Allocation of Income Attributable to Notional Principal Contracts -- Final Regulations Under Section 863

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations which set forth the source of income attributable to certain notional principal contracts (notional principal contract income). These final regulations are necessary to provide guidance to foreign and domestic corporations and individuals.

 DATES: These regulations are effective for notional principal contract income includible in income on or after February 13, 1991. Section 1.863-7(b)(2)(iv) may be applied to notional principal contract income includible in income prior to February 13, 1991. An election is provided to apply the rules of section 1.863-7 to notional principal contract income includible in income before December 24, 1986.

 FOR FURTHER INFORMATION CONTACT: Charles T. Plambeck of the Office of Associate Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (Attention: CC:CORP:T:R) (202-566-6284, not a toll-free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-0132. The estimated average annual burden per respondent is 3 minutes. This time estimate is included in the burden of Form 1120X.

 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.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, D.C. 20224, and 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.

BACKGROUND

 On August 1, 1989, the Federal Register published proposed amendments (54 FR 31703) to the Income Tax Regulations (26 CFR Part 1) under section 863 of the Internal Revenue Code. No written comments from the Small Business Administration or the public responding to the proposed amendments were received. No public hearing was requested or held. Accordingly, the proposed amendments are adopted as modified by this Treasury Decision.

EXPLANATION OF PROVISIONS

 In response to oral comments, section 1.863-7(a)(1) is amended to include commodity swaps and to clarify the interrelationship of these regulations with the source rules of section 988. Section 1.863-7(a)(1) provides that if the notional principal contract is a section 988 transaction, section 1.863-7 does not apply. In such a case, a cross-reference to the source rules of section 1.988-4T is provided. A "properly reflected on the books" standard is added to the qualified business unit exception of section 1.863-7(b)(2)(iv). This is intended to assure that substantially uniform source rules will apply to income from notional principal contracts in functional and nonfunctional currencies.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) and the Regulatory Flexibility Act (5 U.S.C. Chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805 (f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted without response to the Administrator of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Charles Thelen Plambeck, of the Office of Associate Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and the Treasury Department participated in developing the regulations.

LIST OF SUBJECTS

 26 CFR sections 1.861-1 - 1.997-1

 Income taxes, Aliens, Exports, DISC, Foreign investments in U.S., Foreign tax credit, FSC, Sources of income, U.S. investments abroad.

 26 CFR Part 602

 Reporting and Recordkeeping Requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Parts 1 and 602 are amended to read as follows:

PART 1 -- [AMENDED]

Paragraph 1. The authority for Part 1 is amended in part by removing the citation "Section 1.863-7T is issued under 26 U.S.C. 863(a)" and by adding the following citation:

Authority: 26 U.S.C. 7805 * * * Section 1.863-7 is issued under 26 U.S.C. 863(a).

Par. 2. Section 1.863-7T is removed.

Par. 3. New section 1.863-7 is added in the appropriate place to read as follows:

SECTION 1.863-7 ALLOCATION OF INCOME ATTRIBUTABLE TO CERTAIN NOTIONAL PRINCIPAL CONTRACTS UNDER SECTION 863(a).

(a) SCOPE -- (1) INTRODUCTION. This section provides rules relating to the source and, in certain cases, the character of notional principal contract income. However, this section does not apply to income from a section 988 transaction within the meaning of section 988 and the regulations thereunder, relating to the treatment of certain nonfunctional currency transactions. Notional principal contract income is income attributable to a notional principal contract. A notional principal contract is a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. An agreement between a taxpayer and a qualified business unit (as defined in section 989(a)) of the taxpayer, or among qualified business units of the same taxpayer, is not a notional principal contract, because a taxpayer cannot enter into a contract with itself.

(2) EFFECTIVE DATE. This section applies to notional principal contract income includible in income on or after February 13, 1991. However, any taxpayer desiring to apply paragraph (b)(2)(iv) of this section to notional principal contract income includible in income prior to February 13, 1991 in lieu of temporary Income Tax Regulations section 1.863-7T(b)(2)(iv) may (on a consistent basis) so choose. See paragraph (c) of this section for an election to apply the rules of this section to notional principal contract income includible in income before December 24, 1986.

(b) SOURCE OF NOTIONAL PRINCIPAL CONTRACT INCOME -- (1) GENERAL RULE. Unless paragraph (b)(2) or (3) of this section applies, the source of notional principal contract income shall be determined by reference to the residence of the taxpayer as determined under section 988(a)(3)(B)(i).

(2) QUALIFIED BUSINESS UNIT EXCEPTION. The source of notional principal contract income shall be determined by reference to the residence of a qualified business unit of a taxpayer if --

(i) The taxpayer's residence, determined under section 988(a)(3)(B)(i), is the United States;

(ii) The qualified business unit's residence, determined under section 988(a)(3)(B)(ii), is outside the United States;

(iii) The qualified business unit is engaged in the conduct of a trade or business where it is a resident as determined under section 988(a)(3)(B)(ii); and

(iv) The notional principal contract is properly reflected on the books of the qualified business unit. Whether a notional principal contract is properly reflected on the books of such qualified business unit is a question of fact. The degree of participation in the negotiation and acquisition of a notional principal contract shall be considered in this determination. Participation in connection with the negotiation or acquisition of a notional principal contract may be disregarded if the district director determines that a purpose for such participation was to affect the source of notional principal contract income.

(3) EFFECTIVELY CONNECTED NOTIONAL PRINCIPAL CONTRACT INCOME. Notional principal contract income that under principles similar to those set forth in section 1.864-4(c) arises from the conduct of a United States trade or business shall be sources in the United States and such income shall be treated as effectively connected to the conduct of a United States trade or business for purposes of sections 871(b) and 882(a)(1).

(c) ELECTION -- (1) ELIGIBILITY AND EFFECT. A taxpayer described in paragraph (b)(2)(i) of this section may make an election to apply the rules of this section to all, but not part, of the taxpayer's income attributable to notional principal contracts for all taxable years (or portion thereof) beginning before December 24, 1986, for which the period of limitations for filing a claim for refund under section 6511(a) has not expired. A taxpayer not described in paragraph (b)(2)(i) of this section that is engaged in trade or business within the United States may make an election to apply the rules of this section to all, but not part, of the taxpayer's income described in paragraph (b)(3) of this section for all taxable years (or portion thereof) beginning before December 24, 1986, for which the period of limitations for filing a claim for refund under section 6511(a) has not expired. If a taxpayer makes an election pursuant to this paragraph (c)(1) in the time and manner provided in paragraph (c)(2) and (3) of this section, then, with respect to such taxable years (or portion thereof), no tax shall be deducted or withheld under sections 1441 and 1442 with respect to payments made by the taxpayer pursuant to a notional principal contract the income attributable to which is subject to such election. The election may be revoked only with the consent of the Commissioner.

(2) TIME FOR MAKING ELECTION. The election specified in paragraph (c)(1) of this section shall be made by May 15, 1991.

(3) MANNER OF MAKING ELECTION. The election described in paragraph (c)(1) of this section shall be made by attaching a statement to the tax return or an amended tax return for each taxable year beginning before December 24, 1986, in which the taxpayer accrued or received notional principal contract income. The statement shall --

(i) Contain the name, address, and taxpayer identifying number of the electing taxpayer;

(ii) Identify the election as a "Notional Principal Contract Election under section 1.863-7"; and

(iii) Specify each taxable year described in paragraph (c)(1) of this section in which payments were made.

(d) EXAMPLE. The operation of this section is illustrated by the following example:

(1) On January 1, 1990, X, a calendar year domestic corporation, entered into an interest rate swap contract with FZ, an unrelated foreign corporation. X does not have a qualified business unit outside the United States. Under the contract, X is required to pay FZ fixed rate dollar amounts, and FZ is required to pay X floating rate dollar amounts, each determined solely by reference to a notional dollar denominated principal amount specified under the contract. The contract is a notional principal contract under section 1.863-7(a) because the contract provides for the payment of amounts at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for a promise to pay similar amounts.

(2) Assume that during 1990 X had notional principal contract income of $100 in connection with the notional principal contract described in (1) above. Also assume that the contract provides that payments more than 30 days late give rise to a $5 fee, and that X receives such a fee in 1990. Under paragraph (b)(1) of this section, the source of X's $100 of income attributable to the swap agreement is domestic. The $5 fee is not notional principal contract income.

(e) CROSS REFERENCES. See section 1.861-9T(b) for the allocation of expense to certain notional principal contracts. For rules relating to the source of income from nonfunctional currency notional principal contracts, see section 1.988-4T. For rules relating to the taxable amount of notional principal contract income allocable under this section to sources inside or outside the United States, see section 1.863-1(c).

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

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

Authority: 26 U.S.C. 7805.

Par. 5. Section 602.101(c) is amended by adding in the appropriate place in the table the entry "section 1.863-7 . . . 1545-0132" and by removing the entry "section 1.863-7T . . . 1545-0132."

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