Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules 397

under the criteria of the Regulatory

Flexibility Act.

List of Subjects in 14 CFR Part 71

Airspace, Incorporation by reference,

Navigation (Air).

The Proposed Amendment

In consideration of the foregoing, the

Federal Aviation Administration

proposes to amend 14 CFR part 71 as

follows:

PART 71—[AMENDED]

1. The authority citation for 14 CFR

part 71 continues to read as follows:

Authority: 49 U.S.C. app. 1348(a), 1354(a),

1510; E.O. 10854, 24 FR 9565, 3 CFR, 1959–

1963 Comp., p. 389; 49 U.S.C. 106(g): 14 CFR

11.69.

§ 71.1 [Amended]

2. The incorporation by reference in

14 CFR 71.1 of the Federal Aviation

Administration Order 7400.9B, Airspace

Designations and Reporting Points,

dated July 18, 1994 and effective

September 16, 1994, is amended as

follows:

Paragraph 6005 Class E airspace areas

extending upward from 700 feet above the

surface of the earth.

* * * * *

ASO GA E5 Hampton, GA [New]

Clayton County—Tara Field Airport, GA

(Lat. 33°23′21′′ N, long. 84°19′55′′ W)

That airspace extending upward from 700

feet above the surface within a 6.8-mile

radius of Clayton County—Tara Field

Airport; excluding that airspace within the

Atlanta, GA, Peachtree City, GA, and Griffin,

GA, Class E airspace areas.

* * * * *

Issued in College Park, Georgia, on

December 16, 1994.

Walter E. Denley,

Acting Manager, Air Traffic Division,

Southern Region.

[FR Doc. 95–00077 Filed 1–3–95; 8:45 am]

BILLING CODE 4910–13–M

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI–42–94]

RIN 1545–AS85

Mark to Market for Dealers in

Securities

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations relating to the

mark-to-market method of accounting

for securities that is required to be used

by a dealer in securities. The proposed

regulations address the relationship

between mark-to-market accounting and

the accrual of stated interest and

discount and the amortization of

premium and between mark-to-market

accounting and the tax treatment of bad

debts. They also provide rules relating

to certain dispositions and acquisitions

of securities required to be marked to

market, the exemption from mark-tomarket treatment of securities in certain

securitization transactions, and the

identification requirements for

obtaining exemption from mark-tomarket treatment. Finally, these

proposed regulations provide guidance

relating to the exclusion of REMIC

residual interests from the definition of

security and to the relationship between

the mark-to-market provisions and the

integrated transaction rules in the

proposed regulations on debt

instruments with contingent payments.

This document also provides notice of

a public hearing on these proposed

regulations.

DATES: Written comments must be

received by April 4, 1995. Outlines of

oral comments to be presented at a

public hearing scheduled for May 3,

1995, at 10 a.m. must be received by

April 4, 1995.

ADDRESSES: Send submissions to:

CC:DOM:CORP:T:R (FI–42–94), room

5228, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044. In the alternative,

submissions may be hand delivered

between the hours of 8 a.m. and 5 p.m.

to: CC:DOM:CORP:T:R (FI–42–94),

Courier’s Desk, Internal Revenue

Service, 1111 Constitution Avenue NW,

Washington, DC.

The public hearing will be held in the

Internal Revenue Auditorium, 7400

Corridor, Internal Revenue Building,

1111 Constitution Ave., NW,

Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT:

Concerning § 1.475(c)–2(a)(4), Carol A.

Schwartz, (202) 622–3920; concerning

other sections of the regulations, Robert

B. Williams, (202) 622–3960, or JoLynn

Ricks, (202) 622–3920; concerning

submissions and the hearing, Michael

Slaughter, (202) 622–7190 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information

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 (44 U.S.C.

3504(h)). Comments on the collection of

information should be sent to the Office

of Management and Budget, Attn: Desk

Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503, with copies to the Internal

Revenue Service, Attn: IRS Reports

Clearance Officer, PC:FP, Washington,

DC 20224.

The collection of information is in

§ 1.475(b)–4. The information required

to be recorded under § 1.475(b)–4 is

required by the IRS to determine

whether exemption from mark-tomarket treatment is properly claimed.

This information will be used to make

that determination upon audit of

taxpayers’ books and records. The likely

recordkeepers are businesses or other

for-profit institutions.

Estimated total annual recordkeeping

burden: 2,500 hours.

The estimated annual burden per

recordkeeper varies from 15 minutes to

3 hours, depending on individual

circumstances, with an estimated

average of 1 hour.

Estimated number of recordkeepers:

2,500.

Background

Section 475 of the Internal Revenue

Code requires mark-to-market

accounting for dealers in securities,

broadly defined. Section 475 was added

by section 13223 of the Revenue

Reconciliation Act of 1993 (Pub. L. 103–

66, 107 Stat. 481), and is effective for all

taxable years ending on or after

December 31, 1993.

On December 29, 1993, temporary

regulations (T.D. 8505, 58 FR 68747)

and cross-reference proposed

regulations (FI–72–93, 58 FR 68798)

were published to furnish guidance on

several issues, including the scope of

exemptions from the mark-to-market

requirements, certain transitional issues

relating to the scope of exemptions, and

the meaning of the statutory terms

‘‘dealer in securities’’ and ‘‘held for

investment.’’ This notice contains

proposed regulations that supplement,

and in a few cases revise, the proposed

regulations that were published last

December.

Explanation of Provisions

Stated Interest, Discount, and Premium

The proposed regulations contained

in this notice provide rules for taking

into account interest (including original

issue discount (OID) and market

discount), premium, and certain gains
398 Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules

and losses on securities that are debt

instruments. In general, immediately

before a debt instrument is marked to

market, Code provisions related to

calculating interest must be applied,

and basis must be correspondingly

adjusted. The mark-to-market

computations do not affect either the

amount treated as interest earned from

a debt instrument or the taxable years in

which that interest is taken into

account.

For example, immediately before a

debt instrument is marked to market,

accruals of unpaid qualified stated

interest (QSI) must be taken into

account, and basis must be

correspondingly increased. This is true

regardless of the taxpayer’s regular

method of accounting. Marking a debt

instrument to market under section

475(a) precludes the deferral that a cashbasis taxpayer might have experienced

in the absence of the statutory

provision, and the current accrual under

the proposed regulations is needed in

order to preserve the interest character

of the QSI.

For debt instruments acquired with

original issue discount or market

discount, the proposed regulations

require that, immediately before the

mark-to-market gain or loss is computed

under section 475(a), any OID or market

discount accrued through the date of

computation must be taken into

account, and basis must be

correspondingly increased. The amount

of discount attributable to a particular

period of time is computed under

sections 1272 through 1275 (in the case

of OID) and sections 1276 through 1278

(in the case of market discount). Thus,

for example, the computation of OID

attributable to a particular period takes

into account any reduction for

acquisition premium under section

1272(a)(7).

As indicated in the preceding

paragraph, the proposed regulations

provide that, in the case of a market

discount bond to which section 475(a)

applies, the holder must take market

discount into account as it accrues,

regardless of whether the holder elected

under section 1278(b) to do so for all of

its bonds. This rule is necessary to

prevent market discount from producing

gain on the mark instead of interest

income. This provision, however, does

not impose a section 1278(b) election on

the taxpayer, because it does not apply

to bonds that are not marked to market

under section 475.

For taxable debt instruments acquired

with amortizable bond premium, the

proposed regulations provide that, if a

dealer has made an election to amortize

premium under section 171, any

amortization for the taxable year (or for

the portion of the taxable year during

which the instrument is held by the

dealer) must be taken into account (and

basis must be appropriately reduced)

before the mark-to-market gain or loss is

computed under section 475. Because

section 171 applies only to instruments

not held primarily for sale to customers

in the ordinary course of the taxpayer’s

trade or business, this proposed

regulatory provision is applicable only

to premium instruments described in

section 475(b)(1) for which the taxpayer

has not made the identification

described in section 475(b)(2).

In the case of tax-exempt bonds, the

proposed regulations require basis to be

reduced as required by section

1016(a)(5) or (6) before mark-to-market

gain or loss is computed.

If a dealer acquires a bond with

premium and a section 171 election first

applies to the bond in a taxable year

after the year of acquisition, the

proposed regulations require the dealer

to amortize premium based on the

original basis, without regard to any

mark-to-market adjustments that may

have been taken into account before the

section 171 election became effective,

but with regard to the adjustments

required under section 171(b)(1). Thus,

for example, if a dealer acquires in year

1 an instrument that is subject to section

475(a) and that has $10 of amortizable

premium and if the dealer makes an

election to amortize premium that is

first effective in year 4 (when

unamortized premium attributable to

years 1 through 3 is $4), the dealer takes

into account the appropriate portion of

the remaining $6 of amortizable bond

premium (as required under section

171(b)(3)) each taxable year before

computing the mark-to-market

adjustment on the instrument. Any

mark-to-market basis adjustments in

taxable years 1 through 3 are ignored in

determining the amount of amortizable

bond premium to which the election

applies.

Under section 475(a)(2), a dealer in

securities recognizes mark-to-market

gain or loss on a security, other than

inventory, as if the security were sold

on the last business day of the taxable

year. Although there may be

circumstances under which marking a

security to market produces results

similar to the actual sale of the security,

the statutory reference to the deemed

sale prescribes the amount of gain or

loss to be taken into account and does

not trigger all of the consequences of a

sale and reacquisition under the Code.

For example, when a dealer in securities

marks a bond (or other security) to

market and takes recognized gain or loss

into account, the dealer has not actually

sold and reacquired the bond. Thus,

under the proposed regulations,

marking a debt instrument does not

create, increase, or reduce market

discount, acquisition premium, or bond

premium.

The proposed regulations also contain

a special rule to provide the proper

character for mark-to-market gains or

losses on a market discount instrument

that was originally identified as held for

investment by the dealer. This rule is

necessary to ensure that all market

discount is ultimately characterized as

interest income and not as gain from the

sale of a security.

Worthless Debts

The proposed regulations provide

rules for marking a partially or wholly

worthless debt to market. These rules

coordinate the mark-to-market rules

with the bad debt rules under the Code.

The amount of gain or loss recognized

under section 475(a)(2) when a debt

instrument is marked to market

generally is the difference between the

adjusted basis and the fair market value

of the debt. Under the proposed

regulations, if a debt becomes partially

or wholly worthless during a taxable

year, the amount of any gain or loss

required to be taken into account under

section 475(a) is determined using a

basis that reflects the worthlessness.

The basis of the mark-to-market debt is

treated as having been reduced by the

amount of any book or regulatory

charge-off (including the establishment

of a specific allowance for a loan loss)

for which a deduction could have been

taken, without regard to whether any

portion of the charge-off is, in fact,

deducted or charged to a tax reserve for

bad debts. The difference between this

adjusted basis and the fair market value

of the debt is the amount of gain or loss

to be taken into account under section

475(a)(2). Thus, if the debt is wholly

worthless, its basis would be reduced to

zero and no gain or loss would be taken

into account under section 475(a)(2).

This proposed treatment preserves the

longstanding distinctions between

losses due to the worthlessness of debts

and other losses on debt instruments

held by a taxpayer. See § 1.166–1(a),

which requires bad debts to be taken

into account either as a specific

deduction in respect of debts or as a

deduction for a reasonable addition to a

reserve for bad debts. See also §§ 1.585–

3 and 1.593–7(c), which require a

reserve-method taxpayer to charge bad

debts to the reserve for bad debts. In

addition, computing the mark-to-market

adjustment as if the debt’s basis had

been adjusted to reflect worthlessness
Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules 399

preserves a taxpayer’s ability to

postpone claiming a deduction for

partial worthlessness until the debt

becomes wholly worthless. To the

extent that a debt has been previously

charged off, mark-to-market gain is

treated as a recovery.

The rules that are provided for bad

debts in the proposed regulations do not

apply to debts accounted for by a dealer

as inventory under section 475(a)(1).

Although it is possible for a debt that is

in inventory to become partially

worthless prior to sale, the likelihood or

frequency of such an occurrence is

difficult to ascertain given the speed

with which inventory is sold.

Comments are requested, however,

concerning whether similar rules are

necessary for partially worthless debt

that is accounted for as inventory of the

dealer.

Dispositions

Section 475(a) states that regulations

may provide for securities held by a

dealer to be marked to market at times

other than the end of the dealer’s

taxable year. In general, the proposed

regulations provide that, if a dealer in

securities ceases to be the owner of a

security for tax purposes, and if the

security would have been marked to

market under section 475(a) if the

dealer’s taxable year had ended

immediately before the dealer ceases to

own it, then (whether or not the security

is inventory in the hands of the dealer)

the dealer must recognize gain or loss as

if the security had been sold for its fair

market value immediately before the

dealer ceases to own it. Any gain or loss

so recognized is taken into account at

that time.

In the absence of a mark upon

disposition, a gain on a security held by

a dealer could be deferred by

transferring the security before the end

of the taxable year to a related nondealer in an intercompany transaction

or in a non-recognition, carry-over-basis

transaction. This potential for abuse is

avoided if marking to market is required

in every case in which a dealer ceases

to be the owner of a security for tax

purposes. The proposed requirement is

analogous to the requirement that

applies to dispositions of securities that

are required to be marked to market

under section 1256.

Transfers to which the proposed rule

applies include the following: (a)

Transfers to a controlled corporation

under section 351; (b) Transfers to a

trust (other than a grantor trust); (c)

Transfers by gift to a charitable or noncharitable donee; (d) Transfers to other

members of the same controlled group;

(e) Transfers to a partnership under

section 721; and (f) Transfers of

mortgages to a REMIC under section

860F(b).

In the case of a transfer by a dealer to

a partnership, the basis of a security

transferred is generally its fair market

value, because the security is marked to

market immediately before the transfer.

Thus, no special allocation issues arise.

If there is any difference between a

transferred security’s basis after the

mark and its fair market value (because,

for example, the security transferred had

been properly identified as held for

investment but ceased to be so held at

some time prior to the date of transfer),

any special allocation of built-in gain or

loss with respect to that security in the

hands of the partnership will be made

under section 704 and the regulations

thereunder.

The mark to market immediately

before disposition is separate and

distinct from the disposition

transaction. Thus, for example, the gain

or loss from the mark is not gain or loss

from a deferred intercompany

transaction under § 1.1502–13.

Securities Acquired With Substituted

Basis

The proposed regulations provide

rules for situations where a dealer in

securities receives a security with a

basis in its hands that is determined, in

whole or in part, either by reference to

the basis of the security in the hands of

the transferor or by reference to other

property held at any time by the dealer.

In these cases, section 475(a) applies

only to post-acquisition gain and loss

with respect to the security. That is,

section 475(a) applies only to changes in

value of the security occurring after its

acquisition. See section 475(b)(3). The

character of the mark-to-market gain or

loss is determined as provided under

section 475(d)(3). The character of preacquisition gain or loss (that is, the

built-in gain or loss at the date the

dealer acquires the security) and the

time for taking that gain or loss into

account are determined without regard

to section 475. The fact that a security

has a substituted basis in the dealer’s

hands does not affect the security’s date

of acquisition for purposes of

determining the timeliness of an

identification under section 475(b).

The proposed regulations provide

rules for the identification of securities

contributed and received in

securitization transactions. Under the

proposed regulations, a taxpayer that

expects to contribute securities to a trust

or other entity in exchange for interests

therein may identify the contributed

securities as held for investment (within

the meaning of section 475(b)(1)(A)) or

not held for sale (within the meaning of

section 475(b)(1)(B)) only if it expects

each of the interests received (whether

or not a security within the meaning of

section 475(c)(2)) to be either held for

investment or not held for sale to

customers in the ordinary course of the

taxpayer’s business. Thus, for example,

if a mortgage banker securitizes its loans

and does not intend to hold for

investment (or for other than sale to

customers) all of the interests received

in the securitization transaction, the

mortgage banker will be required to

account for its inventory of mortgages at

fair market value under section

475(a)(1), regardless of whether the

mortgages are to be sold to a trust or

contributed to a REMIC.

Under the proposed regulations, if a

dealer engages in a securitization

transaction that results in dispositions

of only partial interests in the

contributed securities, the dealer is not

permitted to identify the contributed

securities as exempt under section

475(b)(1)(A) or (B). As a result, all of the

contributed securities must be

accounted for under section 475(a).

Moreover, under the mark-ondisposition rule of these proposed

regulations, the dealer is required to

mark the securities to market

immediately before the securitization

transaction. The Service invites

comments on whether there are other

administrable approaches that reflect

the fact that only a partial disposition of

the securities has occurred.

In other securitization transactions, a

taxpayer transfers securities to a trust

(or other entity) in a transaction that is

not a disposition of the securities for tax

purposes. The trust issues certificates

(or other forms of interest) that represent

secured debt of the taxpayer rather than

debt of the trust or ownership of the

underlying securities. In these cases, if

the taxpayer retains the full ownership

of the contributed securities for tax

purposes and if the contributed

securities otherwise qualify to be

identified as held for investment or not

held for sale, then the taxpayer may

identify the securities as held for

investment or not held for sale

notwithstanding the transfer.

Further, if a transfer of securities is a

disposition, a taxpayer may identify the

interests received in a securitization

transaction as exempt from mark-tomarket if the interests are described in

section 475(b)(1) and are not treated for

tax purposes as continuing ownership of

the securities transferred. This

identification is permitted even if the

securitized assets were marked to

market under section 475. For example,

a taxpayer may identify some of the
400 Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules

REMIC regular interests received on the

transfer of mortgage securities to a

REMIC, even if the mortgages were

subject to section 475(a). Conversely, a

taxpayer that has marked mortgages to

market but subsequently contributes

those mortgages to a grantor trust and

receives beneficial interests therein may

not identify the beneficial interests as

exempt from mark-to-market treatment,

because the beneficial interests

represent continued ownership of the

contributed securities, whose eligibility

for exemption was determined when

they were acquired.

The proposed regulations clarify that

an identification of a security as exempt

must specify the subparagraph of

section 475(b)(1) under which the

exemption is claimed and that the time

by which a dealer must identify a

security as exempt is not affected by

whether the dealer has a substituted

basis in the security. The proposed

regulations also provide rules for

determining whether an identification

of a security as exempt is timely where

a dealer engages in certain integrated

transactions described in § 1.1275–6 as

proposed on December 16, 1994 (FI–59–

91, 59 FR 64884, 64905).

Definition of Dealer in Securities

Section 475(c)(1) defines a dealer in

securities as a taxpayer who regularly

purchases securities from, or sells

securities to, customers in the ordinary

course of a trade or business or who

regularly offers to enter into, assume,

offset, assign or otherwise terminate

positions in securities with customers in

the ordinary course of a trade or

business.

The proposed regulations provide that

whether a taxpayer is transacting

business with customers is determined

based on all of the facts and

circumstances.

Under section 475(c)(1)(B) and the

proposed regulations, the term dealer in

securities includes a taxpayer that, in

the ordinary course of its trade or

business, regularly holds itself out as

being willing and able to enter into

either side of a transaction enumerated

in section 475(c)(1)(B). For instance, if

a taxpayer regularly holds itself out as

being willing to enter a swap in which

it is either the fixed or the floating

payor, the taxpayer is a swaps dealer.

The proposed regulations clarify that

a life insurance company does not

become a dealer in securities solely by

selling annuity, endowment, or life

insurance policies to its customers.

Under the temporary regulations

published on December 29, 1993 (T.D.

8505), a contract that is treated for

federal income tax purposes as an

annuity, endowment, or life insurance

contract is deemed to have been

identified as held for investment, and is

therefore not marked to market by the

policy holder. This was necessary

because variable life and annuity

products fall within the literal language

of section 475(c)(2)(E). Because many

life insurance companies sell these

insurance contracts to their customers,

some commentators asked whether

these life insurance companies were

dealers in securities. There is no

indication that Congress intended for a

life insurance company that was not

otherwise a dealer in securities to be

characterized as a dealer merely because

it sells life insurance policies to its

customers. These proposed regulations

provide the appropriate clarification.

Definition of Security

The temporary regulations that were

published on December 29, 1993 (T.D.

8505), exclude certain items from the

definition of security. Among the

excluded items are liabilities of the

taxpayer and negative value residual

interests (NVRIs) in a REMIC and other

arrangements that are determined to

have substantially the same economic

effect as NVRIs (for example, a widely

held partnership that holds

noneconomic REMIC residual interests).

Those rules are needed to carry out the

purposes of section 475 and other Code

provisions, including section 860E.

These proposed regulations clarify

that a liability of the taxpayer means a

debt issued by the taxpayer. Also, for

the reasons given below, these proposed

regulations exclude all REMIC residual

interests from the definition of security.

A typical REMIC holds a pool of longterm, real estate mortgages originated at

a ‘‘blended’’ interest rate. These

mortgages are used to support the

issuance of regular interests, which are

treated as debt, with varied maturities

and interest rates. The REMIC takes cash

flows on the mortgages and redirects

them to holders of the regular interests.

As a result, there is generally a

mismatch in the recognition of interest

income from the mortgages and the

interest expense attributable to the

regular interests. This mismatch of

interest income and interest deductions

results in taxable income or loss that

does not represent economic gain or

loss. Some commentators refer to this as

‘‘phantom’’ income or loss.

Phantom income or loss is allocated

to the holders of the residual interests

in a REMIC even though that income or

loss does not represent any economic

benefit or detriment to those holders.

Further, sections 860C and 860E require

a residual interest holder to pay taxes on

a portion of phantom income (called

‘‘excess inclusion’’) and to increase the

basis of the residual interest by the

amount of phantom income. Because

this basis increase does not represent

economic value, a subsequent mark to

market is likely to result in a loss.

Permitting taxpayers to take this loss

into account currently under the markto-market provisions effectively

undermines the Congressional mandate

embodied in section 860E to require

current taxation of phantom income.

Although the adverse effect of section

475 on section 860E is most apparent

when the residual interests being

considered are NVRIs, residual interests

with positive value present the same

issue. Many residual interests with

positive value, in spite of being entitled

to REMIC distributions, have

substantially the same economic effect

as NVRIs and thus are already excluded

by the temporary regulations from the

definition of ‘‘security.’’ The IRS is

concerned, however, that residual

interests may be structured in a way that

avoids embodying substantially the

same economic effects as an NVRI but

that still undermines the purposes of

section 860E. The proposed regulations,

therefore, contain a rule that would

remove from the category of securities

subject to section 475 all residual

interests that are acquired after January

4, 1995. Also removed are arrangements

that are acquired after that date and are

determined to have substantially the

same economic effect as a REMIC

residual interest (for instance, an

interest in a widely held partnership

holding residual interests). The

temporary regulations continue to apply

to all residual interests described

therein for all taxable years ending on

or after December 31, 1993.

In addition, the Commissioner has

determined that, if a residual interest, or

an interest or arrangement that has

substantially the same economic effect,

is not a security within the meaning of

section 475, it should not be treated as

inventory under other provisions.

Additional guidance on this matter will

be issued.

Comments are requested concerning

whether there are any residual interests

that do not undermine section 860E

upon being marked to market. If

comments are received that describe any

such interests, subsequent guidance

may provide that they are included in

the mark-to-market regime. In this

regard, it is important that any

mechanism for identifying these

interests not impose an undue burden

on either taxpayers or the IRS.
Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules 401

Additional Comments Requested

The provisions of section 475

generally apply in determining the

taxable income of a dealer that may also

be subject to various international

provisions of the Code. The Service is

considering the possibility of using the

definitions contained in section 475 and

the regulations thereunder for purposes

of various international provisions,

except where a modification of the

provisions is necessary to carry out the

purposes of those international

provisions. Comments on this issue also

are welcome.

Finally, the Service is considering

whether there are additional situations

in which securities should not be

accounted for under section 475(a). (The

temporary and proposed regulations

that were published on December 29,

1993, listed some such situations.) For

example, a dealer in securities may

acquire at original issue and in

exchange for property certain noninterest-bearing debt instruments that

are not subject to the interest imputation

provisions of section 1274 or 483.

Because these instruments will seldom

appreciate in value, it may be

inappropriate to subject them to the

mark-to-market regime.

Dates of Applicability

The proposed regulations will apply

to identifications made, securities

acquired, or events occurring, on or after

January 4, 1995, or to taxable years

beginning on or after January 1, 1995, as

appropriate.

Special Analyses

It has been determined that this notice

of proposed rulemaking is not a

significant regulatory action as defined

in EO 12866. Therefore, a regulatory

assessment is not required. It also has

been determined that section 553(b) of

the Administrative Procedure Act (5

U.S.C. chapter 5) and the Regulatory

Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and,

therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to

section 7805(f) of the Code, this notice

of proposed rulemaking will be

submitted to the Chief Counsel for

Advocacy of the Small Business

Administration for comment on its

impact on small business.

Comments and Public Hearing

Before these proposed regulations are

adopted as final regulations,

consideration will be given to any

written comments (a signed original and

eight (8) copies) that are submitted

timely to the IRS. All comments will be

available for public inspection and

copying.

A public hearing has been scheduled

for Wednesday, May 3, 1995 at 10 a.m.

The public hearing will be held in the

Internal Revenue Auditorium, 7400

corridor, Internal Revenue Building,

1111 Constitution Avenue NW,

Washington, DC 20224. Because of

access restrictions, visitors will not be

admitted beyond the Internal Revenue

Building lobby more than 15 minutes

before the hearing starts.

The rules of 26 CFR 601.601(a)(3)

apply to the hearing.

Persons that wish to present oral

comments at the hearing must submit

written comments by April 4, 1995 and

submit an outline of the topics to be

discussed and the time to be devoted to

each topic (signed original and eight (8)

copies) by April 4, 1995.

A period of 10 minutes will be

allotted to each person for making

comments.

An agenda showing the scheduling of

the speakers will be prepared after the

deadline for receiving outlines has

passed. Copies of the agenda will be

available free of charge at the hearing.

Drafting Information

The principal authors of these

regulations are Robert B. Williams and

JoLynn Ricks, Office of Assistant Chief

Counsel (Financial Institutions &

Products). However, other personnel

from the IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by adding entries

in numerical order to read as follows:

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

Section 1.475(a)–1 also issued under 26

U.S.C. 475(e).

Section 1.475(a)–2 also issued under 26

U.S.C. 475(a) and 26 U.S.C. 475(e).

Section 1.475(a)–3 also issued under 26

U.S.C. 475(e).

* * * * *

Section 1.475(b)–3 also issued under 26

U.S.C. 475(e).

Section 1.475(b)–4 also issued under 26

U.S.C. 475(b)(2) and 26 U.S.C. 475(e).

Section 1.475(c)–1 also issued under 26

U.S.C. 475(e).

* * * * *

Section 1.475(c)–2 also issued under 26

U.S.C. 475(e) and 26 U.S.C. 860G(e).

* * * * *

Section 1.475(e)–1 also issued under 26

U.S.C. 475(e).

* * * * *

Par. 2. Section 1.475–0 is added to

read as follows:

§ 1.475–0 Table of contents.

This section lists headings contained

in §§ 1.475–0, 1.475(a)–1, 1.475(a)–2,

1.475(a)–3, 1.475(b)–1, 1.475(b)–2,

1.475(b)–3, 1.475(b)–4, 1.475(c)–1,

1.475(c)–2, 1.475(d)–1, and 1.475(e)–1.

§ 1.475–0 Table of contents.

§ 1.475(a)–1 Mark to market of debt

instruments.

(a) Overview.

(b) No effect on amount of market discount,

acquisition premium, or bond premium.

(c) Accrual of interest, discount, and

premium.

(1) Qualified stated interest.

(2) General rule regarding accrual of

discount.

(3) Bond premium.

(d) Mandatory current inclusion of market

discount.

(1) General rule.

(2) Interaction with section 1278(b).

(e) Recognition of market discount that

accrued before section 475(a) applies to

a market discount bond.

(1) General rule.

(2) Examples.

(f) Worthless debts

(1) Computation of mark-to-market gain or

loss.

(2) Treatment of mark-to-market gain or

loss.

(g) Additional rules applicable to reservemethod taxpayers.

(h) Example.

§ 1.475(a)–2 Mark to market upon

disposition of security by a dealer.

(a) General rule.

(b) Example.

§ 1.475(a)–3 Acquisition by a dealer of a

security with a substituted basis.

(a) Scope.

(b) Rules.

§ 1.475(b)–1 Scope of exemptions from

mark-to-market requirement.

(a) Securities held for investment or not held

for sale.

(b) Securities deemed identified as held for

investment.

(1) In general.

(2) Control defined.

(c) Securities deemed not held for

investment.

(1) General rule for dealers in notional

principal contracts and derivatives.

(2) Exception for securities not acquired in

dealer capacity.

§ 1.475(b)–2 Exemptions—Transitional

issues.

(a) Transitional identification.
402 Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules

(1) Certain securities previously identified

under section 1236.

(2) Consistency requirement for other

securities.

(b) Corrections on or before January 31, 1994.

(1) Purpose.

(2) To conform to § 1.475(b)–1(a)

(i) Added identifications.

(ii) Limitations.

(3) To conform to § 1.475(b)–1(c).

(c) Effect of corrections.

§ 1.475(b)–3 Exemption of securities in

certain securitization transactions.

(a) Exemption of contributed assets.

(b) Exemption of resulting interests.

(1) General rule.

(2) Examples.

§ 1.475(b)–4 Exemptions—Identification

requirements.

(a) Identification of the basis for exemption.

(b) Time for identifying a security with a

substituted basis.

(c) Securities involved in integrated

transactions under § 1.1275–6.

(1) Definitions.

(2) Synthetic debt held by a taxpayer as a

result of legging in.

(3) Securities held after legging out.

§ 1.475(c)–1 Definitions—Dealer in

securities.

(a) Sellers of nonfinancial goods and services.

(b) Taxpayers that purchase securities but do

not sell more than a negligible portion of

the securities.

(1) Exemption from dealer status.

(2) Negligible portion.

(3) Special rules.

(c) Dealer-customer relationship.

(1) [Reserved].

(2) Transactions described in section

475(c)(1)(B).

(d) Issuance of life insurance products.

§ 1.475(c)–2 Definitions—Security.

(a) In general.

(b) Negative value REMIC residuals.

(c) Special rules.

(d) Synthetic debt held by a taxpayer as a

result of an integrated transaction under

§ 1.1275–6.

§ 1.475(d)–1 Character of gain or loss.

§ 1.475(e)–1 Effective dates.

(a) Taxable years ending on or after December

31, 1993.

(b) Taxable years beginning on or after

January 1, 1995.

(c) Securities acquired on or after January 4,

1995.

(d) Events occurring on or after January 4,

1995

Par. 3. Section 1.475(a)–1 is added to

read as follows:

§ 1.475(a)–1 Mark to market of debt

instruments.

(a) Overview. This section provides

rules for taking into account interest

accruals and gain and loss on a debt

instrument to which section 475(a)

applies. Paragraph (b) of this section

clarifies that the mark-to-market

computation affects neither the amount

treated as interest earned from a debt

instrument nor the taxable year in

which that interest is taken into

account. Paragraph (c) of this section

prescribes general rules. Paragraph (d)

of this section prescribes additional

rules for instruments acquired with

market discount. Paragraph (e) of this

section provides rules for taking into

account market discount that accrued

on a bond before the bond became

subject to the mark-to-market

requirements. Paragraph (f) of this

section prescribes rules for computing

the mark-to-market gain or loss on

partially or wholly worthless debts, and

paragraph (g) provides rules for dealers

accounting for bad debts using a reserve

method of accounting.

(b) No effect on amount of market

discount, acquisition premium, or bond

premium. Marking a debt instrument to

market does not create, increase, or

reduce market discount, acquisition

premium, or bond premium, nor does it

affect the adjusted issue price of, or

accruals of original issue discount (OID)

on, a bond issued with OID.

(c) Accrual of interest, discount, and

premium. In general, the amount of gain

or loss from marking a debt instrument

to market is computed after adjustments

to basis for accruals of stated interest,

discount, and premium.

(1) Qualified stated interest.

Immediately before a debt instrument is

marked to market under section 475(a),

the holder of the instrument must take

any unpaid accrued qualified stated

interest into account and must

correspondingly increase the basis of

the instrument. The holder must later

decrease the basis of the instrument

when accrued qualified stated interest is

actually received. (See § 1.1273–1(c) for

the definition of qualified stated interest

and § 1.446–2(b) for the rule governing

its accrual.)

(2) General rule regarding accrual of

discount. If a bond that was acquired

with OID or market discount is marked

to market under section 475(a), then,

immediately before the bond is marked

to market, the discount accrued through

that date (determined under section

1272, 1275(d), or 1276, as applicable) is

included in gross income, to the extent

not previously included, and the bond’s

basis is correspondingly increased for

amounts so included. (Because accrued

OID is determined under all of the rules

of section 1272 and the regulations

thereunder, it is computed taking into

account the reduction for acquisition

premium that is required by section

1272(a)(7).) See paragraph (d) of this

section, which requires the current

inclusion in income of market discount

on bonds marked to market. See

paragraph (e) of this section for

exceptions, and additional rules, for

market discount bonds that become

subject to section 475(a) after

acquisition.

(3) Bond premium. If a debt

instrument that is subject to the basis

adjustment required by section 1016(a)

(5) or (6) is marked to market under

section 475(a), then, immediately before

the debt instrument is marked to

market, the required basis adjustment

must be made. Accordingly, the markto-market adjustment is computed after

the basis of the debt instrument has

been adjusted under section 1016(a) (5)

or (6) for disallowed amortizable bond

premium (in the case of tax-exempt

bonds) or deductible bond premium (in

the case of taxable bonds). If an election

under section 171(c) is made after the

first taxable year in which section 475(a)

applies to the bond, the amount of bond

premium is determined under section

171(b)(1) without regard to any basis

adjustments that may have been

required as a result of the bond being

marked to market in prior taxable years.

See paragraph (b) of this section for the

rule that marking a debt instrument to

market does not affect bond premium.

(d) Mandatory current inclusion of

market discount—(1) General rule. If

section 475(a) applies to a bond during

any portion of a taxable year, gross

income for that taxable year includes

the market discount attributable to the

portion of the year to which section

475(a) applies (as determined under

section 1276(b)). Section 1276 does not

apply to the bond except with respect to

market discount, if any, that accrued

before the bond became subject to

section 475(a). Similarly, section 1277

does not apply to the bond except with

respect to any net direct interest

expense (as defined in section 1277(c))

that accrued before the bond became

subject to section 475(a). See paragraph

(e) of this section for additional rules

governing this situation. For purposes of

the Code other than the purposes

described in the last sentence of section

1278(b)(1), any amount included in

gross income under this paragraph (d)(1)

is treated as interest. The bond’s basis

is correspondingly increased for any

amount so included in gross income.

(2) Interaction with section 1278(b).

Paragraph (d)(1) of this section applies

to a dealer, even if the dealer has not

elected under section 1278(b) to include

market discount currently. If the dealer

has not made that election, however,

this paragraph (d) does not require

current inclusion of market discount on

any bond to which section 475(a) does

not apply.
Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules 403

(e) Recognition of market discount

that accrued before section 475(a)

applies to a market discount bond—(1)

General rule. In the case of a debt

instrument that is acquired with market

discount, that is not subject to an

election under section 1278(b), and that

first becomes subject to section 475(a) in

the taxpayer’s hands on a date after its

acquisition, this paragraph (e) governs

the recognition of market discount that

is attributable (as determined under

section 1276(b)) to any period before

section 475(a) applies to the debt

instrument. To the extent that the

market discount described in the

preceding sentence is greater than the

excess, if any, of the fair market value

of the debt instrument at the time it

became subject to section 475(a) over its

adjusted basis at that time, section

1276(a)(1) applies to any gain

recognized under section 475(a). To the

extent of any remaining market discount

that had accrued before section 475(a)

became applicable, section 1276(a)

applies no later than it would have

applied if section 475(a) did not apply

to the bond. For example, section

1276(a) applies to the previously

accrued market discount as partial

principal payments are made. Except as

provided in the preceding sentences,

gain recognized under section 475(a) is

not recharacterized as interest by

section 1276(a).

(2) Examples. The rules of paragraphs

(d) and (e) of this section are illustrated

by the following examples:

Example 1.

(i) Facts. Bond X was issued on January 1,

1996, for $1,000. Bond X matures on

December 31, 2005, provides for a principal

payment of $1,000 on the maturity date, and

provides for interest payments at a rate of

8%, compounded annually, on December 31

of each year. D is a dealer in securities within

the meaning of section 475(c)(1). On January

1, 1997, D purchased bond X for $955. D had

not elected under section 1278(b) to include

market discount in gross income currently.

Under section 475(b), section 475(a) did not

apply to bond X until January 1, 1999, at

which time bond X had a fair market value

of $961. On December 31, 1999, bond X had

a fair market value of $980.

(ii) Holdings. In the absence of an election

under section 1276(b)(2), market discount on

bond X accrues under section 1276(b)(1) at

the rate of $5 per year. On January 1, 1999,

when bond X became subject to section

475(a), $10 of market discount had accrued,

but the excess of the bond’s fair market value

on January 1, 1999, over its adjusted basis on

that date (the built-in gain) was only $6

($961—$955). During 1999, D is required to

include as interest income the $5 of market

discount that accrues during that year, and D

increases by that amount its basis in the bond

and the amount to be used in computing

mark-to-market gain or loss. On December 31,

1999, B must mark bond X to market and

recognize a gain of $14 ($980—[$961 + $5]).

Under section 1276(a)(1) and (4) and

paragraph (e)(1) of this section, $4 of that $14

gain is treated as interest income. The $4 is

the amount by which the market discount of

$10 that had accrued on January 1, 1999,

exceeded the $6 built-in gain on that date.

Example 2.

(i) Facts. The facts are the same as in

Example 1, except that, in addition, D sells

bond X for its fair market value of $1,000 on

June 30, 2000.

(ii) Holdings. Immediately before the sale,

D is required to include as interest income

the $2.50 of market discount that accrued

during the portion of the year through June

30, and D increases by that amount its basis

in the bond and the amount to be used in

computing mark-to-market gain or loss. Also,

under § 1.475(a)–2, immediately before the

sale, D recognizes $17.50 of mark-to-market

gain (the increase in value since the

preceding mark to market, less the basis

increase of $2.50 from the market discount

accrual. See § 1.475(a)–2). On the sale, D also

recognizes the $6 of built-in gain, all of

which is recharacterized as ordinary interest

income under section 1276(a)(4).

Example 3.

(i) Facts. The facts are the same as in

Example 1, except that, during 2001, the

issuer of bond X made a partial principal

payment in the amount of $20.

(ii) Holdings. Under paragraph (e)(1) of this

section and section 1276(a)(4), $6 of the

partial principal payment is included in D’s

2001 income as interest income. The $6 is the

portion of the $10 of market discount that

had accrued at the time bond X became

subject to section 475(a) and that had not

previously caused gain or a partial principal

payment to be treated as interest income.

(f) Worthless debts—(1) Computation

of mark-to-market gain or loss. This

paragraph (f) applies to any dealer that,

under section 475(a)(2), marks to market

either a debt that was charged off during

the year because it became partially

worthless or a debt that became wholly

worthless during the taxable year

(without regard to whether the debt was

charged off). Any gain or loss

attributable to marking a debt to market

is determined by deeming the debt’s

adjusted basis to be the debt’s adjusted

basis under § 1.1011–1, less the amount

charged off during the taxable year or

during any prior taxable year, to the

extent that amount has not previously

reduced tax basis. A debt that becomes

wholly worthless is deemed to have an

adjusted basis of zero. The deemed

adjusted basis, however, is used solely

for this paragraph (f). Thus, any portion

of a loss attributable to a bad debt

continues to be accounted for under the

bad debt provisions of the Code, and the

basis of the debt continues to be

adjusted as otherwise required under

the Code.

(2) Treatment of mark-to-market gain

or loss. To the extent that a debt has

been previously charged off, mark-tomarket gain is treated as a recovery.

Thus, for example, a dealer using the

section 585 reserve method of

accounting for bad debts must credit to

the reserve any portion of mark-tomarket gain that is treated as a recovery

of a bad debt previously charged to the

reserve account, and the dealer must

include any excess in gross income as

required by § 1.585–3(a). Similarly, if a

dealer is a large bank that changed to

the specific charge-off method of

accounting for bad debts using the

elective cut-off procedures described in

§ 1.585–7, the dealer must charge to the

reserve for pre-disqualification loans all

losses recognized as a result of marking

to market a debt that is a predisqualification loan within the

meaning of § 1.585–7(b)(2). Marking a

pre-disqualification loan to market,

however, is not a disposition of that

loan under § 1.585–7(d).

(g) Additional rules applicable to

reserve-method taxpayers. If a dealer

accounts for bad debts using the reserve

method of accounting under section 585

or 593, the following additional rules

apply in computing a reasonable

addition to a reserve—

(1) To determine the amount of total

loans outstanding, the outstanding

balance on a debt that is marked to

market is increased or decreased by the

amount of any mark-to-market gain or

loss recognized, except that the

outstanding balance of the debt may

never exceed the actual balance

currently due; and

(2) If the reasonable addition to the

reserve is computed based on a

percentage of taxable income, any gain

or loss attributable to marking a debt to

market must be taken into account in

computing taxable income.

(h) Example. This example illustrates

paragraphs (f) and (g) of this section.

Example.

(i) B, a calendar year taxpayer, is a dealer

that marks some of its debts to market under

section 475(a)(2). Additionally, B is a bank

that accounts for bad debts using the section

585 reserve method of accounting. B has not

made an election to use the conformity

method of accounting described in § 1.166–

2(d)(3).

(ii) On December 31, 1995, B has total

loans outstanding of $1,000,000 and a bad

debt reserve balance of $1000. Among the

loans that B marks to market is loan X. On

January 1, 1995, loan X had a book and tax

basis of $100. During the taxable year, loan

taxable became partially worthless, and B

charged off the loan by $5. Thus, loan X had

a book basis of $95 and a tax basis of $100.

The fair market value of loan X was $94 on

December 31, 1995.

(iii) B computes the amount of gain or loss

to be taken into account under section
404 Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules

475(a)(2) with respect to loan X using the

rules of paragraph (f) of this section. Under

paragraph (f)(1) of this section, B treats the

adjusted tax basis of loan X as having been

reduced by the $5 charge-off. Thus, B

determines that it is required to take into

account a $1 mark-to-market loss based on

the difference between B’s adjusted basis in

loan X of $95, as determined under

paragraph (f)(1) of this section, and loan X’s

fair market value of $94.

(iv) Further, B decides to claim a bad debt

deduction with respect to loan X in 1995,

rather than waiting until loan X becomes

totally worthless. Thus, B charges the $5 of

partial worthlessness to its reserve for bad

debts. In computing a reasonable addition to

the reserve under section 585(b), B reduces

the amount of its total loans outstanding by

$6 ($5 charged to the reserve for bad debts,

plus $1 mark-to-market loss).

(v) On December 31, 1997, loan X has a fair

market value of $93 and an adjusted basis

(and outstanding principal balance) of $90.

No additional worthlessness occurred with

respect to loan X in 1996 or 1997. B

determines that it is required to recognize a

$3 mark-to-market gain with respect to loan

X. Because B previously charged $5 to the

bad debt reserve with respect to loan X, the

entire $3 is a recovery item and must be

credited to the bad debt reserve. See

paragraph (f)(2) of this section. In computing

a reasonable addition to the reserve for 1997,

B does not increase the balance of its total

loans outstanding by the $3 mark-to-market

gain, because that adjustment would increase

the balance to an amount in excess of the

actual outstanding principal balance of $90.

See paragraph (g)(1) of this section.

Par. 4. Section 1.475(a)–2 is added to

read as follows:

§ 1.475(a)–2 Mark to market upon

disposition of security by a dealer.

(a) General rule. If a dealer in

securities ceases to be the owner of a

security for federal income tax purposes

and if the security would have been

marked to market under section 475(a)

if the dealer’s taxable year had ended

immediately before the dealer ceases to

own it, then (whether or not the security

is inventory in the hands of the dealer)

the dealer must recognize gain or loss

on the security as if it were sold for its

fair market value immediately before the

dealer ceases to own it, and gain or loss

is taken into account at that time. The

amount of any gain or loss subsequently

realized must be properly adjusted, in

the form of a basis adjustment or

otherwise, for gain or loss taken into

account under this paragraph (a). See

§ 1.475(b)–4(b) for the rule governing

when a security with substituted basis

must be identified if it is to be exempted

from the application of section 475(a).

(b) Example. The rule of paragraph (a)

of this section is illustrated by the

following example.

Example.

(i) Facts. D is a dealer in securities within

the meaning of section 475(c)(1) and is a

member of a consolidated group that uses the

calendar year as its taxable year. On February

1, 1995, D acquired for $100 a debt

instrument issued by an unrelated party. On

June 1, 1995, D sold the debt instrument to

another member of the group, M1, for $110,

which was the fair market value of the

security on that date. D would have been

required to mark the debt instrument to

market under section 475(a) if its taxable year

had ended immediately before it sold the

debt instrument to M1.

(ii) Holding. Under paragraph (a) of this

section, D marks the debt instrument to

market immediately before the sale to M1 and

takes into account $10 of gain. The gain is

not deferred intercompany gain. As a result,

D’s basis in the debt instrument increases to

$110 immediately before the sale.

Accordingly, there is no gain or loss on the

sale, and M1’s basis in the debt instrument

is $110.

Par. 5. Section 1.475(a)–3 is added to

read as follows:

§ 1.475(a)–3 Acquisition by a dealer of a

security with a substituted basis.

(a) Scope. This section applies if—

(1) A dealer in securities acquires a

security that is subject to section 475(a)

and the dealer’s basis in the security is

determined, in whole or in part, by

reference to the basis of that security in

the hands of the person from whom the

security was acquired; or

(2) A dealer in securities acquires a

security that is subject to section 475(a)

and the dealer’s basis in the security is

determined, in whole or in part, by

reference to other property held at any

time by the dealer.

(b) Rules. If this section applies to a

security—

(1) Section 475(a) applies only to

changes in value of the security

occurring after the acquisition; and

(2) Any built-in gain or loss with

respect to the security (based on the

difference between the fair market value

of the security on the date the dealer

acquired it and its basis to the dealer on

that date) is taken into account at the

time, and has the character, provided by

the sections of the Code that would

apply to the built-in gain or loss if

section 475(a) did not apply to the

security.

Par. 6. Section 1.475(b)–3 is added to

read as follows:

§ 1.475(b)–3 Exemption of securities in

certain securitization transactions.

(a) Exemption of contributed assets. If

a taxpayer expects to contribute

securities (for example, mortgages) to a

trust or other entity, including a REMIC,

in exchange for interests therein

(including ownership interests or debt

issued by the trust or other entity), the

contributed securities qualify as held for

investment (within the meaning of

section 475(b)(1)(A)) or not held for sale

(within the meaning of section

475(b)(1)(B)) only if the taxpayer

expects each of the interests received

(whether or not a security within the

meaning of section 475(c)(2)) to be

either held for investment or not held

for sale to customers in the ordinary

course of the taxpayer’s trade or

business.

(b) Exemption of resulting interests—

(1) General rule. If a taxpayer

contributes securities to a trust or other

entity in exchange for interests therein

(including ownership interests or debt

issued by the trust or other entity) and

if, for federal income tax purposes, the

ownership of the interests received is

not treated as ownership of the

securities contributed, the interests

received may be identified as being

described in section 475(b)(1), even if

some or all of the contributed securities

were not so described and could not

have been so identified. For purposes of

determining the timeliness of an

identification of an interest received, the

interest is treated as acquired on the day

of its receipt.

(2) Examples. The following examples

illustrate the principles of paragraph

(b)(1) of this section.

Example 1. Identification of REMIC regular

interests. If a taxpayer holds mortgages that

are marked to market under section 475 and

the taxpayer contributes the mortgages to a

REMIC in exchange for REMIC regular

interests that are described in section

475(b)(1), the taxpayer may identify the

regular interests as exempt from mark-tomarket treatment. This is permissible because

REMIC regular interests are debt securities

issued by the REMIC and do not represent

continued ownership of the contributed

mortgages.

Example 2. Identification of interests in a

grantor trust. If a taxpayer contributes

securities to a grantor trust and receives

beneficial interests therein and if the

taxpayer marked the contributed securities to

market under section 475, the taxpayer

cannot identify the beneficial interests in the

grantor trust as exempt from mark-to-market

treatment. Because ownership of a beneficial

interest in a grantor trust represents

continued ownership of an undivided

interest in the contributed assets, no new

security has been acquired.

Par. 7. Section 1.475(b)1–4 is added

to read as follows:

§ 1.475(b)–4 Exemptions—Identification

requirements.

(a) Identification of the basis for

exemption. An identification of a

security as exempt does not satisfy

section 475(b)(2) if it fails to identify the

subparagraph of section 475(b)(1) in

which the security is described.
Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules 405

(b) Time for identifying a security with

a substituted basis. For purposes of

determining the timeliness of an

identification under section 475(b)(2),

the date that a dealer acquires a security

is not affected by whether the dealer’s

basis in the security is determined, in

whole or in part, either by reference to

the basis of the security in the hands of

the person from whom the security was

acquired or by reference to other

property held at any time by the dealer.

See § 1.475(a)–3 for rules governing how

the dealer accounts for such a security

if this identification is not made.

(c) Securities involved in integrated

transactions under § 1.1275–6—(1)

Definitions. The following terms are

used in this paragraph (c) with the

meanings that are given to them by

§ 1.1275–6: integrated transaction,

legging into, legging out, qualifying debt

instrument, § 1.1275–6 hedge, and

synthetic debt instrument.

(2) Synthetic debt held by a taxpayer

as a result of legging in. If a taxpayer

becomes the holder of a synthetic debt

instrument as the result of legging into

an integrated transaction, then, for

purposes of the timeliness of an

identification under section 475(b)(2),

the synthetic debt instrument is treated

as having the same acquisition date as

the qualifying debt instrument. A preleg-in identification of the qualifying

debt instrument under section 475(b)(2)

applies to the synthetic debt instrument

as well.

(3) Securities held after legging out. If

a taxpayer legs out of an integrated

transaction, then, for purposes of the

timeliness of an identification under

section 475(b)(2), the qualifying debt

instrument, or the § 1.1275–6 hedge,

that remains in the taxpayer’s hands is

generally treated as having been

acquired, originated, or entered into, as

the case may be, immediately after the

leg-out. If any loss or deduction

determined under § 1.1275–6(d)(2)(ii)(B)

is disallowed by § 1.1275–6(d)(2)(ii)(D)

(which disallows deductions when a

taxpayer legs out of an integrated

transaction within 30 days of legging

in), then, for purposes of this section

and section 475(b)(2), the qualifying

debt instrument that remains in the

taxpayer’s hands is treated as having

been acquired on the same date that the

synthetic debt instrument was treated as

having been acquired.

Par. 8. Section 1.475(c)–1, as

proposed on December 29, 1993 (58 FR

68798), is amended as follows:

1. The heading of the section is

revised.

2. Paragraphs (c) and (d) are added.

3. The revision and additions read as

follows:

§ 1.475(c)–1 Definitions—Dealer in

securities.

* * * * *

(c) Dealer-customer relationship.

Whether a taxpayer is transacting

business with customers is determined

on the basis of all of the facts and

circumstances.

(1) [Reserved].

(2) Transactions described in section

475(c)(1)(B). For purposes of section

475(c)(1)(B), the term dealer in

securities includes, but is not limited to,

a taxpayer that, in the ordinary course

of the taxpayer’s trade or business,

regularly holds itself out as being

willing and able to enter into either side

of a transaction enumerated in section

475(c)(1)(B). An example of a taxpayer

willing to enter into either side of a

transaction is a taxpayer willing to enter

into an interest rate swap and either pay

a fixed interest rate and receive a

floating rate or pay a floating rate and

receive a fixed rate.

(d) Issuance of life insurance

products. A life insurance company that

is not otherwise a dealer in securities

under section 475(c)(1) does not become

a dealer solely because it regularly

issues life insurance products to its

customers in the ordinary course of a

trade or business. For purposes of the

preceding sentence, the term life

insurance product means a contract that

is treated for federal income tax

purposes as an annuity, endowment, or

life insurance contract. See sections 817

and 7702.

Par. 9. Section 1.475(c)–2, as

proposed on December 29, 1993 (58 FR

68798), is amended as follows:

1. The heading of the section is

revised.

2. Paragraph (a)(2) is revised.

3. Paragraph (a)(3) is amended by

adding ‘‘; or’’ in lieu of the period at the

end of that paragraph.

4. Paragraph (a)(4) and paragraph (d)

are added.

5. The revisions and additions read as

follows:

§ 1.475(c)–2 Definitions—Security.

(a) * * *

(2) A debt issued by the taxpayer

(including a synthetic debt instrument,

within the meaning of § 1275–6(b), that

the taxpayer is treated as having issued

as a result of an integrated transaction

under § 1.1275–(6);

(3) * * * ; or

(4) A REMIC residual interest, or an

interest or arrangement that is

determined by the Commissioner to

have substantially the same economic

effect, if the residual interest or the

interest or arrangement is acquired on or

after January 4, 1995.

* * * * *

(d) Synthetic debt held by a taxpayer

as a result of an integrated transaction

under § 1.1275–6. If, as the result of an

integrated transaction under § 1.1275–6,

a taxpayer is treated as the holder of a

synthetic debt instrument (within the

meaning of § 1.1275–6(b)), the synthetic

debt instrument is a security held by the

taxpayer within the meaning of section

475(c)(2)(C). See § 1.475(b)–4(c) for rules

governing identification of such a

synthetic debt instrument for purposes

of section 475(b).

Par. 10. Section 1.475(e)–1, as

proposed on December 29, 1993 (58 FR

68798), is revised to read as follows:

§ 1.475(e)–1. Effective dates.

(a) Taxable years ending on or after

December 31, 1993. The following

sections apply to taxable years ending

on or after December 31, 1993:

§§ 1.475(b)–1 (concerning the scope of

exemptions from mark-to-market

requirement), 1.475(b)–2 (concerning

transitional issues relating to

exemptions), 1.475(c)–1(a) (concerning

sellers of nonfinancial goods and

services) and (b) (concerning taxpayers

that purchase securities but do not sell

more than a negligible portion of the

securities), 1.475(c)–2 (concerning the

definition of security), and 1.475(d)–1

(concerning the character of gain or

loss). Note, however, that, by its terms,

§ 1.475(c)–2(a)(4) applies only to

interests or arrangements that are

acquired on or after January 4, 1995, and

the integrated transactions to which

§ 1.475(c)–2(d) applies will exist only

after the effective date of § 1.1275–6.

(b) Taxable years beginning on or

after January 1, 1995. The following

sections apply to taxable years

beginning on or after January 1, 1995:

§§ 1.475(a)–1 (concerning mark to

market accounting for debt instruments)

and 1.475(c)–1(c) (concerning the

dealer-customer relationship) and (d)

(concerning the issuance of life

insurance products).

(c) Securities acquired on or after

January 4, 1995. The following sections

apply to securities acquired, originated,

or entered into on or after January 4,

1995: §§ 1.475(a)–3 (concerning

acquisition by a dealer of a security with

a substituted basis), 1.475(b)–3(a)

(concerning securities the taxpayer

expects to contribute to a trust or other

entity in a securitization transaction),

and 1.475(b)–3(b) (concerning securities

received in a securitization transaction).

(d) Events occurring on or after

January 4, 1995.
406 Federal Register / Vol. 60, No. 2 / Wednesday, January 4, 1995 / Proposed Rules

(1) Section 1.475(a)–2 (concerning

marking a security to market upon

disposition) applies to dispositions

occurring on or after January 4, 1995.

(2) Section 1.475(b)–4 (concerning the

identification requirements for

obtaining an exemption from mark-tomarket treatment) applies to

identifications made on or after January

4, 1995.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95–13 Filed 01–03–95; 8:45 am]

BILLING CODE 4830–01–U

26 CFR Part 1

[IA–55–94]

RIN 1545–AT13

Accuracy-related Penalty

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations which provide

guidance as to when a taxpayer may rely

upon the advice of others as evidence of

reasonable cause and good faith within

the meaning of section 6664(c) of the

Internal Revenue Code of 1986 for

purposes of avoiding the accuracyrelated penalty of section 6662, and

what constitutes reasonable cause and

good faith within the meaning of section

6664(c) as it applies to the substantial

understatement penalty of section

6662(b)(2) with respect to tax shelter

items of a corporation. The proposed

regulations implement changes to the

accuracy-related penalty under section

6662 that were made by Title VII of the

Uruguay Round Agreements Act (the

Act) implementing the Uruguay Round

of the General Agreement on Tariffs and

Trade. Finally, this document provides

notice of a public hearing on the

proposed amendments to the

regulations.

DATES: Written comments must be

received by April 7, 1995. The IRS

intends to hold a public hearing on

these proposed regulations on April 28,

1995, beginning at 10 a.m. Persons

wishing to speak at the hearing must

submit outlines of their comments by

April 7, 1995.

ADDRESSES: Send submissions to:

Internal Revenue Service, Attn:

CC:DOM:CORP:T:R (IA–55–94), room

5228, POB 7604, Ben Franklin Station,

Washington, DC 20044. The public

hearing will be held in the IRS

Auditorium, Internal Revenue Building,

1111 Constitution Avenue, NW,

Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the regulations, David L.

Meyer, 202–622–6232; concerning

submissions, Christina Vasquez, 202–

622–6803. (These are not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 6662 of the Internal Revenue

Code (Code) imposes an accuracyrelated penalty on certain

underpayments of tax. Section 6664(c)

provides that no accuracy-related

penalty is imposed with respect to any

portion of an underpayment if it is

shown that there was a reasonable cause

for such portion and that the taxpayer

acted in good faith with respect to such

portion.

Under current regulations interpreting

sections 6662 and 6664, a taxpayer’s

good faith reliance on the advice

(including an opinion) of a professional

tax advisor may be taken into account

for purposes of determining whether the

taxpayer will be subject to an accuracyrelated penalty. See, e.g., §§ 1.6662–

4(g)(4)(ii) and 1.6664–4(b).

Section 6662(b)(2) of the Code

imposes a penalty for a substantial

understatement of income tax. An

understatement is substantial if it

exceeds the greater of 10 percent of the

tax required to be shown on the

taxpayer’s return for the taxable year, or

$5,000 ($10,000 in the case of a

corporation other than an S corporation

or a personal holding company). An

understatement is defined as the excess

of (1) the amount of tax required to be

shown on the taxpayer’s return, over (2)

the amount of tax imposed which is

shown on the return, reduced by any

rebate.

The Code provides that the amount of

an understatement is reduced to the

extent that certain conditions are met.

For example, section 6662(d)(2), prior to

amendment by the Act (Pub. L. 103–

465), provided that an understatement is

reduced by the portion of the

understatement attributable to a tax

shelter item of the taxpayer (the section

6662 tax shelter rule) if: (1) there is

substantial authority for the taxpayer’s

treatment of the tax shelter item; and (2)

the taxpayer reasonably believed (at the

time its return was filed) that its

treatment of such item was more likely

than not the proper treatment.

The substantial understatement

penalty was first adopted in section 323

of the Tax Equity and Fiscal

Responsibility Act of 1982, Pub. L. 97–

248. At that time, Congress believed that

the new standards would ‘‘assure that

taxpayers who take highly aggressive

filing positions are penalized while

those who endeavor in good faith to

self-assess are not penalized’’ and that,

with respect to tax shelters, ‘‘if the

principal purpose of a transaction is the

reduction of tax, it is not unreasonable

to hold participants to a higher standard

than ordinary taxpayers.’’ H.R. Conf.

Rep. No. 97th Cong., 2d Sess. 575–76

(1982), 1982–2 C.B.650. More recently,

Congress has been concerned that the

substantial understatement penalty has

not been effectively deterring corporate

tax shelter transactions and thus, in

Section 744 of the Act, eliminated the

section 6662 tax shelter rule as it

applies to corporations. As a result of

this change, ‘‘the standards applicable

to corporate tax shetlers are tightened’’

and ‘‘in no instance [will] this

modification result in a penalty not

being imposed where a penalty would

have been imposed under prior law.’’ S.

Rep. No. 412, 103d Cong., 2d Sess. 165

(1994); H.R. Rep. No. 826, 103d Cong.,

2d Sess. 198–99 (1994). The change is

effective for transactions occurring after

December 8, 1994.

The proposed regulations set forth in

this document address issues related to

the section 6662 tax shelter rule and the

reasonable cause exception of section

6664. This guidance includes, but is not

limited to, rules that reflect the

amendment of section 6662 by the Act.

Explanation of Provisions

Reliance on Tax Advisor

The proposed regulations set forth

general rules clarifying when a taxpayer

may be considered to have reasonably

relied in good faith upon advice

(including an opinion provided by a

professional tax advisor). These rules

apply to all taxpayers and to both tax

shelter items and non-tax shelter items.

In particular, the rules apply in

determining whether reasonable cause

and good faith exist for purposes of

section 6664(c) and also apply in

determining whether a taxpayer other

than a corporation is considered to have

reasonably relied in good faith on an

opinion in order to satisfy the

‘‘reasonable belief’’ requirement of the

section 6662 tax shelter rule.

In general, the proposed regulations

require advice to be based on all

material facts (including, for example,

the taxpayer’s purposes for entering into

a transaction) and to relate applicable

law to such facts in reaching its

conclusion. The advice must not be

based upon unreasonable factual or

legal assumptions (including

assumptions as to future events), nor