposed regulations adopt the language of the statute. See new proposed section 1.404A-4(b).

FOREIGN CURRENCY RULES

One commentator requested guidance with respect to a number of foreign currency issues. Sections 985-989 were subsequently enacted by the Tax Reform Act of 1986. These sections, effective for taxable years beginning after December 31, 1986, address many of the problems identified by the commentator. Paragraph (d)(1) in new proposed section 1.404A-4 clarifies that, for taxable years beginning after December 31, 1986, income or loss of foreign branches and earnings and profits (or deficits in earnings and profits) of foreign corporations are determined in functional currency as defined in section 985. For taxable years beginning before January 1, 1987, paragraph (d)(2) in new proposed section 1.404A-4 provides that the rules in effect for those taxable years determine the amount of income or loss or earnings and profits (or deficit in earnings and profits) for the foreign branch or subsidiary. A new paragraph (d)(3) provides special rules for those circumstances where the net worth method of accounting is used.

SECTION 1.404A-5: ADDITIONAL LIMITATIONS ON AMOUNTS TAKEN INTO

New proposed section 1.404A-5 clarifies the evidentiary requirements and rules on actuarial assumptions. No significant changes are made to the rules in prior proposed section 1.404A-6, which are now contained in new proposed section 1.404A-5.

SECTION 1.404A-6: ELECTIONS UNDER SECTION 404A AND OTHER CHANGES

TIME AND MANNER FOR MAKING ELECTIONS

Paragraph (b)(5) of prior proposed section 1.404A-2 provided that elections made under section 404A must be made no later than the time prescribed by law for filing the United States tax return for a United States taxpayer's taxable year. For a qualified foreign plan maintained by a foreign corporation, the regulations have been modified to conform the filing requirements to the general rules applicable to tax accounting elections on behalf of foreign corporations under section 964. For example, under the new proposed regulations, a section 404A election need not be made before the United States shareholder's tax liability is affected by the earnings and profits of the foreign corporation. Such an effect on the United States shareholder's tax liability may occur as the result of any of the following: a dividend distribution, an income inclusion under section 951(a), a section 1248 transaction, a section 864(e) basis adjustment by earnings and profits, or an inclusion in income of the earnings of a qualified electing fund under section 1293(a)(1).

The prior proposed regulations provided that, in order for "protective" or "Method (2)" elections to be effective, taxpayers who made those elections had to file amended returns no later than 90 days after the date on which the final regulations were published in the Federal Register. See Ann. 81-114, Ann. 81-148 and Ann. 82-128, reproduced as an appendix to this preamble. Otherwise, the elections would have no effect. Numerous commentators suggested that the 90-day period is inadequate for taxpayers to evaluate the final regulations, collect the required data, make the appropriate actuarial calculations, decide whether the election is beneficial, and file the required returns. Thus, the deadlines for perfecting retroactive elections and making or perfecting certain other elections in new proposed section 1.404A-7 have generally been extended to 365 days after the publication of final regulations.

SINGLE PLAN

As originally proposed, section 1.404A-2(b)(6)(i) provided that an election may be made with respect to each plan that qualifies as a "single plan". The term "single plan" has for this purpose the same definition as it has in section 1.414( )-1(b). Commentators asked for an illustration of the application of this single plan rule to an existing deferred compensation plan that is split into two single plans for purposes of section 404A. Thus, a new example has been added in paragraph (a)(2) of new proposed section 1.404A-6.

SECTION 481(a) ADJUSTMENT

New proposed section 1.404A-6(a) addresses the adoption of methods of accounting and changes in methods of accounting with respect to a foreign deferred compensation plan for which an election under section 404A has been made. It clarifies, for example, that an initial election with respect to a pre-existing plan, termination of an election, revocation of an election, and a change in actuarial funding method, constitute changes in methods of accounting under section 446(e) and section 481(a). To compute the section 481(a) adjustment upon a change in method of accounting under section 404A, section 1.404A-6(f)(6) of the prior proposed regulations required a historical computation. Taxpayers were to compute contributions, deductions or reductions in earnings and profits from the establishment of the plan to the first day of the first year in which a section 404A election was made. Commentators argued that this historical approach was unduly burdensome.

The new proposed regulations respond to commentators' concerns by generally replacing the historical computation requirement with a "snapshot" approach to determining the amount of the section 481(a) adjustment for purposes of section 404A. As illustrated below, the snapshot approach is adopted in the proposed regulations in an effort to reduce substantially taxpayers' recordkeeping and compliance burdens.

The snapshot approach is generally intended to compare (i) the extent to which an employer has accelerated deductions (or reductions in earnings and profits) under its old method of accounting for deferred compensation with (ii) the acceleration (if any) that would have been allowed under its new method of accounting. In the interest of avoiding historical calculations and other complexities, the snapshot approach generally attempts to compare the old and new methods of accounting based, to the extent possible, on actual reserve or fund balances existing at the time of the change. These balances generally have been reduced for amounts actually paid to plan participants and beneficiaries. However, amounts actually paid to participants and beneficiaries would be the same under both an employer's old method and its new method of accounting. Therefore, deductions attributable to such payments can be eliminated from consideration in determining both the old and the new method amounts that are compared.

In other words, in the case of both the old method and the new method of accounting, the extent of acceleration is measured by reference to a common baseline: the amount actually paid to plan participants and beneficiaries (i.e., a pay-as-you-go method). Thus, the snapshot approach generally measures the extent to which an employer, under its old method of accounting, has claimed deductions (or reductions in earnings and profits) that exceed the amount actually paid to plan participants and beneficiaries as of the change in accounting method. This amount (generally referred to as the "Old Method Closing Amount") is then compared to the deductions (or reductions in earnings and profits) in excess of the amount actually paid to plan participants and beneficiaries that the employer would have claimed for the same period under its new method of accounting (generally referred to as the "New Method Opening Amount"). The section 481(a) adjustment is equal to the difference between the Old Method Closing Amount and the New Method Opening Amount. The comparison is based on the status of the plan as the beginning of the year of a change in accounting method.

To illustrate, if the employer has used a funded method of accounting for deferred compensation, the Old Method Closing Amount equals the amount of the fund balance as of the beginning of the year that the accounting method is changed. In determining the amount of the section 481(a) adjustment for purposes of section 404A, this fund balance is compared with a New Method Opening Amount. The New Method Opening Amount will depend on which new method of accounting the employer elects. If the employer makes a qualified funded plan election, the New Method Opening Amount generally will equal the amount of the fund balance, adjusted as appropriate to reflect the limitations in section 404A(b) and (d) on prior contributions to the fund that could have been taken into account under section 404A. If, however, the employer makes a qualified reserve plan election, the New Method Opening Amount generally will be the amount of the reserve under section 404A(c). Alternatively, if the new method of accounting is a non-section 404A method (i.e., a pay-as-you-go method), the New Method Opening Amount generally will be zero.

As the foregoing discussion indicates, the new method will not necessarily be a section 404A method (a qualified funded plan method or qualified reserve plan method), and the old method will not necessarily be a non-section 404A method. The section 481(a) adjustment and the proposed snapshot approach to computing the adjustment apply whether the employer is changing to or from a section 404A method or from one section 404A method to another. For example, assume that a foreign branch has a qualified funded plan with a trust fund balance of 15 of functional currency (as defined in section 985(b)). Assume that this fund balance resulted from FC10 of deductible contributions to the fund under section 404A, plus FC5 of net investment income earned within the fund. Under the snapshot approach, the Old Method Closing Amount upon a change to qualified reserve plan treatment is FC15. Assuming that the reserve under the qualified reserve plan method is FC20 as of the date of the method change, the New Method Opening Amount is FC20, and the amount of the section 481(a) adjustment under section 404A is a negative FC5.

By using the amount of the fund balance in determining both the Old Method Closing Amount and the New Method Opening Amount, the proposed regulations require consideration of both the deductions previously taken by the employer and the accumulated net income (or inside build-up) of a fund in calculating the amount of the section 481(a) adjustment for purposes of section 404A. The Service believes that, in addition to permitting the adoption of a simplified method for determining the section 481(a) adjustment, consideration of a fund's accumulated net income under the snapshot approach avoids additional complexities that might result from the application of sections 61 and 1001 at the time of an election under section 404A. For example, consider an employer that makes a qualified funded plan election after having used a funded method of accounting for a foreign deferred compensation plan that is not a qualified funded plan. Ordinarily, the value of the fund (which is used to satisfy the employer's plan liabilities) will exceed the employer's contributions to the fund (net of the fund's previous payments to plan participants and beneficiaries). If the snapshot method were not applied, arguably sections 61 and 1001 would result in a recognition of income (or increase in earnings and profits) by the employer at the time of the election equal to the excess of the value of the fund over the employer's basis in the fund. This result is consistent with the treatment of a change in method of accounting that consists of a qualified funded plan election as involving a change in the status of the fund from a grantor trust (defined and treated in accordance with sections 671 through 679) to a non-grantor trust (treated in a manner analogous to the treatment of a trust under a section 401(a) tax- qualified plan). The Service solicits comments from interested parties on this analysis and on the utility of the snapshot approach in reducing taxpayer burden.

EFFECT OF SECTION 404A(d)(1) LIMITS ON SECTION 481(a)

Since the limitations of section 404A(d)(1) are part of the section 404A method of accounting under the new proposed regulations, the snapshot section 481(a) adjustment calculation must take into account the cumulative foreign amount limitation in section 404A(d) and new proposed section 1.404A-4. This is a departure from section 1.404A-6(f)(9) in the prior proposed regulations. The snapshot approach includes a simplified method to make this adjustment in computing the section 481(a) adjustment. More specifically, paragraph (g) of new proposed section 1.404A-6 allows taxpayers to use the snapshot approach to compute the initial cumulative United States and foreign law limitations under section 404A(d) as of the beginning of a year of change in method of accounting. The rules to initialize the cumulative United States amount, cumulative foreign amount and the aggregate amount rely on the constant relationship between these three amounts (i.e., the aggregate amount always equals the lesser of the two cumulative amounts).

SECTION 481(a) ADJUSTMENT PERIOD

As required by section 404A(g)(5), the period for taking into account the section 481(a) adjustment arising from an election or a re-election under section 404A is 15 years. Additionally, new proposed section 1.404A-6(e)(2)(iii) provides for a six-year section 481(a) adjustment period for a change in method of accounting arising from the termination or revocation of an election under section 404A, and for any other change in accounting method under section 404A. This new paragraph also requires netting of any section 481(a) adjustment remaining from a previous change in method in determining the amount to be taken into account during the six-year section 481(a) adjustment period. The example in new proposed section 1.404A- 6(e)(4) illustrates this netting rule.

Examples in the new proposed regulations illustrate the principle under section 446(e) and its underlying administrative procedures that the District Director may modify a taxpayer's calculated section 481(a) adjustment under section 404A if the District Director (1) determines that the taxpayer used an erroneous method of accounting in an open year prior to the year in which the taxpayer's qualified funded plan or qualified reserve plan election is effective, and (2) requires the taxpayer to change its erroneous method of accounting in that earlier open year. For example, if a taxpayer erroneously deducted FC100 for amounts accrued under a reserve plan in an open year prior to the effective date of a qualified reserve plan election under section 404A, the District Director could require the taxpayer to change its method of accounting in that earlier open year and to take a positive FC100 section 481(a) adjustment into account entirely in that earlier open year (rather than permitting the positive FC100 amount to be netted against any New Method Opening Amount under the snapshot approach and spread prospectively over a 15- year section 481(a) adjustment period). See section 2.02 of Rev. Proc. 92-20, 1992-1 C.B. 685.

SECTION 1.404A-7: EFFECTIVE DATE AND RETROACTIVE APPLICATION.

Prior proposed section 1.404A-2(c), relating to retroactive elections, has been moved to section 1.404A-7. This change was made because the rules relating to retroactive elections are relatively discrete and thus logically should be set apart from the general election rules. Because the importance of these rules will greatly diminish within a few years, their placement at the end of the regulations will improve the clarity of the remainder of the regulations for the future. Other specific changes to the retroactive election rules are discussed below.

ALL-OR-NOTHING RULE

Many commentators criticized the rule in paragraph (c)(2)(ii) of prior proposed section 1.404A-2 as an improper interpretation of section 2(e)(2) of the Act of December 28, 1980 (Pub. L. 96-603). Prior proposed section 1.404A-2(c)(2)(i) provided that a taxpayer could elect, during its "open period", for section 404A to apply to a qualified foreign plan maintained by a foreign subsidiary. However, prior proposed section 1.404A-2(c)(2)(i) conditioned that election for any plan on a taxpayer electing to apply section 404A with respect to all written plans of every foreign subsidiary (whether or not wholly owned) that defer the receipt of compensation and that satisfy the requirements of section 404A(e)(1) and (2). Commentators argued that the "all-or-nothing rule" of section 2(e)(2) of the Act of December 28, 1980, simply provides that a taxpayer may elect to have section 404A apply for certain prior years, and that such an election must be made for all of a taxpayer's foreign subsidiaries. It does not, however, require that a taxpayer make an election under section 404A for any of its foreign subsidiaries' plans. According to this view, once the election is made to have section 404A apply to the foreign subsidiaries for prior years, the consequences of making or not making an election under section 404A will be determined as though section 404A had been in effect for those years.

After further consideration, the proposed regulations adopt the commentators' view of section 2(e)(2) of the Act of December 28, 1980. Thus, if a taxpayer makes an election to have section 404A apply retroactively to its foreign subsidiaries during its open period, the election to have section 404A apply must be made for all of a taxpayer's foreign subsidiaries (whether or not wholly owned) during a taxpayer's open period. Accordingly, if a taxpayer elects to have section 404A apply during a taxpayer's open period, it may not rely on any other law or rule of law to reduce earnings and profits (or accumulated profits) of any foreign subsidiary with respect to deferred compensation expenses, regardless of whether the taxpayer elects to apply section 404A to any specific deferred compensation plan. Paragraph (b) of new section 1.404A-7 reflects this view, and paragraph (c)(5) illustrates this rule with an example.

MAKING, PERFECTING AND REVOKING RETROACTIVE ELECTIONS

New proposed section 1.404A-7 provides rules for making, perfecting and revoking retroactive effective date elections as well as retroactive plan-by-plan elections for qualified foreign plans maintained by foreign subsidiaries and for qualified funded plans maintained by foreign branches. Taxpayers are afforded 365 days after publication of the final regulations to decide whether to perfect or revoke retroactive elections or to make, revoke or re-elect in intervals of six or more years, effective for taxable years in the open period (as defined in new proposed section 1.404A-7(g)(6)) and continuing after taxable years beginning after December 31, 1979. Taxpayers must file amended returns and attach statements in order to perfect a retroactive election and to conform all items to the treatment consistent with election or revocation. If the amended returns and statements are not timely filed, the retroactive elections will be deemed revoked.

ALTERNATIVE TO CONTEMPORANEOUS EVIDENCE REQUIREMENT

Many commentators criticized the rule in prior proposed section 1.404A-2(c)(4)(iii) prohibiting a retroactive election if a taxpayer was unable to calculate the requisite section 481(a) adjustment based upon actual data, because, in effect, it unduly restricted taxpayers' ability to make retroactive elections. The commentators were concerned that many taxpayers would lack "actual data", and thus be unable to make the election, and that, even if such data were technically available, its retrieval would be prohibitively burdensome. After further consideration, the Service has altered this requirement. Accordingly, new proposed section 1.404A-7(f) provides that the section 481(a) adjustment must be made based upon contemporaneous substantiation quality data. If contemporaneous substantiation quality data is not readily available, however, the adjustment may be based on data which are combinations of actual contemporaneous evidence and reasonable actuarial backward projections of substantiation quality data.

For the convenience of taxpayers, Ann. 81-114, 1981 I.R.B. 21, Ann. 81-148, 1981-39 I.R.B. 15, and Ann. 82-128, 1982-39 I.R.B. 103, concerning Method (1) and Method (2) elections, are reproduced below.

APPENDIX

This announcement provides guidance relating to section 404A of the Internal Revenue Code. Until proposed regulations are published, taxpayers may rely on the guidance provided below.

Section 404A, added by the Act of December 28, 1980 Pub. L. 96- 603 (1981-5 I.R.B. 31), allows taxpayers to make certain elections concerning deductions for amounts paid or accrued by an employer under qualified foreign plans. The two types of qualified foreign plans are qualified funded plans and qualified reserve plans. A qualified foreign plan is any written plan which defers the receipt of compensation and which satisfies two requirements. First, the plan must be for the exclusive benefit of the employer's employees or their beneficiaries. Second, 90 percent or more of the amounts taken into account for the taxable year under the plan must be attributable to services performed by nonresident aliens, the compensation for which is not subject to federal income tax. In addition, the employer must properly elect to have section 404A apply to such plan. If an employer does not make such an election, deductions (or reductions in earnings and profits) are allowed only as provided under section 404 for plans and trusts meeting the requirements of that section.

The rules of section 404A are applicable for taxable years beginning after December 31, 1979, and for certain prior years to the extent the taxpayer elects to have the provisions of section 404A of the Code apply retroactively. Pending the issuance of regulations relating to such elections, the elections referred to in section 404A(e)(3) and (f)(2) of the Code may be made either by (1) claiming the permissible deduction or credit on the taxpayer's income tax return for the first taxable year ending on or after December 31, 1980, including extensions (or an amended return that is filed no later than the end of the extended time period prescribed in section 6081, whether or not such time is actually extended for filing the taxpayer's return), or (2) attaching a statement of election to the taxpayer's income tax return within the time period described in the first method. If the election is made by attaching a statement of election under method (2), the taxpayer's current return would not include deductions or in the case of foreign subsidiaries, take into account reductions in earnings and profits that relate to foreign deferred compensation plans. Deductions or credits consistent with the election would be included on an amended return, to be filed no later than the deadline (described below) for revoking the election. Under either method, the taxpayer must attach to the return a list of plans with respect to which the elections are made. Method (1) or method (2) may also be used for the elections described in section 2(e) of Pub. L. 96-603. When method (2) is used in connection with section 2(e) of Pub. L. 96-603, taxpayers need not amend past returns until regulations are issued.

A taxpayer must determine the amount deductible under section 404A(d) based, in part, on the cumulative foreign amount as defined in section 404A(d)(2)(B). No deduction is allowable under section 404A unless the cumulative foreign amount is established in one of the documents described in section 404A(g)(2)(A)(i), (ii) or (iii) of the Code. Section 404A(g)(2)(A)(iii) authorizes the Secretary to promulgate regulations that would accept certain unspecified statements or evidence as being sufficient to establish the amount of the deduction under foreign law. Until such time as regulations are promulgated under section 404A(g)(2)(A)(iii), the requirements of that section will be considered to be satisfied by a statement prepared at or before the time the return is filed, which lists separately for each plan the cumulative foreign amount and which states that such cumulative foreign amount has been determined pursuant to the requirements of the appropriate foreign tax law. The statement must be prepared by the U.S. taxpayer or a person authorized to practice before the Service. While a taxpayer need not attach any of these documents to its tax return, the taxpayer must furnish the documents for examination upon request of the Internal Revenue Service.

Taxpayers that have made the elections described in section 404A and/or section 2(e) of Pub. L. 96-603 under method (2) need not prepare the statement, described in the immediately preceding paragraph, until they amend their returns. In addition, taxpayers that have made the election described in section 404A for taxable years beginning after December 31, 1979, under Method (1), and have made the election described in section 2(e) of Pub. L. 96-603 under method (2) will satisfy section 404A(g)(2)(A)(iii) if the cumulative foreign amount in the statement reflects the aggregate foreign deductions allowed under foreign law for taxable years commencing after December 31, 1979.

Taxpayers that have already made an election, referred to in this announcement, that does not conform with the requirements stated herein may perfect that election on an amended return filed by the later of September 23, 1981 or by the due date of the taxpayer's income tax return for the first taxable year beginning after December 31, 1979, including extensions. These taxpayers may also satisfy section 404A(g)(2)(A)(iii), to the extent applicable as previously described in this announcement, by preparing the required statement within the same time limits for perfecting the elections under sections 404A(e)(3) and (f)(2).

The qualified reserve plan election, including any retroactive election described in section 2(e)(2) of Pub. L. 96-603, may be revoked on an amended return for the first taxable year ending on or after December 31, 1980, without the consent of the Commissioner until 90 days after the publication of final regulations regarding such elections. Similarly, the qualified foreign plan election and the retroactive election described in section 2(e)(3) may be revoked within the same period.

It is anticipated that the effective date of the final regulations generally will be for taxable years beginning after December 31, 1979, and such prior years as may be affected by an election under section 2(e) of Pub. L. 96-603. Accordingly, taxpayers may be required to amend their tax returns to the extent that deductions or credits claimed are inconsistent with final regulations.

ANNOUNCEMENT 81-148, 1981-39 I.R.B. 15

On June 24, 1981, the Internal Revenue Service issued Announcement 81-114, 1981-28 I.R.B. 21. The announcement was intended to provide pre-regulation guidance to taxpayers concerning recent legislation under section 404A. Taxpayers have expressed concern with respect to a statement in that announcement, with respect to reductions of earnings and profits if section 404A is not elected. Announcement 81-114 is clarified as follows:

The decision not to elect section 404A will not affect the computation of earnings and profits with respect to contributions to plans as allowed under prior law. In the case of an accrued liability to a reserve plan, however, such accrued liability reduces earnings and profits only as provided in section 404A with respect to the taxable years described in section 2(e) of Pub. L. 96-603, 1980-2 C.B. 684.

ANNOUNCEMENT 82-128, 1982-39 I.R.B. 103

Taxpayers that are interested in making the elections referred to in section 404A(e)(3) and (f)(2) of the Internal Revenue Code may continue to use the "method (1)" or "method (2)" election described in Announcement 81-114, 1981-28 I.R.B. 21 for taxable years beginning after December 31, 1979, until further guidance is made available. Pending the issuance of regulations under section 404A, qualified foreign plans must comply with the reporting requirements and other rules contained in Announcement 81-114.

EFFECTIVE DATES.

The amendments are proposed generally to apply to taxable years beginning after December 31, 1979. The prohibited transaction rules in section 1.404A-2(a) are proposed to be effective [INSERT THE DATE OF PUBLICATION OF THESE PROPOSED REGULATIONS IN THE FEDERAL REGISTER]. If a taxpayer elected pursuant to section 2(e)(2) of the Act of December 28, 1980, the amendments are proposed to apply to certain prior taxable years beginning after December 31, 1970.

SPECIAL ANALYSES.

It has been determined that these proposed rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these proposed regulations and, therefore, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

COMMENTS AND REQUESTS TO APPEAR AT THE PUBLIC HEARING.

Before adopting these proposed regulations, consideration will be given to any written comments that are submitted (preferably a signed original and eight copies) to the Commissioner of Internal Revenue. All comments will be available for public inspection and copying in their entirety. Because the Treasury Department expects to issue final regulations on this matter as soon as possible, a public hearing will be held at 10:00 a.m. on October 5, 1993, in Room 2615, Internal Revenue Building, 1111 Constitution Ave., N.W., Washington, D.C. Written comments must be received by [INSERT DATE THAT IS 60 DAYS AFTER THE DATE OF PUBLICATION OF THESE PROPOSED REGULATIONS IN THE FEDERAL REGISTER]. Requests to speak (with outlines of oral comments) at the public hearing must be received by September 14, 1993. See notice of hearing published elsewhere in this issue of the Federal Register.

DRAFTING INFORMATION.

The principal author of these proposed regulations is Elizabeth A. Purcell of the Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations), Internal Revenue Service. However, personnel from other offices of the Service and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR 1.401-0 THROUGH 1.419A-2T.

Bonds, Employee benefit plans, Income taxes, Pensions, Reporting and recordkeeping requirements, Securities, Trusts and trustees.

WITHDRAWAL OF PROPOSED AMENDMENTS.

The proposed amendments to 26 CFR part 1, relating to sections 1.404A-0, 1.404A-1, 1.404A-2, 1.404A-3, 1.404A-4, 1.404A-5 and 1.404A-6, published in the Federal Register for April 8, 1985 (50 FR 13821), are withdrawn.

PROPOSED AMENDMENTS TO THE REGULATIONS.

Accordingly, the proposed amendments to 26 CFR part 1 are added to read as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31,

Paragraph 1. The authority citation for part 1 is amended by adding the following citations to read as follows:

Authority: 26 U.S.C. 7805 * * * sections 1.404A-1, 1.404A-2, 1.404A-3, 1.404A-4, 1.404A-5, 1.404A-6 and 1.404A-7 also issued under 26 U.S.C. 404A. * * *

Par. 2. Sections 1.404A-0 through 1.404A-7 are added as follows:

SECTION 1.404A-0 TABLE OF CONTENTS.

This section 1.404A-0 lists the major headings that appear in sections 1.404A-1 through 1.404A-7.

SECTION 1.404A-1 GENERAL RULES CONCERNING DEDUCTIONS AND ADJUSTMENTS

(a) In general.

SECTION 1.404A-2 RULES FOR QUALIFIED FUNDED PLANS.

(a) In general.

SECTION 1.404A-3 RULES FOR QUALIFIED RESERVE PLANS.

(a) Amounts taken into account with respect to qualified

SECTION 1.404A-4 UNITED STATES AND FOREIGN LAW LIMITATIONS ON

(a) In general.

SECTION 1.404A-5 ADDITIONAL LIMITATIONS ON AMOUNTS TAKEN INTO

(a) Restrictions for nonqualified individuals.

SECTION 1.404A-6 ELECTIONS UNDER SECTION 404A AND CHANGES IN METHODS

(a) Elections, changes in accounting methods, and changes

SECTION 1.404A-7 EFFECTIVE DATE, RETROACTIVE ELECTIONS, AND

(a) In general.

SECTION 1.404A-1 GENERAL RULES CONCERNING DEDUCTIONS AND ADJUSTMENTS

(a) In general. Section 404A provides the exclusive means by which an employer may take a deduction or reduce earnings and profits for deferred compensation in situations other than those in which a deduction or reduction of earnings and profits is permitted under section 404. A deduction or reduction of earnings and profits is permitted under section 404A for amounts paid or accrued by an employer under a foreign deferred compensation plan, in the taxable year in which the amounts are properly taken into account under sections 1.404A-1 through 1.404A-7, if each of the following requirements is satisfied:

(1) The plan is a written plan maintained by the employer that provides deferred compensation.

(2) The plan is maintained for the exclusive benefit of the employer's employees or their beneficiaries.

(3) 90 percent or more of the amounts taken into account under the plan are attributable to services performed by nonresident aliens, the compensation for which is not subject to United States federal income tax.

(4) An election under section 1.404A-6 or 1.404A-7 is made to treat the plan as either a qualified funded plan or a qualified reserve plan and to select a plan year.

(b) 90-percent test -- (1) Reserve plans. Paragraph (a)(3) of this section is not satisfied by a reserve plan unless 90 percent or more of the actuarial present value of the total vested benefits (i.e., benefits not subject to substantial risk of forfeiture) accrued under the plan is attributable to services performed by nonresident aliens, the compensation for which is not subject to United States federal income tax.

(2) Funded plans -- (i) Individual account plans. Paragraph (a)(3) of this section is not satisfied by a funded plan with individual accounts unless 90 percent or more of the amounts allocated to individual accounts (as described in section 414(i)) under the plan are allocated to the accounts of nonresident aliens and are attributable to services the compensation for which is not subject to United States federal income tax.

(ii) Plans without individual accounts. Paragraph (a)(3) of this section is not satisfied by a funded plan not described in paragraph (b)(2)(i) of this section unless 90 percent or more of the actuarial present value of the total benefits accrued under the plan is attributable to services performed by nonresident aliens the compensation for which is not subject to United States federal income tax.

(c) Calculation of 90 percent amounts -- (1) In general. In determining whether the tests described in paragraphs (b)(1) and (b)(2)(ii) of this section are satisfied, accrued benefits and the actuarial present values of accrued benefits may be calculated under any reasonable method. See section 1.404A-5(a) for rules describing the calculation of accrued benefits attributable to services for which the compensation is subject to United States federal income tax.

(2) Safe harbor. The requirement of paragraph (a)(3) of this section will be deemed satisfied with respect to a plan if --

(i) The participants' benefits under the plan increase generally in proportion to their compensation taken into account under the plan; and

(ii) The sum of the following amounts does not exceed five percent of all compensation taken into account under the plan for the plan year --

(A) The compensation of United States citizens and residents taken into account under the plan; and

(B) Any other compensation subject to United States federal income tax taken into account under the plan.

(3) Anti-abuse rule. Notwithstanding paragraph (c)(2) of this section, the requirement of paragraph (a)(3) of this section will not be deemed satisfied under paragraph (c)(2) of this section if the Commissioner determines that a significant purpose of the plan is to secure benefits not otherwise eligible for tax benefits under the Internal Revenue Code to participants who are United States citizens or residents.

(4) Example. The principles of paragraphs (c)(2) and (c)(3) of this section are illustrated by the following example:

Example. A foreign branch of a domestic corporation

(d) Deductions and reductions of earnings and profits. Deductions and reductions of earnings and profits for amounts paid by an employer to a plan that provides deferred compensation that does not meet the requirements of paragraph (a) of this section are governed exclusively by section 404, without regard to whether the plan benefits foreign employees.

(e) Definitions. The following definitions apply for purposes of section 404A and sections 1.404A-1 through 1.404A-7:

Actuarial present value. "Actuarial present value" is defined in section 1.401(a)(4)-12.

Aggregate amount. "Aggregate amount" is defined in section 1.404A-4(g)(4).

Appropriate foreign tax law. "Appropriate foreign tax law" is defined in section 1.404A-4(g)(3).

Authorized officer. "Authorized officer" is defined in section 1.404A-5(b)(7).

Carryover contributions. "Carryover contributions" are defined in section 1.404A-2(d)(4).

Change in method of accounting. "Change in method of accounting" is defined in section 1.404A-6(a).

Closing year. "Closing year" is defined in section 1.404A- 6(f)(4)(ii).

Contributions accumulated to pay deferred compensation. "Contributions accumulated to pay deferred compensation" are defined in section 1.404A-2(b)(2).

Contributions to a trust. "Contributions to a trust" are defined in section 1.404A-2(b)(1).

Controlled foreign corporation. "Controlled foreign corporation" means a controlled foreign corporation as defined in sections 953(c)(1)(B) and 957.

Cumulative foreign amount. "Cumulative foreign amount" is defined in section 1.404A-4(g)(2).

Cumulative limitation. "Cumulative limitation" is defined in section 1.404A-4(b).

Cumulative United States amount. "Cumulative United States amount" is defined in section 1.404A-4(g)(1).

Deductible limit. "Deductible limit" is defined in section 1.404A-2(d)(1)(i).

Deductions. "Deductions" are defined in section 1.404A-1(f)(1).

Deferred compensation -- (i) In general. "Deferred compensation" means any item the deductibility of which is determined by reference to section 404, without regard to whether section 404 permits a deduction and without regard to whether elections are made under section 1.404A-6 or 1.404A-7. Deferred compensation, as described in the preceding sentence, does not include deferred benefits described in section 404(b)(2)(B).

(ii) Social security. A plan under which a foreign government (including a political subdivision, agency or instrumentality thereof) makes a contribution or a direct payment to a participant (or the participant's beneficiary) does not provide deferred compensation to the extent of such contributions or payments. Thus, for example, a foreign country's social security system generally will not be considered as providing deferred compensation. However, the fact that employers are required to maintain the plan by reason of foreign law, or the fact that the plan supplements social security benefits provided by a foreign country, or provides benefits in lieu of such social security benefits, does not prevent a plan from providing deferred compensation.

(iii) Termination indemnity plans. The determination of whether a plan (including a termination indemnity plan) provides deferred compensation must generally be made under paragraph (i) of this definition in light of all of the facts and circumstances. Benefits paid under a plan, including a plan denominated a termination indemnity plan will generally be treated as deferred compensation if --

(A) A major purpose of the plan is to provide for the payment of retirement benefits;

(B) The plan has a benefit formula providing for payment based at least in part upon length of service;

(C) The plan provides for the payment of benefits to employees (or their beneficiaries) after the employee's retirement, death or other termination of employment; and

(D) It meets such other requirements as may be prescribed by the Commissioner in guidance of general applicability with respect to termination indemnity plans.

(iv) Example. The definition of deferred compensation is illustrated by the following example:

Example. A domestic corporation maintains a branch

Earnings and profits. "Earnings and profits" means earnings and profits computed in accordance with sections 312 and 964(a) and, for taxable years beginning after December 31, 1986, section 986 and the regulations thereunder; and for purposes of section 902 in taxable years beginning before January 1, 1987, accumulated profits within the meaning of section 902(c) as in effect on the day before the enactment of the Tax Reform Act of 1986.

Employer. "Employer" means a person that maintains a plan for the payment of deferred compensation for services provided to it by its employees. "Employer" for purposes of the acceleration of the section 481(a) adjustment is defined in section 1.404A-6(e)(2)(iv).

Equivalent of a trust. "Equivalent of a trust" means a fund --

(i) The corpus and income of which is separately identifiable and segregated, through a separate legal entity, from the general assets of the employer;

(ii) The corpus and income of which is not subject, under the applicable foreign law, to the claims of the employer's creditors prior to the claims of employees and their beneficiaries under the plan;

(iii) The corpus and income of which, by law or by contract, cannot at any time prior to the satisfaction of all liabilities with respect to employees under the plan be used for, or diverted to, any purpose other than providing benefits under the plan; and

(iv) The corpus and income of which is held by a person who has a legally enforceable duty to operate the fund prudently.

Erroneous deduction. "Erroneous deduction" is defined in section 1.404A-7(d)(3)(ii).

Exclusive benefit. "Exclusive benefit" has the same meaning as in sections 1.401-2 and 1.413-1(d).

Fixed or determinable benefits. "Fixed or determinable benefits" are defined in section 1.404A-2(d)(1)(i).

Full funding limitation. "Full funding limitation" is defined in section 1.404A-5(c)(2).

Functional currency. "Functional currency" (abbreviated as FC) means the functional currency of a taxpayer or a qualified business unit determined in accordance with section 985(b) and the regulations thereunder, or, for taxable years beginning before January 1, 1987, the currency in which the employer's books and records were maintained for United States tax purposes.

Funded method. "Funded method" is defined in section 1.404A- 6(f)(2)(iv).

Initial aggregate amount. "Initial aggregate amount" is defined in section 1.404A-6(g)(2)(iii).

Initial Cumulative foreign amount. "Initial Cumulative foreign amount" is defined in section 1.404A-6(g)(2)(ii).

Initial Cumulative United States amount. "Initial Cumulative United States amount" is defined in section 1.404A-6(g)(2)(i).

Initial section 404A(d) amounts. "Initial section 404A(d) amounts" are defined in section 1.404A-6(g).

Liability. "Liability" is defined in section 1.404A-1(f)(2).

Majority domestic corporate shareholders. "Majority domestic corporate shareholders" are defined in section 1.404A-6(c)(2)(ii)(C).

Method of accounting. "Method of accounting" is defined in section 1.404A-6(a)(1).

Method (1) election. "Method (1) election" is defined in section 1.404A-7(g)(1).

Method (2) election. "Method (2) election" is defined in section 1.404A-7(g)(2).

New Method Opening Amount. "New Method Opening Amount" is defined in section 1.404A-6(f)(3).

Noncontrolled foreign corporation. "Noncontrolled foreign corporation" means a foreign corporation other than a controlled foreign corporation.

Nonqualified individual. "Nonqualified individual" is defined in section 1.404A-5(a)(1).

Nonqualified plan. "Nonqualified plan" is defined in section 1.404A-6(f)(3)(iii).

Old Method Closing Amount. "Old Method Closing Amount" is defined in section 1.404A-6(f)(2).

Open period. "Open period" is defined in section 1.404A-7(g)(6).

Open years. "Open years" are defined in section 1.404A-7(g)(3).

Opening reserve. "Opening reserve" is defined in section 1.404A- 6(f)(3)(i).

Opening year. "Opening year" is defined in section 1.404A- 6(f)(4)(i).

Pay-as-you-go method. "Pay-as-you-go method" is defined in section 1.404A-6(f)(2)(iii).

Period of adjustment. "Period of adjustment" is defined in section 1.404A-6(e)(2).

Permitted plan year. "Permitted plan year" means the plan year of a plan providing deferred compensation ending with or within the employer's taxable year.

Plan year. "Plan year" means the annual accounting period of a plan providing deferred compensation.

Primary evidence. "Primary evidence" is defined in section 1.404A-5(b)(2).

Prior deduction. "Prior deduction" is defined in section 1.404A- 7(d)(3)(i).

Protective election. "Protective election" is defined in section 1.404A-7(g)(2).

Qualified business unit. "Qualified business unit" is defined in section 989(a).

Qualified foreign plan. "Qualified foreign plan" means a plan that meets the requirements of paragraph (a) of this section.

Qualified funded plan. "Qualified funded plan" means a qualified foreign plan for which an election has been made under section 1.404A-6 or 1.404A-7 by the taxpayer to treat the plan as a qualified funded plan.

Qualified reserve plan. "Qualified reserve plan" means a qualified foreign plan for which an election has been made by the taxpayer under section 1.404A-6 or 1.404A-7 to treat the plan as a qualified reserve plan.

Reasonable actuarial assumptions. "Reasonable actuarial assumptions" are defined in section 1.404A-5(c).

Reductions in earnings and profits. "Reductions in earnings and profits" are defined in section 1.404A-1(f)(1).

Reserve method. "Reserve method" is defined in section 1.404A- 6(f)(2)(ii).

Retirement annuity. "Retirement annuity" is defined in section 1.404A-2(b)(3).

Retroactive effective date election. "Retroactive effective date election" is defined in section 1.404A-7(b)(1).

Retroactive period. "Retroactive period" is defined in section 1.404A-7(g)(4).

Retroactive plan-by-plan election. "Retroactive plan-by- plan election" is defined in section 1.404A-7(c)(1) and (d)(1).

Revocation of election. "Revocation of election" is defined in section 1.404A-6(d)(1).

Secondary evidence. "Secondary evidence" is defined in section 1.404A-5(b)(4).

Separate funding entity. "Separate funding entity" is defined in section 1.404A-6(f)(4)(iii).

Short taxable year. "Short taxable year" is defined in section 1.404A-7(d)(2).

Single plan. "Single plan" is defined in section 1.404A-6(a)(2).

Substantial risk of forfeiture. "Substantial risk of forfeiture" is defined in section 1.404A-3(b)(2).

Substantiation quality data. "Substantiation quality data" means less than precise data that is nevertheless the best data available for the plan year at reasonable expense.

Taxable year of a controlled foreign corporation. "Taxable year of a controlled foreign corporation" means the taxable year as defined in sections 441(b) and 7701(a)(23), subject to section 898.

Taxable year of a noncontrolled foreign corporation. "Taxable year of a noncontrolled foreign corporation" means the taxable year as defined in sections 441(b) and 7701(a)(23).

Taxpayer. "Taxpayer" is defined in section 7701(a)(14).

Termination of election. "Termination of election" is defined in section 1.404A-6(c)(1).

Transition period. "Transition period" is defined in section 1.404A-7(g)(5).

Trust. "Trust" means a trust (as defined in section 301.7701- 4(a) of this chapter) or the equivalent of a trust.

Unit credit method. "Unit credit method" is defined in section 1.404A-3(b)(2).

United States tax significance. "United States tax significance" is defined in section 1.404A-6(b)(2)(ii).

Written plan. "Written plan" means a plan that is defined by plan instruments or required under the law of a foreign country, or both. An insurance contract can constitute a written plan.

(f) Application of other Code requirements -- (1) Deductibility requirement -- (i) In general. In order to deduct amounts under section 404A, amounts contributed to a qualified funded plan or properly added to a reserve with respect to a qualified reserve plan must otherwise be deductible. The standards under section 404 are to be used in determining whether an amount would otherwise be deductible for this purpose. Thus, amounts may be taken into account under section 404A only to the extent that they are ordinary and necessary expenses during the taxable year in carrying on a trade or business and are compensation for personal services actually rendered before the end of the year. Similarly, in order to reduce earnings and profits under section 404A by amounts contributed to a qualified funded plan or properly added to a reserve with respect to a qualified reserve plan, earnings and profits must otherwise be able to be reduced by such amounts under the general principles of sections 312, 901, 902, 960, and 964.

(ii) Capitalization requirements. In determining if an amount would otherwise be deductible (or able to be used to reduce earnings and profits) for purposes of paragraph (g)(1)(i) of this section, the fact that the amount is required to be capitalized (e.g., under section 263A) is ignored. Additionally, while section 404A and sections 1.404A-1 through 1.404A-7 refer generally to permissible deductions or reductions of earnings and profits for deferred compensation, those references are intended to refer both to situations under which amounts may be taken into account as deductions or reductions of earnings and profits and to situations under which amounts may be taken into account through inclusion in the basis of inventory or through capitalization.

(2) Section 461 requirements. In determining whether any amount of deferred compensation may be taken into account under section 404A by an accrual method taxpayer, the conditions for accrual under section 461 must be met with respect to the amount by the last day of the taxable year. For this purpose, an amount determined under sections 1.404A-1 through 1.404A-7 establishes the fact of the liability and determines the amount of the liability with reasonable accuracy. See section 1.461-4(d)(2)(iii), which generally provides that the economic performance requirement of section 461(h) is satisfied to the extent that any amount is otherwise properly taken into account under sections 1.404A-1 through 1.404A-7.

SECTION 1.404A-2 RULES FOR QUALIFIED FUNDED PLANS.

(a) In general. Except as provided in this section and in sections 1.404A-4 and 1.404A-5, the amount taken into account for a taxable year with respect to a qualified funded plan is the amount of the contributions paid by the employer to the trust in that year (regardless of whether the employer uses an accrual method of accounting). Accretions in a trust are not considered contributions to a plan.

(b) Payment to a trust -- (1) Contribution requirements. Contributions paid under a qualified funded plan may not be taken into account unless they are --

(i) Paid to a trust which is operated in accordance with the requirements of section 401(a)(2);

(ii) Paid for a retirement annuity under which retirement benefits are provided and which is for the exclusive benefit of the employer's employees or their beneficiaries; or

(iii) Paid directly to a participant or beneficiary (rather than a trust).

(2) Trust requirements -- (i) General rule. A contribution does not satisfy paragraph (b)(1)(i) of this section unless it is accumulated in the trust for the purpose of being distributed as deferred compensation. Whether a contribution is being accumulated in the trust for the purpose of being distributed as deferred compensation depends on the facts and circumstances. For purposes of paragraph (b)(1)(i) of this section, the fact that a trust has been (or has not been) involved in transactions that would be described in section 4975(c)(1) (and not exempted under section 4975(c)(2) or 4975(d)), e.g., contributions made in the form of a promissory note, if the plan were subject to section 4975(c)(1), is an important factor in determining whether the trust is not (or is) considered to be operated in accordance with the requirements of section 401(a)(2). In addition, a contribution to a trust does not satisfy paragraph (b)(1)(i) of this section unless it has substance.

(ii) Effective date. The section 4975(c)(1) factor in determining compliance with section 401(a)(2) provided in this paragraph (b)(2) is taken into account for all transactions entered into after [INSERT THE DATE OF PUBLICATION OF THESE PROPOSED REGULATIONS IN THE FEDERAL REGISTER].

(3) Retirement annuity. A retirement annuity means a retirement annuity (as defined in section 404(a)(2)) except that the retirement annuity need not be part of a plan that meets the requirements of section 401(a) or 401(d). Notwithstanding the preceding sentence, the retirement annuity described therein need not be issued by an insurance company qualified to do business in a State in the United States if the taxpayer(s) and/or sponsoring employer(s) of the plan have shifted the risk of making payments under the plan to an entity that is qualified to do business in the country (or countries) where the plan is maintained.

(4) Effect of reversion of overfunded contributions. If any portion of a contribution to a trust may revert to the benefit of the employer before the satisfaction of all liabilities to employees or their beneficiaries covered by the trust, no amount of the contribution may be taken into account under this section.

(5) Example. The principles of paragraph (b) of this section are illustrated by the following example:

Example. A foreign subsidiary of a domestic corporation

(c) Contribution deemed made before payment -- (1) Time of payment to trust. Regardless of whether an employer uses the cash or an accrual method of accounting, for purposes of this section, a contribution to a trust that is paid after the close of an employer's taxable year is deemed to have been paid on the last day of that taxable year if --

(i) The payment is made on account of the taxable year and is made not later than the 15th day of the ninth month after the close of the taxable year;

(ii) The payment is treated by the plan in the same manner that the plan would treat a payment actually received on the last day of the taxable year; and

(iii) Either --

(A) The employer notifies the plan administrator or trustee in writing that the payment to the plan is designated on account of the taxable year;

(B) The taxpayer claims the payment as a deduction on its tax return for the taxable year; or

(C) The employer reduces earnings and profits with respect to the payment.

(2) Time of designation. Any designation of a payment pursuant to paragraph (c)(1)(iii)(A) of this section must occur not later than the time described in paragraph (c)(1)(i) of this section.

(3) Irrevocable designation. After a payment has been designated or claimed on a return in the manner provided in paragraph (c)(1)(iii)(A) of this section as being on account of a taxable year, the designation or claim may not be retracted or changed.

(d) Limitation for qualified funded plans -- (1) Plans with fixed or determinable benefits -- (i) Limit on amount taken into account. Contributions made to a qualified funded plan under which the benefits are fixed or determinable are not taken into account under this section to the extent they exceed the amount that would be taken into account under section 404(a)(1)(A)(ii) and (iii) (determined without regard to the last sentence of paragraph (A) of section 404(a)(1) and without regard to whether the trust is exempt under section 501(a)). Benefits are considered fixed or determinable for this purpose if either benefits under or contributions to the plan are definitely determinable within the meaning of section 1.401- 1(b)(1)(i). The limit described in the first sentence of this paragraph (d)(1)(i) is determined on the basis of the permitted plan year of the qualified foreign plan. Thus, the limit for the employer's taxable year is the limit for the plan year ending with or within the employer's taxable year.

(ii) Actuarial valuation requirements. In determining the amount to be taken into account under this section, an actuarial valuation must be made not less frequently than once every three years. However, an actuarial valuation must be made for the first plan year of the plan for which an election under section 1.404A-6 is in effect. For interim years, a reasonable actuarial determination of whether the full funding limit in section 1.404A-5(c)(2) applies to the qualified funded plan must be made. The Commissioner may require a full actuarial valuation in an interim year under appropriate circumstances. See section 1.404A-6 for rules on changes in methods of accounting.

(2) Plans without fixed or determinable benefits. Contributions made to a qualified funded plan under which the benefits are not fixed or determinable may not be taken into account under this section to the extent they exceed the limitations of section 404(a)(3) (determined without regard to whether the payment is made to a trust that is exempt under section 501(a)).

(3) Limitations where more than one type of plan is maintained. Where payments are made for a taxable year to more than one type of qualified funded plan, the amounts that may be taken into account for the taxable year with respect to the payments are subject to the limitations of section 404(a)(7). The amount that is taken into account under this paragraph (d)(3) is determined without regard to whether the payment satisfies the minimum funding standard described in section 412.

(4) Carryover contributions. In the event that the aggregate amount of contributions paid during an employer's taxable year in which an election under section 404A is in effect (reduced by an amount described in section 404A(g)(1)) exceeds the amount that may be taken into account under section 404A(a) and this section (computed without regard to section 404A(d) and section 1.404A-4), the excess contributions are treated as an amount paid in the succeeding taxable year with respect to that qualified foreign plan. A carryover contribution is also taken into account in determining whether a carryover contribution exists for a succeeding taxable year.

(5) Additional rules. The Commissioner may prescribe additional rules for determining the amount that may be taken into account under this paragraph (d) in guidance of general applicability.

(e) Examples. The principles of this section are illustrated by the following examples:

Example 1. A qualified funded plan under which benefits are

Example 2. Assume the same facts as in Example 1, except

Example 3. P, a domestic corporation, owns all of the one

SECTION 1.404A-3 RULES FOR QUALIFIED RESERVE PLANS.

(a) Amounts taken into account with respect to qualified reserve plans -- (1) General rule. Except as provided in sections 1.404A-4 and 1.404A-5, the amount taken into account for a taxable year with respect to a qualified reserve plan equals the sum of --

(i) The reasonable addition during the permitted plan year to a reserve for liabilities under the plan as described in paragraph (b) of this section; and

(ii) The amortization of certain increases or decreases in the plan reserve over ten years, as described in paragraph (c) of this section.

(2) Amounts less than zero. If the amount to be taken into account under this section is less than zero, that amount must be treated as an increase in income and earnings and profits for the taxable year.

(3) Exclusive rules for qualified reserve plans. No amounts may be taken into account with respect to a qualified reserve plan except as provided for in this section. Thus, for example, no deduction is allowed for benefit payments from the reserve. Similarly, no amount may be taken into account for any payments made by the employer that are used either to reinsure the liabilities or benefits under a qualified reserve plan or to fund separately all or a portion of the benefits under a qualified reserve plan. These amounts may, however, be taken into account as contributions to a qualified funded plan to the extent the requirements of section 1.404A-2 are satisfied.

(b) Reasonable addition to a reserve for liabilities -- (1) General rule. Except as provided in section 1.404A-7(f)(2), the reasonable addition to a reserve for a plan year equals the increase in the reserve, determined under the unit credit method as described in paragraph (b)(2) of this section, that arises from the passage of time and from additional service and expected changes in compensation in the current plan year for employees who were included in the reserve as of the end of the prior plan year. Thus, the reasonable addition to the reserve includes an element of interest on the reserve as of the beginning of the plan year (less the interest on the benefit payments during the plan year) and the actuarial present value of the expected increase in vested benefits accrued during the current plan year for employees who were included in the reserve as of the end of the prior plan year, determined without reference to any plan amendment during the plan year.

(2) Unit credit method required. The reserve for the employer's liability must be determined under the unit credit method. Thus, the reserve must be the actuarial present value of the employer's liability, taking into account service and compensation only through the valuation date. In determining the reserve under this section, benefits that are subject to a substantial risk of forfeiture may not be taken into account. The term "substantial risk of forfeiture" has the meaning stated in section 83, except that the term "property" in all events includes benefits accrued under a qualified reserve plan.

(3) Timing of valuation. The determination of the reserve and the reasonable addition to the reserve must be made as of the last day of the plan year.

(4) Permissible actuarial assumptions -- (i) Interest rates -- (A) In general. Notwithstanding any other provision of sections 1.404A-1 through 1.404A-7, no amount may be taken into account under section 404A with respect to a qualified reserve plan unless the rate (or rates) of interest for the plan that are selected by the employer are within the permissible range. The interest rate selected by the employer for the plan under this paragraph must remain in effect for that plan until the first plan year for which that rate is no longer within the permissible range. At that time, a new rate of interest must be selected by the employer from within the permissible range applicable at that time.

(B) Permissible range. For purposes of this paragraph (b)(4), the term "permissible range" means a rate of interest that is not more than 1.2 and not less than the product of 0.8 multiplied by the average rate of interest for the highest quality long-term corporate bonds denominated in the functional currency of the qualified business unit of the employer whose books reflect the plan's liabilities for the 15-year period ending on the last day before the beginning of the employer's taxable year. If there is no market in long-term corporate bonds denominated in the relevant functional currency, or if the qualified business unit computes its income or earnings and profits in dollars under section 1.985-3, the employer must use a rate that can be demonstrated clearly to reflect income, based on all relevant facts and circumstances, including appropriate rates of inflation and commercial practices.

(ii) Plan benefits. Except as otherwise provided by the Commissioner, changes in plan benefits or applicable foreign law that become effective (whether or not retroactively) in a future plan year may not be taken into account until the plan year the change is effective. Notwithstanding the above, the reserve calculation may take into account cost-of-living adjustments that are part of the employee's vested accrued benefit, using assumptions regarding cost- of-living adjustments that are consistent with the interest rate assumptions described in paragraph (b)(4)(i) of this section and the terms of the plan. Thus, for example, a cost-of-living adjustment that does not require any future service on the part of the employee and is not subject to employer discretion may be taken into account.

(c) ten-year amortization for certain changes in reserves -- (1) Actuarial valuation. Each plan year an actuarial valuation must be made as of the end of the plan year, comparing the actual reserve with the expected value of the reserve. Any difference between the actual reserve determined as of the end of the plan year and the expected value of the reserve as of that date must be amortized in level amounts of principal over ten years, beginning in the plan year of the actuarial valuation. This amortization applies regardless of whether the difference is attributable to changes in employee population, changes in plan provisions, or changes in actuarial assumptions.

(2) Expected value of reserve. The expected value of the reserve as of the end of the plan year is equal to the sum of the reserve as of the end of the prior plan year plus the reasonable addition to the reserve for the plan year described in paragraph (b) of this section less the benefit payments during the plan year. Thus, the expected value of the reserve is generally determined on the basis of the plan in effect and the actuarial assumptions used as of the end of the prior plan year, but, because it includes the reasonable addition to the reserve, includes the effect of expected changes in compensation, service and vesting during the current plan year.

(3) Special rule for certain cost of living adjustments. Notwithstanding the general rule that the increase in liability from a plan amendment is amortized over ten years, if under foreign law a shorter period for amortization is required, that shorter period shall be substituted for ten years in this paragraph (c) if the amendment is a cost of living adjustment that either --

(i) Relates primarily to retirees; or

(ii) Is for employees of a foreign corporation in a taxable year beginning before [INSERT DATE THAT IS 90 DAYS AFTER THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER].

(4) Anti-abuse rule. The Commissioner may reclassify any item included by a taxpayer as a reasonable addition to a reserve as instead subject to amortization over ten years if the Commissioner determines that the taxpayer's classification of that item circumvents the intent of section 404A(c)(4). Thus, for example, if the Commissioner determines that the vesting provisions of the plan cause the increase in vested benefits to be unreasonably large in a single plan year, the reasonable addition under paragraph (b) of this section must be calculated without recognizing any changes in vesting for the plan year.

(d) Examples. The principles of this section are illustrated by the following examples:

Example 1. S, a foreign subsidiary of P, a domestic

Example 2. (a) Employer Y hired 10,000 employees in 1980,

                                                      Number of

1980         41          16              5              9,979

                             End of Year       End of Year

1980           10,000            100                  0

                             End of Year         End of Year

1980               0           1.049706                    0

(b) Computation of amounts taken into account for 1980.

(c) Computation of amounts taken into account for 1981.

(d) Computation of amount taken into account for 1982. The

(e) Computation of amount taken into account for 1983.

(f) Computation of amount taken into account for 1984.

(g) Alternative computation method. The amounts taken into

                              1982

       Worksheet For Calculating Amount Taken Into Account

(1) Reserve at end of Prior Year                            - 0 -

(2) Interest on (1) to end of Current Year                  - 0 -

(3) Present Value of the Expected Increase in Vested

(4) Benefit Payments during current year                    - 0 -

(5) Interest on (4) from date of payment through end of

(6) Reasonable addition to the reserve

(7) Expected value of reserve                               - 0 -

(8) Actual value of reserve                               733,134

(9) Amount to be amortized (8) - (7)                      733,134

(10) Remaining 10 Percent Bases from Prior Years

(11) 10 percent Bases whose 10 years ended last year        - 0 -

(12) (9) + (10) - (11)                                    733,134

(13) 10 percent of (12)                                    73,313

(14) Amount Taken Into Account for Current Year

                              1983

       Worksheet For Calculating Amount Taken Into Account

(1) Reserve at end of Prior Year                          733,134

(2) Interest on (1) to end of Current Year                 58,651

(3) Present Value of the Expected Increase in Vested

(4) Benefit Payments during current year                      369

(5) Interest on (4) from date of payment through end of

(6) Reasonable addition to the reserve

(7) Expected value of reserve                           2,216,613

(8) Actual value of reserve                             2,533,194

(9) Amount to be amortized (8) - (7)                      316,581

(10) Remaining 10 Percent Bases from Prior Years

(11) 10 percent Bases whose 10 years ended last year        - 0 -

(12) (9) + (10) - (11)                                  1,049,715

(13) 10 percent of (12)                                   104,971

(14) Amount Taken Into Account for Current Year

                              1984

       Worksheet For Calculating Amount Taken Into Account

(1) Reserve at end of Prior Year                        2,533,194

(2) Interest on (1) to end of Current Year                202,656

(3) Present Value of the Expected Increase in Vested

(4) Benefit Payments during current year                    6,396

(5) Interest on (4) from date of payment through end of

(6) Reasonable addition to the reserve

(7) Expected value of reserve                           5,379,553

(8) Actual value of reserve                             5,117,062

(9) Amount to be amortized (8) - (7)                     (262,491)

(10) Remaining 10 Percent Bases from Prior Years

(11) 10 percent Bases whose 10 years ended last year        - 0 -

(12) (9) + (10) - (11)                                    787,224

(13) 10 percent of (12)                                    78,722

(14) Amount Taken Into Account for Current Year

Example 3. (a) The facts are the same as in Example 2,

                              1984

       Worksheet For Calculating Amount Taken Into Account

(1) Reserve at end of Prior Year                        2,533,194

(2) Interest on (1) to end of Current Year                202,656

(3) Present Value of the Expected Increase in Vested

(4) Benefit Payments during current year                    6,396

(5) Interest on (4) from date of payment through end of

(6) Reasonable addition to the reserve

(7) Expected value of reserve                           6,131,835

(8) Actual value of reserve                             6,569,498

(9) Amount to be amortized (8) - (7)                      437,663

(10) Remaining 10 Percent Bases from Prior Years

(11) 10 percent Bases whose 10 years ended last year        - 0 -

(12) (9) + (10) - (11)                                  1,487,378

(13) 10 percent of (12)                                   148,738

(14) Amount Taken Into Account for Current Year

SECTION 1.404A-4 UNITED STATES AND FOREIGN LAW LIMITATIONS ON

(a) In general. Section 404A(d) and this section place two limits on the amount taken into account for a taxable year with respect to a qualified foreign plan under section 404A(b) and (c) and sections 1.404A-2 and 1.404A-3. First, as set forth in paragraph (b) of this section, the cumulative amounts that are or have been taken into account under section 404A through the end of the current year may not exceed the cumulative amounts deductible under foreign law in that period. Because the foreign law deduction is cumulative, however, amounts previously disallowed under this rule are taken into account in later years as the amount deductible under foreign law increases. Second, for taxable years beginning before January 1, 1987, or such later year determined under section 902(c)(3)(A), the rule in paragraph (c) of this section further limits the amount taken into account during those taxable years. Because section 404A(d) and this section apply solely to amounts that would otherwise be taken into account under section 1.404A-2 or 1.404A-3, these limitations are applied without regard to amounts taken into account under section 481 (i.e., without regard to the portion of a section 481(a) adjustment that is taken into account during any taxable year within the section 481(a) adjustment period, as defined in section 1.404A- 6(e)(2)). See section 1.404A-6, however, for rules applying the section 404A(d) limitations to the calculation of the section 481(a) adjustment.

(b) Cumulative limitation. The amount taken into account with respect to a qualified foreign plan for any taxable year equals --

(1) The lesser of --

(i) The cumulative United States amount; or

(ii) The cumulative foreign amount;

(2) Reduced by the aggregate amount.

(c) Special rule for foreign corporations in pre-pooling years. For a taxable year of a foreign corporation beginning before January 1, 1987, or such later year determined under section 902(c)(3)(A), the reduction in earnings and profits determined under paragraph (b) of this section with respect to a qualified foreign plan may not exceed the amount allowed as a deduction under the appropriate foreign tax laws for such taxable year. See Example 3 of paragraph (h) of this section for an illustration of this rule.

(d) Rules relating to foreign currency -- (1) Taxable years beginning after December 31, 1986. For taxable years beginning after December 31, 1986, the cumulative United States amount, the cumulative foreign amount, and the aggregate amount must be computed in the employer's functional currency. See generally section 964 and sections 985 through 989 for rules applicable to determining and translating into dollars the amount of income or loss of foreign branches and earnings and profits (or deficits in earnings and profits) of foreign corporations.

(2) Taxable years beginning before January 1, 1987. For taxable years beginning before January 1, 1987, the cumulative United States amount, the cumulative foreign amount, and the aggregate amount must be computed in the currency in which the foreign branch or foreign subsidiary kept its books and records. See Rev. Rul. 75-106, 1975-1 C.B. 31 (see section 601.601(d)(2)(ii)(b) of this chapter), for rules for determining the amount of income or loss of foreign branches using a net worth method of accounting. See Rev. Rul. 75-107, 1975-1 C.B. 32 (see section 601.601(d)(2)(ii)(b) of this chapter), for rules for determining the amount of income or loss of foreign branches using a profit and loss method of accounting. See sections 312, 902, and 1248 and the regulations thereunder for rules for determining the earnings and profits of noncontrolled foreign corporations. See section 964 and the regulations thereunder for rules for determining the earnings and profits of foreign corporations for purposes of subpart F.

(3) Special rules for the net worth method of accounting. For purposes of section 1.964-1(e)(4), an amount of deduction that is accrued but not paid at the end of the employer's taxable year with respect to a qualified funded plan must be treated as a short-term liability. In the case of a qualified reserve plan, for purposes of section 1.964-1(e), the amount of the reserve taken into account as a liability on the balance sheet as of the beginning of the taxable year must be limited to the aggregate amount, and the amount of the reserve taken into account as a liability on the balance sheet as of the close of the taxable year must be limited to the sum of the aggregate amount and the amount taken into account for the taxable year. For purposes of section 1.964-1(e)(4), each annual increase in the aggregate amount must be treated as a long-term liability incurred on the last day of the employer's taxable year to which the increase relates. As of the close of each taxable year, a portion of the aggregate amount equal to the amount of benefits expected to be paid during the succeeding taxable year must be reclassified as a short-term liability. The reclassified amount must be allocated to the annual increases in the aggregate amount on a first-in-first-out basis. Similar rules apply for purposes of determining the amount of reserve taken into account by a foreign branch using the net worth method of accounting for taxable years beginning before January 1, 1987, and by a qualified business unit that uses the United States dollar approximate separate transactions method of accounting under section 1.985-3 in a taxable year beginning after December 31, 1986.

(e) Maintenance of more than one type of qualified foreign plan by an employer. In determining the deduction or reduction in earnings and profits when an employer maintains one plan for purposes of foreign law that is treated as two separate plans for purposes of section 1.404A-6(a)(2), the cumulative United States amount for each plan must be combined for purposes of paragraphs (a) and (b) of this section. See Example 5 of paragraph (h) of this section for an illustration of this rule.

(f) United States and foreign law limitations not applicable. The limitations set forth in this section do not apply to the adjustments required by section 481, section 446(e) and section 2(e)(3)(A) of Public Law 96-603.

(g) Definitions -- (1) Cumulative United States amount. The term "cumulative United States amount" means (with respect to a qualified foreign plan) the amount determined under section 404A (without regard to section 404A(d)) for the taxable year of the employer and for all consecutive prior taxable years for which an election under section 404A was in effect for the plan plus the "initial section 404A amount" within the meaning of section 1.404A-6(g)(2)(i).

(2) Cumulative foreign amount. The term "cumulative foreign amount" means (with respect to a qualified foreign plan) the cumulative amount allowed as a deduction under the appropriate foreign tax law for the taxable year of the employer and for all consecutive prior taxable years for which an election under section 404A was in effect for the plan plus the initial section 404A amount within the meaning of section 1.404A-6(g)(2)(ii).

(3) Appropriate foreign tax law. The appropriate foreign tax law is the income tax law of the country (other than the United States) that is the principal place of business of the qualified business unit of the employer whose books reflect the plan liabilities.

(4) Aggregate amount. The term "aggregate amount" means (with respect to a qualified foreign plan) amounts permitted to be taken into account under section 404A(d)(1) for all consecutive prior taxable years for which an election under section 404A was in effect for the plan plus the initial section 404A amount required by section 1.404A-6(g)(2)(iii).

(h) Examples. The principles of this section are illustrated by the following examples:

Example 1. X, a foreign subsidiary of a domestic

Example 2. A qualified reserve plan is maintained by a

                              1985       1986       1987       1988

(1) Amount determined

(2) Cumulative United

(3) Cumulative foreign

(4) Lesser of cumulative

(5) Reduced by aggregate

                            800,000   800,000     400,000     200,000

(6) Amount taken into

Example 3. Assume the same facts as in Example 2 for all

                              1985       1986       1987       1988

(1) Amount determined

(2) Amount allowed as a

(3) Cumulative United

(4) Cumulative foreign

(5) Lesser of cumulative

(6) Reduced by aggregate

                            800,000   800,000     600,000     200,000

(7) Amount taken into

(8) Amount taken into

Example 4. Z, a domestic corporation, maintains a

                                                         Combined

                    1984     1985     1984     1985     1984    1985

(2) Amount allowed

(3) Cumulative

(4) Combined

(5) Cumulative

(6) Aggregate

(7) Lesser of

(9) Reduced by the

Example 5. A qualified reserve plan is maintained by M, the

SECTION 1.404A-5 ADDITIONAL LIMITATIONS ON AMOUNTS TAKEN INTO

(a) Restrictions for nonqualified individuals -- (1) General rule. Notwithstanding any other provisions of sections 1.404A-1 through 1.404A-7, no amount may be taken into account under section 404A for any contribution or amount accrued that is attributable to services performed either in the current or in a prior taxable year - -

(i) By a citizen or resident of the United States who is a highly compensated employee (within the meaning of section 414(q)) (or, for taxable years beginning before January 1, 1989, by a citizen or resident of the United States who is an officer, shareholder, or highly compensated (within the meaning of section 1.410(b)-1(d)); or

(ii) In the United States, the compensation for which is subject to tax under chapter 1 of subtitle A of the Internal Revenue Code.

(2) Determination of service attribution -- (i) Not limited to actual service. Service performed by individuals described in paragraph (a)(1)(i) of this section includes service credited to those individuals. Service performed in the United States includes service credited in relation (directly or indirectly) to any United States service.

(ii) Amounts attributable to service performed in the United States. The accrued benefit attributable to services described in this paragraph (a) is the excess, if any, of the total accrued benefit over the accrued benefit determined without credit for time spent performing services described in this paragraph (a) and without regard to the compensation levels for that time.

(b) Records to be provided by taxpayer -- (1) In general. Notwithstanding any other provisions of sections 1.404A-1 through 1.404A-7, no amount may be taken into account under section 404A for any contribution or amount accrued unless the taxpayer attaches a statement to its United States income tax return for any taxable year for which a qualified foreign plan maintained by an employer has United States tax significance. This statement must specify the name and type of qualified foreign plan; the cumulative United States amount, the cumulative foreign amount, and the aggregate amount with respect to the plan; the name and country of organization of the employer; and any other information the Commissioner may prescribe by forms and accompanying instructions or by revenue procedure.

(2) Primary evidence. The statement described in paragraph (b)(1) of this section and any required forms must be completed in good faith with all of the information called for and with the calculations referenced in paragraph (b)(1) of this section. Except as provided in paragraph (b)(4) of this section, one of the following documents must be attached to the United States income tax return --

(i) A statement from the foreign tax authorities specifying the amount of the deduction allowed in computing taxable income under the appropriate foreign tax law for the relevant year or years with respect to the qualified foreign plan; or

(ii) If the return under the appropriate foreign tax law shows the deduction for plan contributions or plan reserves as a separate identifiable item, a copy of the foreign tax return for the relevant year or years with respect to the qualified foreign plan.

(3) Additional requirements. The statement or return attached pursuant to paragraph (b)(2) of this section may be either the original, a duplicate original, a duly certified or authenticated copy, or a sworn copy. If only a sworn copy of a receipt or return is attached, there must be kept readily available for comparison on request the original, a duplicate original, or a duly certified or authenticated copy.

(4) Secondary evidence. Where the statement or return described in paragraph (b)(2)(i) or (b)(2)(ii) of this section is not available, all of the following information must be attached to the United States income tax return --

(i) A certified statement setting forth the cumulative foreign amount for each taxable year to which section 404A applies;

(ii) The excerpts from the employer's books and records showing either the change in the reserve or contributions made with respect to the plan for the taxable year to which section 404A applies; and

(iii) The computations of the foreign deduction relating to the plan to be established by data such as excerpts from the foreign law, assessment notices, or other documentary evidence.

(5) Foreign language. If the relevant returns, books, records or computations are not maintained in the English language, the taxpayer must furnish, upon request, a certified translation that is satisfactory to the District Director.

(6) Additional information required by District Director. If the taxpayer upon request of the District Director fails, without justification, to furnish any additional information that is significant, the provisions of section 982 will apply.

(7) Authorized officer to complete documents. The documents required by this section and by sections 1.404A-6 and 1.404A-7 must be signed by an authorized officer of the taxpayer (as defined in section 6062 or 6063) who must verify under penalty of perjury that the statement and all other documents submitted are true and correct to his knowledge and belief.

(8) Transitional rule -- good faith effort. For taxable years ending before [INSERT DATE THAT IS 90 DAYS AFTER THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER] a taxpayer will be treated as satisfying this paragraph (b) if it makes a good faith effort to provide reasonable documentation.

(c) Actuarial requirements -- (1) Reasonable actuarial assumptions. Except as otherwise specifically provided in sections 1.404A-2 and 1.404A-3 and this paragraph (c), in the case of a qualified reserve plan or a qualified funded plan under which benefits are fixed or determinable, no amount may be taken into account under section 404A unless costs, liabilities, rates of interest, and other factors under the plan are determined on the basis of actuarial assumptions and methods each of which is reasonable (taking into account the experience of the plan and reasonable expectations), or which, in the aggregate, result in an amount being taken into account that is equivalent to that which would be determined if each such assumption and method were reasonable, and that, in combination, offer the actuary's best estimate of anticipated experience under the plan. For plan years beginning before January 1, 1988, the preceding sentence is satisfied if costs, liabilities, rates of interest, and other factors under the plan are determined on the basis of actuarial assumptions and methods that are reasonable in the aggregate (taking into account the experience of the plan and reasonable expectations) and that, in combination, offer the actuary's best estimate of anticipated experience under the plan. Except to the extent required under that paragraph, the interest rate determined under section 1.404A-3(b)(4) may not be considered in determining whether other actuarial assumptions are reasonable in the aggregate for this purpose.

(2) Full funding limitation. Notwithstanding any other provisions of sections 1.404A-1 through 1.404A-7, no amount may be taken into account under section 404A if the amount causes the assets in the trust (in the case of a qualified funded plan) or if taking into account the amount causes the amount of the reserve (in the case of a qualified reserve plan) to exceed the amount described in section 412(c)(7)(A)(i).

SECTION 1.404A-6 ELECTIONS UNDER SECTION 404A AND CHANGES IN METHODS

(a) Elections, changes in accounting methods, and changes in plan years -- (1) In general -- (i) Methods of accounting. An election under section 404A with respect to a qualified foreign plan constitutes the adoption of a method of accounting if the election is made in the taxable year in which the plan is adopted. Any election under section 404A with respect to a pre- existing plan, however, constitutes a change in method of accounting requiring the Commissioner's consent under section 446 (e) and an adjustment under section 481(a). Additionally, any other change in the method used to determine the amount taken into account under section 404A(a), as well as the revocation of any election under section 404A, constitutes a change in accounting method subject to the consent and adjustment requirements of sections 446(e) and 481(a). This section provides procedures for obtaining the Commissioner's consent to make certain changes in methods of accounting under section 404A. Additionally, section 1.404A-7 provides special procedural rules applicable (along with the rules under this section) for retroactive and transition-period elections under section 404A.

(ii) Changes not involving accounting methods. Any change in treatment, adjustment, or correction described in section 1.446- 1(e)(2)(ii)(b) (e.g., correction of computational errors) is not a change in accounting method. While a retroactive qualified funded plan election under section 1.404A-7(c) constitutes a change in method of accounting, a mere election to apply the effective date of section 404A under section 1.404A-7(b) retroactively does not necessarily result in a change in accounting method. Additionally, a retroactive election for funded foreign branch plans under section 1.404A-7(d) will not be treated as a change in method of accounting, except to the extent that the taxpayer took erroneous deductions under its method of accounting prior to the beginning of its open period. Finally, a change of actuarial assumptions will not be treated as a change in method of accounting for purposes of this section.

(2) Single plan -- (i) General rule. Except as otherwise provided, the rules of this section regarding elections, revocations, and re-elections, and the adoption or change of a plan year, apply separately (i.e., on a plan-by-plan basis) to each plan that qualifies as a single plan (as defined in section 1.414( )-1(b)). For purposes of this definition, a separate reserve maintained by an employer exclusively for its liability under a plan is considered a plan asset that is available exclusively to pay benefits to employees who are covered by the plan and to their beneficiaries. Although a plan may be treated as a reserve plan under foreign law, this treatment is not binding for purposes of section 404A and this section.

(ii) Example. The principles of this paragraph (a)(2) are illustrated by the following example:

Example. S is a wholly-owned foreign subsidiary of P, a

(b) Initial elections under section 404A -- (1) In general. The Commissioner's consent to elect initially under section 404A to treat a single plan as a qualified funded plan or as a qualified reserve plan is granted automatically if the taxpayer complies with the requirements of this paragraph (b). Except as provided in section 1.404A-7, an initial election under this section with respect to any qualified foreign plan may be made only for a taxable year beginning after December 31, 1979.

(2) Time for making election -- (i) Foreign branch plans. Except as provided in section 1.404A-7, the initial election for a qualified foreign plan maintained by a foreign branch must be made no later than the time prescribed by law for filing the United States return (including extensions) for the first taxable year for which the election is to be effective.

(ii) Foreign corporation plans. Except as provided in section 1.404A-7, the initial election for a qualified foreign plan maintained by a foreign corporation must be made no later than the time allowed for making elections under sections 1.964-1 and 1.964- 1T. Thus, the election under section 404A may be deferred until the earnings and profits of the foreign corporation have United States tax significance, as defined in sections 1.964-1 and 1.964-1T. United States tax significance may occur in a number of ways, including, for example, a dividend distribution, an income inclusion under section 951(a), a section 1248 transaction, a step-up of basis by earnings and profits for purposes of valuing assets for interest allocation purposes under section 864(e), or an inclusion in income of the earnings of a qualified electing fund under section 1293(a)(1).

(3) Manner in which election is to be made -- (i) Foreign branch plans. In the case of a qualified foreign plan maintained by a domestic corporation, the initial election must be made by the taxpayer by attaching a list of plans for which section 404A treatment is desired to a return filed within the time prescribed in paragraph (b)(2)(i) of this section.

(ii) Controlled foreign corporation plans. If a qualified foreign plan is maintained by a controlled foreign corporation, the initial election under this section must be made in the manner prescribed by sections 1.964-1 and 1.964-1T and must include a list of all plans for which the election is made.

(iii) Noncontrolled foreign corporation plans. If a qualified foreign plan is maintained by a noncontrolled foreign corporation, the initial election under this section must be made in the manner prescribed by sections 1.964-1 and 1.964-1T and must include a list of all plans for which the election is made, as if the noncontrolled foreign corporation were a controlled foreign corporation. In applying the rules of sections 1.964-1 and 1.964-1T, the term "majority domestic corporate shareholders" is substituted for the term "controlling United States shareholders" wherever it appears in sections 1.964-1 and 1.964-1T. The term "majority domestic corporate shareholders" has the meaning set forth in section 1.985-2(c)(3)(i).

(4) Other requirements for election. For each plan listed, pursuant to paragraph (b)(3) of this section, the taxpayer must designate whether it elects to treat the plan as a qualified funded plan or qualified reserve plan, and must designate a plan year. Additionally, for each plan listed, the taxpayer must disclose the amount of any section 481(a) adjustment, as well as the initial cumulative United States amount, the initial cumulative foreign amount, and the initial aggregate amount defined in paragraph (g) of this section. See section 1.404A-5(b) for rules on additional information required, signing and verifying required statements, and notices and forms necessary to elect under section 404A. Additionally, see section 1.404A-7(d)(1) for required agreement to assessment of tax for retroactive elections for funded foreign branch plans.

(c) Termination of election when a plan ceases to be a qualified foreign plan -- (1) In general. An election under section 404A with respect to a foreign deferred compensation plan is terminated if at any time on or after the first day of the first taxable year for which the election is effective the plan ceases to be a qualified foreign plan by reason of a failure to satisfy the conditions of section 404A(e)(1) or (2). Thus, for example, the election is terminated (subject to the consent of the Commissioner) if more than 10 percent of the amounts taken into account under the plan are attributable to services performed by employees subject to United States federal income tax. As used in this section, the term "termination" refers only to situations under which a plan ceases to be a qualified foreign plan by reason of a failure to satisfy the conditions of section 404(e)(1) or (2). Thus, the term is distinguished from a voluntary revocation of an election (i.e., under paragraph (d)(1) of this section), which also causes a plan to cease to be a qualified foreign plan. Upon termination of an election under section 404A, a change in method of accounting is required. The conditional advance consent of the Commissioner is granted for this change in method of accounting. This conditional consent may be withdrawn, however, if the District Director determines that tax avoidance was a purpose of the termination or if the procedures in paragraph (c)(2) of this section are not satisfied.

(2) Rules for changing method of accounting upon termination of election -- (i) Time for making change -- (A) Foreign branch plans. Except as provided in section 1.404A-7, in the case of a plan of a foreign branch the change in method of accounting required upon termination of a section 404A election must be made no later than the time prescribed by law for filing the United States return (including extensions) for the taxable year in which the plan ceases to satisfy the requirements of section 404A(e)(1) or (2).

(B) Foreign corporation plans. Except as provided in section 1.404A-7, in the case of a plan of a foreign corporation the change in method of accounting required upon termination of a section 404A election shall be made no later than the first year after the termination in which the earnings and profits of the foreign corporation have United States tax significance, as defined in sections 1.964-1 and 1.964-1T. See paragraph (b)(2)(ii) of this section for United States tax significance examples.

(ii) Procedures for changing method of accounting upon termination of election -- (A) Foreign branch plans. The change in method of accounting required upon termination of a section 404A election with respect to a foreign branch plan must be made by attaching a statement to the return described in paragraph (c)(2)(i)(A) of this section disclosing the amount of any section 481(a) adjustment (required under paragraph (e) of this section and computed in accordance with paragraph (f) of this section) arising upon the change.

(B) Controlled foreign corporation plans. The change in method of accounting required upon termination of a section 404A election with respect to a controlled foreign corporation plan must be made in the manner prescribed by sections 1.964-1 and 1.964-1T and must include disclosure of the amount of any section 481(a) adjustment (required under paragraph (e) of this section and computed in accordance with paragraph (f) of this section) arising upon the change.

(C) Noncontrolled foreign corporation plans. The change in method of accounting required upon termination of a section 404A election with respect to a noncontrolled foreign corporation plan must be made in the manner prescribed by sections 1.964-1 and 1.964- 1T and must include disclosure of the amount of any section 481(a) adjustment (required under paragraph (e) of this section and computed in accordance with paragraph (f) of this section) arising upon the change. In applying the rules of sections 1.964-1 and 1.964-1T, the term "majority domestic corporate shareholders" is substituted for the term "controlling United States shareholders" wherever it appears in sections 1.964-1 and 1.964-1T. The term "majority domestic corporate shareholders" has the meaning set forth in section 1.985- 2(c)(3)(i).

(d) Other changes in methods of accounting and changes in plan year -- (1) Application for consent. Except as provided in paragraph (c) of this section or in section 1.404A-7, once an initial election under section 404A is effective with respect to a plan, the taxpayer must separately apply to obtain the express consent of the Commissioner prior to changing any method of accounting with respect to a foreign deferred compensation plan. Application for the consent of the Commissioner is required whether or not the method being changed is proper or permitted under the Internal Revenue Code and regulations thereunder. Any change in method of accounting not described in this paragraph (d)(1) must be made in accordance with the requirements of section 446(e) and the regulations thereunder. The procedures prescribed in this paragraph (d), however, are the exclusive procedures for making the following changes in method of accounting --

(i) Revocation of a section 404A election;

(ii) Re-election under section 404A following termination or revocation of a section 404A election;

(iii) Changing the treatment of a plan from a qualified funded plan to a qualified reserve plan (or the converse); or

(iv) Changing the actuarial funding method used to determine costs under a qualified funded plan.

(2) Procedures for other changes in method of accounting -- (i) Foreign branch plans. To request consent to a change in method of accounting described in paragraph (d)(1) of this section, the taxpayer must file an application on Form 3115 with the Commissioner generally within 180 days after the beginning of the taxable year in which the change is requested to be effective. In the case of a revocation of an election under section 404A, however, the 180-day period in the preceding sentence is extended to the time prescribed by law for filing the United States return for the taxable year of the change.

(ii) Foreign corporation plans. For a controlled foreign corporation or a noncontrolled foreign corporation, a request for consent to revocation or to another change in method of accounting must be made in accordance with the rules of sections 1.964-1 and 1.964-1T.

(3) Plan year. A taxpayer must secure the consent of the Commissioner to change the plan year of a qualified foreign plan. Termination or revocation of a section 404A election will not effect a change in the plan year of the plan.

(e) Application of section 481 -- (1) In general. A change in method described in this section constitutes a change in method of accounting to which section 481 applies. Except as otherwise provided in this paragraph and in paragraph (f) of this section, this adjustment must be made in accordance with section 481 and the regulations thereunder in those circumstances. For purposes of section 481(a)(2), any change in method described in this section is considered a change in method of accounting initiated by the taxpayer.

(2) Period of adjustment -- (i) In general. The section 481(a) adjustment period is determined under the rules of this paragraph (e)(2).

(ii) Election or re-election. In the case of an election or a re-election following termination or revocation, the section 481(a) adjustment required by paragraph (e)(1) of this section must be taken into account ratably over a 15-year period, beginning with the first taxable year for which the election or re-election is effective. This section 481(a) adjustment period also applies to a change from a qualified funded plan to a qualified reserve plan.

(iii) Termination or revocation of election and all other changes in method. The adjustment required by paragraph (e)(1) of this section for all changes in method (other than those described in paragraph (e)(2)(ii) of this section), including changes in election from a qualified reserve plan to a qualified funded plan, must be taken into account ratably over a six-year period, beginning with the first taxable year for which the change is effective. If an unamortized section 481(a) adjustment amount (e.g., from a previous change) remains at the end of a change in method of accounting to which this paragraph (e)(2)(iii) applies, the net amount of all of the section 481(a) adjustments must be taken into account ratably over this six-year section 481(a) adjustment period.

(iv) Acceleration of section 481(a) adjustment. If the employer ceases to engage in the relevant trade or business at any time prior to the expiration of the applicable section 481(a) adjustment period provided in paragraph (e)(2)(ii) or (e)(2)(iii) of this section, the employer must take into account, in the taxable year of cessation, the balance of any section 481(a) adjustment not previously taken into account in computing taxable income (in the case of a branch) or earnings and profits (in the case of a foreign corporation). For purposes of this paragraph (e)(2)(iv), whether or not an employer ceases to engage in the trade or business is to be determined under administrative procedures issued under section 1.446-1(e). In applying those procedures, "employer" is to be defined in the same manner as "taxpayer" is defined under those procedures.

(3) Allocation and source. The amount of any net negative section 481(a) adjustment determined under this section and taken into account for a taxable year must be allocated and apportioned under section 1.861-8 in the same manner as a deduction or reduction in earnings and profits under section 404A. Any net positive section 481(a) adjustment that is taken into account for a taxable year first must be reduced by directly allocating to such adjustment the employer's section 404A expense that is subject to apportionment (including any amount that otherwise would be capitalized); to the extent a net positive section 481(a) adjustment exceeds the amount of the employer's section 404A expense for the taxable year, such excess must be sourced or otherwise classified in the same manner as section 404A deductions or reductions in earnings and profits are allocated and apportioned.

(4) Example. The principles of this paragraph (e) are illustrated by the following example:

Example. X, a domestic corporation, made an initial election under section 404A to treat an existing deferred compensation plan maintained by its foreign branch as a qualified reserve plan, effective beginning in X's 1985 taxable year. X's foreign branch maintains its books and records in FC, the functional currency. Previously, X had consistently used a permissible method of accounting with respect to the plan. The section 481(a) adjustment arising from X's change in accounting method upon its section 404A election was a negative FC150,000. Beginning with its 1985 taxable year, X took into account a negative FC10,000 each year (FC150,000/15). Effective beginning in X's 1988 taxable year, X received the Commissioner's express consent to change from a qualified reserve plan to a qualified funded plan. The section 481(a) adjustment attributable solely to the 1988 change was a positive FC132,000. Beginning with its 1988 taxable year, and for each of the five succeeding taxable years, X took into account a positive FC2,000, as computed below.

Negative 1985 section

Section 481(a) adjustment period                         / 6

(f) Computation of section 481(a) adjustment -- (1) In general. For purposes of section 404A, except as provided in section 1.404A- 7(f)(1)(ii)(C), the amount of the section 481(a) adjustment required under paragraph (e)(1) of this section equals --

(i) The Old Method Closing Amount; less

(ii) The New Method Opening Amount.

(2) Old Method Closing Amount -- (i) In general. Except as otherwise provided in paragraph (f)(2)(ii), (iii), or (iv) of this section (or as otherwise prescribed by the Commissioner), the Old Method Closing Amount equals --

(A) The total of all past deductions taken with respect to liabilities under the plan; plus

(B) The net income earned directly or indirectly by any separate funding entity (e.g., account or trust) with respect to the plan, but only to the extent that such net income has not previously been taken into account in determining taxable income (in the case of a foreign branch) or earnings and profits (in the case of a foreign corporation); minus

(C) The total of all past payments under the plan made to plan participants and beneficiaries by the employer, the trust, or the separate funding entity.

(ii) Taxpayer formerly using a reserve method -- (A) In general. If a taxpayer has consistently taken amounts with respect to the plan into account under a reserve method, the Old Method Closing Amount equals the closing reserve balance at the end of the closing year calculated under the taxpayer's reserve method. For purposes of the preceding sentence, a reserve method means a method of accrual based on the actuarial present value of expected future plan benefits.

(B) Former qualified reserve plan. To request the Commissioner's consent in the case of a former qualified reserve plan, the closing reserve balance must be adjusted for any unamortized increases or decreases to the reserve described in section 1.404A-3(c) that have not yet been taken into account. For example, if the closing reserve balance is FC100,000, but FC10,000 of the closing reserve balance consists of an unamortized increase in the reserve that has not previously been taken into account due to the ten-year amortization requirements of section 1.404A-3(c), the Old Method Closing Amount is FC90,000.

(iii) Taxpayer formerly using pay-as-you-go method. If the taxpayer has consistently taken amounts into account with respect to the plan based only on actual payments of plan benefits to participants and beneficiaries, the Old Method Closing Amount equals zero.

(iv) Taxpayer formerly using a funded method -- (A) Payment to separate funding entity. If the taxpayer has consistently taken amounts into account with respect to the plan based only on actual payments to a separate funding entity and on payments by the employer (but not by the funding entity) to plan participants or beneficiaries, the Old Method Closing Amount equals the balance in the separate funding entity at the end of the closing year, including amounts attributable, directly or indirectly, to net investment income that has not previously been taken into account in determining taxable income (in the case of a foreign branch) or earnings and profits (in the case of a foreign corporation).

(B) Former qualified funded plan. In the case of a former qualified funded plan, the Old Method Closing Amount generally equals the amount described in paragraph (f)(2)(iv)(A) of this section, adjusted, however, by --

(1) Reducing the amount properly to reflect any net limitations under section 404A(b) and (g) (e.g., the full funding limitation for a qualified funded plan) that were applied in determining amounts taken into account under the former section 404A method of accounting; and

(2) Increasing the amount properly to reflect any amounts that are not paid during the closing year but that are permitted to be taken into account in the closing year under section 404A(b)(2) (relating to payments made after the close of the taxable year).

(v) Section 404A(d) limitation. In computing the Old Method Closing Amount upon the termination or revocation of an election under section 404A, the limitations of section 404A(d) and section 1.404A-4 must be taken into account. Thus, if the Old Method Closing Amount is determined under paragraph (f)(2)(ii)(B) or (f)(2)(iv)(B) of this section, the amount otherwise determined under those paragraphs shall be reduced by applying the section 404A(d) and section 1.404A-4 limitations to the extent the cumulative United States amount under section 1.404A-4 exceeds the cumulative foreign amount under section 1.404A-4.

(3) New Method Opening Amount -- (i) Qualified reserve plan. In the case of an election to treat a plan as a qualified reserve plan, the New Method Opening Amount equals the balance of the reserve as of the end of the last day of the closing year, calculated under the rules of section 404A(c) and section 1.404A-3 based on plan information and data as of that date. The New Method Opening Amount must be reduced (or increased) for any unamortized increases (or decreases) to the reserve described in section 404A(c)(4) and section 1.404A-3(c).

(ii) Qualified funded plan. In the case of an election to be treated as a qualified funded plan, the New Method Opening Amount equals the amount of funds in the trust as of the beginning of the first day of the opening year, adjusted as necessary to take into account the rules of section 404A(b) and (g). If the separate funding entity does not qualify as a trust under section 1.404A-1(e), the New Method Opening Amount in the case of a qualified funded plan is zero because there is no balance in a trust as defined in section 1.404A- 1(e).

(iii) Nonqualified plan. In the case of any plan that ceases to be a qualified foreign plan (either by reason of the termination or revocation of a section 404A election), the New Method Opening Amount is zero.

(iv) Section 404A(d) limitation. In computing the New Method Opening Amount upon an election under section 404A, the limitation on deductions of section 404A(d) and section 1.404A-4 must be taken into account. Thus, if the New Method Opening Amount is determined under paragraph (f)(2)(i) or (f)(2)(ii) of this section, the amount otherwise determined must be reduced to the extent the cumulative United States amount computed under section 1.404A-4 exceeds the cumulative foreign amount computed under section 1.404A-4. See paragraph (g) of this section for initialization of amounts taken into account under section 404A(d).

(4) Definitions and special rules -- (i) Opening year. For purposes of this section, the opening year is the first taxable year for which the new method of accounting is effective with respect to a plan. For example, in the case of an election to treat a foreign corporation plan as a qualified reserve plan beginning in 1989, the opening year is 1989, even though the election may not be made until 1994 pursuant to paragraph (b)(2)(ii) of this section.

(ii) Closing year. For purposes of this section, the closing year is the taxable year immediately preceding the opening year.

(iii) Separate funding entity. A separate funding entity described in paragraphs (f)(2)(ii)(B) and (f)(2)(iv) of this section is any entity that satisfies the first requirement in the definition of the equivalent of a trust in section 1.404A-1(e) (segregation in a separate legal entity) and, in practice, also satisfies the third requirement in that definition (dedication to payment of plan benefits) with respect to benefits under the relevant plan.

(iv) Special rules for certain foreign corporation plans. In the case of a foreign corporation's plan for which no method has been used for some or all prior taxable years because no calculation of earnings and profits has been necessary for those years (see, e.g., paragraph (b)(2)(ii) of this section), the employer may assume that the old method has been consistent with any method actually used consistently in immediately prior years. If no calculation of earnings and profits has been made for prior years, in determining the Old Method Closing Amount, the taxpayer may assume the method used was a method described in paragraph (f)(2)(iii) of this section. This assumed method used in the calculation of the Old Method Closing Amount must actually be used by the taxpayer for all the prior taxable years to the extent reductions of earnings and profits for those years are ever determined with respect to the plan.

(v) Reference to rules applicable in the case of failure to consider net investment income in computing section 481(a) adjustment. The treatment of net investment income earned by a funding vehicle that has not previously taken into account by the taxpayer in determining taxable income (in the case of a foreign branch) or earnings and profits (in the case of a foreign corporation), and that is not properly considered (as required under paragraphs (f)(2)(i)(B) and (f)(2)(iv)(A) of this section) in determining the amount of the section 481(a) adjustment for purposes of section 404A, is determined under other applicable provisions, which may include sections 61, 671 through 679, and 1001.

(vi) Certain section 481(a) adjustments treated as carryover contributions. In the case of an election for a plan to be treated as a qualified funded plan, any net positive section 481(a) adjustment is treated as a carryover contribution (within the meaning of section 1.404A-2(d)(4)) to the extent that the adjustment is attributable to limits (that would be taken into account under section 1.404A- 2(d)(4)) on the amounts previously contributed to the trust under the plan that could be taken into account under section 404A.

(5) Examples. The principles of paragraph (f) of this section are illustrated by the following examples:

Example 1. Nonqualified reserve plan to qualified reserve

Example 2. Nonqualified reserve plan to qualified reserve

Example 3. Nonqualified funded plan to qualified reserve

Example 4. Nonqualified funded plan to qualified funded

Example 5. Z, the wholly owned foreign subsidiary of Y, a

Example 6. Nonqualified reserve plan to qualified reserve

                    1984   1985   1986   1987   1988   1989   1990

Amount allowed as

Cumulative U.S.

Cumulative

Lesser of

Reduced by the

Amount taken into

Positive section

Total increase

(g) Initial section 404A(d) amounts -- (1) In general. By making an election under section 404A, a taxpayer adopts section 404A(d) as part of its method of accounting. Section 1.404A-4 provides rules to apply the limitations of section 404A(d) in taxable years when an election under section 404A is in effect. This paragraph (g) provides rules to compute initial amounts under section 404A(d) in the opening year. These rules are based on the rules to compute the New Method Opening Amount in paragraph (f)(3) of this section.

(2) Computation of amounts. As of the first day of the opening year, the initial section 404A(d) amounts are as follows:

(i) The initial cumulative United States amount equals the New Method Opening Amount without regard to any reduction under paragraph (f)(3)(iv) of this section.

(ii) The initial cumulative foreign amount equals the New Method Opening Amount computed as though the appropriate foreign tax law were the new method of accounting and without regard to paragraph (f)(3)(iv) of this section.

(iii) The initial aggregate amount equals the lesser of --

(A) The initial cumulative United States amount; and

(B) The initial cumulative foreign amount.

(3) Example. The principles of paragraph (g) of this section are illustrated by the following example:

Example. A foreign subsidiary of a domestic corporation

SECTION 1.404A-7 EFFECTIVE DATE, RETROACTIVE ELECTIONS, AND

(a) In general -- (1) Effective date. Except as otherwise provided in this section, section 404A applies to taxable years beginning after December 31, 1979.

(2) Overview of retroactive elections for taxable years beginning before January 1, 1980 -- (i) Plans of foreign subsidiaries. Section 2(e)(2) of Public Law 96-603 permitted a taxpayer to make section 404A apply retroactively for all of its foreign subsidiaries. Paragraph (b) of this section describes and provides the time and manner to make, perfect, or revoke this retroactive effective date election. If a retroactive effective date election was made, the taxpayer was also eligible to make a qualified funded plan election or a qualified reserve plan election effective retroactively for any of its subsidiaries' plans that met the requirements of section 1.404A-1(a) (other than paragraph (4) thereof) for the relevant period. Paragraph (c) of this section describes and provides the time and manner to make, perfect, or revoke these retroactive plan-by-plan elections for foreign subsidiaries.

(ii) Plans of foreign branches. Section 2(e)(3) of Public Law 96-603 permitted a taxpayer to make a qualified funded plan election retroactively for any plans maintained by a foreign branch that met the requirements of section 1.404A-1(a) (other than paragraph (4) thereof) for the relevant period. Paragraph (d) of this section describes and provides the time and manner to make this retroactive plan-by-plan qualified funded plan election for plans maintained by foreign branches.

(3) Overview of special transition rules for election, revocation, and re-election. Paragraph (e) of this section provides the time and manner to make and revoke qualified funded plan and qualified reserve plan elections for a taxpayer's transition period.

(b) Retroactive effective date elections for foreign subsidiaries -- (1) In general. Section 2(e)(2) of Public Law 96-603 permitted a taxpayer to make section 404A effective during the taxpayer's open period. If the election was made, the taxpayer accepted section 404A (including, for example, section 1.404A-1(d)) as the operative law for all foreign subsidiaries (whether or not controlled foreign corporations) during the taxpayer's entire open period. If the election was made, section 404A applies to all distributions from accumulated profits (or earnings and profits) earned after December 31, 1970 (unless the election is revoked pursuant to paragraph (b)(3) of this section, if applicable). If accumulated profits were earned prior to January 1, 1971, a change in method of accounting is required for the foreign subsidiary's taxable year that ends with or within the first taxable year in the taxpayer's open period. A section 481(a) adjustment is required for amounts taken into account prior to the beginning of the foreign subsidiary's year of change and must be computed applying the rules of section 1.404A-6(f).

(2) Time and manner to make, perfect, or revoke election. The retroactive effective date election described in paragraph (b)(1) of this section is not effective unless the election was actually made no later than the time prescribed by law for filing the United States return for the first taxable year ending on or after December 31, 1980, including extensions (whether or not the time was actually extended for filing the taxpayer's return), and unless the taxpayer perfects the election by filing a statement indicating the taxpayer's agreement to perfect the election with an amended return for the first taxable year ending on or after December 31, 1980, on or before [INSERT DATE THAT IS 365 DAYS AFTER THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER]. In order to be effective, the perfection must be made in the manner provided in section 1.404A- 6(b)(3)(ii) or (iii). An election that is not perfected is considered retroactively revoked.

(3) Requirement to amend returns -- (i) In general. In addition to the amended return required by paragraph (b)(2) of this section, the taxpayer must file any other amended United States returns that are necessary to conform the treatment of all items affected by the election or revocation to the treatment consistent with the election or revocation within the time period described in paragraph (b)(2) of this section. If no adjustments are necessary, the amended return required by paragraph (b)(2) of this section must contain a statement to that effect.

(ii) Required statements. All amended returns required by this paragraph (b)(3) must be accompanied by a statement containing --

(A) The open years, open period and retroactive period of the taxpayer;

(B) The taxable year for which the election is perfected or revoked;

(C) A statement that the election (or elections) are perfected or revoked pursuant to the authority contained in section 1.404A-7; and

(D) A signature and verification as provided in section 1.404A- 5(b)(7).

(c) Retroactive plan-by-plan elections for foreign subsidiaries -- (1) In general. Any taxpayer that makes a retroactive effective date election described in paragraph (a)(2)(i) of this section under the rules of paragraph (b) of this section may, at its option, also elect to treat any foreign plan of a subsidiary that met the requirements of section 1.404A-1(a) (other than paragraph (4) thereof) for the relevant period as a qualified funded plan or as a qualified reserve plan under section 404A, beginning in any taxable year of the foreign subsidiary that ends with or within the taxpayer's open period (or for any earlier taxable year beginning after December 31, 1971, for which earnings and profits of the subsidiary had no United States tax significance). Alternatively, the taxpayer may decide to make no such plan-by-plan election with respect to any particular plan or plans of any of its foreign subsidiaries. Rules similar to those contained in section 1.404A-6 (including, where applicable, the requirement to obtain the consent of the Commissioner) are used to effect such plan-by-plan elections. If the plan existed in a taxable year beginning prior to the first year for which the election was effective, a change in method of accounting is required for the year of the election. The year of change for purposes of computing the section 481(a) adjustment is the first year that the election is effective.

(2) Time and manner to make, perfect, or revoke election. A taxpayer that is eligible to make a plan-by-plan election described in paragraph (c)(1) of this section may make or perfect such an election by attaching a statement to that effect on an amended return for the year that the election is to be effective on or before [INSERT DATE THAT IS 365 DAYS AFTER THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER]. In order to be effective, the perfection of a plan- by-plan election must be made in the manner provided in section 1.404A-6(b)(3)(ii) or (iii). An election that is not perfected is considered retroactively revoked. Any election made or perfected under this paragraph (c) will continue in effect for taxable years beginning after the taxpayer's open period, unless revoked under paragraph (c)(4) or (e) of this section or section 1.404A-6.

(3) Requirement to amend returns. In addition to the amended return required by paragraph (c)(2) of this section, the taxpayer must file any other amended United States returns that are necessary to conform the treatment of all items affected by the election or revocation to the treatment consistent with the election or revocation. All amended returns must be accompanied by the statement described in paragraph (b)(3)(ii) of this section (substituting "made, perfected, or revoked" for "perfected or revoked" where applicable) and all of the information required by section 1.404A- 6(b)(4) (and section 1.404A-6(c)(2)(ii), if applicable, in the case of a termination). If no adjustments are necessary, the amended return required by paragraph (c)(2) of this section must contain a statement to that effect.

(4) Revocation after initial election and re-election permitted. Any taxpayer that makes an initial election for any plan under paragraph (c)(2) of this section may, under the rules of that paragraph, revoke the election for any taxable year after the sixth consecutive taxable year for which the election is effective, and may re-elect for any taxable year after the sixth consecutive taxable year for which the election is not in effect (regardless of whether the election is not in effect due to revocation or termination of the election as defined in section 1.404A-6(c)(1)). The consecutive changes in method of accounting described in the first sentence of this paragraph (c)(3) must be made under the rules in section 1.404A- 6 regarding the section 481(a) adjustment period. The Commissioner may approve a letter ruling request (see section 601.201 of this chapter) to shorten the six-year waiting period upon a showing of extraordinary circumstances.

(5) Examples. The principles of paragraphs (b) and (c) of this section are illustrated by the following examples:

Example 1. P, a domestic corporation, wholly owns two

(i) For 1978 and 1979, P reduced the earnings and profits of S and T by the amount of the pension liability that had accrued under the plans as follows --

Taxable year   S's Plan 1          S's Plan 2          T's plan

1978           FC30,000             FC5,000            FC70,000

Total reduction

Total reduction

     S         FC100,000

(ii) In 1981, P made a retroactive effective date election pursuant to section 2(e)(2) of Public Law 96-603 and paragraph (b) of this section for taxable years beginning after December 31, 1977, and ending before January 1, 1980, P's open period. Thus, with respect to its open period, P has made section 404A the operative law for all distributions of earnings and profits (or accumulated profits) earned after December 31, 1970 for S and T. The consequences of making or not making the retroactive plan-by-plan election under section 404A for each foreign plan will be determined as though section 404A had been in effect for those years. Accordingly, earnings and profits of S and T may not be reduced with respect to amounts accrued under their respective plans unless the plans met the requirements of section 1.404A-1(a) for those years in the open period.

(iii) P made a retroactive plan-by-plan election to treat S's Plan 1 as a qualified reserve plan for P's retroactive period. The amount taken into account under section 1.404A-3 for S's Plan 1 calculated under section 404A was FC25,000 for 1978 and FC35,000 for 1979. No election under section 404A was made for S's Plan 2 or for T's plan. Thus, no amount of the accrued but unpaid pension liability attributable to S's Plan 2 or to T's plan may reduce S's or T's respective 1978 and 1979 earnings and profits. P amended its tax returns for 1978 and 1979 to reflect the correct reduction of earnings and profits of FC25,000 and FC35,000 with respect to S's Plan 1 and no reduction for those years with respect to S's Plan 2 or T's plan. Since S's and T's plans were established during the open period, no section 481(a) adjustment is required.

Example 2. Q, a domestic corporation, has wholly owned R, a

(i) R's earnings and profits were earned and distributed to Q as follows --

                                             Distribution of

1968                FC10,000

     Subtotal                   50,000

1971                  30,000

     Subtotal                  150,000

1976                  40,000

     Subtotal                  250,000

Total              FC450,000

(ii) In 1981, Q made a retroactive effective date election

(iii) Q made a retroactive plan-by-plan election to treat R's plan as a qualified reserve plan effective beginning in 1971. Of the distribution of FC200,000 to Q in 1975, section 404A applies to FC150,000, because these accumulated profits (or earnings and profits) were earned in taxable years beginning after December 31, 1970 and were also distributed in 1975, within Q's open period. However, section 404A does not apply to the FC50,000 distribution made from accumulated profits earned before December 31, 1970. Since R's plan was established before Q's open period, a section 481(a) adjustment is required. This section 481(a) adjustment must be taken into account in determining earnings and profits beginning with the 1971 year of change.

(d) Retroactive plan-by-plan qualified funded plan elections for certain plans of foreign branches -- (1) In general. Section 2(e)(3) of Public Law 96-603 permitted a taxpayer to make a qualified funded plan election retroactively for any plans maintained by a foreign branch that met the requirements of section 1.404A-1(a) (other than paragraph (4) thereof) for the relevant period. As a condition of making this election, a taxpayer is required to agree to the assessment of all deficiencies (including interest thereon) arising during those taxable years within the open period (even those taxable years that are not open years as defined in paragraph (g)(4) of this section) to the extent that the deficiencies arise from erroneous deductions claimed by the taxpayer with respect to all of the taxpayer's foreign branches that maintained a deferred compensation plan. For a taxpayer that agrees to the assessment of tax in an election under this paragraph (d), a change in method of accounting is necessary (and a section 481(a) adjustment is required in accordance with the provisions of section 1.404A-6) with respect to any erroneous deductions claimed by the taxpayer under its method of accounting in taxable years ending prior to the beginning of the open period. For such a change in method of accounting, the year of change is the first taxable year in the open period, and the method of accounting to which the taxpayer is required to change is the method permitted during the open period under this paragraph (d).

(2) Amounts allowed as a deduction. If an election under section 2(e)(3) of Public Law 96-603 was made under the rules of this paragraph (d), the aggregate of the taxpayer's prior deductions is allowed as a deduction ratably over a 15-year period, beginning with the taxpayer's first taxable year beginning after December 31, 1979. A fractional part of a year which is a taxable year (as defined in sections 441(b) and 7701(a)(23)) is a taxable year for purposes of the 15-year period.

(3) Definitions -- (i) Prior deduction -- (A) In general. The term "prior deduction" means a deduction with respect to a qualified funded plan (i.e., a plan that met the requirements of section 1.404A-1(a) for the relevant period, and with respect to which a qualified funded plan election was made under the rules of this paragraph (d)) maintained by a foreign branch of a taxpayer for a taxable year beginning before January 1, 1980 --

(1) That the taxpayer claimed;

(2) That was not allowable under the law in effect prior to the enactment of section 404A;

(3) With respect to which, on December 1, 1980, the assessment of a deficiency was not barred by any law or rule of law; and

(4) That would have been allowable if section 404A applied to taxable years beginning before January 1, 1980.

(B) Application of section 404A(d). Because the prior deductions are limited by the amounts that may be taken into account under section 404A, the computation of those prior deductions for the relevant taxable years is subject to the limitations described in section 404A(d) and section 1.404A-4. However, once the aggregate of prior deductions is calculated, the aggregate, or any portion thereof permitted to be taken into account over the 15-year period of paragraph (d)(2) of this section, is not subject to the limitations prescribed by section 404A(d) and section 1.404A-4.

(ii) Erroneous deduction. The term "erroneous deduction" means an amount that is not deductible under section 404(a) (including section 404(a)(5)), that was deducted on a taxpayer's income tax return with respect to a foreign deferred compensation plan.

(4) Time and manner to make, perfect, or revoke election -- (i) In general. A plan-by-plan election described in paragraph (d)(1) of this section is not effective unless the election was actually made no later than the time prescribed by law for filing the United States return for the first taxable year ending on or after December 31, 1980, including extensions (whether or not the time was actually extended for filing the taxpayer's return), and unless the taxpayer perfects the election by filing a statement indicating the taxpayer's agreement to perfect the election with an amended return for the first taxable year ending on or after December 31, 1980, on or before [INSERT DATE THAT IS 365 DAYS AFTER THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER]. In order to be effective, the perfection must be made in the manner provided in section 1.404A- 6(b)(3)(ii) or (iii). An election that is not perfected is considered retroactively revoked. Any election under this paragraph (d) will continue in effect for taxable years beginning after the taxpayer's open period, unless revoked under paragraph (e) of this section or section 1.404A-6.

(ii) Requirement to amend returns. In addition to the amended return required by paragraph (d)(4)(i) of this section, the taxpayer must file any other amended United States returns that are necessary to conform the treatment of all items affected by the election or revocation to the treatment consistent with the election or revocation under this paragraph (d) within the time period described in paragraph (d)(4)(i) of this section. All amended returns must be accompanied by the statement described in paragraph (b)(3)(ii) of this section and all of the information required by section 1.404A- 6(b)(4) (and section 1.404A-6(c)(2)(ii), if applicable, in the case of a termination). If no adjustments are necessary, the amended return required by paragraph (d)(4)(i) of this section must contain a statement to that effect.

(5) Examples. The principles of this paragraph (d) are illustrated by the following examples:

Example 1. (i) During its open taxable years 1977 through

                         1977      1978      1979      Total

Amount deductible

Amount deductible

(ii) The assessment (including interest) for the open years 1977 through 1979 is based on adjustments to the erroneous deductions of FC240 (FC300 less FC60).

(iii) The amount of the prior deductions taken into account ratably over 15 years as provided in paragraph (d)(2) of this section, beginning in 1981, is a negative FC210 (FC60 less FC270).

(iv) No section 481(a) adjustment is required because X took no deductions with respect to the plan prior to the beginning of its open period.

Example 2. (i) Z, a domestic corporation, maintained a

                         1965      1978      Total

Amount deducted

Amount deductible

Amount deductible

(ii) Under paragraph (d)(1) of this section, Z agreed to an assessment of deficiencies for its 1978 taxable year based on its FC74 (FC80 - FC6) of erroneous deductions as defined in paragraph (d)(3)(ii) of this section.

(iii) The FC34 (FC40 - FC6) of prior deductions is permitted to be taken into account as a deduction over the 15- year period beginning with its 1980 taxable year as provided in paragraph (d)(2) of this section.

(iv) Additionally, because Z took erroneous deductions under its method of accounting prior to the beginning of its open period, it is required to change to the method of accounting permitted during the open period, and must take a section 481(a) adjustment (determined under the snapshot method of section 1.404A-6(f)) into account over the 15-year section 481(a) adjustment period of section 1.404A- 6(e)(2)(ii) beginning in its 1978 year of change. See paragraph (d)(1) of this section.

Example 3. A foreign branch which computes its income under

(e) Special transition rules for election, revocation and re- election -- (1) In general. This paragraph (e) provides the time and manner for making and revoking qualified funded plan and qualified reserve plan elections for a taxpayer's transition period. A taxpayer may make an election, revoke an election, and re-elect to treat any plan that met the requirements of section 1.404A-1(a) (other than paragraph (4) thereof) for the relevant period as a qualified funded plan or a qualified reserve plan under this paragraph (e) for the transition period without regard to whether a retroactive election is made under paragraph (b), (c), or (d) of this section. However, an election made under paragraph (c) or (d) of this section is deemed to continue in effect for taxable years beginning after December 31, 1979, unless revoked under paragraph (c)(4) of this section or this paragraph (e) or terminated or revoked under section 1.404A-6(f). See paragraphs (c)(2) and (d)(4)(i) of this section.

(2) Time and manner initially to elect and revoke -- (i) In general. Taxpayers that wish to make an election under this paragraph (e) may have, but were not required to have, made a Method (1) or Method (2) election for the taxable year for which an election is made under this paragraph. Those taxpayers that wish to make (or perfect) an election under this paragraph (e) must attach a statement to that effect on an amended return for the year the election is to be effective on or before [INSERT DATE THAT IS 365 DAYS AFTER THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER]. An election previously made that is not perfected is considered retroactively revoked.

(ii) Requirement to amend returns. In addition to the amended return required by paragraph (e)(2)(i) of this section, the taxpayer must file any other amended United States returns that are necessary to conform the treatment of all items affected by the election or revocation to the treatment consistent with the election or revocation under this paragraph (e) within the time period described in paragraph (e)(2)(i) of this section. All amended returns must be accompanied by the statement described in paragraph (b)(3)(ii) of this section (substituting "made, perfected, or revoked" for "perfected or revoked" where applicable) and all of the information required by section 1.404A-6(b)(4) (and section 1.404A-6(c)(2)(ii), if applicable, in the case of a termination). If no adjustments are necessary, the amended return required by paragraph (e)(2)(i) of this section must contain a statement to that effect.

(3) Revocation after initial election and re-election permitted. Any taxpayer that makes an initial election for any plan under paragraph (e)(2) of this section may, under the rules of that paragraph, revoke the election for any taxable year after the sixth consecutive taxable year for which the election is effective, and may re-elect for any taxable year after the sixth consecutive taxable year for which the election is not in effect (whether the election is not in effect due to either revocation or termination of the election as defined in section 1.404A-6(c)(1)). The consecutive changes in method of accounting described in the first sentence of this paragraph (e)(3) must be made under the rules in section 1.404A-6 regarding the section 481(a) adjustment period. The Commissioner may approve a letter ruling request to shorten the six-year waiting period upon a showing of extraordinary circumstances.

(4) Example. The principles of paragraph (e)(3) of this section are illustrated by the following example:

Example. (i) L, a domestic corporation, has wholly owned

Plan-by-plan election    Plan-by-plan election

1971 - 1974              1975 - 1981

(ii) A section 481(a) adjustment is required for the years of change 1975, 1982 and 1988.

(f) Special data rules for retroactive elections -- (1) Retroactive calculation of section 481(a) adjustments -- (i) General rule. Retroactive elections may be made only if the taxpayer calculates the section 481(a) adjustment required by section 1.404A-6 based on substantiation quality data. Substantiation quality data generally must be current as of the date of the change in method of accounting. Nevertheless, if contemporaneous substantiation quality data is not readily available, the taxpayer may calculate the section 481(a) adjustment based on backward projections to earlier years from the first taxable year beginning before January 1, 1980, for which sufficient contemporaneous substantiation quality data is readily available. However, such projections must satisfy the substantiation requirements in paragraph (f)(1)(ii) of this section, however. Furthermore, the taxpayer may not use any of the approaches provided for under this paragraph (f) if circumstances indicate that the overall result is a material distortion of the amounts allowable.

(ii) Substantiation requirement for retroactive reserves -- (A) In general. Although reasonable actuarial estimates and projections may be used, the calculation of the opening balance of the reserve for the first year for which a qualified reserve plan election under paragraph (c)(1) of this section is effective must nonetheless be based on some actual contemporaneous evidence. Thus, the opening balance may be based on actual aggregate covered payroll, the actual number of covered employees, or a contemporaneous actuarial valuation that used reasonable actuarial methods. For example, if the taxpayer has contemporaneous records of the number of covered employees and the aggregate covered payroll, it may estimate other actuarial information, such as average age and marital status, based on reasonable actuarial methods (e.g., using substantiation quality data as of another date and adjusting for actual or expected changes for the interim years). The resulting combination of actual contemporaneous evidence and reasonably estimated data may be used to calculate the opening reserve. If a contemporaneous actuarial valuation is used as the basis of an opening reserve, the results of the valuation must be adjusted to reflect any difference between the actuarial method used in that actuarial valuation and the unit credit method, as required by section 404A(c) and section 1.404A-3(b).

(B) Interpolation. In cases where an taxpayer can meet the substantiation requirement of paragraph (f)(1)(ii)(A) of this section for some years, but cannot meet that requirement in intervening years (including the year of the change in method of accounting), the taxpayer may interpolate a reserve balance for the intervening years based on reasonable actuarial methods. In the absence of evidence to the contrary, it is assumed that a pro rata allocation of amounts to those intervening years is a reasonable actuarial method. This paragraph (f)(1)(ii)(B) does not authorize any interpolation for years in which other evidence indicates that it would cause a material distortion (such as a year during which the work force was on strike and no deferred compensation benefits were accrued). In addition, this paragraph (f)(1)(ii)(B) does not authorize extrapolation of reserve balances to years that are not intervening years between years that meet the substantiation requirements of paragraph (f)(1)(ii)(A) of this section.

(C) Extrapolation. If the first year for which the taxpayer is able to meet the substantiation requirements of paragraph (f)(1)(ii)(A) of this section ("the substantiation year") is later than the year of the change in method of accounting, an taxpayer may use the approach described in this paragraph (f)(1)(ii)(C) to determine the section 481(a) adjustments described in section 1.404A- 6(f) in years prior to the substantiation year. Under this approach, the taxpayer's closing balance under its prior method as of the date of the change in the method of accounting is compared with the opening balance in the substantiation year. If the closing balance exceeds the opening balance, the excess is the amount to be used in calculating the adjustment under section 481, as required by section 1.404A-6. However, if the closing balance of the taxpayer's reserve under its method used for years prior to the election under section 404A is less than the opening balance for the substantiation year, the opening balance as of the date of the change in method in accounting is assumed to be equal to the closing balance. Thus, if the closing balance is less than the opening balance for the substantiation year, there is no adjustment under section 481. In such a case, the difference between the opening balance as of the date of the change in method of accounting and the opening balance for the substantiation year is allocated to the years prior to the substantiation year based on reasonable actuarial methods using all available information.

(2) Determination of reasonable addition to a reserve in interim years. In the case of a qualified reserve plan that is using the interpolation option of paragraph (f)(1)(ii)(B) of this section or that is described in the last sentence in paragraph (f)(1)(ii)(C) of this section, none of the increase in the reserve in the intervening year is considered a reasonable addition to the reserve under section 1.404A-3(b). Thus, the entire amount of the increase must be considered an amount to be amortized over ten years under section 1.404A-3(c).

(3) Protective elections. For those taxpayers that relied on the prior position of the Internal Revenue Service by making a Method (1) election under which the section 481(a) adjustment was computed in a manner inconsistent with this section or by making a Method (2) election under which no section 481(a) adjustment was reflected in the original return, appropriate adjustments required by section 404A and its underlying regulations must be made on an amended return filed no later than [INSERT DATE THAT IS 365 DAYS AFTER THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER] for the first year the election is effective and for all subsequent affected years for which a return has been filed. If no adjustments are necessary, an amended return should be filed for the first year stating that no adjustments are necessary.

(g) Definitions and special rules -- (1) Method (1) election. The term "Method (1) election" means an election that was made under Method (1) (as defined in Ann. 81-114, 1981-28 I.R.B. 21) (see section 601.601(d)(2)(ii)(b) of this chapter) by claiming the deduction or credit allowable under section 404A on the taxpayer's income tax return for the first taxable year ending on or after December 31, 1980, including extensions (or an amended return filed no later than the end of the extended time period prescribed in section 6081, whether or not such time was actually extended for filing the taxpayer's return).

(2) Protective or Method (2) election. The term "protective election" or "Method (2) election" means an election that was made under Method (2) (as defined in Ann. 81-114, 1981- 28 I.R.B. 21) (see section 601.601(d)(2)(ii)(b) of this chapter) without claiming deductions attributable to a qualified foreign plan on the taxpayer's income tax return (or, in the case of foreign subsidiaries, without taking into account reductions of earnings and profits).

(3) Open years of the taxpayer. The term "open years of the taxpayer" means open taxable years beginning after December 31, 1971, and for which, on December 31, 1980, the making of a refund, or the assessment of a deficiency, was not barred by any law or rule of law.

(4) Retroactive period. The term "retroactive period" means a taxpayer's taxable years (whether or not the making of a refund, or the assessment of a deficiency, was barred by any law or rule of law for any taxable year) in the following range --

(i) Any taxable year selected by the taxpayer between taxable years beginning after December 31, 1970 and before January 1, 1980 (the beginning taxable year); and

(ii) The last taxable year beginning before January 1, 1980 (the ending taxable year).

(5) Transition period. The term "transition period" means taxable years beginning after December 31, 1979, and before [INSERT THE DATE OF PUBLICATION OF FINAL REGULATIONS IN THE FEDERAL REGISTER].

(6) Open period. For purposes of this section, the term "open period" means, with respect to any taxpayer, all taxable years beginning after December 31, 1971, and beginning before January 1, 1980, and for which, on December 31, 1980, the making of a refund, or the assessment of a deficiency, was not barred by any law or rule of law.

Michael P. Dolan