Bulletin No. 2006-41October 10, 2006

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2006–50, page 672.Federal rates; adjusted federal rates; adjusted federallong-term rate and the long-term exempt rate. For pur-poses of sections 382, 642, 1274, 1288, and other sectionsof the Code, tables set forth the rates for October 2006.

Rev. Rul. 2006–51, page 632.Low-income housing credit; satisfactory bond; “bondfactor” amounts for the period January through De-cember 2006. This ruling provides the monthly bond factoramounts to be used by taxpayers who dispose of qualifiedlow-income buildings or interests therein during the periodJanuary through December 2006.

T.D. 9283, page 633.Final regulations under sections 168(k) and 1400L(b) of theCode provide guidance regarding the additional first yeardepreciation deduction for qualified property and 50-percentbonus depreciation property under section 168(k) and for qual-ified New York Liberty Zone property under section 1400L(b).

T.D. 9285, page 656.Final regulations under section 448 of the Code provide rulesrelating to the use of a nonaccrual-experience method of ac-counting by taxpayers using an accrual method of accountingand performing services. The regulations affect qualifying tax-payers that want to adopt, change to, or change a nonaccrual-experience method of accounting under section 448(d)(5).

REG–109367–06, page 683.Proposed regulations clarify the circumstances in which ac-counts or notes receivable are “acquired ... for services ren-dered” within the meaning of section 1221(a)(4) of the Code.

A public hearing is scheduled for November 7, 2006. Simul-taneously with the publication of these proposed regulations inthe Federal Register, the following revenue rulings are beingdeclared obsolete: Rev. Ruls. 72–238 and 73–558.

Notice 2006–78, page 675.This notice announces the phase-out of the qualified hybrid mo-tor vehicle credit and the new advanced lean burn technologymotor vehicle credit for passenger automobiles and light trucksmanufactured by Toyota Motor Corporation that are purchasedfor use or lease in the United States beginning on October 1,2006.

Notice 2006–84, page 677.This notice concludes that income from performing services atthe U.S. Naval Base at Guantanamo Bay is not income earnedin a restricted country (Cuba) for purposes of the limitation setforth in section 911(d)(8)(A) of the Code and thus, an individ-ual working at Guantanamo Bay is eligible for the section 911foreign earned income exclusion, provided that the other re-quirements of that section are met.

Notice 2006–85, page 677.This notice announces that the IRS and Treasury intend to issueregulations under section 367(b) to address certain triangularreorganizations involving foreign corporations. The regulationswill apply to triangular reorganizations where either the parentcorporation or its subsidiary are foreign and where the sub-sidiary acquires from the parent, in exchange for property, par-ent stock that is used to acquire the stock or assets of a targetcorporation. The regulations will treat the transfer of propertyfrom the subsidiary to its parent as a distribution of propertyunder section 301(c) and make corresponding adjustments.

(Continued on the next page)

Finding Lists begin on page ii.

Notice 2006–86, page 680.This notice provides interim guidance under section 152(c)(4)of the Code, the rule for determining which taxpayer may claima qualifying child when two or more taxpayers claim the samechild. It clarifies that, unless the special rule in section 152(e)applies, the tie-breaking rule in section 152(c)(4) applies tothe head of household filing status, the child and dependentcare credit, the child tax credit, the earned income credit, theexclusion for dependent care assistance, and the dependencydeduction as a group, rather than on a section-by-section basis.

October 10, 2006 2006–41 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents are compiled semiannually into Cumulative Bulletins,which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2006–41 I.R.B. October 10, 2006

Place missing child here.

October 10, 2006 2006–41 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 42.—Low-IncomeHousing Credit

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Low-income housing credit; satisfac-tory bond; “bond factor” amounts forthe period January through December2006. This ruling provides the monthlybond factor amounts to be used by taxpay-ers who dispose of qualified low-incomebuildings or interests therein during the pe-riod January through December 2006.

Rev. Rul. 2006–51

In Rev. Rul. 90–60, 1990–2 C.B.3, the Internal Revenue Service provided

guidance to taxpayers concerning the gen-eral methodology used by the TreasuryDepartment in computing the bond factoramounts used in calculating the amount ofbond considered satisfactory by the Secre-tary under § 42(j)(6) of the Internal Rev-enue Code. It further announced that theSecretary would publish in the InternalRevenue Bulletin a table of bond factoramounts for dispositions occurring duringeach calendar month.

Rev. Proc. 99–11, 1999–1 C.B. 275,established a collateral program as an al-ternative to providing a surety bond fortaxpayers to avoid or defer recapture ofthe low-income housing tax credits under§ 42(j)(6). Under this program, taxpayersmay establish a Treasury Direct Accountand pledge certain United States Treasury

securities to the Internal Revenue Serviceas security.

This revenue ruling provides in Table1 the bond factor amounts for calculat-ing the amount of bond considered satis-factory under § 42(j)(6) or the amount ofUnited States Treasury securities to pledgein a Treasury Direct Account under Rev.Proc. 99–11 for dispositions of qualifiedlow-income buildings or interests thereinduring the period January through Decem-ber 2006.

Table 1Rev. Rul. 2006–51

Monthly Bond Factor Amounts for Dispositions ExpressedAs a Percentage of Total Credits

Calendar Year Building Placed in Serviceor, if Section 42(f)(1) Election Was Made,

the Succeeding Calendar Year

Month ofDisposition

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Jan ’06 16.49 30.74 43.01 53.65 62.94 64.28 65.95 67.76 69.76 72.19 74.98Feb ’06 16.49 30.74 43.01 53.65 62.94 64.14 65.81 67.62 69.61 72.03 74.80Mar ’06 16.49 30.74 43.01 53.65 62.94 64.00 65.67 67.47 69.46 71.89 74.63Apr ’06 16.49 30.74 43.01 53.65 62.94 63.87 65.53 67.33 69.32 71.73 74.46May ’06 16.49 30.74 43.01 53.65 62.94 63.73 65.40 67.20 69.18 71.58 74.30Jun ’06 16.49 30.74 43.01 53.65 62.94 63.61 65.27 67.06 69.05 71.44 74.15Jul ’06 17.40 32.42 45.37 56.59 66.39 67.61 70.07 72.72 75.62 79.01 82.82

Aug ’06 17.40 32.42 45.37 56.59 66.39 67.47 69.93 72.57 75.47 78.86 82.65Sep ’06 17.40 32.42 45.37 56.59 66.39 67.34 69.79 72.43 75.33 78.71 82.49Oct ’06 17.40 32.42 45.37 56.59 66.39 67.20 69.66 72.30 75.19 78.56 82.34Nov ’06 17.40 32.42 45.37 56.59 66.39 67.07 69.53 72.16 75.05 78.42 82.19Dec ’06 17.40 32.42 45.37 56.59 66.39 66.95 69.40 72.03 74.92 78.28 82.04

2006–41 I.R.B. 632 October 10, 2006

Table 1 (cont’d)Rev. Rul. 2006–51

Monthly Bond Factor Amounts for Dispositions ExpressedAs a Percentage of Total Credits

Calendar Year Building Placed in Serviceor, if Section 42(f)(1) Election Was Made,

the Succeeding Calendar Year

Month ofDisposition

2003 2004 2005 2006

Jan ’06 78.01 81.02 83.60 83.98Feb ’06 77.81 80.77 83.28 83.98Mar ’06 77.61 80.53 83.00 83.98Apr ’06 77.42 80.32 82.76 83.98May ’06 77.25 80.12 82.54 83.98Jun ’06 77.08 79.93 82.35 83.98Jul ’06 86.92 90.99 94.61 97.21

Aug ’06 86.74 90.79 94.41 97.21Sep ’06 86.56 90.60 94.23 97.21Oct ’06 86.39 90.42 94.07 97.21Nov ’06 86.23 90.25 93.92 97.21Dec ’06 86.08 90.09 93.78 97.21

For a list of bond factor amounts ap-plicable to dispositions occurring duringother calendar years, see: Rev. Rul. 98–3,1998–1 C.B. 248; Rev. Rul. 2001–2,2001–1 C.B. 255; Rev. Rul. 2001–53,2001–2 C.B. 488; Rev. Rul. 2002–72,2002–2 C.B. 759; Rev. Rul. 2003–117,2003–2 C.B. 1051; Rev. Rul. 2004–100,2004–2 C.B. 718; and Rev. Rul. 2005–67,2005–43 I.R.B. 771.

DRAFTING INFORMATION

The principal author of this revenueruling is David McDonnell of the Officeof Associate Chief Counsel (Passthroughsand Special Industries). For further in-formation regarding this revenue ruling,contact Mr. McDonnell at (202) 622–3040(not a toll-free call).

Section 168.—AcceleratedCost Recovery System26 CFR 1.168(d)(1): Applicable conventions—half-year and mid-quarter convention.

T.D. 9283

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Special DepreciationAllowance

AGENCY: Internal Revenue Service(IRS), Treasury

ACTION: Final and temporary regula-tions.

SUMMARY: This document contains finalregulations relating to the depreciation ofproperty subject to section 168 of the In-ternal Revenue Code (MACRS property)and the depreciation of computer softwaresubject to section 167. Specifically, thesefinal regulations provide guidance regard-ing the additional first year depreciation al-lowance provided by sections 168(k) and1400L(b) for certain MACRS property andcomputer software. The regulations reflect

changes to the law made by the Job Cre-ation and Worker Assistance Act of 2002,the Jobs and Growth Tax Relief Reconcil-iation Act of 2003, the Working FamiliesTax Relief Act of 2004, the American JobsCreation Act of 2004, and the Gulf Oppor-tunity Zone Act of 2005.

DATES: Effective Dates: These regula-tions are effective August 31, 2006.

Applicability Dates: For dates ofapplicability, see §§1.167(a)–14(e),1.168(d)–1(d), 1.168(d)–1T(d), 1.168(k)–1(g), 1.169–3(g), and 1.1400L(b)–1(g).

FOR FURTHER INFORMATIONCONTACT: Douglas Kim, (202)622–3110 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to26 CFR part 1. On September 8, 2003, theIRS and Treasury Department publishedtemporary regulations (T.D. 9091, 2003–2C.B. 939) in the Federal Register (68 FR52986) relating to the additional first yeardepreciation deduction provisions of sec-tions 168(k) and 1400L(b) of the InternalRevenue Code (Code). On the same date,the IRS published a notice of proposedrulemaking (REG–157164–02, 2003–2

October 10, 2006 633 2006–41 I.R.B.

C.B. 1004) cross-referencing the tempo-rary regulations in the Federal Register(68 FR 53008). On March 1, 2004, thetemporary regulations (T.D. 9091) wereamended by the temporary regulations(T.D. 9115, 2004–1 C.B. 680) publishedby the IRS and Treasury Department in theFederal Register (69 FR 9529) relatingto the depreciation of property acquired ina like-kind exchange or as a result of aninvoluntary conversion, and the notice ofproposed rulemaking (REG–157164–02)was amended by the notice of proposedrulemaking (REG–106590–00, 2004–1C.B. 704, REG–138499–02, 2003–2 C.B.541) published by the IRS in the Fed-eral Register (69 FR 9560) cross-ref-erencing T.D. 9115. No public hearingwas requested or held. Several com-ments responding to the notice of pro-posed rulemaking (REG–157164–02)were received. After consideration of allthe comments, the proposed regulations(REG–157164–02) as amended by thisTreasury decision are adopted as final, andthe corresponding temporary regulations(T.D. 9091) are removed. The revisionsare discussed below. Additionally, minorchanges are made to the temporary regula-tions (T.D. 9115) to reflect the proper citesof the final regulations.

Section 1400N(d), which was addedto the Code by section 101(a) of the GulfOpportunity Zone Act of 2005, PublicLaw 109–135 (119 Stat. 2577), generallyallows a 50-percent additional first yeardepreciation deduction (GO Zone addi-tional first year depreciation deduction)for qualified Gulf Opportunity Zone prop-erty. Notice 2006–67, 2006–33 I.R.B.248, provides guidance with respect to theGO Zone additional first year deprecia-tion deduction. Because Notice 2006–67contains citations to the temporary regu-lations under section 168(k) (T.D. 9091),the IRS intends to update Notice 2006–67to change these citations to this Treasurydecision.

Explanation of Provisions

Section 167 allows as a depreciation de-duction a reasonable allowance for the ex-haustion, wear, and tear of property usedin a trade or business or held for the pro-duction of income. The depreciation al-lowable for tangible, depreciable propertyplaced in service after 1986 generally is

determined under section 168 (MACRSproperty). The depreciation allowable forcomputer software that is placed in serviceafter August 10, 1993, and is not an amorti-zable section 197 intangible is determinedunder section 167(f)(1).

Section 168(k)(1) allows a 30-percentadditional first year depreciation deduc-tion for qualified property acquired afterSeptember 10, 2001, and, in most cases,placed in service before January 1, 2005.Section 168(k)(4) allows a 50-percent ad-ditional first year depreciation deductionfor 50-percent bonus depreciation prop-erty acquired after May 5, 2003, and, inmost cases, placed in service before Jan-uary 1, 2005. Section 1400L(b) allowsa 30-percent additional first year depre-ciation deduction for qualified New YorkLiberty Zone property (Liberty Zone prop-erty) acquired after September 10, 2001,and placed in service before January 1,2007 (January 1, 2010, in the case of qual-ifying nonresidential real property and res-idential rental property).

The final regulations provide the re-quirements that must be met for deprecia-ble property to qualify for the additionalfirst year depreciation deduction providedby sections 168(k) and 1400L(b). Further,the final regulations instruct taxpayershow to determine the additional first yeardepreciation deduction and the amountof depreciation otherwise allowable foreligible depreciable property. Unlessspecifically stated, references to the tem-porary regulations are to T.D. 9091.

Property Eligible for the Additional FirstYear Depreciation Deduction

The final regulations retain the rulescontained in the temporary regulationsproviding that depreciable property mustmeet four requirements to be qualifiedproperty under section 168(k)(2) (prop-erty for which the 30-percent additionalfirst year depreciation deduction is al-lowable) or 50-percent bonus depreciationproperty under section 168(k)(4) (propertyfor which the 50-percent additional firstyear depreciation deduction is allowable).These requirements are: (1) the depre-ciable property must be of a specifiedtype; (2) the original use of the depre-ciable property must commence with thetaxpayer after September 10, 2001, forqualified property or after May 5, 2003,

for 50-percent bonus depreciation prop-erty; (3) the depreciable property must beacquired by the taxpayer within a speci-fied time period; and (4) the depreciableproperty must be placed in service by aspecified date.

Several commentators questionedwhether these requirements must be met inthe year in which the depreciable propertyis placed in service by the taxpayer. Thestatute is clear that additional first yeardepreciation is allowed in the taxable yearin which qualified property or 50 percentbonus depreciation property is placed inservice by the taxpayer for use in its tradeor business or for production of income.Therefore, only property that meets all ofthese requirements in the year in whichplaced in service by the taxpayer for usein its trade or business or for productionof income is allowed additional first yeardepreciation in the year the property isplaced in service by the taxpayer for usein its trade or business or for productionof income. In response to this comment,the final regulations state more explicitlythat all of the requirements must be met inthe first taxable year in which the propertyis subject to depreciation by the taxpayerwhether or not depreciation deductions areallowable.

Property of a Specified Type

The final regulations retain the rulescontained in the temporary regulationsproviding that qualified property or50-percent bonus depreciation propertymust be one of the following: (1) MACRSproperty that has a recovery period of 20years or less; (2) computer software asdefined in, and depreciated under, section167(f)(1); (3) water utility property as de-fined in section 168(e)(5) and depreciatedunder section 168; or (4) qualified lease-hold improvement property depreciatedunder section 168.

The final regulations also retain therules contained in the temporary regula-tions providing that qualified property or50-percent bonus depreciation propertydoes not include: (1) property excludedfrom the application of section 168 as aresult of section 168(f); (2) property thatis required to be depreciated under thealternative depreciation system of section168(g) (ADS); (3) any class of propertyfor which the taxpayer elects not to deduct

2006–41 I.R.B. 634 October 10, 2006

the 30-percent or 50-percent additionalfirst year depreciation; or (4) qualifiedNew York Liberty Zone leasehold im-provement property as defined in section1400L(c).

Property is required to be depreciatedunder the ADS if the property is describedunder section 168(g)(1)(A) through (D)or if other provisions of the Code re-quire depreciation for the property tobe determined under the ADS (for ex-ample, section 263A(e)(2)(A) or section280F(b)(1)). A commentator questionedwhether depreciable property held by tax-payers that made the election under section263A(d)(3) should be excluded from eli-gibility for the additional first year depre-ciation deduction. Section 263A(e)(2)(A)provides that if a taxpayer (or a relatedperson) makes an election under section263A(d)(3) (relating to an election not toapply section 263A to any plant producedin any farming business carried on by thetaxpayer), the ADS applies to all propertyof the taxpayer used predominantly in thefarming business and placed in service inany taxable year during which any suchelection is in effect. Section 168(k) doesnot exclude property for which the sec-tion 263A(d)(3) election was made fromthe application of section 168(k)(2)(D)(i),which provides that property requiredto be depreciated under the ADS is notqualified property and 50-percent bonusdepreciation property. For this reason,the final regulations do not adopt the sug-gestion that depreciable property held bytaxpayers that made the election undersection 263A(d)(3) is eligible for the ad-ditional first year depreciation deduction.Another commentator requested clarifica-tion as to whether the reference to “prop-erty described in section 263A(e)(2)(A)”in §1.168(k)–1T(b)(2)(ii)(A)(2) includesonly property held by a taxpayer thathas made an election under section263A(d)(3). In response to this com-ment, the final regulations clarify thatif the taxpayer (or a related person)has made the election under section263A(d)(3), the property described insection 263A(e)(2)(A) is not eligible forthe additional first year depreciation de-duction.

Original Use

The final regulations clarify and makeconforming changes to the original userules in the temporary regulations in sev-eral respects. First, a commentator in-quired whether the rule providing that thecost of reconditioned or rebuilt propertyacquired by the taxpayer does not satisfythe original use requirement also appliesto self-constructed property. A few com-mentators inquired whether the 20-percenttest for determining whether property is re-conditioned or rebuilt applies to self-con-structed property. The IRS and TreasuryDepartment intended that these rules ap-ply to the cost of any reconditioned or re-built property, whether the taxpayer orig-inally acquired the property or self-con-structed the property. Accordingly, the fi-nal regulations clarify that the cost of re-conditioned or rebuilt property does notsatisfy the original use requirement andthat the 20-percent test applies to acquiredor self-constructed property.

Second, Example 2 of §1.168(k)–1T(b)(3)(v) provides that property heldprimarily for sale to customers in theordinary course of a person’s business(inventory) does not constitute a use forpurposes of the original use requirement.A commentator noted that this rule is notin the operative rules of the temporaryregulations. In response to this comment,the final regulations make the rule explicitand provide that if a person initially ac-quires new property and holds the propertyas inventory and a taxpayer subsequentlyacquires the property from the person foruse primarily in the taxpayer’s trade orbusiness or primarily for the taxpayer’sproduction of income, the taxpayer is con-sidered the original user of the property.The final regulations also provide that ifa taxpayer initially acquires new propertyand holds the property as inventory andthen subsequently withdraws the propertyfrom inventory and uses the property pri-marily in the taxpayer’s trade or businessor primarily for the taxpayer’s productionof income, the taxpayer is considered theoriginal user of the property. In both sit-uations, the final regulations provide thatthe original use of the property by the tax-payer commences on the date on which thetaxpayer uses the property primarily in thetaxpayer’s trade or business or primarilyfor the taxpayer’s production of income.

A commentator questioned whether Ex-ample 2 in §1.168(k)– 1T(b)(3)(v) is theappropriate place to resolve the issue ofthe tax treatment of demonstrator auto-mobiles for depreciation and other pur-poses when the issue may have a poten-tial broader scope and significance thatmay continue to arise long after the addi-tional first year depreciation under section168(k) has ceased to be available. The IRSand Treasury Department believe that thisexample illustrates only the concept that ifproperty is held by a person as inventoryand then sold to a taxpayer for use in thetaxpayer’s trade or business, the taxpayeris the original user of the property, and,therefore, that this example is in the appro-priate place.

Third, the final regulations retain thespecial rules contained in the temporaryregulations for certain sale-leasebacktransactions and syndication transactions.A commentator suggested that the titleof §1.168(k)–1T(b)(3)(iii)(B), “Syndica-tion transaction,” should be changed inthe final regulations to reflect that thisrule, by its terms, can apply to any saleof property within three months after thedate on which it is placed in service, re-gardless of whether that sale constitutes asyndication. The final regulations adoptthis suggestion and modify the titles of,and make conforming changes to, the ap-plicable paragraphs. Similar changes alsoare made to the paragraphs relating to theplaced-in-service date requirement.

Fourth, the final regulations modifythe provision in the temporary regula-tions to implement section 403(a) of theWorking Families Tax Relief Act of 2004,(Public Law 108–311, 118 Stat. 1166)(October 4, 2004) (WFTRA) and section337 of the American Jobs Creation Actof 2004 (Public Law 108–357, 118 Stat.1418) (October 22, 2004) (AJCA). Section403(a) of the WFTRA amended section168(k) by adding the provision in section168(k)(2)(E)(iii). Section 403(f) of theWFTRA provides that this amendment iseffective as if included in the provisionsof the Job Creation and Worker Assis-tance Act of 2002 (Public Law 107–147,116 Stat. 21) (March 9, 2002) (JCWAA).Section 337(a) of the AJCA amended thesyndication transaction provision in sec-tion 168(k)(2)(E)(iii)(II) by adding at theend the following: “(or, in the case of mul-tiple units of property subject to the same

October 10, 2006 635 2006–41 I.R.B.

lease, within 3 months after the date thefinal unit is placed in service, so long asthe period between the time the first unitis placed in service and the time the lastunit is placed in service does not exceed12 months).” Section 337(b) of the AJCAprovides that this amendment is effectivefor property sold after June 4, 2004.

Fifth, if property placed in service bya person is sold and leased back withinthree months, and a syndication transac-tion occurs within three months after thesale-leaseback, a commentator questionedwhether the purchaser of the propertyin the syndication transaction is consid-ered the original user of the propertyand whether the property is treated ashaving been placed in service by the pur-chaser in the syndication transaction. Pur-suant to §§1.168(k)–1T(b)(3)(iii)(C) and(5)(ii)(C), the purchaser of the property inthe syndication transaction is consideredthe original user of the property and theproperty is treated as having been placedin service by the purchaser in the syndi-cation transaction. The final regulationsretain this rule and provide an exampleillustrating both the original use and theplaced in service aspects of this situation.

Finally, the final regulations retain therule contained in the temporary regulationsproviding that if, in the ordinary courseof its business, a taxpayer sells fractionalinterests in qualified property or 50-per-cent bonus depreciation property to un-related third parties, each first fractionalowner of the property is considered as theoriginal user of its proportionate share ofthe property. A commentator questionedwhether the rule requiring the sale to be tounrelated third parties means that the pur-chasers must be unrelated to the seller, thepurchasers must be unrelated to each other,or both. The IRS and Treasury Departmentintended that the purchasers be unrelatedto the seller. Accordingly, the final regula-tions clarify this point.

A commentator questioned whetherthere are circumstances when theplaced-in-service year of property isbefore the taxable year of original use.Pursuant to §1.46–3(d)(1)(ii), property isconsidered placed in service in the tax-able year in which the property is placedin a condition or state of readiness andavailability for a specifically assignedfunction, whether in a trade or business, inthe production of income, in a tax-exempt

activity, or in a personal activity. Originaluse begins when new property is placed inservice. Consequently, the placed-in-ser-vice year of new property cannot be beforethe taxable year in which original use ofthe property occurs.

Acquisition of Property

The final regulations modify the ac-quisition dates in the temporary regula-tions to reflect section 405 of the Gulf Op-portunity Zone Act of 2005 (Public Law109–135, 119 Stat. 2577) (December 21,2005) (GOZA). Section 405(a)(1) of theGOZA amended section 168(k)(4)(B)(ii)to provide that 50-percent bonus depreci-ation property is property (I) acquired bythe taxpayer after May 5, 2003, and be-fore January 1, 2005, but only if no writ-ten binding contract for the acquisition ofthe property was in effect before May 6,2003, or (II) acquired by the taxpayer pur-suant to a written binding contract whichwas entered into after May 5, 2003, andbefore January 1, 2005. Section 405(b)provides that this amendment is effectiveas if included in section 201 of the Jobsand Growth Tax Relief and ReconciliationAct of 2003 (Public Law 108–27, 117 Stat.752) (May 28, 2003).

Binding Contracts

The final regulations also modify inthree respects the rules contained in thetemporary regulations defining a bindingcontract. First, the temporary regulationsprovide that if a contract provides for afull refund of the purchase price in lieu ofany damages allowable by law in the eventof breach or cancellation by the seller, thecontract is not considered binding. A com-mentator suggested that this rule shouldapply to a breach or cancellation by thebuyer, not the seller. However, the IRSand Treasury Department believe that thisrule relates to a breach or cancellation byeither party. Accordingly, the final regu-lations provide that if a contract providesfor a full refund of the purchase price inlieu of any damages allowable by law inthe event of breach or cancellation, thecontract is not considered binding.

Second, with respect to a contract sub-ject to a condition, the temporary regula-tions provide that a contract that imposessignificant obligations on the taxpayer ora predecessor will be treated as binding

notwithstanding the fact that insubstantialterms remain to be negotiated by the par-ties to the contract. A commentator ques-tioned whether this rule implies that a con-tract that imposes significant obligationswill not be treated as binding if substan-tial terms remain to be negotiated. TheIRS and Treasury Department believe thatthis implication was not intended. As aconsequence, the final regulations clarifythis rule by providing that a contract thatimposes significant obligations on the tax-payer or a predecessor will be treated asbinding notwithstanding the fact that cer-tain terms remain to be negotiated by theparties to the contract.

Third, with respect to a supply agree-ment, a commentator suggested that theexistence of agreed pricing terms shouldnot be relevant in determining whether ornot a supply agreement is a binding con-tract, except to the extent that their absencecauses the contract not to be enforceableunder local law. The commentator furthersuggested that if the existence of pricingterms is considered relevant to the resultin the example of the operative rule andin some of the examples that illustrate theapplication of the rule, that requirementshould be stated in the operative rule, andif not relevant, the references to pricingterms should be deleted. Pricing terms arenot relevant in determining whether a sup-ply agreement is a binding contract for pur-poses of these regulations. Accordingly,the final regulations adopt the suggestionby eliminating the reference to agreed pric-ing terms in the example of the operativerule. While the examples that illustratethe application of the rule continue to con-tain the agreed price as a fact, the conclu-sions in these examples depend upon onlywhether or not the quantity and the de-sign specification of the property to be pur-chased are specified.

Self-constructed property

With respect to self-constructed prop-erty, the final regulations clarify the rulesin the temporary regulations in severalrespects. First, with respect to propertydescribed in section 168(k)(2)(B) (longerproduction period property) or section168(k)(2)(C) (certain aircraft), the finalregulations clarify that if a taxpayer en-ters into a written binding contract afterSeptember 10, 2001, and before January 1,

2006–41 I.R.B. 636 October 10, 2006

2005, with another person to manufacture,construct, or produce such property andthe manufacture, construction, or produc-tion begins after December 31, 2004, thetaxpayer has acquired the property pur-suant to a written binding contract enteredinto after September 10, 2001, and beforeJanuary 1, 2005 (for qualified property) orafter May 5, 2003, and before January 1,2005 (for 50-percent bonus depreciationproperty).

Second, a commentator asked whetherthe rules in the temporary regulations pro-viding for when construction begins are in-tended also to apply to manufacture andproduction because self-constructed prop-erty can be manufactured, constructed, orproduced for purposes of the additionalfirst year depreciation deduction. The IRSand Treasury Department intended theserules to apply to manufacture, construc-tion, or production. Accordingly, the finalregulations make this clarification.

Third, the temporary regulations pro-vide that construction of property beginswhen physical work of a significant na-ture begins and the determination of whenphysical work of a significant naturebegins depends on the facts and circum-stances. The temporary regulations alsoprovide that physical work of a significantnature will not be considered to begin be-fore the taxpayer incurs or pays more than10 percent of the total cost of the property(excluding the cost of any land and prelim-inary activities). Several commentatorsquestioned whether this 10-percent test isa safe harbor. The preamble to the tempo-rary regulations (68 FR 52987) states thatthe 10-percent test is a safe harbor. Conse-quently, the final regulations are clarifiedto provide that the 10-percent test is a safeharbor. Further, when another party manu-factures, constructs, or produces propertyfor the taxpayer, the final regulations clar-ify that the safe harbor test must be metby the taxpayer. Thus, under the final reg-ulations, a taxpayer can determine whenmanufacture, construction, or productionof the property begins either (1) by usingthe 10 percent safe harbor or (2) by usingits own facts and circumstances.

Fourth, the final regulations retain therules contained in the temporary regula-tions relating to components of self-con-structed property. One of these rules isthat if the binding contract to acquire a

component is entered into, or the man-ufacture, construction, or production ofa component begins, after September 10,2001, for qualified property, or after May5, 2003, for 50-percent bonus deprecia-tion property, and before January 1, 2005,but the manufacture, construction, or pro-duction of the larger self-constructed prop-erty begins after December 31, 2004, thecomponent qualifies for the additional firstyear depreciation deduction (assuming allother requirements are met) but the largerself-constructed property does not. In thecase of a self-constructed component thatis to be incorporated into a larger self-constructed property, some commentatorsnoted that the applicability of this rule islimited. Specifically, one commentatorstated that if the 10 percent test mentionedin the preceding paragraph is not a safeharbor test, then the only case in whichself-constructed components could qualifyfor the additional first year depreciationdeduction is one in which the taxpayer’spre-January 1, 2005, costs are 10 percentor less of the total cost of the larger self-constructed property (but more than 10percent of the total cost of the component).Another commentator stated that a self-constructed component that is to be incor-porated into a larger self-constructed prop-erty may not be placed in service beforethe larger self-constructed property. TheIRS and Treasury Department agree thatthe rule has limited applicability. The ruleapplies when the larger self-constructedproperty is property that is manufactured,constructed, or produced by the taxpayerfor its own use and that is described in sec-tion 168(k)(2)(B) (longer production pe-riod property) or section 168(k)(2)(C) (cer-tain aircraft) and, therefore, the property iseligible for the extended placed-in-servicedate of January 1, 2006.

Disqualified transactions

The final regulations clarify the dis-qualified transaction rules in the tempo-rary regulations to reflect section 403(a) ofthe WFTRA. This section amended section168(k) by adding section 168(k)(2)(E)(iv),which provides limitations related to usersand related parties (disqualified transac-tions). Section 168(k)(2)(E)(iv) providesthat the term qualified property does notinclude any property if: (I) the user ofsuch property (as of the date on which the

property is originally placed in service) ora person that is related (within the mean-ing of section 267(b) or 707(b)) to suchuser or to the taxpayer had a written bind-ing contract in effect for the acquisitionof the property at any time on or beforeSeptember 10, 2001; or (II) in the caseof property manufactured, constructed, orproduced for such user’s or person’s ownuse, the manufacture, construction, or pro-duction of the property began at any timeon or before September 10, 2001. Section403(f) of the WFTRA provides that thisamendment is effective as if included in theprovisions of the JCWAA.

Finally, the IRS and Treasury Depart-ment decided to add new examples to illus-trate the above rules. Further, in Example10 of §1.168(k)–1T(b)(4)(v), a commen-tator inquired whether the taxpayer (S)is considered to be self-constructing theproperty, acquiring the property, or both.The IRS and Treasury Department in-tended to have the taxpayer both self-con-structing and acquiring the property. Thefinal regulations make this clarification.

A commentator questioned whetherthe result in Example 10 of §1.168(k)–1T(b)(4)(v) also would apply if beforeSeptember 11, 2001, a partnership beganconstruction of a power plant for its ownuse, then after September 10, 2001, andbefore completion of the plant, there is atechnical termination of the partnershipunder section 708(b)(1)(B), and then sub-sequently the new partnership incurredadditional expenditures to complete theconstruction of the power plant and placedthe power plant in service before January1, 2005. Assuming the terminated part-nership and the new partnership are notrelated parties, the new partnership is con-sidered to have acquired the uncompletedpower plant and completed the construc-tion of the power plant and, thus, the resultin Example 10 of §1.168(k)–1T(b)(4)(v)will apply to the new partnership in thiscase. While the additional first year de-preciation deduction for Liberty Zoneproperty requires the property to be ac-quired by purchase, the same result wouldapply because for purposes of that require-ment, §1.1400L(b)–1T(c)(5)(ii) treats thenew partnership as acquiring the propertyby purchase and the final regulations re-tain this rule.

October 10, 2006 637 2006–41 I.R.B.

Placed-in-service Date

The final regulations retain the rule con-tained in the temporary regulations provid-ing, pursuant to section 168(k)(2)(A)(iv)and section 168(k)(4)(B)(iii), that quali-fied property or 50-percent bonus depre-ciation property is property that is placedin service by the taxpayer before January1, 2005. The temporary regulations alsoprovide that property described in section168(k)(2)(B) (longer production periodproperty) must be placed in service beforeJanuary 1, 2006. The final regulationsmodify this extended placed-in-servicedate requirement in two respects. First, thefinal regulations reflect that the extendedplaced-in-service date of before January1, 2006, also applies to property describedin section 168(k)(2)(C) (certain aircraft),which was added to section 168(k) bysection 336 of the AJCA. Second, the fi-nal regulations reflect that the extendedplaced-in-service date of before January1, 2006, is extended for one year to beforeJanuary 1, 2007, for property to whichAnnouncement 2006–29, 2006–19 I.R.B.879 applies. Announcement 2006–29applies to property described in section168(k)(2)(B) or (C) that is either placed inservice by the taxpayer or manufacturedby a person in the Gulf Opportunity (GO)Zone, the Rita GO Zone, or the WilmaGO Zone, provided the taxpayer wasunable to meet the December 31, 2005,placed-in-service date deadline for suchproperty as a result of Hurricane Katrina,Hurricane Rita, or Hurricane Wilma.

Qualified Leasehold ImprovementProperty

The final regulations retain the rulescontained in the temporary regulations re-lating to qualified leasehold improvementproperty. The temporary regulations pro-vide that qualified leasehold improvementproperty means any improvement, whichis section 1250 property, to an interior por-tion of a building that is nonresidential realproperty if, among other things, the im-provement is made under or pursuant to alease by the lessee (or any sublessee) of theinterior portion, or by the lessor of that in-terior portion. A commentator questionedwhether this rule means an improvementthat is permitted or required by a lease.The IRS and Treasury Department believe

that the improvement must be made un-der or pursuant to a lease, regardless ofwhether the improvement is permitted orrequired under the lease.

Computation of Additional First YearDepreciation Deduction and OtherwiseAllowable Depreciation

The final regulations retain the rulescontained in the temporary regulations fordetermining the amount of the additionalfirst year depreciation deduction and oth-erwise allowable depreciation deduction.In addition, the final regulations clarifythat the additional first year depreciationdeduction generally is allowable in thefirst taxable year in which the qualifiedproperty or 50-percent bonus depreciationproperty is placed in service by the tax-payer for use in its trade or business or forthe production of income.

Election Not to Claim Additional FirstYear Depreciation Deduction

With respect to the election not to claimthe additional first year depreciation de-duction, the final regulations retain therules contained in the temporary regu-lations for making this election and fordefining what is a class of property forpurposes of the election. For any classof property that is qualified property, ataxpayer may elect out of the 30-per-cent additional first year depreciationdeduction for any class of qualified prop-erty. For any class of property that is50-percent bonus depreciation property,a taxpayer may elect either to deduct the30-percent, instead of the 50-percent, ad-ditional first year depreciation or to deductno additional first year depreciation. Acommentator asked whether a taxpayerwith 50-percent bonus depreciation prop-erty must make two elections to elect notto deduct any additional first year depre-ciation. The final regulations clarify thatonly one election is needed to elect notto deduct both the 30-percent and 50-per-cent additional first year depreciation for50-percent bonus depreciation property.

If a taxpayer elects not to deduct any ad-ditional first year depreciation for a classof property, another commentator askedwhether the depreciation adjustments un-der section 56 apply to property includedin such class for purposes of computing

the taxpayer’s alternative minimum tax-able income. The non-applicability of thedepreciation adjustments under section 56provided by section 168(k)(2)(G) appliesonly to qualified property or 50-percentbonus depreciation property. If a taxpayerelects not to deduct any additional firstyear depreciation for a class of property,the property included in such class is notqualified property or 50-percent bonus de-preciation property. Accordingly, the fi-nal regulations provide that if a taxpayerelects not to deduct any additional firstyear depreciation for a class of property,the depreciation adjustments under section56 apply to that property for purposes ofcomputing the taxpayer’s alternative min-imum taxable income.

The final regulations also include theprocedures provided by section 3.04 ofRev. Proc. 2002–33, 2002–1 C.B. 963, forrevoking an election not to deduct the ad-ditional first year depreciation for a classof property. These procedures providethat this election is revocable only withthe prior written consent of the Commis-sioner of Internal Revenue and, to seekthe Commissioner’s consent, the taxpayermust submit a request for a letter ruling.However, the final regulations also pro-vide an automatic 6-month extension fromthe due date of the taxpayer’s Federaltax return (excluding extensions) for theplaced-in-service year to revoke the elec-tion, provided the taxpayer timely filed itsFederal tax return for the placed-in-serviceyear.

Liberty Zone Property

Generally, the requirements for deter-mining the eligibility of property for theadditional first year depreciation deduc-tion for Liberty Zone property provided bysection 1400L(b) are similar to the require-ments for the 30-percent additional firstyear depreciation deduction for qualifiedproperty provided by section 168(k)(1) inthe final regulations. The final regula-tions made several changes to the tempo-rary regulations with respect to the LibertyZone property, which are discussed below.

The final regulations retain the rule con-tained in the temporary regulations provid-ing that Liberty Zone property includes thesame property that is described as qualifiedproperty or 50-percent bonus depreciationproperty for purposes of section 168(k). In

2006–41 I.R.B. 638 October 10, 2006

addition, Liberty Zone property includesnonresidential real property or residentialrental property to the extent such prop-erty rehabilitates real property damaged,or replaces real property destroyed or con-demned, as a result of the terrorist attacksof September 11, 2001. Real property isconsidered to have been destroyed or con-demned only if an entire building or struc-ture was destroyed or condemned as a re-sult of the terrorist attacks of September11, 2001. Property is treated as replac-ing destroyed or condemned property if, aspart of an integrated plan, the property re-places real property that is included in acontinuous area that includes real propertydestroyed or condemned. A commentatornoted that the temporary regulations sim-ply reiterate the statute but do not definethe word continuous. The IRS and Trea-sury Department believe that the commonmeaning of continuous applies.

The temporary regulations define realproperty as a building or its structuralcomponents, or other tangible real prop-erty except: (1) property described insection 1245(a)(3)(B) (relating to depre-ciable property used as an integral partof a specified activity or as a specifiedfacility); (2) property described in sec-tion 1245(a)(3)(D) (relating to a singlepurpose agricultural or horticultural struc-ture); and (3) property described in section1245(a)(3)(E) (relating to storage facilityused in connection with the distributionof petroleum or any primary product ofpetroleum). A commentator suggestedthat these exclusions to the definition ofreal property should be deleted in the finalregulations. As a result of this definition,nonresidential real property or residentialrental property that rehabilitates or re-places any of the excluded properties thatwere damaged, destroyed, or condemned,is not eligible for the Liberty Zone addi-tional first year depreciation deduction.For this reason, the IRS and Treasury De-partment agree. Accordingly, the finalregulations provide that real property is abuilding or its structural components, orother tangible real property.

The temporary regulations provide thatLiberty Zone property does not includeproperty that is described as qualifiedproperty or 50-percent bonus depreci-ation property for purposes of section168(k), or property that is described in§1.168(k)–1T(b)(2)(ii). The property de-

scribed in §1.168(k)–1T(b)(2)(ii) is prop-erty that is: (1) described in section 168(f);(2) required to be depreciated under thealternative depreciation system; (3) in-cluded in any class of property for whichthe taxpayer elects out of the additionalfirst year depreciation deduction undersection 168(k); or (4) qualified LibertyZone leasehold improvement property.Instead of providing a cross-reference to§1.168(k)–1(b)(2)(ii), the final regula-tions list the property that is describedin §1.168(k)–1(b)(2)(ii) with one modifi-cation to the exclusion for property thatis included in any class of property forwhich the taxpayer elects out of the ad-ditional first year depreciation deductionunder section 168(k). In this regard, acommentator stated that while section1400L(b)(2)(C)(iv) provides that the elec-tion out rules for purposes of section1400L(b) are to be similar to the electionout rules under section 168(k), section1400L(b)(2)(C)(iv) does not mean that thesame election must be made with respectto both sections 168(k) and 1400L(b).Accordingly, the commentator suggestedthat a taxpayer be permitted to elect notto apply section 168(k) to its property ofa particular class of property to the extentthat such property is not located withinthe Liberty Zone, while still being entitledto the benefits of section 1400L(b) for itsproperty of the same class that is locatedwithin the Liberty Zone. The IRS andTreasury Department agree with this sug-gestion. Accordingly, the final regulationsmake clear that Liberty Zone propertyis not property included in any class ofproperty for which the taxpayer elects outof the additional first year depreciationdeduction under section 1400L(b).

The final regulations retain the rule con-tained in the temporary regulations provid-ing that Liberty Zone property is propertythat is acquired by the taxpayer by pur-chase after September 10, 2001, but onlyif no written binding contract for the ac-quisition of the property was in effect be-fore September 10, 2001. The term bypurchase is defined in section 179(d) and§1.179–4(c). The final regulations also re-tain the rule contained in the temporaryregulations providing that the new partner-ship resulting from a technical terminationunder section 708(b)(1)(B) or a transfereein section 168(i)(7) transactions is deemedto acquire the depreciable property by pur-

chase. A commentator suggested that therule should apply only if the old transferorpartnership had itself acquired the prop-erty by purchase, as the mere existence ofa technical termination does not providesufficient reason to deem the statutory pur-chase requirement to have been met. Thefinal regulations do not adopt this sugges-tion. The rule is the result of the rulesprovided in the temporary regulations re-garding the additional first year deprecia-tion deduction under sections 168(k) and1400L(b) that allow the new partnershipresulting from a technical termination tobe entitled to the additional first year de-preciation deduction for eligible propertythat was placed in service by the termi-nated partnership during the taxable yearof termination. As a result, the IRS andTreasury Department determined that therule should not be changed.

The final regulations also retain therules contained in the temporary regula-tions for electing not to deduct the LibertyZone additional first year depreciationdeduction for a class of property. In addi-tion, the final regulations for this electioninclude provisions similar to those previ-ously discussed relating to the alternativeminimum tax and the revocation of theelection with respect to the election not todeduct the additional first year deprecia-tion deduction under section 168(k).

Special Rules

Similar to the temporary regulations,the final regulations provide special rulesfor the following situations: (1) qualifiedproperty, 50-percent bonus depreciationproperty, or Liberty Zone property placedin service and disposed of in the same tax-able year; (2) redetermination of basis ofqualified property, 50-percent bonus de-preciation property, or Liberty Zone prop-erty; (3) recapture of additional first yeardepreciation for purposes of section 1245and section 1250; (4) a certified pollutioncontrol facility that is qualified property,50-percent bonus depreciation property,or Liberty Zone property; (5) like-kindexchanges and involuntary conversionsof qualified property, 50-percent bonusdepreciation property, or Liberty Zoneproperty; (6) a change in use of qualifiedproperty, 50-percent bonus depreciationproperty, or Liberty Zone property; (7)the computation of earnings and profits;

October 10, 2006 639 2006–41 I.R.B.

(8) the increase in the limitation of theamount of depreciation for passenger au-tomobiles; and (9) the step-up in basisdue to a section 754 election. For someof these situations, the final regulationsmodify or clarify the rules contained inthe temporary regulations. In addition, thefinal regulations provide rules for two newsituations: the rehabilitation credit undersection 47 and the computation of depre-ciation for purposes of section 514(a)(3).

Property placed in service and disposedof in the same taxable year

With respect to qualified property,50-percent bonus depreciation property,or Liberty Zone property placed in ser-vice and disposed of in the same taxableyear, the final regulations retain the rulescontained in the temporary regulations. Ingeneral, the regulations provide that theadditional first year depreciation deduc-tion is not allowed. If qualified propertyor 50-percent bonus depreciation propertyis placed in service and disposed of bya taxpayer in the same taxable year andthen, in a subsequent taxable year, is reac-quired and again placed in service by thetaxpayer, a commentator inquired whetherthe additional first year depreciation de-duction is allowable in the subsequenttaxable year. Because the property is usedproperty in the subsequent taxable year,the additional first year depreciation de-duction is not allowable for the propertyin the subsequent taxable year. Accord-ingly, in this situation, the final regulationsclarify that the additional first year depre-ciation deduction is not allowable for theproperty in the subsequent taxable year.

The temporary regulations provide twoexceptions to the general rule. First, theadditional first year depreciation deduc-tion is allowable for qualified property,50-percent bonus depreciation property, orLiberty Zone property placed in service bya terminated partnership in the same tax-able year in which a technical terminationof the partnership occurs. In this case, thenew partnership, and not the terminatedpartnership, claims the additional first yeardepreciation deduction. Second, the ad-ditional first year depreciation deductionis allowable for qualified property, 50-per-cent bonus depreciation property, or Lib-erty Zone property placed in service bya transferor in the same taxable year in

which the property is transferred in a trans-action described in section 168(i)(7). Inthis case, the additional first year depre-ciation deduction for the transferor’s tax-able year in which the property is placedin service is allocated between the trans-feror and the transferee on a monthly basis.The allocation shall be made in accordancewith the rules in §1.168(d)–1(b)(7)(ii) forallocating the depreciation deduction be-tween the transferor and the transferee.If the transferee has a different taxableyear than the transferor, a commentatorquestioned whether the allocation of theadditional first year depreciation deduc-tion would be made between the transferorand the transferee in accordance with theabove rules. Because the allocation rulesin §1.168(d)–1(b)(7)(ii) cover this situa-tion, the IRS and Treasury Department didnot modify the rule in the final regulations.

Redetermination of basis

The final regulations also retain therules contained in the temporary regula-tions with respect to a redeterminationof basis of qualified property, 50-percentbonus depreciation property, or LibertyZone property (for example, due to a con-tingent purchase price or a discharge ofindebtedness). These rules apply to a rede-termination of the unadjusted depreciablebasis of the property occurring beforeJanuary 1, 2005 (January 1, 2006, for theextended placed-in-service date property)for qualified property or 50-percent bonusdepreciation property, or before January 1,2007 (January 1, 2010, in the case of non-residential real property and residentialrental property) for Liberty Zone property.A commentator suggested that the rulesshould be expanded to include redeter-minations of basis occurring on or afterthese dates. The commentator pointedout that the rule results in additional firstyear depreciation not being allowable foradditional purchase price paid on or afterJanuary 1, 2005, with respect to qualifiedproperty or 50-percent bonus depreciationproperty acquired before 2005. The finalregulations do not adopt this suggestion.While the current rule may be unfavorablewhen, for example, a redetermination ofbasis results in an increase of basis onor after January 1, 2005, for qualifiedproperty or 50-percent bonus depreciationproperty acquired before 2005, the current

rule may be favorable when, for exam-ple, a redetermination of basis results ina decrease of basis on or after January 1,2005, with respect to qualified propertyor 50-percent bonus depreciation propertyacquired before 2005. Further, the IRSand Treasury Department limited the rulesto redeterminations occurring before thedates mentioned above to be consistentwith the dates on which property mustbe placed in service to be eligible for theadditional first year depreciation deduc-tion. For this reason, the IRS and TreasuryDepartment determined not to change therule in the final regulations.

In the case of a redetermination ofbasis that results in a decrease in basis,a commentator noted that the operativerule provides that the taxpayer includesin the taxpayer’s income the excess ad-ditional first year depreciation deductionpreviously claimed for the qualified prop-erty, the 50-percent bonus depreciationproperty, or the Liberty Zone property butthe example illustrating the applicationof this rule allows the taxpayer to reducecurrent year depreciation deductions bythe amount of the excess additional firstyear depreciation deduction previouslyclaimed for the qualified property, the50-percent bonus depreciation property,or Liberty Zone property. Because theIRS and Treasury Department recognizethat the lump-sum inclusion in incomeapproach provided in the operative rule ofthe temporary regulation may adverselyaffect real estate investment trusts andsimilar entities, the final regulations pro-vide that the excess additional first yeardepreciation deduction offsets the amountotherwise allowable for depreciation forthe taxable year. Even if the amount ofthe offset exceeds the amount otherwiseallowable for depreciation for the taxableyear, the taxpayer takes into account anegative depreciation deduction in com-puting taxable income.

The final regulations retain the rulecontained in the temporary regulationsproviding that, for purposes of the redeter-mination of basis rules: (1) an increase inbasis occurs in the taxable year an amountis taken into account under section 461;and (2) a decrease in basis occurs in thetaxable year an amount is taken into ac-count under section 451. A commentatorquestioned whether because the event inquestion is giving rise to a basis adjust-

2006–41 I.R.B. 640 October 10, 2006

ment, rather than to an item of incomeor deduction, it is appropriate for the ruleto tie the timing of the adjustment to ac-counting method rules concerning thetiming of income and deductions. Thecommentator also noted that one apparenteffect of applying the accounting methodrules is to override the basis reductionrule of section 1017(a) as illustrated inExample 2 of §1.168(k)–1T(f)(2)(iv). TheIRS and Treasury Department did not in-tend to change the section 1017(a) rules.While the IRS and Treasury Departmentcontinue to believe that the current ruleis appropriate, the final regulations havebeen modified for cases in which the Code,the regulations under the Code, or otherpublished guidance expressly providesan exception to such rule (for example,section 1017(a)). Therefore, Example 2 of§1.168(k)–1(f)(2)(iv) in the final regula-tions reflects the basis adjustment rules ofsection 1017(a).

Like-kind exchanges and involuntaryconversions

With respect to MACRS property orcomputer software acquired in a like-kindexchange under section 1031 or as a re-sult of an involuntary conversion undersection 1033, the final regulations changethe rules contained in the temporary reg-ulations (T.D. 9091 as amended by T.D.9115) in several respects. First, the finalregulations modify the scope of this provi-sion to include property described in sec-tion 168(k)(2)(C) (certain aircraft), whichwas added to section 168(k) by section 336of the AJCA, and to include property towhich Announcement 2006–29, 2006–19I.R.B. 879, applies if the time of replace-ment is after September 10, 2001, and be-fore January 1, 2007. As previously noted,Announcement 2006–29 applies to prop-erty described in section 168(k)(2)(B) or(C) that is either placed in service by thetaxpayer or manufactured by a person inthe Gulf Opportunity (GO) Zone, the RitaGO Zone, or the Wilma GO Zone, pro-vided the taxpayer was unable to meet theDecember 31, 2005, placed-in-service datedeadline for such property as a result ofHurricane Katrina, Hurricane Rita, or Hur-ricane Wilma. Similar changes also aremade to the paragraph relating to the com-putation of the additional first year depre-ciation deduction for MACRS property or

computer software acquired in a like-kindexchange or as a result of an involuntaryconversion.

A commentator inquired whether therules should be expanded to include ex-changed or involuntarily converted prop-erty that is subject to former section 168(the accelerated cost recovery system orACRS) or that is pre–1981 depreciationproperty. The current rules apply onlyto exchanged or involuntarily convertedproperty that is MACRS property in or-der to conform with §1.168(i)–6T (relat-ing to depreciation of property acquired inlike-kind exchanges or as a result of in-voluntary conversions). Accordingly, theIRS and Treasury Department believe thatthis issue is outside the scope of these reg-ulations and should be addressed when thetemporary regulations under §1.168(i)–6Tare finalized.

Second, the temporary regulations de-fine the time of replacement as the laterof when the acquired MACRS propertyor acquired computer software is placedin service, or the time of disposition ofthe exchanged or involuntarily convertedproperty. A commentator expressed con-cern that in the case of an involuntaryconversion under section 1033, the finalregulations may confer an unintendedbenefit in the case of taxpayers who ac-quired property prior to September 11,2001, in order to replace property that wasultimately requisitioned or condemnedafter September 10, 2001, but as to whichthe threat or imminence of condemna-tion existed prior to that date. The IRSand Treasury Department acknowledgethat the rule confers a benefit under suchcircumstances, but continue to believethat the rule is appropriate. Addition-ally, the IRS and Treasury Departmentdecided to provide rules in the final reg-ulations to address how the additionalfirst year depreciation deduction is treatedwhen §1.168(i)–6T(d)(4) applies. Section1.168(i)–6T(d)(4) applies when, in an in-voluntary conversion, a taxpayer acquiresand places in service acquired MACRSproperty before the time of dispositionof the involuntarily converted MACRSproperty. If the time of disposition of theinvoluntarily converted MACRS prop-erty is after December 31, 2004, or, inthe case of property described in section168(k)(2)(B) or (C), after December 31,2005 (or after December 31, 2006, in

the case of property described in section168(k)(2)(B) or (C) to which Announce-ment 2006–29 applies), the final regula-tions provide that the time of replacementis when the acquired MACRS property isplaced in service, provided the threat orimminence of requisition or condemnationof the converted property existed prior toJanuary 1, 2005, or, in the case of propertydescribed in section 168(k)(2)(B) or (C),existed before January 1, 2006 (or existedbefore January 1, 2007, in the case ofproperty described in section 168(k)(2)(B)or (C) to which Announcement 2006–29applies). In this case, the final regulationsalso modify the income inclusion rulein §1.168(i)–6T(d)(4) to allow the addi-tional first year depreciation deduction onthe remaining carryover basis of the ac-quired MACRS property that is qualifiedproperty, 50-percent bonus depreciationproperty, or Liberty Zone property.

Third, the final regulations clarify therules contained in the temporary regula-tions relating to the computation of theadditional first year depreciation deduc-tion for property described in section168(k)(2)(B) (longer production periodproperty) and for alternative minimum taxpurposes. In both cases, the temporaryregulations provide a cross-reference to§1.168(k)–1T(d) (computation of depreci-ation deduction for qualified property or50-percent bonus depreciation property).A commentator suggested that the purposeof the reference to §1.168(k)–1T(d) shouldbe clarified. The final regulations adoptthis suggestion by deleting the cross-ref-erence and providing rules for computingthe additional first year depreciation de-duction for property described in section168(k)(2)(B) (longer production periodproperty) and for alternative minimum taxpurposes.

Also, a commentator questionedwhether the rule that the additional firstyear depreciation is calculated separatelywith respect to the carryover basis and theexcess basis is appropriate, and suggestedthat the rule should be simplified by elim-inating the requirement of separate calcu-lations. The IRS and Treasury Departmentbelieve that the rule is appropriate becauseit conforms with §1.168(i)–6T, whichrequires separate calculations of deprecia-tion for the carryover basis and the excessbasis.

October 10, 2006 641 2006–41 I.R.B.

Fourth, the final regulations clarifythe rules contained in the temporary reg-ulations relating to exchanged or invol-untarily converted MACRS property orexchanged or involuntarily convertedcomputer software that is placed in serviceand disposed of in an exchange or involun-tary conversion in the same taxable year.In this case, the temporary regulationsprovide that the additional first year de-preciation deduction is not allowable forthe exchanged or involuntarily convertedMACRS property or the exchanged or in-voluntarily converted computer softwareif the MACRS property or computer soft-ware is placed in service and disposed ofin an exchange or involuntary conversionin the same taxable year. A commentatorsuggested that the final regulations clarifythat the reference in the above rule to theMACRS property or computer softwarethat is placed in service and disposed of inthe same taxable year is the exchanged orinvoluntarily converted MACRS propertyor exchanged or involuntarily convertedcomputer software. The final regulationsadopt this suggestion.

Finally, a new example is added andthe facts in several of the examples areclarified to reflect that the acquired prop-erty must be new property in order to meetthe original use requirement and, there-fore, qualify for the additional first year de-preciation deduction.

Change in use

The final regulations retain the rulescontained in the temporary regulationsproviding when the use of qualified prop-erty, 50-percent bonus depreciation prop-erty, or Liberty Zone property changesin the hands of the same taxpayer duringthe placed-in-service year or a subse-quent taxable year. One of these rulesprovide that if property is acquired by ataxpayer for personal use and, during asubsequent taxable year, is converted bythe taxpayer from personal use to businessor income-producing use, the additionalfirst year depreciation deduction is allow-able for the property in the taxable yearthe property is converted to business orincome-producing use (assuming all therequirements for the additional first yeardepreciation deduction are met). Anotherrule provides that if depreciable propertyis not qualified property, 50-percent bonus

depreciation property, or Liberty Zoneproperty in the placed-in-service year, theadditional first year depreciation deduc-tion is not allowable for the property evenif a change in the use of the property subse-quent to the placed-in-service year resultsin the property being qualified property,50-percent bonus depreciation property,or Liberty Zone property in the taxableyear of the change in use. A commentatorquestioned whether these two rules areinconsistent. The commentator furthernoted that under §1.167(a)–11(e)(1)(i),property that is ready for use in a per-sonal activity is considered to be placedin service. The IRS and Treasury De-partment do not believe that the two rulesare inconsistent. Property is eligible forthe additional first year depreciation de-duction if in the first year in which theproperty is subject to depreciation, theproperty meets all the requirements toqualify for the additional first year depre-ciation deduction. In the case of propertythat changes from personal use to a busi-ness or income-producing use, the firstyear such property is subject to deprecia-tion is the year of conversion to business orincome-producing use. But in the case ofproperty that changes from a depreciableuse not eligible for the additional first yeardepreciation deduction to a depreciableuse that is eligible for the additional firstyear depreciation deduction, such propertydid not meet the requirements to qualifyfor the additional first year depreciationdeduction in the first year in which theproperty is subject to depreciation.

Earnings and profits

The final regulations retain the rule con-tained in the temporary regulations pro-viding that the additional first year de-preciation deduction is not allowable forpurposes of computing earnings and prof-its. A commentator suggested that becausethis provision interprets section 312(k), theregulations under section 312 should in-clude a cross-reference to the regulationsunder section 168(k). The IRS and Trea-sury Department agree and, accordingly,the final regulations adopt this suggestion.

280F(a)(1) limitation

The final regulations also retain therules contained in the temporary regula-

tions providing the increase in the lim-itation under section 280F(a)(1) of theamount of depreciation for certain passen-ger automobiles that are qualified propertyor 50-percent bonus depreciation property.A commentator had three inquiries aboutthis increase in the limitation under section280F(a)(1). First, the commentator askedwhether the increase in the limitation canbe taken as a section 179 expense. Theincrease in the limitation under section280F(a)(1) that is provided in the finalregulations may be taken as a section 179expense. Second, the commentator askedwhether the increase in the limitation ofamount of depreciation for certain pas-senger automobiles needs to be proratedin a short taxable year. Because the ad-ditional first year depreciation deductionis not prorated for a short taxable year,the increase in the limitation under section280F(a)(1) that is provided in the final reg-ulations also is not prorated. Third, whencalculating depreciation for an asset withless than 100 percent business use, thecommentator asked whether the businessuse percentage is applied to the increasein the limitation of amount of depreciationfor certain passenger automobiles. If ataxpayer’s business use of the automobileis less than 100 percent, the business usepercentage is applied to the automobile’sdepreciation deduction, including the ad-ditional first year depreciation deduction,for the taxable year. The IRS and TreasuryDepartment believe that these issues areoutside the scope of these regulations and,accordingly, the final regulations do notaddress these issues.

Section 754 election

Finally, the final regulations retain therules contained in the temporary regula-tions relating to any increase in basis ofqualified property, 50-percent bonus de-preciation property, or Liberty Zone prop-erty due to a section 754 election. Underthese rules, such increase in basis gener-ally is not eligible for the additional firstyear depreciation deduction. However, ifqualified property, 50-percent bonus de-preciation property, or Liberty Zone prop-erty is placed in service by a partnershipin the taxable year the partnership termi-nates under section 708(b)(1)(B), any in-crease of basis of the qualified property,50-percent bonus depreciation property, or

2006–41 I.R.B. 642 October 10, 2006

Liberty Zone property due to a section 754election is eligible for the additional firstyear depreciation deduction. A commen-tator requested that we expand this termi-nating partnership rule to any increase inbasis due to a section 754 election thatarises before or during the placed-in-ser-vice year of the property. The IRS andTreasury Department decided not to do so.The rule for a termination of a partnershipunder section 708(b)(1)(B) was made to beconsistent with the special rule allowingthe new partnership, instead of the termi-nated partnership, to claim the additionalfirst year depreciation deduction for prop-erty placed in service during the taxableyear of termination and contributed by theterminated partnership to a new partner-ship. The IRS and Treasury Departmentbelieve that these rules should not be ex-panded to cover any other situations.

A commentator also suggested that weclarify the regulation to provide that anyincrease in basis due to a section 754 elec-tion that arises before or during the year inwhich the qualified property, 50-percentbonus depreciation property, or LibertyZone property is placed in service willbe taken into account for the additionalfirst year depreciation deduction. The IRSand Treasury Department did not adoptthis suggestion in the final regulations.The additional first year depreciation de-duction rules provide for the acceleratedrecovery of a taxpayer’s cost of qualifiedproperty, 50-percent bonus depreciationproperty, or Liberty Zone property. Manybasis increases resulting from a section754 election bear no relation whatso-ever to the cost of qualified property,50-percent bonus depreciation property,or Liberty Zone property. For example, ifa partnership with a section 754 electionin effect made a liquidating distributionof high-basis property to a partner withlow basis in his partnership interest, thebasis of the partnership’s undistributedproperty would be increased under section734(b) by an amount equal to the decreasein basis to the distributed property undersection 732(b). The amount of the section734(b) basis increase allocable to qualifiedproperty under section 755 would have nocorrelation to the taxpayer’s cost of theproperty. The IRS and Treasury Depart-ment believe that the rules regarding anybasis increase due to a section 754 election

should remain limited to those provided inthe temporary regulations.

Rehabilitation credit

Several commentators asked whetherproperty that is qualified property, 50-per-cent bonus depreciation property, or Lib-erty Zone property qualifies for the reha-bilitation credit under section 47. Section47 allows a rehabilitation credit for quali-fied rehabilitation expenditures for certainbuildings. Section 47(c)(2) defines theterm qualified rehabilitation expendi-ture as meaning, in general, any amountproperly chargeable to capital accountfor property for which depreciation isallowable under section 168 and that isnonresidential real property, residentialrental property, real property that has aclass life of more than 12.5 years, or anaddition or improvement thereof. How-ever, a qualified rehabilitation expendituredoes not include any expenditure with re-spect to which the taxpayer does not usethe straight line method over a recoveryperiod determined under section 168(c) or(g). Because the additional first year de-preciation deduction is not a straight linemethod, the IRS and Treasury Departmenthave decided to provide in the final regu-lations that if qualified rehabilitation ex-penditures (as defined in section 47(c)(2)and §1.48–12(c)) are qualified property,50-percent bonus depreciation property, orLiberty Zone property, the taxpayer mayclaim the additional first year depreciationdeduction for the unadjusted depreciablebasis of the qualified rehabilitation expen-ditures and may claim the rehabilitationcredit (provided the requirements of sec-tion 47 are met) for the remaining basis ofthe qualified rehabilitation expenditures(unadjusted depreciable basis less theadditional first year depreciation deduc-tion allowed or allowable, whichever isgreater) provided the taxpayer depreciatesthe remaining adjusted depreciable basisof such expenditures using the straight linemethod over a recovery period determinedunder section 168(c) or (g). The taxpayermay also claim the rehabilitation creditfor the portion of the basis of the qualifiedrehabilitated building that is attributableto the qualified rehabilitation expendituresif the taxpayer elects not to deduct theadditional first year depreciation for the

class of property that includes the quali-fied rehabilitated expenditures.

Depreciation under section 514(a)(3)

Finally, a few commentators questionedwhether a tax-exempt partner in a partner-ship that has debt-financed property maytake advantage of the additional first yeardepreciation deduction. In computingunder section 512 the unrelated businesstaxable income for any taxable year, sec-tion 514 provides the rules for determiningthe amount of unrelated business taxableincome related to debt-financed property.Under section 514(a)(3), the deductions al-lowable with respect to each debt-financedproperty is the sum of the deductions un-der chapter 1 of the Code that are directlyconnected with the debt-financed propertyor the income therefrom, except that ifthe debt-financed property is depreciableproperty, the allowance must be computedonly by use of the straight-line method.The final regulations provide that the ad-ditional first year depreciation deductionis not allowable for purposes of section514(a)(3).

Changes in Method of Accounting

The IRS and Treasury Department in-tend to issue administrative guidance pro-viding procedures for automatic consentfor taxpayers that wish to seek a change inmethod of accounting to comply with thesefinal regulations.

Effective Date

In general, the final regulations applyto qualified property or Liberty Zone prop-erty acquired by a taxpayer after Septem-ber 10, 2001, and for 50-percent bonusdepreciation property acquired by a tax-payer after May 5, 2003. Modifications to§1.168(k)–1(b)(3)(iii)(B) and (5)(ii)(B) re-lating to syndication and other lease trans-actions that provide a special rule for mul-tiple units of property subject to the samelease apply to property sold after June 4,2004.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessment

October 10, 2006 643 2006–41 I.R.B.

is not required. It also has been deter-mined that section 553(b) of the Admin-istrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to these regulationsand, because these regulations do not im-pose on small entities a collection of infor-mation requirement, the Regulatory Flex-ibility Act (5 U.S.C. chapter 6) does notapply. Therefore, a Regulatory Flexibil-ity Analysis is not required. Pursuant tosection 7805(f) of the Code, the notice ofproposed rulemaking was previously sub-mitted to the Chief Counsel for Advocacyof the Small Business Administration forcomment on its impact on small business.

Drafting Information

The principal author of these regula-tions is Douglas H. Kim, Office of As-sociate Chief Counsel (Passthroughs andSpecial Industries). However, other per-sonnel from the IRS and Treasury Depart-ment participated in their development.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 is amendedas follows:

PART 1—INCOME TAXES

Paragraph 1. The authority for part 1continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.48–12 is amended by

adding a new sentence at the end of para-graph (a)(2)(i) and adding a new sentenceat the end of paragraph (c)(8)(i) to read asfollows:

§1.48–12 Qualified rehabilitated building;expenditures incurred after December 31,1981.

(a) * * *(2) * * *(i) * * * The last sentence of paragraph

(c)(8)(i) of this section applies to qualifiedrehabilitation expenditures that are qual-ified property under section 168(k)(2) orqualified New York Liberty Zone propertyunder section 1400L(b) acquired by a tax-payer after September 10, 2001, and toqualified rehabilitation expenditures thatare 50 percent bonus depreciation property

under section 168(k)(4) acquired by a tax-payer after May 5, 2003.

* * * * *(c) * * *(8) * * *(i) * * * However, see

§1.168(k)–1(f)(10) if the qualifiedrehabilitation expenditures are qualifiedproperty or 50-percent bonus depreciationproperty under section 168(k) and see§1.1400L(b)–1(f)(9) if the qualifiedrehabilitation expenditures are qualifiedNew York Liberty Zone property undersection 1400L(b).

* * * * *Par. 3. Section 1.167(a)–14 is amended

by revising paragraphs (b)(1), (e)(2), and(e)(3) to read as follows:

§1.167(a)–14 Treatment of certainintangible property excluded from section197.

* * * * *(b) * * * (1) In general. The amount

of the deduction for computer soft-ware described in section 167(f)(1) and§1.197–2(c)(4) is determined by amortiz-ing the cost or other basis of the computersoftware using the straight line methoddescribed in §1.167(b)–1 (except that itssalvage value is treated as zero) and anamortization period of 36 months begin-ning on the first day of the month that thecomputer software is placed in service.Before determining the amortization de-duction allowable under this paragraph(b), the cost or other basis of computersoftware that is section 179 property, asdefined in section 179(d)(1)(A)(ii), mustbe reduced for any portion of the basisthe taxpayer properly elects to treat asan expense under section 179. In addi-tion, the cost or other basis of computersoftware that is qualified property undersection 168(k)(2) or §1.168(k)–1, 50-per-cent bonus depreciation property undersection 168(k)(4) or §1.168(k)–1, or qual-ified New York Liberty Zone propertyunder section 1400L(b) or §1.1400L(b)–1,must be reduced by the amount of theadditional first year depreciation deduc-tion allowed or allowable, whichever isgreater, under section 168(k) or section1400L(b) for the computer software. Ifcosts for developing computer software

that the taxpayer properly elects to deferunder section 174(b) result in the develop-ment of property subject to the allowancefor depreciation under section 167, therules of this paragraph (b) will apply to theunrecovered costs. In addition, this para-graph (b) applies to the cost of separatelyacquired computer software if the cost toacquire the software is separately statedand the cost is required to be capitalizedunder section 263(a).

* * * * *(e) * * *(2) Change in method of account-

ing. See §1.197–2(l)(4) for rules relat-ing to changes in method of accountingfor property to which §1.167(a)–14 ap-plies. However, see §1.168(k)–1(g)(4) or1.1400L(b)–1(g)(4) for rules relating tochanges in method of accounting for com-puter software to which the third sentencein §1.167(a)–14(b)(1) applies.

(3) Qualified property, 50-percentbonus depreciation property, qualifiedNew York Liberty Zone property, or section179 property. This section also applies tocomputer software that is qualified prop-erty under section 168(k)(2) or qualifiedNew York Liberty Zone property undersection 1400L(b) acquired by a taxpayerafter September 10, 2001, and to computersoftware that is 50-percent bonus depre-ciation property under section 168(k)(4)acquired by a taxpayer after May 5, 2003.This section also applies to computer soft-ware that is section 179 property placedin service by a taxpayer in a taxable yearbeginning after 2002 and before 2010.

§1.167(a)–14T [Removed]

Par. 4. Section 1.167(a)–14T is re-moved.

Par. 5. Section 1.168(d)–1 is amendedby revising paragraph (d)(2) to read as fol-lows:

§1.168(d)–1 Applicableconventions—half-year and mid-quarterconvention.

* * * * *(d) * * *(2) Qualified property, 50-percent

bonus depreciation property, or quali-fied New York Liberty Zone property. Thissection also applies to qualified property

2006–41 I.R.B. 644 October 10, 2006

under section 168(k)(2) or qualified NewYork Liberty Zone property under section1400L(b) acquired by a taxpayer afterSeptember 10, 2001, and to 50-percentbonus depreciation property under section168(k)(4) acquired by a taxpayer afterMay 5, 2003.

* * * * *Par. 6. In §1.168(d)–1T, paragraphs

(b)(3)(ii) and (d)(2) are amended as fol-lows:

1. The last sentence in paragraph(b)(3)(ii) is amended by removing the lan-guage “§1.168(k)–1T(f)(1)” and adding“§1.168(k)–1(f)(1)” in its place.

2. The last sentence in paragraph(b)(3)(ii) is amended by removing the lan-guage “§1.1400L(b)–1T(f)(1)” and adding“§1.1400L(b)–1(f)(1)” in its place.

3. Paragraph (d)(2) is revised.The revision reads as follows:

§1.168(d)–1T Applicableconventions-half-year and mid-quarterconventions (temporary).

* * * * *(d) * * *(2) Qualified property, 50-percent

bonus depreciation property, or quali-fied New York Liberty Zone property. Forfurther guidance, see §1.168(d)–1(d)(2).

* * * * *Par. 7. Section 1.168(i)–6T is amended

by adding a new sentence at the end ofparagraph (d)(4) to read as follows:

§1.168(i)–6T Like-kind exchanges andinvoluntary conversions (temporary).

* * * * *(d) * * *(4) * * * However, see

§1.168(k)–1(f)(5)(v) for replacementMACRS property that is qualified prop-erty or 50-percent bonus depreciationproperty and §1.1400L(b)–1(f)(5) forreplacement MACRS property that isqualified New York Liberty Zone prop-erty.

* * * * *Par. 8. Section 1.168(k)–0T is redes-

ignated as §1.168(k)–0 and newly desig-nated §1.168(k)–0 is amended as follows:

1. The word “temporary” is removedfrom the section heading.

2. The introductory text and the table ofcontents heading are revised.

3. The entries for §1.168(k)–1(b)(3)(ii)(A) and (B) are added.

4. The entries for §1.168(k)–1(b)(3)(iii), (iii)(B), and (iii)(C) are re-vised.

5. The entry for §1.168(k)–1(b)(4)(iii)(B) is revised.

6. The entries for §1.168(k)–1(b)(4)(iii)(B)(1) and (2) are added.

7. The entries for §1.168(k)–1(b)(5)(ii),(ii)(B), and (ii)(C) are revised.

8. The entry for §1.168(k)–1(b)(5)(v) isadded.

9. The entries for §1.168(k)–1(e)(6),(7), (7)(i), and (7)(ii) are added.

10. The entries for §1.168(k)–1(f)(5)(iii)(C) and (D) are added.

11. The entry for §1.168(k)–1(f)(5)(v)is redesignated as §1.168(k)–1(f)(5)(vi).

12. The entries for §1.168(k)–1(f)(5)(v), (v)(A), and (v)(B) are added.

13. The entries for §1.168(k)–1(f)(10)and (11) are added.

14. The entries for §1.168(k)–1(g)(5)and (6) are added.

The additions and revisions read as fol-lows:

§1.168(k)–0 Table of contents.

This section lists the headings that ap-pear in §1.168(k)–1.

§1.168(k)–1 Additional first yeardepreciation deduction.

* * * * *(b) * * *(3) * * *(ii) * * *(A) Personal use to business or income-

producing use.(B) Inventory to business or income-

producing use.(iii) Sale-leaseback, syndication, and

certain other transactions.

* * * * *(B) Syndication transaction and certain

other transactions.(C) Sale-leaseback transaction fol-

lowed by a syndication transaction andcertain other transactions.

* * * * *(4) * * *(iii) * * *(B) When does manufacture, construc-

tion, or production begin.(1) In general.

(2) Safe harbor.

* * * * *(5) * * *(ii) Sale-leaseback, syndication, and

certain other transactions. * * *(B) Syndication transaction and certain

other transactions.(C) Sale-leaseback transaction fol-

lowed by a syndication transaction andcertain other transactions.

* * * * *(v) Example.

* * * * *(e) * * *(6) Alternative minimum tax.(7) Revocation.(i) In general.(ii) Automatic 6-month extension.

* * * * *(f) * * *(5) * * *(iii) * * *(C) Property having a longer production

period.(D) Alternative minimum tax.

* * * * *(v) Acquired MACRS property or ac-

quired computer software that is acquiredand placed in service before disposition ofinvoluntarily converted MACRS propertyor involuntarily converted computer soft-ware.

(A) Time of replacement.(B) Depreciation of acquired MACRS

property or acquired computer software.

* * * * *(10) Coordination with section 47.(11) Coordination with section

514(a)(3).(g) * * *(5) Revisions to paragraphs

(b)(3)(ii)(B) and (b)(5)(ii)(B).(6) Rehabilitation credit.Par. 9. Section 1.168(k)–1T is redes-

ignated as §1.168(k)–1 and newly desig-nated §1.168(k)–1 is amended as follows:

1. The word “temporary” is removedfrom the section heading.

2. Paragraph (a)(2)(iii) is revised.3. Paragraph (a)(2)(iv) is amended

by removing the language “§1.168(k)–1T(a)(2)(iii)” and adding “§1.168(k)–1(a)(2)(iii)” in its place.

4. Paragraph (b)(1) is revised.5. Paragraph (b)(2)(i)(A) is amended

by removing the language “§1.168(k)–

October 10, 2006 645 2006–41 I.R.B.

1T(a)(2)(ii)” and adding “§1.168(k)–1(a)(2)(ii)” in its place.

6. Paragraphs (b)(2)(ii)(A)(2),(b)(3)(i), and (b)(3)(ii) are revised.

7. The heading of paragraph (b)(3)(iii)is revised.

8. Paragraphs (b)(3)(iii)(B) and (C) arerevised.

9. The first and second sentences ofparagraph (b)(3)(iv) are revised.

10. Paragraph (b)(3)(v) is amended byrevising the fourth sentence in Example 4and by adding new Example 5.

11. Paragraph (b)(4)(i)(B) is revised.12. The last sentences of paragraphs

(b)(4)(ii)(A), (B), and (D) are revised.13. Paragraph (b)(4)(iii)(A) is amended

by adding a new sentence at the end.14. Paragraphs (b)(4)(iii)(B) and

(b)(4)(iv)(A) are revised.15. Paragraph (b)(4)(v) is amended by

revising the third sentence in Example 10,by adding a sentence at the end of Example11, and by adding Examples 12, 13 and 14.

16. Paragraph (b)(5)(i) is revised.17. The heading of paragraph (b)(5)(ii)

is revised.18. Paragraphs (b)(5)(ii)(B) and (C) are

revised.19. Paragraph (b)(5)(v) is added.20. Paragraph (d)(1)(i) is revised.21. Paragraph (d)(1)(ii) is amended

by removing the language “§1.168(k)–1T(a)(2)(iii)” and adding “§1.168(k)–1(a)(2)(iii)” in its place.

22. Paragraphs (d)(1)(iii) and(e)(1)(ii)(B) are revised.

23. Paragraphs (e)(6) and (e)(7) areadded.

24. Paragraph (f)(1)(i) is amended byadding a new sentence at the end.

25. The introductory text of paragraph(f)(2) is revised.

26. Paragraph (f)(2)(ii) and the intro-ductory text of paragraph (f)(2)(iii) are re-vised.

27. Paragraph (f)(2)(iv) is amended byrevising Example 2.

28. Paragraph (f)(5)(i) is revised.29. Paragraphs (f)(5)(ii)(F) and

(f)(5)(ii)(J)(2) are revised.30. Paragraphs (f)(5)(ii)(K) and (L) are

added.31. Paragraph (f)(5)(iii)(A) is revised.32. The last sentence of paragraph

(f)(5)(iii)(B) is revised.33. Paragraphs (f)(5)(iii)(C) and (D)

are added.

34. Paragraph (f)(5)(v) is redesignatedas paragraph (f)(5)(vi) and newly desig-nated paragraph (f)(5)(vi) is amended byrevising the facts in Examples 1, 3, 4, and5, and by adding new Example 6.

35. New paragraph (f)(5)(v) is added.36. Paragraphs (f)(10) and (11) are

added.37. Paragraph (g)(1) is revised.38. The last sentence in paragraph

(g)(3)(ii) is removed.39. Paragraphs (g)(5) and (6) are added.The additions and revisions read as fol-

lows:

§1.168(k)–1 Additional first yeardepreciation deduction.

(a) * * *(2) * * *(iii) Unadjusted depreciable basis is the

basis of property for purposes of section1011 without regard to any adjustments de-scribed in section 1016(a)(2) and (3). Thisbasis reflects the reduction in basis for thepercentage of the taxpayer’s use of prop-erty for the taxable year other than in thetaxpayer’s trade or business (or for the pro-duction of income), for any portion of thebasis the taxpayer properly elects to treatas an expense under section 179 or sec-tion 179C, and for any adjustments to ba-sis provided by other provisions of the In-ternal Revenue Code and the regulationsthereunder (other than section 1016(a)(2)and (3)) (for example, a reduction in basisby the amount of the disabled access creditpursuant to section 44(d)(7)). For propertysubject to a lease, see section 167(c)(2).

* * * * *(b) Qualified property or 50-percent

bonus depreciation property—(1) In gen-eral. Qualified property or 50-percentbonus depreciation property is deprecia-ble property that meets all the followingrequirements in the first taxable year inwhich the property is subject to depre-ciation by the taxpayer whether or notdepreciation deductions for the propertyare allowable:

(i) The requirements in §1.168(k)–1(b)(2) (description of property);

(ii) The requirements in §1.168(k)–1(b)(3) (original use);

(iii) The requirements in §1.168(k)–1(b)(4) (acquisition of property); and

(iv) The requirements in §1.168(k)–1(b)(5) (placed-in-service date).

(2) * * *(ii) * * *(A) * * *(2) Required to be depreciated under the

alternative depreciation system of section168(g) pursuant to section 168(g)(1)(A)through (D) or other provisions of the In-ternal Revenue Code (for example, prop-erty described in section 263A(e)(2)(A) ifthe taxpayer (or any related person as de-fined in section 263A(e)(2)(B)) has madean election under section 263A(d)(3), orproperty described in section 280F(b)(1)).

* * * * *(3) * * *(i) In general. For purposes of the

30-percent additional first year deprecia-tion deduction, depreciable property willmeet the requirements of this paragraph(b)(3) if the original use of the prop-erty commences with the taxpayer afterSeptember 10, 2001. For purposes of the50-percent additional first year deprecia-tion deduction, depreciable property willmeet the requirements of this paragraph(b)(3) if the original use of the propertycommences with the taxpayer after May5, 2003. Except as provided in paragraphs(b)(3)(iii) and (iv) of this section, origi-nal use means the first use to which theproperty is put, whether or not that usecorresponds to the use of the propertyby the taxpayer. Thus, additional capitalexpenditures incurred by a taxpayer to re-condition or rebuild property acquired orowned by the taxpayer satisfies the orig-inal use requirement. However, the costof reconditioned or rebuilt property doesnot satisfy the original use requirement.The question of whether property is recon-ditioned or rebuilt property is a questionof fact. For purposes of this paragraph(b)(3)(i), property that contains used partswill not be treated as reconditioned orrebuilt if the cost of the used parts is notmore than 20 percent of the total cost ofthe property, whether acquired or self-con-structed.

(ii) Conversion to business or income-producing use—(A) Personal use to busi-ness or income-producing use. If a tax-payer initially acquires new property forpersonal use and subsequently uses theproperty in the taxpayer’s trade or busi-ness or for the taxpayer’s production of in-come, the taxpayer is considered the orig-inal user of the property. If a person ini-

2006–41 I.R.B. 646 October 10, 2006

tially acquires new property for personaluse and a taxpayer subsequently acquiresthe property from the person for use in thetaxpayer’s trade or business or for the tax-payer’s production of income, the taxpayeris not considered the original user of theproperty.

(B) Inventory to business or income-producing use. If a taxpayer initially ac-quires new property and holds the propertyprimarily for sale to customers in the ordi-nary course of the taxpayer’s business andsubsequently withdraws the property frominventory and uses the property primarilyin the taxpayer’s trade or business or pri-marily for the taxpayer’s production of in-come, the taxpayer is considered the orig-inal user of the property. If a person ini-tially acquires new property and holds theproperty primarily for sale to customers inthe ordinary course of the person’s busi-ness and a taxpayer subsequently acquiresthe property from the person for use pri-marily in the taxpayer’s trade or businessor primarily for the taxpayer’s productionof income, the taxpayer is considered theoriginal user of the property. For purposesof this paragraph (b)(3)(ii)(B), the origi-nal use of the property by the taxpayercommences on the date on which the tax-payer uses the property primarily in thetaxpayer’s trade or business or primarilyfor the taxpayer’s production of income.

(iii) Sale-leaseback, syndication, andcertain other transactions. * * *

(B) Syndication transaction and certainother transactions. If new property is orig-inally placed in service by a lessor (includ-ing by operation of paragraph (b)(5)(ii)(A)of this section) after September 10, 2001(for qualified property), or after May 5,2003 (for 50-percent bonus depreciationproperty), and is sold by the lessor or anysubsequent purchaser within three monthsafter the date the property was originallyplaced in service by the lessor (or, in thecase of multiple units of property subjectto the same lease, within three months af-ter the date the final unit is placed in ser-vice, so long as the period between thetime the first unit is placed in service andthe time the last unit is placed in servicedoes not exceed 12 months), and the userof the property after the last sale duringthe three-month period remains the sameas when the property was originally placedin service by the lessor, the purchaser ofthe property in the last sale during the

three-month period is considered the orig-inal user of the property.

(C) Sale-leaseback transaction fol-lowed by a syndication transaction andcertain other transactions. If a sale-lease-back transaction that satisfies the require-ments in paragraph (b)(3)(iii)(A) of thissection is followed by a transaction thatsatisfies the requirements in paragraph(b)(3)(iii)(B) of this section, the originaluser of the property is determined in ac-cordance with paragraph (b)(3)(iii)(B) ofthis section.

(iv) Fractional interests in property. If,in the ordinary course of its business, a tax-payer sells fractional interests in propertyto third parties unrelated to the taxpayer,each first fractional owner of the propertyis considered as the original user of its pro-portionate share of the property. Further-more, if the taxpayer uses the property be-fore all of the fractional interests of theproperty are sold but the property contin-ues to be held primarily for sale by the tax-payer, the original use of any fractional in-terest sold to a third party unrelated to thetaxpayer subsequent to the taxpayer’s useof the property begins with the first pur-chaser of that fractional interest. * * *

(v) * * *Example 4. * * * On June 1, 2003, G sells to

I, an unrelated party to G, the remaining unsold 3/8fractional interests in the aircraft. * * *

Example 5. On September 1, 2001, JJ, an equip-ment dealer, buys new tractors that are held by JJ pri-marily for sale to customers in the ordinary course ofits business. On October 15, 2001, JJ withdraws thetractors from inventory and begins to use the tractorsprimarily for producing rental income. The holdingof the tractors by JJ as inventory does not constitutea “use” for purposes of the original use requirementand, therefore, the original use of the tractors com-mences with JJ on October 15, 2001, for purposes ofparagraph (b)(3) of this section. However, the trac-tors are not eligible for the additional first year de-preciation deduction because JJ acquired the tractorsbefore September 11, 2001.

(4) * * *(i) * * *(B) 50-percent bonus depreciation

property. For purposes of the 50-percentadditional first year depreciation deduc-tion, depreciable property will meet therequirements of this paragraph (b)(4) ifthe property is—

(1) Acquired by the taxpayer after May5, 2003, and before January 1, 2005, butonly if no written binding contract for theacquisition of the property was in effectbefore May 6, 2003; or

(2) Acquired by the taxpayer pursuantto a written binding contract that was en-tered into after May 5, 2003, and beforeJanuary 1, 2005.

(ii) * * *(A) * * * If the contract provided for a

full refund of the purchase price in lieu ofany damages allowable by law in the eventof breach or cancellation, the contract isnot considered binding.

(B) * * * A contract that imposes sig-nificant obligations on the taxpayer ora predecessor will be treated as bindingnotwithstanding the fact that certain termsremain to be negotiated by the parties tothe contract.

* * * * *(D) * * * For example, if the provi-

sions of a supply or similar agreement statethe design specifications of the property tobe purchased, a purchase order under theagreement for a specific number of assetsis treated as a binding contract.

* * * * *(iii) * * *(A) * * * If a taxpayer enters into a

written binding contract (as defined inparagraph (b)(4)(ii) of this section) afterSeptember 10, 2001, and before January 1,2005, with another person to manufacture,construct, or produce property describedin section 168(k)(2)(B) (longer productionperiod property) or section 168(k)(2)(C)(certain aircraft) and the manufacture, con-struction, or production of this propertybegins after December 31, 2004, the ac-quisition rule in paragraph (b)(4)(i)(A)(2)or (B)(4)(i)(B)(2) of this section is met.

(B) When does manufacture, construc-tion, or production begin—(1) In general.For purposes of paragraph (b)(4)(iii) ofthis section, manufacture, construction,or production of property begins whenphysical work of a significant nature be-gins. Physical work does not includepreliminary activities such as planningor designing, securing financing, explor-ing, or researching. The determinationof when physical work of a significantnature begins depends on the facts andcircumstances. For example, if a retailmotor fuels outlet or other facility is to beconstructed on-site, construction beginswhen physical work of a significant naturecommences at the site; that is, when workbegins on the excavation for footings,pouring the pads for the outlet, or the driv-

October 10, 2006 647 2006–41 I.R.B.

ing of foundation pilings into the ground.Preliminary work, such as clearing a site,test drilling to determine soil condition,or excavation to change the contour ofthe land (as distinguished from excava-tion for footings) does not constitute thebeginning of construction. However, if aretail motor fuels outlet or other facilityis to be assembled on-site from modularunits manufactured off-site and deliveredto the site where the outlet will be used,manufacturing begins when physical workof a significant nature commences at theoff-site location.

(2) Safe harbor. For purposes of para-graph (b)(4)(iii)(B)(1) of this section, ataxpayer may choose to determine whenphysical work of a significant nature be-gins in accordance with this paragraph(b)(4)(iii)(B)(2). Physical work of a sig-nificant nature will not be considered tobegin before the taxpayer incurs (in thecase of an accrual basis taxpayer) or pays(in the case of a cash basis taxpayer)more than 10 percent of the total cost ofthe property (excluding the cost of anyland and preliminary activities such asplanning or designing, securing financ-ing, exploring, or researching). Whenproperty is manufactured, constructed,or produced for the taxpayer by anotherperson, this safe harbor test must be sat-isfied by the taxpayer. For example, if aretail motor fuels outlet or other facilityis to be constructed for an accrual basistaxpayer by another person for the totalcost of $200,000 (excluding the cost ofany land and preliminary activities such asplanning or designing, securing financing,exploring, or researching), constructionis deemed to begin for purposes of thisparagraph (b)(4)(iii)(B)(2) when the tax-payer has incurred more than 10 percent(more than $20,000) of the total cost ofthe property. A taxpayer chooses to applythis paragraph (b)(4)(iii)(B)(2) by filingan income tax return for the placed-in-ser-vice year of the property that determineswhen physical work of a significant na-ture begins consistent with this paragraph(b)(4)(iii)(B)(2).

* * * * *(iv) Disqualified transactions—(A) In

general. Property does not satisfy the re-quirements of this paragraph (b)(4) if theuser of the property as of the date on whichthe property was originally placed in ser-

vice (including by operation of paragraphs(b)(5)(ii), (iii), and (iv) of this section), ora related party to the user or to the tax-payer, acquired, or had a written bindingcontract (as defined in paragraph (b)(4)(ii)of this section) in effect for the acquisi-tion of the property at any time beforeSeptember 11, 2001 (for qualified prop-erty), or before May 6, 2003 (for 50-per-cent bonus depreciation property). In addi-tion, property manufactured, constructed,or produced for the use by the user of theproperty or by a related party to the useror to the taxpayer does not satisfy the re-quirements of this paragraph (b)(4) if themanufacture, construction, or productionof the property for the user or the relatedparty began at any time before September11, 2001 (for qualified property), or beforeMay 6, 2003 (for 50-percent bonus depre-ciation property).

* * * * *(v) * * *Example 10. * * * Between May 6, 2003, and

June 30, 2003, S, a calendar-year taxpayer, beganconstruction, and incurred another $1,200,000 tocomplete the construction, of the power plant and, onAugust 1, 2003, S placed the power plant in service.* * *

Example 11. * * * In addition, the sale-leasebackrules in paragraphs (b)(3)(iii)(A) and (b)(5)(ii)(A) ofthis section do not apply because the equipment wasoriginally placed in service by T before September11, 2001.

Example 12. On July 1, 2001, KK began con-structing property for its own use. KK placed thisproperty in service on September 15, 2001. On Oc-tober 15, 2001, KK sells the property to LL, an unre-lated party, and leases the property back from LL ina sale-leaseback transaction. Pursuant to paragraph(b)(4)(iv) of this section, the property does not qual-ify for the additional first year depreciation deductionbecause the property was constructed for KK, the userof the property, and that construction began prior toSeptember 11, 2001.

Example 13. On June 1, 2004, MM decided toconstruct property described in section 168(k)(2)(B)for its own use. However, one of the component partsof the property had to be manufactured by anotherperson for MM. On August 15, 2004, MM enteredinto a written binding contract with NN to acquirethis component part of the property for $100,000.The manufacture of the component part commencedon September 1, 2004, and MM received the com-pleted component part on February 1, 2005. Thecost of this component part is 9 percent of the totalcost of the property to be constructed by MM. MMbegan constructing the property described in sec-tion 168(k)(2)(B) on January 15, 2005, and placedthis property (including all component parts) in ser-vice on November 1, 2005. Pursuant to paragraph(b)(4)(iii)(C)(2) of this section, the self-constructedcomponent part of $100,000 manufactured by NN forMM is eligible for the additional first year deprecia-

tion deduction (assuming all other requirements aremet) because the manufacturing of the componentpart began after September 10, 2001, and before Jan-uary 1, 2005, and the property described in section168(k)(2)(B), the larger self-constructed property,was placed in service by MM before January 1, 2006.However, pursuant to paragraph (b)(4)(iii)(A) of thissection, the cost of the property described in section168(k)(2)(B) (excluding the cost of the self-con-structed component part of $100,000 manufacturedby NN for MM) is not eligible for the additional firstyear depreciation deduction because construction ofthe property began after December 31, 2004.

Example 14. On December 1, 2004, OO enteredinto a written binding contract (as defined in para-graph (b)(4)(ii) of this section) with PP to manufac-ture an aircraft described in section 168(k)(2)(C) foruse in OO’s trade or business. PP begins to manu-facture the aircraft on February 1, 2005. OO placesthe aircraft in service on August 1, 2005. Pursuantto paragraph (b)(4)(iii)(A) of this section, the aircraftmeets the requirements of paragraph (b)(4)(i)(B)(2)of this section because the aircraft was acquired byOO pursuant to a written binding contract entered intoafter May 5, 2003, and before January 1, 2005.

(5) Placed-in-service date—(i) In gen-eral. Depreciable property will meet therequirements of this paragraph (b)(5) ifthe property is placed in service by thetaxpayer for use in its trade or businessor for production of income before Jan-uary 1, 2005, or, in the case of propertydescribed in section 168(k)(2)(B) or (C),is placed in service by the taxpayer foruse in its trade or business or for pro-duction of income before January 1, 2006(or placed in service by the taxpayer foruse in its trade or business or for produc-tion of income before January 1, 2007, inthe case of property described in section168(k)(2)(B) or (C) to which section 105of the Gulf Opportunity Zone Act of 2005(Public Law 109–135, 119 Stat. 2577) ap-plies (for further guidance, see Announce-ment 2006–29, 2006–19 I.R.B. 879, and§601.601(d)(2)(ii)(b) of this chapter)).

(ii) Sale-leaseback, syndication, andcertain other transactions. * * *

(B) Syndication transaction and cer-tain other transactions. If qualified prop-erty is originally placed in service afterSeptember 10, 2001, or 50-percent bonusdepreciation property is originally placedin service after May 5, 2003, by a lessor(including by operation of paragraph(b)(5)(ii)(A) of this section) and is soldby the lessor or any subsequent purchaserwithin three months after the date the prop-erty was originally placed in service by thelessor (or, in the case of multiple units ofproperty subject to the same lease, withinthree months after the date the final unit

2006–41 I.R.B. 648 October 10, 2006

is placed in service, so long as the periodbetween the time the first unit is placed inservice and the time the last unit is placedin service does not exceed 12 months), andthe user of the property after the last saleduring this three-month period remainsthe same as when the property was orig-inally placed in service by the lessor, theproperty is treated as originally placed inservice by the purchaser of the property inthe last sale during the three-month periodbut not earlier than the date of the last sale.

(C) Sale-leaseback transaction fol-lowed by a syndication transaction andcertain other transactions. If a sale-lease-back transaction that satisfies the re-quirements in paragraph (b)(5)(ii)(A) ofthis section is followed by a transactionthat satisfies the requirements in para-graph (b)(5)(ii)(B) of this section, theplaced-in-service date of the property isdetermined in accordance with paragraph(b)(5)(ii)(B) of this section.

* * * * *(v) Example. The application of this

paragraph (b)(5) is illustrated by the fol-lowing example:

Example. On September 15, 2004, QQ acquiredand placed in service new equipment. This equip-ment is not described in section 168(k)(2)(B) or (C).On December 1, 2004, QQ sells the equipment to RRand leases the equipment back from RR in a sale-leaseback transaction. On February 15, 2005, RRsells the equipment to TT subject to the lease withQQ. As of February 15, 2005, QQ is still the userof the equipment. The sale-leaseback transaction ofDecember 1, 2004, between QQ and RR satisfies therequirements of paragraph (b)(5)(ii)(A) of this sec-tion. The sale transaction of February 15, 2005, be-tween RR and TT satisfies the requirements of para-graph (b)(5)(ii)(B) of this section. Consequently, pur-suant to paragraph (b)(5)(ii)(C) of this section, theequipment is treated as originally placed in service byTT on February 15, 2005. Further, pursuant to para-graph (b)(3)(iii)(C) of this section, TT is consideredthe original user of the equipment. Accordingly, theequipment is not eligible for the additional first yeardepreciation deduction.

* * * * *(d) * * *(1) * * * (i) In general. Except as

provided in paragraph (f) of this section,the additional first year depreciation de-duction is allowable in the first taxableyear in which the qualified property or50-percent bonus depreciation property isplaced in service by the taxpayer for use inits trade or business or for the productionof income. Except as provided in para-graph (f)(5) of this section, the allowable

additional first year depreciation deduc-tion for qualified property is determinedby multiplying the unadjusted depreciablebasis (as defined in §1.168(k)–1(a)(2)(iii))of the qualified property by 30 percent.Except as provided in paragraph (f)(5) ofthis section, the allowable additional firstyear depreciation deduction for 50-percentbonus depreciation property is determinedby multiplying the unadjusted depreciablebasis (as defined in §1.168(k)–1(a)(2)(iii))of the 50-percent bonus depreciation prop-erty by 50 percent. Except as provided inparagraph (f)(1) of this section, the 30-per-cent or 50-percent additional first year de-preciation deduction is not affected by ataxable year of less than 12 months. Seeparagraph (f)(1) of this section for quali-fied property or 50-percent bonus depreci-ation property placed in service and dis-posed of in the same taxable year. Seeparagraph (f)(5) of this section for quali-fied property or 50-percent bonus depreci-ation property acquired in a like-kind ex-change or as a result of an involuntary con-version.

* * * * *(iii) Alternative minimum tax. The

30-percent or 50-percent additional firstyear depreciation deduction is allowedfor alternative minimum tax purposes forthe taxable year in which the qualifiedproperty or the 50-percent bonus depreci-ation property is placed in service by thetaxpayer. In general, the 30-percent or50-percent additional first year depreci-ation deduction for alternative minimumtax purposes is based on the unadjusteddepreciable basis of the property for alter-native minimum tax purposes. However,see paragraph (f)(5)(iii)(D) of this sec-tion for qualified property or 50-percentbonus depreciation property acquired ina like-kind exchange or as a result of aninvoluntary conversion.

* * * * *(e) * * *(1) * * *(ii) * * *(B) Not to deduct both the 30-percent

and the 50-percent additional first year de-preciation. If this election is made, no ad-ditional first year depreciation deduction isallowable for the class of property.

* * * * *(6) Alternative minimum tax. If a tax-

payer makes an election specified in para-

graph (e)(1) of this section for a class ofproperty, the depreciation adjustments un-der section 56 and the regulations undersection 56 apply to the property to whichthat election applies for purposes of com-puting the taxpayer’s alternative minimumtaxable income.

(7) Revocation of election—(i) In gen-eral. Except as provided in paragraph(e)(7)(ii) of this section, an election spec-ified in paragraph (e)(1) of this section,once made, may be revoked only with thewritten consent of the Commissioner ofInternal Revenue. To seek the Commis-sioner’s consent, the taxpayer must submita request for a letter ruling.

(ii) Automatic 6-month extension. Ifa taxpayer made an election specified inparagraph (e)(1) of this section for a classof property, an automatic extension of 6months from the due date of the taxpayer’sFederal tax return (excluding extensions)for the placed-in-service year of the classof property is granted to revoke that elec-tion, provided the taxpayer timely filedthe taxpayer’s Federal tax return for theplaced-in-service year of the class of prop-erty and, within this 6-month extension pe-riod, the taxpayer (and all taxpayers whosetax liability would be affected by the elec-tion) files an amended Federal tax returnfor the placed-in-service year of the classof property in a manner that is consistentwith the revocation of the election.

(f) * * *(1) * * *(i) * * * Also if qualified property or

50-percent bonus depreciation property isplaced in service and disposed of duringthe same taxable year and then reacquiredand again placed in service in a subsequenttaxable year, the additional first year de-preciation deduction is not allowable forthe property in the subsequent taxable year.

* * * * *(2) Redetermination of basis. * * * If

the unadjusted depreciable basis (as de-fined in §1.168(k)–1(a)(2)(iii)) of quali-fied property or 50-percent bonus depre-ciation property is redetermined (for ex-ample, due to contingent purchase priceor discharge of indebtedness) before Jan-uary 1, 2005, or, in the case of propertydescribed in section 168(k)(2)(B) or (C),is redetermined before January 1, 2006 (orredetermined before January 1, 2007, inthe case of property described in section

October 10, 2006 649 2006–41 I.R.B.

168(k)(2)(B) or (C) to which section 105of the Gulf Opportunity Zone Act of 2005(Public Law 109–135, 119 Stat. 2577) ap-plies (for further guidance, see Announce-ment 2006–29, 2006–19 I.R.B. 879, and§601.601(d)(2)(ii)(b) of this chapter)), theadditional first year depreciation deduc-tion allowable for the qualified propertyor the 50-percent bonus depreciation prop-erty is redetermined as follows:

* * * * *(ii) Decrease in basis. For the taxable

year in which a decrease in basis of qual-ified property or 50-percent bonus depre-ciation property occurs, the taxpayer shallreduce the total amount otherwise allow-able as a depreciation deduction for allof the taxpayer’s depreciable property bythe excess additional first year deprecia-tion deduction previously claimed for thequalified property or the 50-percent bonusdepreciation property. If, for such taxableyear, the excess additional first year depre-ciation deduction exceeds the total amountotherwise allowable as a depreciation de-duction for all of the taxpayer’s deprecia-ble property, the taxpayer shall take intoaccount a negative depreciation deductionin computing taxable income. The excessadditional first year depreciation deduc-tion for qualified property is determinedby multiplying the amount of the decreasein basis for this property by 30 percent.The excess additional first year depreci-ation deduction for 50-percent bonus de-preciation property is determined by mul-tiplying the amount of the decrease in ba-sis for this property by 50 percent. Forpurposes of this paragraph (f)(2)(ii), the30-percent additional first year deprecia-tion deduction applies to the decrease inbasis if the underlying property is quali-fied property and the 50-percent additionalfirst year depreciation deduction appliesto the decrease in basis if the underly-ing property is 50-percent bonus depreci-ation property. Also, if the taxpayer es-tablishes by adequate records or other suf-ficient evidence that the taxpayer claimedless than the additional first year deprecia-tion deduction allowable for the qualifiedproperty or the 50-percent bonus depreci-ation property before the decrease in basisor if the taxpayer claimed more than theadditional first year depreciation deduc-tion allowable for the qualified propertyor the 50-percent bonus depreciation prop-

erty before the decrease in basis, the ex-cess additional first year depreciation de-duction is determined by multiplying theamount of the decrease in basis by theadditional first year depreciation deduc-tion percentage actually claimed by thetaxpayer for the qualified property or the50-percent bonus depreciation property, asapplicable, before the decrease in basis. Todetermine the amount to reduce the totalamount otherwise allowable as a deprecia-tion deduction for all of the taxpayer’s de-preciable property for the excess deprecia-tion previously claimed (other than the ad-ditional first year depreciation deduction)resulting from the decrease in basis of thequalified property or the 50-percent bonusdepreciation property, the amount of thedecrease in basis of the qualified propertyor the 50-percent bonus depreciation prop-erty must be adjusted by the excess addi-tional first year depreciation deduction thatreduced the total amount otherwise allow-able as a depreciation deduction (as deter-mined under this paragraph) and the re-maining decrease in basis of—

(A) Qualified property or 50-percentbonus depreciation property (except forcomputer software described in paragraph(b)(2)(i)(B) of this section) reduces theamount otherwise allowable as a depreci-ation deduction over the recovery periodof the qualified property or the 50-percentbonus depreciation property, as applica-ble, remaining as of the beginning of thetaxable year in which the decrease in basisoccurs, and using the same depreciationmethod and convention of the qualifiedproperty or 50-percent bonus depreciationproperty, as applicable, that applies in thetaxable year in which the decrease in basisoccurs. If, for any taxable year, the reduc-tion to the amount otherwise allowable asa depreciation deduction (as determinedunder this paragraph (f)(2)(ii)(A)) exceedsthe total amount otherwise allowable as adepreciation deduction for all of the tax-payer’s depreciable property, the taxpayershall take into account a negative depre-ciation deduction in computing taxableincome; and

(B) Computer software (as definedin paragraph (b)(2)(i)(B) of this section)that is qualified property or 50-percentbonus depreciation property reduces theamount otherwise allowable as a depre-ciation deduction over the remainderof the 36-month period (the useful life

under section 167(f)(1)) as of the be-ginning of the first day of the month inwhich the decrease in basis occurs. If,for any taxable year, the reduction to theamount otherwise allowable as a depreci-ation deduction (as determined under thisparagraph (f)(2)(ii)(B)) exceeds the totalamount otherwise allowable as a depreci-ation deduction for all of the taxpayer’sdepreciable property, the taxpayer shalltake into account a negative depreciationdeduction in computing taxable income.

(iii) Definitions. * * * Except as oth-erwise expressly provided by the Inter-nal Revenue Code (for example, section1017(a)), the regulations under the Inter-nal Revenue Code, or other guidance pub-lished in the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter), forpurposes of this paragraph (f)(2):

* * * * *(iv) * * *Example 2. (i) On May 15, 2002, DD, a calen-

dar-year taxpayer, purchased and placed in servicequalified property that is 5-year property at a cost of$400,000. To purchase the property, DD borrowed$250,000 from Bank2. On May 15, 2003, Bank2 for-gives $50,000 of the indebtedness. DD makes theelection provided in section 108(b)(5) to apply anyportion of the reduction under section 1017 to the ba-sis of the depreciable property of the taxpayer. DDdepreciates the 5-year property placed in service in2002 using the optional depreciation table that cor-responds with the general depreciation system, the200-percent declining balance method, a 5-year re-covery period, and the half-year convention.

(ii) For 2002, DD is allowed a 30-percent addi-tional first year depreciation deduction of $120,000(the unadjusted depreciable basis of $400,000 mul-tiplied by .30). In addition, DD’s depreciationdeduction allowable for 2002 for the remaining ad-justed depreciable basis of $280,000 (the unadjusteddepreciable basis of $400,000 reduced by the addi-tional first year depreciation deduction of $120,000)is $56,000 (the remaining adjusted depreciable basisof $280,000 multiplied by the annual depreciationrate of .20 for recovery year 1).

(iii) For 2003, DD’s deduction for the re-maining adjusted depreciable basis of $280,000 is$89,600 (the remaining adjusted depreciable basis of$280,000 multiplied by the annual depreciation rate.32 for recovery year 2). Although Bank2 forgavethe indebtedness in 2003, the basis of the propertyis reduced on January 1, 2004, pursuant to sections108(b)(5) and 1017(a) under which basis is reducedat the beginning of the taxable year following thetaxable year in which the discharge of indebtednessoccurs.

(iv) For 2004, DD’s deduction for the re-maining adjusted depreciable basis of $280,000is $53,760 (the remaining adjusted depreciable basisof $280,000 multiplied by the annual depreciationrate .192 for recovery year 3). However, pursuant toparagraph (f)(2)(ii) of this section, DD must reduce

2006–41 I.R.B. 650 October 10, 2006

the amount otherwise allowable as a depreciationdeduction for 2004 by the excess depreciation pre-viously claimed for the $50,000 decrease in basisof the qualified property. Consequently, DD mustreduce the amount of depreciation otherwise allow-able for 2004 by the excess additional first yeardepreciation of $15,000 (the decrease in basis of$50,000 multiplied by .30). Also, DD must reducethe amount of depreciation otherwise allowable for2004 by the excess depreciation attributable to theremaining decrease in basis of $35,000 (the decreasein basis of $50,000 reduced by the excess additionalfirst year depreciation of $15,000). The reductionin the amount of depreciation otherwise allowablefor 2004 for the remaining decrease in basis of$35,000 is $19,999 (the remaining decrease in basisof $35,000 multiplied by .5714, which is equal to1/remaining recovery period of 3.5 years at January1, 2004, multiplied by 2). Accordingly, assuming thequalified property is the only depreciable propertyowned by DD, for 2004, DD’s total depreciationdeduction allowable for the qualified property is$18,761 ($53,760 minus $15,000 minus $19,999).

* * * * *(5) * * * (i) Scope. The rules of

this paragraph (f)(5) apply to acquiredMACRS property or acquired computersoftware that is qualified property or50-percent bonus depreciation propertyat the time of replacement provided thetime of replacement is after September10, 2001, and before January 1, 2005,or, in the case of acquired MACRS prop-erty or acquired computer software thatis qualified property, or 50-percent bonusdepreciation property, described in section168(k)(2)(B) or (C), the time of replace-ment is after September 10, 2001, andbefore January 1, 2006 (or the time ofreplacement is after September 10, 2001,and before January 1, 2007, in the case ofproperty described in section 168(k)(2)(B)or (C) to which section 105 of the GulfOpportunity Zone Act of 2005 (PublicLaw 109–135, 119 Stat. 2577) applies(for further guidance, see Announce-ment 2006–29, 2006–19 I.R.B. 879, and§601.601(d)(2)(ii)(b) of this chapter)).

(ii) * * *(F) Except as provided in paragraph

(f)(5)(v) of this section, the time of re-placement is the later of—

(1) When the acquired MACRS prop-erty or acquired computer software isplaced in service; or

(2) The time of disposition of the ex-changed or involuntarily converted prop-erty.

* * * * *(J) * * *

(2) Any portion of the basis the taxpayerproperly elects to treat as an expense undersection 179 or section 179C;

* * * * *(K) Year of disposition is the taxable

year that includes the time of disposition.(L) Year of replacement is the taxable

year that includes the time of replacement.(iii) * * * (A) In general. Assuming all

other requirements of section 168(k) andthis section are met, the remaining car-ryover basis for the year of replacementand the remaining excess basis, if any, forthe year of replacement for the acquiredMACRS property or the acquired com-puter software, as applicable, are eligiblefor the additional first year depreciationdeduction. The 30-percent additional firstyear depreciation deduction applies to theremaining carryover basis and the remain-ing excess basis, if any, of the acquiredMACRS property or the acquired com-puter software if the time of replacement isafter September 10, 2001, and before May6, 2003, or if the taxpayer made the elec-tion provided in paragraph (e)(1)(ii)(A)of this section. The 50-percent additionalfirst year depreciation deduction appliesto the remaining carryover basis and theremaining excess basis, if any, of the ac-quired MACRS property or the acquiredcomputer software if the time of replace-ment is after May 5, 2003, and beforeJanuary 1, 2005, or, in the case of acquiredMACRS property or acquired computersoftware that is 50-percent bonus de-preciation property described in section168(k)(2)(B) or (C), the time of replace-ment is after May 5, 2003, and beforeJanuary 1, 2006 (or the time of replace-ment is after May 5, 2003, and beforeJanuary 1, 2007, in the case of 50-percentbonus depreciation property described insection 168(k)(2)(B) or (C) to which sec-tion 105 of the Gulf Opportunity ZoneAct of 2005 (Public Law 109–135, 119Stat. 2577) applies (for further guidance,see Announcement 2006–29, 2006–19I.R.B. 879, and §601.601(d)(2)(ii)(b) ofthis chapter)). The additional first yeardepreciation deduction is computed sep-arately for the remaining carryover basisand the remaining excess basis.

(B) * * * However, the additionalfirst year depreciation deduction is notallowable for the exchanged or invol-untarily converted MACRS property or

the exchanged or involuntarily convertedcomputer software if the exchanged orinvoluntarily converted MACRS propertyor the exchanged or involuntarily con-verted computer software, as applicable,is placed in service and disposed of in anexchange or involuntary conversion in thesame taxable year.

(C) Property having a longer produc-tion period. For purposes of paragraph(f)(5)(iii)(A) of this section, the total of theremaining carryover basis and the remain-ing excess basis, if any, of the acquiredMACRS property that is qualified propertyor 50-percent bonus depreciation propertydescribed in section 168(k)(2)(B) is lim-ited to the total of the property’s remain-ing carryover basis and remaining excessbasis, if any, attributable to the property’smanufacture, construction, or productionafter September 10, 2001 (for qualifiedproperty), or May 5, 2003 (for 50-percentbonus depreciation property), and beforeJanuary 1, 2005.

(D) Alternative minimum tax. The30-percent or 50-percent additional firstyear depreciation deduction is allowed foralternative minimum tax purposes for theyear of replacement of acquired MACRSproperty or acquired computer softwarethat is qualified property or 50-percentbonus depreciation property. The 30-per-cent or 50-percent additional first yeardepreciation deduction for alternativeminimum tax purposes is based on theremaining carryover basis and the remain-ing excess basis, if any, of the acquiredMACRS property or the acquired com-puter software for alternative minimumtax purposes.

* * * * *(v) Acquired MACRS property or ac-

quired computer software that is acquiredand placed in service before dispositionof involuntarily converted MACRS prop-erty or involuntarily converted computersoftware. If, in an involuntary conver-sion, a taxpayer acquires and places inservice the acquired MACRS property orthe acquired computer software beforethe time of disposition of the involun-tarily converted MACRS property or theinvoluntarily converted computer soft-ware and the time of disposition of theinvoluntarily converted MACRS propertyor the involuntarily converted computersoftware is after December 31, 2004, or,

October 10, 2006 651 2006–41 I.R.B.

in the case of property described in sec-tion 168(k)(2)(B) or (C), after December31, 2005 (or after December 31, 2006,in the case of property described in sec-tion 168(k)(2)(B) or (C) to which section105 of the Gulf Opportunity Zone Actof 2005 (Public Law 109–135, 119 Stat.2577) applies (for further guidance, seeAnnouncement 2006–29, 2006–19 I.R.B.879, and §601.601(d)(2)(ii)(b) of thischapter)), then—

(A) Time of replacement. The timeof replacement for purposes of this para-graph (f)(5) is when the acquired MACRSproperty or acquired computer software isplaced in service by the taxpayer, providedthe threat or imminence of requisition orcondemnation of the involuntarily con-verted MACRS property or involuntarilyconverted computer software existed be-fore January 1, 2005, or, in the case ofproperty described in section 168(k)(2)(B)or (C), existed before January 1, 2006(or existed before January 1, 2007, inthe case of property described in section168(k)(2)(B) or (C) to which section 105of the Gulf Opportunity Zone Act of 2005(Public Law 109–135, 119 Stat. 2577) ap-plies (for further guidance, see Announce-ment 2006–29, 2006–19 I.R.B. 879, and§601.601(d)(2)(ii)(b) of this chapter)); and

(B) Depreciation of acquired MACRSproperty or acquired computer software.The taxpayer depreciates the acquiredMACRS property or acquired computersoftware in accordance with paragraph (d)of this section. However, at the time ofdisposition of the involuntarily convertedMACRS property, the taxpayer deter-mines the exchanged basis (as defined in§1.168(i)–6T(b)(7)) and the excess basis(as defined in §1.168(i)–6T(b)(8)) of theacquired MACRS property and begins todepreciate the depreciable exchanged ba-sis (as defined in §1.168(i)–6T(b)(9))of the acquired MACRS property inaccordance with §1.168(i)–6T(c). Thedepreciable excess basis (as definedin §1.168(i)–6T(b)(10)) of the acquiredMACRS property continues to be depreci-ated by the taxpayer in accordance with thefirst sentence of this paragraph. Further,in the year of disposition of the invol-untarily converted MACRS property, thetaxpayer must include in taxable incomethe excess of the depreciation deductionsallowable, including the additional firstyear depreciation deduction allowable, on

the unadjusted depreciable basis of theacquired MACRS property over the ad-ditional first year depreciation deductionthat would have been allowable to the tax-payer on the remaining carryover basis ofthe acquired MACRS property at the timeof replacement (as defined in paragraph(f)(5)(v)(A) of this section) plus the depre-ciation deductions that would have beenallowable, including the additional firstyear depreciation deduction allowable, tothe taxpayer on the depreciable excessbasis of the acquired MACRS propertyfrom the date the acquired MACRS prop-erty was placed in service by the taxpayer(taking into account the applicable con-vention) to the time of disposition of theinvoluntarily converted MACRS property.Similar rules apply to acquired computersoftware.

(vi) Examples. The application of thisparagraph (f)(5) is illustrated by the fol-lowing examples:

Example 1. (i) In December 2002, EE, a calendar-year corporation, acquired for $200,000 and placedin service Canopy V1, a gas station canopy. CanopyV1 is qualified property under section 168(k)(1) andis 5-year property under section 168(e). EE depreci-ated Canopy V1 under the general depreciation sys-tem of section 168(a) by using the 200-percent declin-ing balance method of depreciation, a 5-year recov-ery period, and the half-year convention. EE electedto use the optional depreciation tables to compute thedepreciation allowance for Canopy V1. On January1, 2003, Canopy V1 was destroyed in a fire and wasno longer usable in EE’s business. On June 1, 2003,in an involuntary conversion, EE acquired and placedin service new Canopy W1 with all of the $160,000of insurance proceeds EE received due to the loss ofCanopy V1. Canopy W1 is 50-percent bonus depre-ciation property under section 168(k)(4) and is 5-yearproperty under section 168(e). Pursuant to paragraph(g)(3)(ii) of this section and §1.168(i)–6T(k)(2)(i),EE decided to apply §1.168(i)–6T to the involuntaryconversion of Canopy V1 with the replacement ofCanopy W1, the acquired MACRS property.

* * * * *Example 3. (i) In December 2001, FF, a cal-

endar-year corporation, acquired for $10,000 andplaced in service Computer X2. Computer X2 isqualified property under section 168(k)(1) and is5-year property under section 168(e). FF depreciatedComputer X2 under the general depreciation systemof section 168(a) by using the 200-percent decliningbalance method of depreciation, a 5-year recoveryperiod, and the half-year convention. FF electedto use the optional depreciation tables to computethe depreciation allowance for Computer X2. OnJanuary 1, 2002, FF acquired new Computer Y2by exchanging Computer X2 and $1,000 cash in alike-kind exchange. Computer Y2 is qualified prop-erty under section 168(k)(1) and is 5-year propertyunder section 168(e). Pursuant to paragraph (g)(3)(ii)of this section and §1.168(i)–6T(k)(2)(i), FF decided

to apply §1.168(i)–6T to the exchange of ComputerX2 for Computer Y2, the acquired MACRS property.

* * * * *Example 4. (i) In September 2002, GG, a June

30 year-end corporation, acquired for $20,000 andplaced in service Equipment X3. Equipment X3 isqualified property under section 168(k)(1) and is5-year property under section 168(e). GG depreci-ated Equipment X3 under the general depreciationsystem of section 168(a) by using the 200-percentdeclining balance method of depreciation, a 5-yearrecovery period, and the half-year convention. GGelected to use the optional depreciation tables tocompute the depreciation allowance for EquipmentX3. In December 2002, GG acquired new Equip-ment Y3 by exchanging Equipment X3 and $5,000cash in a like-kind exchange. Equipment Y3 is qual-ified property under section 168(k)(1) and is 5-yearproperty under section 168(e). Pursuant to paragraph(g)(3)(ii) of this section and §1.168(i)–6T(k)(2)(i),GG decided to apply §1.168(i)–6T to the exchangeof Equipment X3 for Equipment Y3, the acquiredMACRS property.

* * * * *Example 5. (i) Same facts as in Example 4. GG

depreciated Equipment Y3 under the general depre-ciation system of section 168(a) by using the 200-percent declining balance method of depreciation, a5-year recovery period, and the half-year convention.GG elected to use the optional depreciation tables tocompute the depreciation allowance for EquipmentY3. On July 1, 2003, GG acquired new EquipmentZ1 by exchanging Equipment Y3 in a like-kind ex-change. Equipment Z1 is 50-percent bonus depreci-ation property under section 168(k)(4) and is 5-yearproperty under section 168(e). Pursuant to paragraph(g)(3)(ii) of this section and §1.168(i)–6T(k)(2)(i),GG decided to apply §1.168(i)–6T to the exchangeof Equipment Y3 for Equipment Z3, the acquiredMACRS property.

* * * * *Example 6. (i) In April 2004, SS, a calendar

year-end corporation, acquired and placed in serviceEquipment K89. Equipment K89 is 50-percent bonusdepreciation property under section 168(k)(4). InNovember 2004, SS acquired and placed in serviceused Equipment N78 by exchanging Equipment K89in a like-kind exchange.

(ii) Pursuant to paragraph (f)(5)(iii)(B) of thissection, no additional first year deduction is al-lowable for Equipment K89 and, pursuant to§1.168(d)–1T(b)(3)(ii), no regular depreciationdeduction is allowable for Equipment K89, for thetaxable year ended December 31, 2004.

(iii) Equipment N78 is not qualified property un-der section 168(k)(1) or 50-percent bonus depreci-ation property under section 168(k)(4) because theoriginal use requirement of paragraph (b)(3) of thissection is not met. Accordingly, no additional firstyear depreciation deduction is allowable for Equip-ment N78.

* * * * *(10) Coordination with section 47—(i)

In general. If qualified rehabilitation ex-penditures (as defined in section 47(c)(2)and §1.48–12(c)) incurred by a taxpayer

2006–41 I.R.B. 652 October 10, 2006

with respect to a qualified rehabilitatedbuilding (as defined in section 47(c)(1)and §1.48–12(b)) are qualified propertyor 50-percent bonus depreciation property,the taxpayer may claim the rehabilitationcredit provided by section 47(a) (providedthe requirements of section 47 are met)—

(A) With respect to the portion of thebasis of the qualified rehabilitated build-ing that is attributable to the qualified re-habilitation expenditures if the taxpayermakes the applicable election under para-graph (e)(1)(i) or (e)(1)(ii)(B) of this sec-tion not to deduct any additional first yeardepreciation for the class of property thatincludes the qualified rehabilitation expen-ditures; or

(B) With respect to the portion of the re-maining rehabilitated basis of the qualifiedrehabilitated building that is attributableto the qualified rehabilitation expendituresif the taxpayer claims the additional firstyear depreciation deduction on the un-adjusted depreciable basis (as defined inparagraph (a)(2)(iii) of this section but be-fore the reduction in basis for the amountof the rehabilitation credit) of the qualifiedrehabilitation expenditures and the tax-payer depreciates the remaining adjusteddepreciable basis (as defined in paragraph(d)(2)(i) of this section) of such expen-ditures using straight line cost recoveryin accordance with section 47(c)(2)(B)(i)and §1.48–12(c)(7)(i). For purposes ofthis paragraph (f)(10)(i)(B), the remainingrehabilitated basis is equal to the unad-justed depreciable basis (as defined inparagraph (a)(2)(iii) of this section but be-fore the reduction in basis for the amountof the rehabilitation credit) of the qual-ified rehabilitation expenditures that arequalified property or 50-percent bonusdepreciation property reduced by the ad-ditional first year depreciation allowed orallowable, whichever is greater.

(ii) Example. The application of thisparagraph (f)(10) is illustrated by the fol-lowing example.

Example. (i) Between February 8, 2004, andJune 4, 2004, UU, a calendar-year taxpayer, incurredqualified rehabilitation expenditures of $200,000with respect to a qualified rehabilitated buildingthat is nonresidential real property under section168(e). These qualified rehabilitation expendituresare 50-percent bonus depreciation property andqualify for the 10-percent rehabilitation credit un-der section 47(a)(1). UU’s basis in the qualifiedrehabilitated building is zero before incurring thequalified rehabilitation expenditures and UU placedthe qualified rehabilitated building in service in July

2004. UU depreciates its nonresidential real propertyplaced in service in 2004 under the general depreci-ation system of section 168(a) by using the straightline method of depreciation, a 39-year recovery pe-riod, and the mid-month convention. UU elected touse the optional depreciation tables to compute thedepreciation allowance for its depreciable propertyplaced in service in 2004. Further, for 2004, UU didnot make any election under paragraph (e) of thissection.

(ii) Because UU did not make any election underparagraph (e) of this section, UU is allowed a 50-per-cent additional first year depreciation deduction of$100,000 for the qualified rehabilitation expendi-tures for 2004 (the unadjusted depreciable basis of$200,000 (before reduction in basis for the rehabili-tation credit) multiplied by .50). For 2004, UU alsois allowed to claim a rehabilitation credit of $10,000for the remaining rehabilitated basis of $100,000(the unadjusted depreciable basis (before reductionin basis for the rehabilitation credit) of $200,000 lessthe additional first year depreciation deduction of$100,000). Further, UU’s depreciation deduction for2004 for the remaining adjusted depreciable basisof $90,000 (the unadjusted depreciable basis (beforereduction in basis for the rehabilitation credit) of$200,000 less the additional first year depreciationdeduction of $100,000 less the rehabilitation creditof $10,000) is $1,059.30 (the remaining adjusteddepreciable basis of $90,000 multiplied by the de-preciation rate of .01177 for recovery year 1, placedin service in month 7).

(11) Coordination with section514(a)(3). The additional first year de-preciation deduction is not allowable forpurposes of section 514(a)(3).

(g) * * *(1) In general. Except as provided in

paragraphs (g)(2), (3), and (5) of this sec-tion, this section applies to qualified prop-erty under section 168(k)(2) acquired bya taxpayer after September 10, 2001, andto 50-percent bonus depreciation propertyunder section 168(k)(4) acquired by a tax-payer after May 5, 2003.

* * * * *(5) Revision to paragraphs

(b)(3)(iii)(B) and (b)(5)(ii)(B) of thissection. The addition of “(or, in the caseof multiple units of property subject tothe same lease, within three months afterthe date the final unit is placed in service,so long as the period between the timethe first unit is placed in service and thetime the last unit is placed in service doesnot exceed 12 months)” to paragraphs(b)(3)(iii)(B) and (b)(5)(ii)(B) of thissection applies to property sold after June4, 2004.

(6) Rehabilitation credit. If a tax-payer did not claim on a Federal taxreturn for any taxable year ending on or

before September 1, 2006, the rehabil-itation credit provided by section 47(a)with respect to the portion of the basisof a qualified rehabilitated building thatis attributable to qualified rehabilitationexpenditures and the qualified rehabilita-tion expenditures are qualified propertyor 50-percent bonus depreciation prop-erty, and the taxpayer did not make theapplicable election specified in paragraph(e)(1)(i) or (e)(1)(ii)(B) of this sectionfor the class of property that includesthe qualified rehabilitation expenditures,the taxpayer may claim the rehabilitationcredit for the remaining rehabilitated basis(as defined in paragraph (f)(10)(i)(B) ofthis section) of the qualified rehabilitatedbuilding that is attributable to the qualifiedrehabilitation expenditures (assuming allthe requirements of section 47 are met) inaccordance with paragraph (f)(10)(i)(B) ofthis section by filing an amended Federaltax return for the taxable year for whichthe rehabilitation credit is to be claimed.The amended Federal tax return must in-clude the adjustment to the tax liability forthe rehabilitation credit and any collateraladjustments to taxable income or to thetax liability (for example, the amount ofdepreciation allowed or allowable in thattaxable year for the qualified rehabilitatedbuilding). Such adjustments must also bemade on amended Federal tax returns forany affected succeeding taxable years.

Par. 10. Section 1.169–3 is amendedby revising paragraphs (a), (b)(2), and (g)to read as follows:

§1.169–3 Amortizable basis.

(a) In general. The amortizable basis ofa certified pollution control facility for thepurpose of computing the amortization de-duction under section 169 is the adjustedbasis of the facility for purposes of deter-mining gain (see part II (section 1011 andfollowing), subchapter O, chapter 1 of theInternal Revenue Code), in conjunctionwith paragraphs (b), (c), and (d) of thissection. The adjusted basis for purposesof determining gain (computed withoutregard to paragraphs (b), (c), and (d) ofthis section) of a facility that performs afunction in addition to pollution control,or that is used in connection with morethan one plant or other property, or both,is determined under §1.169–2(a)(3). Forrules as to additions and improvements to

October 10, 2006 653 2006–41 I.R.B.

such a facility, see paragraph (f) of thissection. Before computing the amorti-zation deduction allowable under section169, the adjusted basis for purposes of de-termining gain for a facility that is placedin service by a taxpayer after September10, 2001, and that is qualified propertyunder section 168(k)(2) or §1.168(k)–1,50-percent bonus depreciation propertyunder section 168(k)(4) or §1.168(k)–1, orqualified New York Liberty Zone propertyunder section 1400L(b) or §1.1400L(b)–1must be reduced by the amount of theadditional first year depreciation deduc-tion allowed or allowable, whichever isgreater, under section 168(k) or section1400L(b), as applicable, for the facility.

(b) * * *(2) If the taxpayer elects to begin the

60-month amortization period with thefirst month of the taxable year succeedingthe taxable year in which the facility iscompleted or acquired and a deprecia-tion deduction is allowable under section167 (including an additional first-yeardepreciation allowance under former sec-tion 179; for a facility that is acquiredby the taxpayer after September 10, 2001,and that is qualified property under section168(k)(2) or §1.168(k)–1 or qualified NewYork Liberty Zone property under section1400L(b) or §1.1400L(b)–1, the additionalfirst year depreciation deduction undersection 168(k)(1) or 1400L(b), as applica-ble; and for a facility that is acquired bythe taxpayer after May 5, 2003, and thatis 50-percent bonus depreciation propertyunder section 168(k)(4) or §1.168(k)–1,the additional first year depreciation de-duction under section 168(k)(4)) withrespect to the facility for the taxable yearin which it is completed or acquired,the amount determined under paragraph(b)(1) of this section shall be reduced byan amount equal to the amount of the de-preciation deduction allowed or allowable,whichever is greater, multiplied by a frac-tion the numerator of which is the amountdetermined under paragraph (b)(1) of thissection, and the denominator of which isthe facility’s total cost. The additionalfirst-year allowance for depreciation un-der former section 179 will be allowableonly for the taxable year in which the fa-cility is completed or acquired and onlyif the taxpayer elects to begin the amorti-zation deduction under section 169 withthe taxable year succeeding the taxable

year in which such facility is completedor acquired. For a facility that is acquiredby a taxpayer after September 10, 2001,and that is qualified property under sec-tion 168(k)(2) or §1.168(k)–1 or qualifiedNew York Liberty Zone property undersection 1400L(b) or §1.1400L(b)–1, see§1.168(k)–1(f)(4) or §1.1400L(b)–1(f)(4),as applicable, with respect to when theadditional first year depreciation deduc-tion under section 168(k)(1) or 1400L(b)is allowable. For a facility that is acquiredby a taxpayer after May 5, 2003, and thatis 50-percent bonus depreciation propertyunder section 168(k)(4) or §1.168(k)–1,see §1.168(k)–1(f)(4) with respect towhen the additional first year deprecia-tion deduction under section 168(k)(4) isallowable.

* * * * *(g) Effective date for qualified prop-

erty, 50-percent bonus depreciation prop-erty, and qualified New York Liberty Zoneproperty. This section applies to a certi-fied pollution control facility. This sectionalso applies to a certified pollution controlfacility that is qualified property under sec-tion 168(k)(2) or qualified New York Lib-erty Zone property under section 1400L(b)acquired by a taxpayer after September 10,2001, and to a certified pollution controlfacility that is 50-percent bonus deprecia-tion property under section 168(k)(4) ac-quired by a taxpayer after May 5, 2003.

§ 1.169–3T [Removed]

Par. 11. Section 1.169–3T is removed.Par. 12. Section 1.312–15 is amended

by adding a new sentence at the end ofparagraph (a)(1) to read as follows:

§1.312–15 Effect of depreciation onearnings and profits.

(a)* * * (1) * * * See §1.168(k)–1(f)(7)with respect to the treatment of the addi-tional first year depreciation deduction al-lowable under section 168(k) for qualifiedproperty or 50-percent bonus depreciationproperty, and §1.1400L(b)–1(f)(7) with re-spect to the treatment of the additional firstyear depreciation deduction allowable un-der section 1400L(b) for qualified NewYork Liberty Zone property, for purposesof computing the earnings and profits of acorporation.

* * * * *

Par. 13. Section 1.1400L(b)–1T is re-designated as §1.1400L(b)–1 and newlydesignated §1.1400l(b)–1 is amended asfollows:

1. The word “(temporary)” is removedfrom the section heading.

2. Paragraph (b) is amended by remov-ing the language “§1.168(k)–1T(a)(2)”and adding “§1.168(k)–1(a)(2)” in itsplace.

3. Paragraph (b)(4) is revised.4. Paragraph (c)(1) is revised.5. Paragraph (c)(2)(i)(A) is amended

by removing the language “§1.168(k)–1T(b)(2)(i)” and adding “§1.168(k)–1(b)(2)(i)” in its place.

6. Paragraph (c)(2)(ii) is revised.7. Paragraph (c)(4) is amended by

removing the language “§1.168(k)–1T(b)(3)” and adding “§1.168(k)–1(b)(3)”in its place.

8. Paragraph (c)(5)(i) is amendedby removing the language “§1.168(k)–1T(b)(4)(ii)” and adding “§1.168(k)–1(b)(4)(ii) in its place, removing thelanguage “§1.168(k)–1T(b)(4)(iii)”and adding “§1.168(k)–1(b)(4)(iii) inits place, and removing the language“§1.168(k)–1T(b)(4)(iv)” and adding“§1.168(k)–1(b)(4)(iv)” in its place.

9. Paragraph (c)(5)(ii) is amendedby removing the language “§1.168(k)–1T(f)(1)(ii)” and adding “§1.168(k)–1(f)(1)(ii)” in its place, and removingthe language “§1.168(k)–1T(f)(1)(iii)”and adding “§1.168(k)–1(f)(1)(iii)” in itsplace.

10. Paragraph (c)(6) is amendedby removing the language “§1.168(k)–1T(b)(5)(ii)” and adding “§1.168(k)–1(b)(5)(ii)” in its place, removing thelanguage “§1.168(k)–1T(b)(5)(iii)”and adding “§1.168(k)–1(b)(5)(iii)” inits place, and removing the language“§1.168(k)–1T(b)(5)(iv)” and adding“§1.168(k)–1(b)(5)(iv)” in its place.

11. Paragraph (d) is amended byremoving the language “§1.168(k)–1T(d)(1)(i)” and adding “§1.168(k)–1(d)(1)(i)” in its place.

12. Paragraphs (e)(6) and (e)(7) areadded.

13. Paragraph (f)(1) is amendedby removing the language “§1.168(k)–1T(f)(1)” and adding “§1.168(k)–1(f)(1)”in its place.

14. Paragraph (f)(2) is amendedby removing the language “§1.168(k)–

2006–41 I.R.B. 654 October 10, 2006

1T(a)(2)(iii)” and adding “§1.168(k)–1(a)(2)(iii)” in its place, and removingthe language “§1.168(k)–1T(f)(2)” andadding “§1.168(k)–1(f)(2)” in its place.

15. Paragraph (f)(3) is amendedby removing the language “§1.168(k)–1T(f)(3)” and adding “§1.168(k)–1(f)(3)”in its place.

16. Paragraph (f)(4) is amendedby removing the language “§1.168(k)–1T(f)(4)” and adding “§1.168(k)–1(f)(4)”in its place.

17. Paragraph (f)(5) is amendedby removing the language “§1.168(k)–1T(f)(5)(ii)(A)” and adding “§1.168(k)–1(f)(5)(ii)(A)” in its place, removing thelanguage “§1.168(k)–1T(f)(5)(ii)(C)”and adding “§1.168(k)–1(f)(5)(ii)(C)”in its place, and removing the lan-guage “§1.168(k)–1T(f)(5)” and adding“§1.168(k)–1(f)(5)” in its place.

18. Paragraph (f)(6) is amendedby removing the language “§1.168(k)–1T(f)(6)” and adding “§1.168(k)–1(f)(6)”in its place.

19. Paragraph (f)(7) is amendedby removing the language “§1.168(k)–1T(f)(7)” and adding “§1.168(k)–1(f)(7)”in its place.

20. Paragraph (f)(8) is amendedby removing the language “§1.168(k)–1T(f)(9)” and adding “§1.168(k)–1(f)(9)”in its place.

21. Paragraphs (f)(9) and (10) areadded.

22. Paragraph (g)(1) is revised.23. Paragraphs (g)(4)(iii), (g)(5), and

(g)(6) are added.The additions and revisions read as fol-

lows:

§1.1400L(b)–1 Additional first yeardepreciation deduction for qualified NewYork Liberty Zone property.

* * * * *(b) * * *(4) Real property is a building or its

structural components, or other tangiblereal property.

(c) Qualified New York Liberty Zoneproperty—(1) In general. Qualified NewYork Liberty Zone property is deprecia-ble property that meets all the followingrequirements in the first taxable year inwhich the property is subject to deprecia-tion by the taxpayer whether or not depre-

ciation deductions for the property are al-lowable—

(i) The requirements in §1.1400L(b)–1(c)(2) (description of property);

(ii) The requirements in §1.1400L(b)–1(c)(3) (substantial use);

(iii) The requirements in §1.1400L(b)–1(c)(4) (original use);

(iv) The requirements in §1.1400L(b)–1(c)(5) (acquisition of property by pur-chase); and

(v) The requirements in §1.1400L(b)–1(c)(6) (placed-in-service date).

(2) * * *(ii) Property not eligible for additional

first year depreciation deduction. Depre-ciable property will not meet the require-ments of this paragraph (c)(2) if—

(A) Section 168(k) or §1.168(k)–1 ap-plies to the property;

(B) The property is described in section168(f);

(C) The property is required to be de-preciated under the alternative deprecia-tion system of section 168(g) pursuant tosection 168(g)(1)(A) through (D) or otherprovisions of the Internal Revenue Code(for example, property described in section263A(e)(2)(A) if the taxpayer (or any re-lated person) has made an election undersection 263A(d)(3), or property describedin section 280F(b)(1));

(D) The property is included in anyclass of property for which the taxpayerelects not to deduct the additional first yeardepreciation under paragraph (e) of thissection; or

(E) The property is qualified NewYork Liberty Zone leasehold improve-ment property as described in section1400L(c)(2).

* * * * *(e) * * *(6) Alternative minimum tax. If a tax-

payer makes an election under this para-graph (e) for a class of property, the depre-ciation adjustments under section 56 andthe regulations under section 56 apply tothe property to which the election appliesfor purposes of computing the taxpayer’salternative minimum taxable income.

(7) Revocation of election—(i) In gen-eral. Except as provided in paragraph(e)(7)(ii) of this section, an election un-der this paragraph (e), once made, may berevoked only with the written consent ofthe Commissioner of Internal Revenue. To

seek the Commissioner’s consent, the tax-payer must submit a request for a letter rul-ing.

(ii) Automatic 6-month extension. Ifa taxpayer made an election under thisparagraph (e) for a class of property, anautomatic extension of 6 months fromthe due date of the taxpayer’s Federaltax return (excluding extensions) for theplaced-in-service year of the class ofproperty is granted to revoke that elec-tion, provided the taxpayer timely filedthe taxpayer’s Federal tax return for theplaced-in-service year of the class of prop-erty and, within this 6-month extensionperiod, the taxpayer (and all taxpayerswhose tax liability would be affected bythe election) files an amended Federal taxreturn for the placed-in-service year of theclass of property in a manner that is con-sistent with the revocation of the election.

* * * * *(f) * * *(9) Coordination with section 47.

Rules similar to those provided in§1.168(k)–1(f)(10) apply for purposesof this paragraph (f)(9).

(10) Coordination with section514(a)(3). Rules similar to those providedin §1.168(k)–1(f)(11) apply for purposesof this paragraph (f)(10).

(g) * * *(1) In general. Except as provided in

paragraphs (g)(2), (3), and (5) of this sec-tion, this section applies to qualified NewYork Liberty Zone property acquired by ataxpayer after September 10, 2001.

* * * * *(4) * * *(iii) Revisions made in paragraphs

(b)(4) and (c)(2)(ii) of this section. Ifa taxpayer did not claim on a Federaltax return for a taxable year ending onor after September 11, 2001, and onor before September 1, 2006, any ad-ditional first year depreciation deduc-tion for qualified New York LibertyZone property because of the applica-tion of §1.1400L(b)–1T(b)(4) or becausethe taxpayer made an election under§1.168(k)–1T(e)(1) for a class of prop-erty that included such qualified NewYork Liberty Zone property, the taxpayermay claim the additional first year depre-ciation deduction for such qualified NewYork Liberty Zone property under thissection in accordance with the applicable

October 10, 2006 655 2006–41 I.R.B.

administrative procedures issued under§1.446–1(e)(3)(ii) for obtaining the Com-missioner’s consent to a change in methodof accounting. Section 481(a) applies toa request to claim the additional first yeardepreciation deduction for such qualifiedNew York Liberty Zone property underthis paragraph (g)(4)(iii).

(5) Revision to paragraphs (b)(4) and(b)(6). The addition of “(or, in the caseof multiple units of property subject tothe same lease, within three monthsafter the date the final unit is placedin service, so long as the period be-tween the time the first unit is placedin service and the time the last unit isplaced in service does not exceed 12months)” to §1.168(k)–1(b)(3)(iii)(B) and§1.168(k)–1(b)(5)(ii)(B) applies to prop-erty sold after June 4, 2004, for purposesof paragraphs (b)(4) and (b)(6) of this sec-tion.

(6) Rehabilitation credit. If a tax-payer did not claim on a Federal taxreturn for a taxable year ending on orbefore September 1, 2006, the rehabil-itation credit provided by section 47(a)with respect to the portion of the basis ofa qualified rehabilitated building that isattributable to qualified rehabilitation ex-penditures and the qualified rehabilitationexpenditures are qualified New York Lib-erty Zone property, and the taxpayer didnot make the election specified in para-graph (e)(1) of this section for the class ofproperty that includes the qualified reha-bilitation expenditures, the taxpayer mayclaim the rehabilitation credit for the re-maining rehabilitated basis (as defined in§1.168(k)–1(f)(10)(i)(B)) of the qualifiedrehabilitated building that is attributableto the qualified rehabilitation expenditures(assuming all the requirements of section47 are met) in accordance with paragraph(f)(9) of this section by filing an amendedFederal tax return for the taxable year forwhich the rehabilitation credit is to beclaimed. The amended Federal tax returnmust include the adjustment to the tax lia-bility for the rehabilitation credit and anycollateral adjustments to taxable incomeor to the tax liability (for example, theamount of depreciation allowed or allow-able in that taxable year for the qualifiedrehabilitated building). Such adjustmentsmust also be made on amended Federaltax returns for any affected succeedingtaxable years.

Steven T. Miller,Acting Deputy Commissionerfor Services and Enforcement.

Approved August 25, 2006.

Eric Solomon,Acting Deputy Assistant Secretary

of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on August 28,2006, 4:28 p.m., and published in the issue of the FederalRegister for August 31, 2006, 71 F.R. 51727)

Section 280G.—GoldenParachute Payments

Federal short-term, mid-term, and long-term ratesare set forth for the month of October 2006. See Rev.Rul. 2006-50, page 672.

Section 382.—Limitationon Net Operating LossCarryforwards and CertainBuilt-In Losses FollowingOwnership Change

The adjusted applicable federal long-term rate isset forth for the month of October 2006. See Rev.Rul. 2006-50, page 672.

Section 412.—MinimumFunding Standards

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 448.—Limitationon Use of Cash Methodof Accounting26 CFR 1.448–2: Nonaccrual of certain amounts byservice providers.

T.D. 9285

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Parts 1 and 602

Nonaccrual-ExperienceMethod of Accounting UnderSection 448(d)(5)

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains finalregulations relating to the use of a nonac-crual-experience method of accounting bytaxpayers using an accrual method of ac-counting and performing services. The fi-nal regulations reflect amendments underthe Job Creation and Worker AssistanceAct of 2002. The final regulations affectqualifying taxpayers that want to adopt,change to, or change a nonaccrual-experi-ence method of accounting under section448(d)(5) of the Internal Revenue Code(Code).

DATES: Effective Date: These regulationsare effective September 6, 2006.

Applicability Date: These regulationsare applicable for taxable years ending onor after August 31, 2006.

Comment Date: Written commentsmust be received by January 4, 2007.These regulations require that a tax-payer’s nonaccrual-experience methodmust be self-tested against the taxpayer’sactual experience to determine whetherthe nonaccrual-experience method clearlyreflects the taxpayer’s experience. Thedetermination of actual experience is re-served in these regulations. Comments arerequested concerning how to determineactual experience for purposes of timelyperforming self-testing. Send submissionsto: CC:PA:LPD:PR (REG–141402–02),Internal Revenue Service, POB 7604, BenFranklin Station, Washington, DC 20044.Taxpayers also may submit commentselectronically to the IRS internet site atwww.irs.gov/regs.

FOR FURTHER INFORMATIONCONTACT: Concerning the regulations,W. Thomas McElroy, Jr., (202) 622–4970;concerning submission of comments,Kelly Banks, (202) 622–0392 (not toll-freenumbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in these final regulations has beenreviewed and approved by the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act of 1995(44 U.S.C. 3507(d)) under control number1545–1855.

2006–41 I.R.B. 656 October 10, 2006

The collection of information in thesefinal regulations is in §1.448–2(d)(8) and(e)(5). This information is required to en-able the IRS to verify that a taxpayer isreporting the correct amount of incomeor gain or claiming the correct amount oflosses, deductions, or credits from the tax-payer’s use of the nonaccrual-experiencemethod of accounting. The collection ofinformation is required to obtain a benefit.

An agency may not conduct or sponsor,and a person is not required to respondto, a collection of information unless thecollection of information displays a validcontrol number.

The estimated annual burden per re-spondent is 3 hours.

Comments concerning the accuracyof this burden estimate and sugges-tions for reducing this burden shouldbe sent to the Internal Revenue Service,Attn: IRS Reports Clearance Officer,SE:W:CAR:MP:T:T:SP, Washington, DC20224, and to the Office of Manage-ment and Budget, Attn: Desk Officer forthe Department of the Treasury, Officeof Information and Regulatory Affairs,Washington, DC 20503.

Books and records relating to a collec-tion of information must be retained aslong as their contents may become mate-rial in the administration of any internalrevenue law. Generally, tax returns and taxreturn information are confidential, as re-quired by 26 U.S.C. 6103.

Background

This document contains amendmentsto the Income Tax Regulations (26 CFRpart 1) under section 448(d)(5). Section448(d)(5) was enacted by section 801 ofthe Tax Reform Act of 1986 (Public Law99–514, 100 Stat. 2085) and was amendedby section 403 of the Job Creation andWorker Assistance Act of 2002 (PublicLaw 107–147, 116 Stat. 21) (JCWA),effective for taxable years ending afterMarch 9, 2002. On September 4, 2003, theIRS and Treasury Department publishedin the Federal Register (68 FR 52543)proposed amendments to the regulationsunder section 448(d) by cross-reference totemporary regulations (REG–141402–02,2003–2 C.B. 932) and temporary regula-tions (68 FR 52496) (T.D. 9090, 2003–2C.B. 891) (collectively, the 2003 regula-tions) relating to the limitation on the use

of the nonaccrual-experience method ofaccounting under section 448(d)(5). Apublic hearing was held on December 10,2003. Written and electronic commentsresponding to the proposed regulationswere received. After consideration of allof the comments, the proposed regulationsare adopted as revised by this Treasury de-cision, and the corresponding temporaryregulations are removed. The revisionsare discussed below.

Explanation of Provisions and Revisionsand Summary of Comments

1. Overview

These final regulations generally followthe rules in the 2003 regulations. The fi-nal regulations include the four safe harbornonaccrual-experience methods providedin the 2003 regulations, but those methodshave been modified to provide more flexi-bility. Unlike the 2003 regulations, the fi-nal regulations do not require as a generalrule that a taxpayer’s nonaccrual-experi-ence method be tested against one of thesafe harbor nonaccrual-experience meth-ods. Instead, the final regulations adopt,with modifications, the general rule fromthe 2003 regulations as a fifth safe harbor.The final regulations also adopt a new gen-eral rule that requires a taxpayer’s nonac-crual-experience method be tested againstactual experience unless the taxpayer hasadopted one of the five safe harbor meth-ods. These final regulations apply to tax-able years ending on or after August 31,2006.

Certain portions of the 2003 regula-tions have been removed or incorporatedinto other paragraphs of the final regu-lations. Section 1.448–2T(d) regardingcertain receivables for which the nonac-crual-experience method is not allowedhas been combined with §1.448–2(c)in the final regulations. Special rulesin various parts of the 2003 regulationssuch as §1.448–2T(e)(2)(ii) and (iii),1.448–2T(e)(3)(iii), 1.448–2T(e)(4)(ii)and (iii), and 1.448–2T(e)(5)(ii) and (iii),have been combined with the specialrules in §1.448–2T(e)(7) and are now in§1.448–2(b), (c), and (d) of the final regu-lations. Most of §1.448–2T(g), (h), and (j)of the 2003 regulations relating to methodsof accounting and audit protection havebeen removed. The IRS and Treasury

Department intend to issue administrativeguidance that will contain procedures forcertain changes in a nonaccrual-experi-ence method of accounting. The generalrule that a nonaccrual-experience methodis a method of accounting to which sec-tions 446 and 481 apply has been movedto §1.448–2(b).

Other portions of the 2003 regulationshave been moved to a new definitions andspecial rules paragraph in §1.448–2(c) ofthe final regulations. Section 1.448–2T(d)regarding accounts receivable is includedin a definition of accounts receivable in§1.448–2(c)(1) of the final regulations.Other terms in the definitions paragraphinclude applicable period, bad debts,charge-offs, determination date, recover-ies, and uncollectible amount. The finalregulations incorporate these definitions,as appropriate, throughout. For exam-ple, in the 2003 regulations the four safeharbor methods include bad debts in thenumerator; however, safe harbor 2 did notrefer to bad debts, but instead describedthem as “accounts receivable actually de-termined to be uncollectible and chargedoff....” These descriptions should not beinterpreted differently. Therefore, the finalregulations use the defined term bad debtsin each numerator. Finally, the examplesare changed to conform to other changeswithin the final regulations.

2. Self-Testing Requirement

The 2003 regulations provide that ataxpayer may use any nonaccrual-expe-rience method of accounting, providedthe taxpayer’s method meets the self-testrequirements. The self-testing in the 2003regulations requires a taxpayer to com-pare its proposed nonaccrual-experiencemethod with one of the four safe harbormethods to determine whether the tax-payer’s proposed method clearly reflectsexperience. Self-testing is required in thefirst taxable year to determine whetherthe proposed method is allowed (first-yearself-testing requirement) and, if allowed,self-testing is required every three taxableyears thereafter (three-year self-testingrequirement). The final regulations pro-vide, as a general rule, that a taxpayer mayuse any nonaccrual-experience methodof accounting that clearly reflects thetaxpayer’s experience. The final regula-tions provide that taxpayers must self-test

October 10, 2006 657 2006–41 I.R.B.

against the taxpayer’s actual experienceto determine whether a method clearlyreflects the taxpayer’s experience unlessthe taxpayer has adopted one of the fivesafe harbor methods. The final regulationsreserve on the definition of actual experi-ence.

a. Appropriateness of self-testingrequirement

Many commentators suggested thattaxpayers should not be required to incuradditional expenses to develop a separatesystem for performing the self-test, notingthat it would be burdensome and impracti-cal for the majority of taxpayers using analternative nonaccrual-experience methodto conduct the self-test due to the limita-tions of their existing automated recordkeeping systems. One commentator sug-gested that the self-test was outside thescope of the JCWA and legislative intent.These commentators all recommendedthat the final regulations omit the self-test-ing requirement.

The JCWA provides that “[a] taxpayermay adopt, or ... change to, a computa-tion or formula that clearly reflects thetaxpayer’s experience,” and that “[a] re-quest [to change] shall be approved ifsuch computation or formula clearly re-flects the taxpayer’s experience.” PublicLaw 107–147, section 403(a). Taxpayersand the IRS must be able to determinewhether a nonaccrual-experience methodclearly reflects the taxpayer’s experience.The Secretary has broad authority to de-termine whether a method of accountingclearly reflects the taxpayer’s income.A self-testing requirement is consistentwith the statute, because it is the mannerby which taxpayers and the IRS deter-mine whether a nonaccrual-experiencemethod clearly reflects the taxpayer’sexperience, and thus, clearly reflects thetaxpayer’s income. Taxpayers must beable to show that a nonaccrual-experiencemethod clearly reflects experience priorto adopting or changing to the method.The requirement to self-test provides anobjective standard for making the deter-mination. Therefore, the final regulationsdo not adopt the recommendation to omita self-testing requirement and retain therule that a taxpayer must maintain booksand records sufficient to prove that thetaxpayer’s nonaccrual-experience method

clearly reflects its experience for the tax-able year of the exclusion.

b. Standard for comparison

Commentators stated that the self-test-ing requirements do not allow taxpayersthe opportunity to demonstrate that a pro-posed method clearly reflects their experi-ence, because under the 2003 regulationsall methods must be compared to one ofthe safe harbors. The commentators statedthat none of the safe harbors reflect ac-tual experience, because all of the safe har-bors are moving averages rather than acomparison of the estimated uncollectibleamount for a taxable year under the tax-payer’s nonaccrual-experience method tothe actual collection experience of that tax-able year’s accounts receivable. Thus, thecommentators stated, the safe harbors mayor may not reflect actual experience as wellas the proposed method.

The final regulations modify theself-testing requirements in response tothese comments and eliminate the re-quirement in the 2003 regulations that ataxpayer’s nonaccrual-experience methodmust be tested against one of the four safeharbor methods. The final regulationsrequire that the taxpayer’s nonaccrual-ex-perience method must be tested against thetaxpayer’s actual experience, unless thetaxpayer is using one of the safe harbornonaccrual-experience methods, whichare deemed to clearly reflect experience.

For taxpayers and the IRS to imple-ment and administer the nonaccrual-ex-perience method, the determination ofactual experience is necessary. Althoughcommentators stated that taxpayers shouldbe allowed to use hindsight and that ac-tual experience would require the use ofdata reflecting the portion of the subjectaccounts receivable that remain uncol-lectible, the commentators did not elabo-rate regarding what “remain uncollectible”means, nor did the commentators set thedate at which accounts receivable “re-main uncollectible.” The determinationand proof of actual experience generally isa simple matter for taxpayers whose col-lection process with respect to the subjectreceivables is complete by the time theFederal income tax return is filed. Thecollection cycle for some taxpayers, how-ever, may routinely span several taxableyears. The commentators did not elaborate

how such a factual determination could bemade prior to filing the Federal incometax return for the applicable taxable year(or alternatively, prior to filing the methodchange request for the applicable tax-able year) in cases in which a taxpayer’scollection cycle for the receivables goesbeyond the date for the filing of the return(or method change). For taxpayers with alonger collection process, the determina-tion of the final actual experience is notpossible by the time the Federal incometax return is filed, and may continue to beincomplete upon examination by the IRS,if the taxpayer’s collection process withrespect to receivables is still in process.Additionally, it is possible that accountsreceivable written off in one taxable yearmay be recovered several taxable yearslater, even for taxpayers whose averagecollection cycle is short. Therefore, thefinal regulations reserve the determinationof actual experience.

The IRS and Treasury Department an-ticipate providing future guidance thatmay change or restrict the rules forself-testing and may address the deter-mination of actual experience. In themeantime, taxpayers may request advanceconsent to use a method other than a safeharbor method, but in the request taxpay-ers must establish to the satisfaction of theCommissioner how the determination ofactual experience is made. Comments arerequested concerning how to determineactual experience. Specifically, the IRSand Treasury Department seek commentson how the use of hindsight data can bemade administrable. For example, howwill the IRS National Office have the nec-essary data furnished with the applicationfor change in method of accounting, andhow will the taxpayer be able to timely per-form the self-testing? In particular, shouldone, fixed determination date be used asa cut-off for all information included inthe determination of actual experience?What facts and circumstances, known bythe filing deadline for a change in methodof accounting and the filing deadline foran original Federal income tax return, cana taxpayer and the IRS rely on to deter-mine the taxpayer’s actual experience forpurposes of the first-year self-testing re-quirements for the application for changein method of accounting and for purposesof the three-year self-testing requirementsfor the filing of the Federal income tax

2006–41 I.R.B. 658 October 10, 2006

return? For a taxpayer that is applyingto adopt or change to a nonaccrual-ex-perience method of accounting, shouldthe taxpayer be allowed to rely on theresults under the proposed method for thecurrent taxable year compared to actualexperience for old taxable years ratherthan a comparison of the results under theproposed method for the current taxableyear compared to actual experience for thecurrent taxable year at the time of filing,provided the taxpayer can demonstratethat there is not a change in the type ofa substantial portion of the outstandingaccounts receivable such that the risk ofloss is substantially decreased? Whatstandards should apply to a taxpayer whohas had a change in the type of a substan-tial portion of the outstanding accountsreceivable? If a taxpayer’s business haschanged in a manner that impacts a sub-stantial portion of its outstanding accountsreceivable, the taxpayer’s historical datafor its receivables could lose much of theirrelevance in determining the taxpayer’scurrent nonaccrual experience.

c. Safe harbor comparison method

The final regulations retain a modifiedversion of the self-test from the 2003 reg-ulations, which required the comparisonof a taxpayer’s method against one ofthe safe harbors. The safe harbor com-parison method in the final regulationsis used in conjunction with the fifth safeharbor nonaccrual-experience method,which allows a taxpayer to use any nonac-crual-experience method provided themethod meets the safe harbor comparisonmethod of self-testing. The safe harborcomparison method provided in the finalregulations allows a taxpayer to com-pare the taxpayer’s method against any ofthe safe harbors 1 through 4 during anyself-testing period, rather than requiringthe safe harbor chosen for comparisonto be treated as a method of accounting.Because any of the safe harbors 1 through4 are deemed to clearly reflect experience,a taxpayer should be able to compareits method against any of the safe har-bors 1 through 4 to determine whether itsmethod clearly reflects experience. TheIRS and Treasury Department anticipatethat the procedures for changes in methodof accounting to use the new safe har-bor nonaccrual-experience method will

be provided in administrative guidance,and that these changes will be made withautomatic consent.

d. Methods that do not clearly reflectexperience

The 2003 regulations provide, as partof the three-year self-test requirement,that if the taxpayer’s cumulative alterna-tive nonaccrual-experience amount ex-cluded from income during the test periodexceeds the taxpayer’s cumulative safeharbor nonaccrual-experience amount, thetaxpayer must recapture the excess intoincome in the third taxable year of thethree-year self-test. The IRS and Trea-sury Department intended this recaptureprovision to allow minor variances orfluctuations produced by the taxpayer’snonaccrual-experience method withoutprohibiting continued use of the method.However, when the taxpayer’s nonac-crual-experience method produces resultsthat are more than minor variations orfluctuations from the three-year self-testamounts, the method does not clearlyreflect the taxpayer’s experience. Therecapture provision addresses situationsin which the taxpayer’s nonaccrual-expe-rience method generally clearly reflectsexperience, but the taxpayer has an anoma-lous taxable year in which the method doesnot clearly reflect experience. However,methods may consistently provide largedistortions from the taxpayer’s actual ex-perience in future taxable years despitemeeting the requirements of the first-yearself-test. Consequently, the final regu-lations include a limit in the three-yearself-testing provisions that, if exceeded,deems the taxpayer’s nonaccrual-experi-ence method to not clearly reflect the tax-payer’s experience. Because the taxpayermust recapture the difference between theuncollectible amount under the taxpayer’snonaccrual-experience method and thetaxpayer’s actual experience, a changefrom the taxpayer’s nonaccrual-experi-ence method to a permissible method inthe subsequent taxable year does not re-quire a section 481(a) adjustment and ismade on a cut-off basis.

Additionally, to provide transparency,the IRS and Treasury Department intendto provide in future guidance descriptionsof methods and characteristics of methodscombined with specific taxpayer circum-

stances that do not clearly reflect experi-ence.

e. Other

Commentators suggested that theself-test was not administrable in the con-text of consolidated groups. The IRS andTreasury Department believe that the finalregulations do not impose more burdenthan any other method of accounting inthe context of a consolidated group. Gen-erally, methods of accounting, includingthe nonaccrual-experience method with itsself-testing requirement, are adopted andapplied separately by each entity withinthe consolidated group (or to separatetrades or businesses within an entity), notat the consolidated group level.

3. Safe Harbor Methods

The 2003 regulations have four safeharbors: safe harbor 1 (the six-year mov-ing average method), safe harbor 2 (theactual experience method), safe harbor 3(the modified Black Motor method), andsafe harbor 4 (the modified moving aver-age method). Comments were received re-garding safe harbors 1, 2, and 4. No com-ments were received regarding safe harbor3.

a. General issues

Commentators questioned the need toimpose different time periods for differentsafe harbor methods. For example, in the2003 regulations, safe harbors 1, 3 and 4are based on a six-year period (the currenttaxable year and the five immediately pre-ceding taxable years), whereas safe har-bor 2 is based on a three year period (thecurrent taxable year and the two imme-diately preceding taxable years). Thesecommentators recommended that, for con-sistency, the safe harbor methods shouldpermit taxpayers to compute the uncol-lectible amounts using a period consistingof the current taxable year and no fewerthan the two immediately preceding tax-able years and no more than the five im-mediately preceding taxable years.

Providing options among the safe har-bors, including those with different timeperiods, is consistent with legislative in-tent to provide taxpayers “with alterna-tive computations or formulas that taxpay-ers may rely upon.” Different taxpayers

October 10, 2006 659 2006–41 I.R.B.

may choose different methods with differ-ent time periods based on their individ-ual circumstances and experience. The fi-nal regulations allow taxpayers flexibilityto choose a period of at least three tax-able years, but not more than six taxableyears (applicable period), for purposes ofthe computations in each of the safe har-bors. The taxable years included in theapplicable period must be the most recent(which may or may not include the cur-rent taxable year, as applicable) and mustbe consecutive.

Additionally, commentators statedthat including the current taxable year incomputations can cause difficulties whenpreparing computations for estimatedtaxes. Therefore, the final regulationsallow taxpayers flexibility with regardto whether the current taxable year isincluded in the applicable period. Thechoice of which taxable years and howmany are included in the applicable pe-riod is part of the taxpayer’s method ofaccounting under a safe harbor, and canbe changed only with the consent of theCommissioner. Taxpayers making sucha change may not have all the historicaldata necessary to compute a section 481(a)adjustment. Therefore, the final regula-tions provide that the change is done ona cut-off basis rather than with a section481(a) adjustment.

Finally, some commentators reiteratedtheir earlier suggestion that the BlackMotor formula should be permitted as anadditional safe harbor method. The IRSand Treasury Department continue to con-clude that the Black Motor formula shouldnot be provided as an additional safe har-bor method because the formula overstatesthe uncollectible amount in many circum-stances. The final regulations add a fifthsafe harbor, which, as discussed above,allows taxpayers to use any alternativenonaccrual-experience method providedthe method meets the requirements ofthe safe harbor comparison method underthe self-testing requirements. The IRSand Treasury Department may provideadditional safe harbors through futurepublished guidance. In addition, if a tax-payer does not wish to rely on one of thesafe harbors, the final regulations pro-vide that a taxpayer may use any otheralternative nonaccrual-experience methodprovided the method clearly reflects itsexperience and the taxpayer requests and

receives consent from the Commissionerto use such method.

Commentators requested that the regu-lations specifically include a statement thatunintentional or immaterial variances willnot cause a taxpayer to be changed to thespecific charge-off method. As discussedin the preamble to the 2003 regulations, theIRS and Treasury Department do not con-template that a taxpayer be changed to thespecific charge-off method due to uninten-tional or immaterial variances, especiallyif a taxpayer is disadvantaged by the vari-ances. Such a rule is unnecessary, partic-ularly with the flexibility added to each ofthe safe harbors.

b. Safe harbor 1 — revenue-based movingaverage method

Safe harbor 1 in the 2003 regulationswas referred to as the six-year movingaverage method. It is renamed the rev-enue-based moving average method in thefinal regulations to reflect the flexibility tochoose between three to six taxable yearsfor the applicable period. The final regula-tions provide that the revenue-based mov-ing average percentage of safe harbor 1(the ratio of net write-offs for the applica-ble period over accounts receivable earnedover the same applicable period) is multi-plied by a taxpayer’s accounts receivablebalance at the end of the taxable year to de-termine the taxpayer’s nonaccrual-experi-ence amount.

A commentator suggested that a safeharbor method should be added that wouldmodify safe harbor 1 to multiply the rev-enue-based moving average percentage bya taxpayer’s total billings (accounts receiv-able earned during the taxable year in lieuof its accounts receivable balance at theend of the taxable year). The commen-tator suggested that this new safe harborwould provide symmetry between the de-nominator of the revenue-based movingaverage percentage and the amount againstwhich the revenue-based moving averagepercentage is multiplied.

The final regulations do not adopt thisrecommendation. The IRS and TreasuryDepartment previously analyzed the ef-fects of multiplying the revenue-basedmoving average percentage by the to-tal billings during the taxable year anddetermined that this computation over-states that portion of the taxpayer’s

year-end accounts receivable balancethat will not be collected. The existingformula is the method provided in for-mer §1.448–2T(e)(2), as contained in T.D.8194, 53 FR 12513 (1988). Althoughthe denominator and multiplicand are notsymmetrical, the method accurately re-flects the year-end receivables that willnot be collected for taxpayers with a shortcollection cycle.

c. Safe harbor 2 — actual experiencemethod

Under safe harbor 2 of the 2003 reg-ulations, the taxpayer’s adjusted nonac-crual-experience amount is determinedby tracking the receivables in the tax-payer’s accounts receivable balance at thebeginning of the current taxable year todetermine the dollar amount of the ac-counts receivable actually determined tobe uncollectible and charged off and notrecovered or determined to be collectibleby the determination date. The determi-nation date is the date selected by thetaxpayer for the taxable year for purposesof safe harbor 2, and may not be later thanthe earlier of the due date, including ex-tensions, for filing the taxpayer’s Federalincome tax return for that taxable year orthe date on which the taxpayer timely filesthe return for that taxable year. Under Op-tion A of safe harbor 2, the computationis repeated for the taxpayer’s accounts re-ceivable balance at the beginning of eachof the two immediately preceding taxableyears. Under Option B of safe harbor 2,taxpayers that do not have the informationnecessary to compute a three-year movingaverage in the first taxable year the methodis used are allowed to transition into themethod year-by-year. The total of theamounts determined to be uncollectible isdivided by the total beginning accountsreceivable balance for those taxable yearsused in the computation to determine thetaxpayer’s three-year (Option A), or upto three-year (Option B), moving averagepercentage. This percentage is then mul-tiplied by the taxpayer’s current year-endaccounts receivable balance to arrive atthe taxpayer’s actual nonaccrual-expe-rience amount. The taxpayer’s actualnonaccrual-experience amount is thenmultiplied by 1.05 to determine the tax-payer’s adjusted nonaccrual-experienceamount.

2006–41 I.R.B. 660 October 10, 2006

As discussed above, the final regula-tions allow flexibility in the applicable pe-riod used in safe harbor 2. Additionally,because the final regulations provide defi-nitions of terms used throughout the regu-lations for consistency, the terms used todescribe the safe harbor 2 formula werechanged to conform to the definitions inthe final regulations. Although the de-scription of the method may look as thoughit has changed substantially, the safe har-bor 2 method is not intended to operatedifferently than the 2003 regulations, otherthan the flexibility in the applicable periodand, as discussed below, the flexibility inthe determination dates and in tracing re-coveries.

Some commentators requested clarifi-cation as to whether safe harbor 2 is basedon a computation that takes into accountall known information arising both beforeand after the determination date. The com-mentators suggested that the 2003 regula-tions may be interpreted as taking into ac-count only all known information arisingon or before determination dates for previ-ous taxable years involved in the compu-tation.

The computation in safe harbor 2, Op-tion A, in the final regulations, contem-plates consideration of all known informa-tion arising on or before the determina-tion date for the current taxable year, in-cluding beginning accounts receivable bal-ances, charge-offs and recoveries, with re-spect to all taxable years included in thecomputation. For example, if an accountreceivable of a calendar year taxpayer ex-ists on January 1, 2006, and is charged offas a bad debt on December 15, 2007, thebad debt should be included in the com-putation in the taxable year it is chargedoff and every subsequent taxable year foras long as the 2006 beginning of the yearaccounts receivable balance is part of thecomputation under this method. Conse-quently, the final regulations clarify that allknown information arising on or before thedetermination date for the current taxableyear, with respect to the taxable years in-cluded in the computation, should be con-sidered.

In the 2003 regulations, Option B al-lows a taxpayer to transition into the ac-tual experience safe harbor method. Thefinal regulations allow a new taxpayer withno beginning accounts receivable to transi-tion under either Option A or Option B (see

§1.448–2(d)(4) of the final regulations).Option B in the final regulations differsfrom Option A in that it allows a taxpayerto use multiple determination dates (onefor each taxable year of the applicable pe-riod) instead of one determination date.Therefore, under Option B in the final reg-ulations, a taxpayer has a choice of the ap-plicable period, three to six taxable years,and the taxpayer uses separate determina-tion dates for each taxable year in the ap-plicable period. That is, a taxpayer mustuse bad debts sustained by the separate de-termination date of each taxable year dur-ing the applicable period rather than baddebts sustained by the determination dateof the current taxable year. The determina-tion date used for each taxable year mustbe the determination date originally usedfor each taxable year at the time the uncol-lectible amount for that taxable year wascomputed. For example, if an account re-ceivable of a calendar year taxpayer ex-ists on January 1, 2006, and is charged offas a bad debt on December 15, 2007, andthe determination date for the 2006 tax-able year is September 1, 2007, the baddebt would never be included in the com-putation because it is charged off after the2006 taxable year determination date. Thismethod was requested by commentatorsto reduce the burden of having to updatethe total bad debts for a particular taxableyear with every future computation that in-cluded that taxable year.

Other commentators requested clarifi-cation as to whether the determination dateused in safe harbor 2 may shift from year toyear. These commentators recommendedthat the final regulations confirm that a tax-payer may use a different determinationdate each taxable year, and that a changeof determination date is not a change inmethod of accounting. Safe harbor 2 con-templates that a taxpayer may file its Fed-eral income tax return at different timesfrom year to year, and that the choice ofa determination date used in the computa-tion is not a method of accounting. How-ever, once a determination date is selectedand used for a particular taxable year, itmay not be changed for that taxable year.Therefore, the final regulations clarify thatthe determination date may be differentfrom year to year, and that a change inthe determination date is not a change inmethod of accounting.

Under Option B of safe harbor 2, the2003 regulations provide that a newlyformed taxpayer that chooses Option Band does not have any accounts receivableupon formation will not be able to excludeany portion of its year-end accounts re-ceivable from income for its first taxableyear because the taxpayer does not haveany accounts receivable on the first dayof the taxable year that can be tracked.Some commentators recommended thatthe final regulations either permit newlyformed taxpayers using Option B to ex-clude a portion of their year-end accountsreceivable balance, or in the alternative,clarify the rules for adopting this safeharbor in the taxpayer’s first taxable yearin order to eliminate the administrativeburden of filing Form 3115, “Applica-tion for Change in Accounting Method,”in the succeeding taxable year. The fi-nal regulations retain this special rule in§1.448–(d)(4) for both safe harbor 2 andsafe harbor 4, because the methods requirea beginning accounts receivable balanceto compute the uncollectible amount. Useof another method in the first taxable yearmay not clearly reflect experience. Thefinal regulations clarify that the taxpayermust begin creating its moving averagein its second taxable year by tracking theaccounts receivable as of the first day ofits second taxable year. The use of oneof the safe harbor nonaccrual-experiencemethods of accounting described in para-graph (f)(2), (f)(4), or (f)(5), if applicable,of the final regulations in a taxpayer’ssecond taxable year in this situation isnot a change in method of accounting.Although the taxpayer must maintain thebooks and records necessary to performthe computations under the adopted safeharbor nonaccrual-experience method, thetaxpayer is not required to affirmativelyelect the method on its Federal income taxreturn for its first taxable year.

Commentators requested that safe har-bor 2 be modified to permit taxpayers touse any reasonable method to determinerecoveries. In response to commentators’concerns about whether taxpayers coulduse assumptions regarding recoveriesrather than specifically trace, the preambleto the 2003 regulations stated that the IRSand Treasury Department do not intendthat a taxpayer be changed to the specificcharge off method due to unintentionaland/or immaterial variances, especially

October 10, 2006 661 2006–41 I.R.B.

if the taxpayer is disadvantaged by suchvariances. Some commentators believethat despite the preamble, the 2003 regula-tions may require taxpayers to specificallytrace 100% of recoveries. The IRS andTreasury Department did not intend to pre-vent taxpayers from using a method thatallocates 100% of recoveries to currenttaxable year bad debts. Commentatorsalso have stated that although some recov-eries may be traceable, some recoveriesmay not be traceable due to lump sumrecoveries from third parties.

The final regulations provide that a tax-payer specifically should trace recoveriesif the taxpayer is able to do so withoutundue burden. However, the IRS andTreasury Department believe if the tax-payer is unable specifically to trace allrecoveries without undue burden, the tax-payer should be able to use any reasonablemethod in determining the amount of re-coveries to be traced to each taxable year’sbad debts. Therefore, the final regulationsallow taxpayers to use a reasonable alloca-tion method. A method will be consideredreasonable if there is a cause and effectrelationship between the allocation baseor ratio and the recoveries. The final reg-ulations also provide that a taxpayer maytrace only recoveries that are traceableand allocate the remaining, untraceable,recoveries to charge-offs of amounts inthe relevant beginning accounts receiv-able balances. Methods that include, forexample, receivables for which the nonac-crual-experience method is not allowed tobe used (see §1.448–2(c)(1)(ii)) generallywill not be considered reasonable.

d. Safe harbor 3 — modified Black Motormethod

Safe harbor 3 is a variation of the for-mula addressed in Black Motor Co. v.Commissioner, 41 B.T.A. 300 (1940),aff’d, 125 F.2d 977 (6th Cir. 1942). Nocomments were received regarding safeharbor 3. The final regulations adopt themethod in the 2003 regulations, with mi-nor revisions made to the terms used inthe formulas to conform the terms usedthroughout the regulations.

e. Safe harbor 4 — modified movingaverage method

The 2003 regulations provide that, forpurposes of safe harbor 4, a taxpayer may

determine the uncollectible amount bymultiplying its accounts receivable bal-ance at the end of the current taxable yearby the ratio of total bad debts charged offfor the current taxable year and the fivepreceding taxable years other than thecredit charges (accounts receivable) thatwere charged off in the same taxable yearthey were generated, adjusted for recov-eries of charge-offs during that period, tothe sum of accounts receivable at the endof the current taxable year and the fivepreceding taxable years.

Some commentators argued that, byeliminating credit charges that were writ-ten off in the same taxable year they weregenerated, the effect of this computationfor a taxpayer’s first taxable year is toeliminate the intended benefit of section448(d)(5). These commentators recom-mended that the final regulations permitnewly formed taxpayers using safe harbor4 to exclude a portion of their year-endaccounts receivable balance, or in the al-ternative, clarify the rules on adoptingthis safe harbor method in the taxpayer’sfirst taxable year in order to eliminate theadministrative burden of filing Form 3115in the succeeding taxable year.

This safe harbor method, like safe har-bor 3, is a variation of the formula ad-dressed in Black Motor Co. v. Com-missioner. Safe harbor 4, by eliminat-ing credit charges that were written offin the same taxable year they were gen-erated, and thereby reducing the amountcomputed under the traditional Black Mo-tor formula, remedies known shortcom-ings generally associated with the BlackMotor formula, and as such, more accu-rately reflects a taxpayer’s nonaccrual-ex-perience. Therefore, the final regulationsretain this rule.

Another commentator pointed out thatthere is a mismatching in the compari-son of write-offs to accounts receivablein the formula used in safe harbor 4 be-cause it compares the total accounts writ-ten off in a taxable year after the year ofsale to the ending balances in accounts re-ceivable for the six-year period. For exam-ple, the sum of the write-offs in each tax-able year for the preceding taxable years’charges for services in year 7 is for ser-vices rendered in years 1 through 6, but theending balances in accounts receivable arefrom years 2 through 7. This commenta-tor opined that, if charges for services and

accounts receivable are increasing, the ra-tio of write-offs from prior balances rel-ative to current receivables would be un-derstated and therefore the uncollectibleamount would be understated. The com-mentator suggested that the sum of thewrite-offs in each taxable year for the pre-ceding taxable years’ charges for servicesshould be divided by the sum of the be-ginning accounts receivable for the currentand five preceding taxable years. The fi-nal regulations adopt this recommendationand, for purposes of safe harbor 4, the de-nominator is changed to reflect the begin-ning of the taxable year accounts receiv-able balances in lieu of accounts receivablebalances at the end of the taxable year.

4. Special Rules

a. Acquisitions and dispositions

A commentator recommended thatthe final regulations clarify that newlyformed or acquired taxpayers in a section351(a) or 721(a) nontaxable transactionare allowed to use predecessor data tocompute their uncollectible amount underthe nonaccrual-experience method. Thefinal regulations adopt this comment andprovide special rules for acquisitions anddispositions. Taxpayers that acquire amajor portion of a trade or business or aunit of a trade or business (for example, ahospital) should include the data from thepredecessor in the computations to avoidpotentially skewing the computations forthe remainder of the applicable period.Additionally, taxpayers that dispose ofa major portion of a trade or businessor a unit of a trade or business shouldnot use the data related to the disposedtrade or business in the computations. Forpurposes of the nonaccrual-experiencemethods of accounting, a new, qualifiedtaxpayer that acquires property in anytransaction to which section 381(a) doesnot apply must adopt a nonaccrual-ex-perience method on the basis of its ownexperience. However, to the extent pre-decessor information is available, the datamust be used in the newly-adopted nonac-crual-experience method.

b. Reportable transactions

Some commentators recommendedthat the book-tax difference that may

2006–41 I.R.B. 662 October 10, 2006

result from the use of the nonaccrual-ex-perience method not be taken into accountin determining whether a transaction is areportable transaction for purposes of thedisclosure rules under §1.6011–4(b)(6).As a result of Notice 2006–6, 2006–5I.R.B. 385, book-tax differences nolonger create reportable transactions un-der §1.6011–4(b)(6). Therefore, it is notnecessary to adopt this recommendation.

c. Short taxable years

As discussed, the 2003 regulations gen-erally provide procedures for taxpayersthat have fewer than the requisite num-ber of taxable years to adopt or changeto a safe harbor nonaccrual-experiencemethod. Some commentators requestedrules on how taxpayers may compute theirnonaccrual-experience amount in the caseof a short taxable year. Commentatorsopined that for certain safe harbors, suchas safe harbors 2, 3 and 4, inaccurate in-come exclusion can arise because a shorttaxable year will have a disproportionateeffect on the numerator and denominatorof the computations. For example, a tax-payer that has a relatively stable balanceof accounts receivable but a short period,such as three months, may generate onlyone-fourth of the normal write-offs. Thesecommentators recommended that the fi-nal regulations provide that, if a taxpayerexperiences a short taxable year, the netwrite-offs for the short period should beannualized in order to prevent distortionof the safe harbor computation. Alterna-tively, these commentators suggested thattaxpayers should be allowed to includedata from the previous twelve months inthe safe harbor computation. For example,for a calendar year taxpayer who experi-ences a short period ending March 31st, thetaxpayer would use data from the twelvemonths prior to the period ending onMarch 31st to compute its nonaccrual-ex-perience amount.

The final regulations provide that tax-payers must make appropriate adjustmentsfor short taxable years for nonaccrual-ex-perience methods that are based on a com-parison of accounts receivable balance tototal bad debts. The IRS and TreasuryDepartment intend to issue administrativeguidance on appropriate adjustments.

d. Periodic systems

As with the 2003 regulations, the fi-nal regulations provide, in §1.448–2(d)(2),that a taxpayer applies its nonaccrual-ex-perience method with respect to each spe-cific account receivable eligible for themethod. The preamble to the 2003 regu-lations states that a taxpayer may continueto use the periodic system described in No-tice 88–51, 1988–1 C.B. 535, in conjunc-tion with any permissible nonaccrual-ex-perience method used by the taxpayer. Theuse of a periodic method remains permis-sible under §1.448–2(d)(2) of the final reg-ulations.

5. Effective date

These final regulations are applicable totaxable years ending on or after August 31,2006. A commentator recommended thatthe final regulations be applied retroac-tively to allow taxpayers to settle any opentaxable year in which the nonaccrual-ex-perience method is an issue under consid-eration in examination, in Appeals, or be-fore the U.S. Tax Court by using one ofthe safe harbor methods, and thus, avoidcontinued disagreements between the gov-ernment and taxpayers. The final regula-tions do not adopt this recommendation.However, the Commissioner may settle anearlier taxable year on the basis of a safeharbor method that clearly reflects the tax-payer’s experience.

6. Procedures for Adoption or Change inMethod of Accounting

The 2003 regulations include specificrules for filing an application to change to anonaccrual-experience method of account-ing. The final regulations omit these rules,which will be provided in administrativeguidance. The guidance will include auto-matic consent procedures for filing an ap-plication to change to one of the safe har-bor nonaccrual-experience methods of ac-counting.

To adopt or change to a method otherthan one of the safe harbor nonaccrual-experience methods of accounting, a tax-payer must request advance consent underthe current procedures for obtaining theconsent of the Commissioner of InternalRevenue to change a method of account-ing for Federal income tax purposes (see,for example, Rev. Proc. 97–27, 1997–1

C.B. 680 (as modified and amplified byRev. Proc. 2002–19, 2002–1 C.B. 696,as amplified and clarified by Rev. Proc.2002–54, 2002–2 C.B. 432). In the in-terest of sound tax administration, a newtaxpayer must request advance consent toadopt a method other than one of the safeharbor nonaccrual-experience methods toensure that the method clearly reflects in-come and experience.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been determinedthat section 553(b) and (d) of the Admin-istrative Procedure Act (5 U.S.C. chapter5) does not apply to these regulations. It ishereby certified that the collection of infor-mation contained in these regulations willnot have a significant regulatory impact ona substantial number of small entities. Thiscertification is based upon the fact that theestimated burden associated with the in-formation collection averages three hoursper respondent. Moreover, for taxpayersthat are eligible to use these regulationsand that follow these regulations, any bur-den due to the collection of informationin these regulations will be outweighed bythe benefit received by accruing less in-come than would otherwise be required.Accordingly, a regulatory flexibility anal-ysis is not required. Pursuant to section7805(f) of the Internal Revenue Code, theproposed regulations preceding these reg-ulations were submitted to the Chief Coun-sel for Advocacy of the Small BusinessAdministration for comment on their im-pact on small business.

Drafting Information

The principal author of these regula-tions is W. Thomas McElroy, Jr. of the Of-fice of Associate Chief Counsel (IncomeTax and Accounting). However, other per-sonnel from the IRS and Treasury Depart-ment participated in their development.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

October 10, 2006 663 2006–41 I.R.B.

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.448–2 is added to read

as follows:

§1.448–2 Nonaccrual of certain amountsby service providers.

(a) In general. This section appliesto taxpayers qualified to use a nonac-crual-experience method of accountingprovided for in section 448(d)(5) withrespect to amounts to be received for theperformance of services. A taxpayer thatsatisfies the requirements of this sectionis not required to accrue any portion ofamounts to be received from the perfor-mance of services that, on the basis of thetaxpayer’s experience, and to the extentdetermined under the computation or for-mula used by the taxpayer and allowedunder this section, will not be collected.Except as otherwise provided in this sec-tion, a taxpayer is qualified to use a nonac-crual-experience method of accounting ifthe taxpayer uses an accrual method ofaccounting with respect to amounts to bereceived for the performance of servicesby the taxpayer and either—

(1) The services are in fields referredto in section 448(d)(2)(A) and described in§1.448–1T(e)(4) (health, law, engineering,architecture, accounting, actuarial science,performing arts, or consulting); or

(2) The taxpayer meets the $5 millionannual gross receipts test of section 448(c)and §1.448–1T(f)(2) for all prior taxableyears.

(b) Application of method and treat-ment as method of accounting. The rulesof section 448(d)(5) and the regulationsare applied separately to each taxpayer.For purposes of section 448(d)(5), theterm taxpayer has the same meaningas the term person defined in section7701(a)(1) (rather than the meaning of theterm defined in section 7701(a)(14)). Thenonaccrual of amounts to be received forthe performance of services is a methodof accounting (a nonaccrual-experiencemethod). A change to a nonaccrual-expe-rience method, from one nonaccrual-expe-rience method to another nonaccrual-ex-perience method, or to a periodic system(for example, see Notice 88–51, 1988–1

C.B. 535, and §601.601(d)(2)(ii)(b) ofthis chapter), is a change in method ofaccounting to which the provisions ofsections 446 and 481 and the regulationsapply. See also paragraphs (c)(2)(i), (c)(5),(d)(4), and (e)(3)(i) of this section. Exceptas provided in other published guidance, ataxpayer who wishes to adopt or change toany nonaccrual-experience method otherthan one of the safe harbor methods de-scribed in paragraph (f) of this sectionmust request and receive advance consentfrom the Commissioner in accordancewith the applicable administrative proce-dures issued under §1.446–1(e)(3)(ii) forobtaining the Commissioner’s consent.

(c) Definitions and special rules—(1)Accounts receivable—(i) In general. Ac-counts receivable include only amountsthat are earned by a taxpayer and other-wise recognized in income through theperformance of services by the taxpayer.For purposes of determining a taxpayer’snonaccrual-experience under any methodprovided in this section, amounts de-scribed in paragraph (c)(1)(ii) of thissection are not taken into account. Exceptas otherwise provided, for purposes ofthis section, accounts receivable do notinclude amounts that are not billed (suchas for charitable or pro bono services)or amounts contractually not collectible(such as amounts in excess of a fee sched-ule agreed to by contract). See paragraph(g) Examples 1 and 2 of this section forexamples of this rule.

(ii) Method not available for certainreceivables—(A) Amounts not earnedand recognized through the performanceof services. A nonaccrual-experiencemethod of accounting may not be usedwith respect to amounts that are not earnedby a taxpayer and otherwise recognizedin income through the performance ofservices by the taxpayer. For example, anonaccrual-experience method may not beused with respect to amounts owed to thetaxpayer by reason of the taxpayer’s activ-ities with respect to lending money, sellinggoods, or acquiring accounts receivableor other rights to receive payment fromother persons (including persons relatedto the taxpayer) regardless of whetherthose persons earned the amounts throughthe provision of services. However, seeparagraph (d)(3) of this section for specialrules regarding acquisitions of a trade orbusiness or a unit of a trade or business.

(B) If interest or penalty charged onamounts due. A nonaccrual-experiencemethod of accounting may not be usedwith respect to amounts due for which in-terest is required to be paid or for whichthere is any penalty for failure to timelypay any amounts due. For this purpose,a taxpayer will be treated as charging in-terest or penalties for late payment if thecontract or agreement expressly providesfor the charging of interest or penalties forlate payment, regardless of the practice ofthe parties. If the contract or agreementdoes not expressly provide for the charg-ing of interest or penalties for late pay-ment, the determination of whether the tax-payer charges interest or penalties for latepayment will be made based on all of thefacts and circumstances of the transaction,and not merely on the characterization bythe parties or the treatment of the transac-tion under state or local law. However, theoffering of a discount for early paymentof an amount due will not be regarded asthe charging of interest or penalties for latepayment under this section, if—

(1) The full amount due is otherwiseaccrued as gross income by the taxpayer atthe time the services are provided; and

(2) The discount for early payment istreated as an adjustment to gross income inthe year of payment, if payment is receivedwithin the time required for allowance ofthe discount. See paragraph (g) Example 3of this section for an example of this rule.

(2) Applicable period—(i) In general.The applicable period is the number of tax-able years on which the taxpayer bases itsnonaccrual-experience method. A changein the number of taxable years included inthe applicable period is a change in methodof accounting to which the procedures ofsection 446 apply. A change in the in-clusion or exclusion of the current taxableyear in the applicable period is a changein method of accounting to which the pro-cedures of section 446 apply. A change inthe number of taxable years included in theapplicable period or the inclusion or exclu-sion of the current taxable year in the ap-plicable period is made on a cut-off basis.

(ii) Applicable period for safe harbors.For purposes of the safe harbors underparagraph (f) of this section the applica-ble period may consist of at least three butnot more than six of the immediately pre-ceding consecutive taxable years. Alter-natively, the applicable period may con-

2006–41 I.R.B. 664 October 10, 2006

sist of the current taxable year and at leasttwo but not more than five of the immedi-ately preceding consecutive taxable years.A period shorter than six taxable years ispermissible only if the period contains themost recent preceding taxable years and allof the taxable years in the applicable pe-riod are consecutive.

(3) Bad debts. Bad debts are accountsreceivable determined to be uncollectibleand charged off.

(4) Charge-offs. Amounts charged offinclude only those amounts that would oth-erwise be allowable under section 166(a).

(5) Determination date. The determi-nation date in safe harbor 2 provided inparagraph (f)(2) of this section is used asa cut-off date for determining all knowndata to be taken into account in the com-putation of the taxable year’s uncollectibleamount. The determination date may notbe later than the earlier of the due date,including extensions, for filing the tax-payer’s Federal income tax return for thattaxable year or the date on which the tax-payer timely files the return for that taxableyear. The determination date may be dif-ferent in each taxable year. However, oncea determination date is selected and usedfor a particular taxable year, it may not bechanged for that taxable year. The choiceof a determination date is not a method ofaccounting.

(6) Recoveries. Recoveries are amountspreviously excluded from income under anonaccrual-experience method or chargedoff that the taxpayer recovers.

(7) Uncollectible amount. The un-collectible amount is the portion of anyaccount receivable amount due that, un-der the taxpayer’s nonaccrual-experiencemethod, will be not collected.

(d) Use of experience to estimate un-collectible amounts—(1) In general. Indetermining the portion of any amountdue that, on the basis of experience, willnot be collected, a taxpayer may use anynonaccrual-experience method that clearlyreflects the taxpayer’s nonaccrual-expe-rience. The determination of whethera nonaccrual-experience method clearlyreflects the taxpayer’s nonaccrual-experi-ence is made in accordance with the rulesunder paragraph (e) of this section. Alter-natively, the taxpayer may use any one ofthe five safe harbor nonaccrual-experiencemethods of accounting provided in para-graphs (f)(1) through (f)(5) of this section,

which are presumed to clearly reflect ataxpayer’s nonaccrual-experience.

(2) Application to specific accountsreceivable. The nonaccrual-experiencemethod is applied with respect to eachaccount receivable of the taxpayer that iseligible for this method. With respect to aparticular account receivable, the taxpayerdetermines, in the manner prescribed inparagraphs (d)(1) or (f)(1) through (f)(5)of this section (whichever applies), the un-collectible amount. The determination isrequired to be made only once with respectto each account receivable, regardless ofthe term of the receivable. The uncol-lectible amount is not recognized as grossincome. Thus, the amount recognized asgross income is the amount that wouldotherwise be recognized as gross incomewith respect to the account receivable, lessthe uncollectible amount. A taxpayer thatexcludes an amount from income during ataxable year as a result of the taxpayer’suse of a nonaccrual-experience methodmay not deduct in any subsequent taxableyear the amount excluded from income.Thus, the taxpayer may not deduct theexcluded amount in a subsequent taxableyear in which the taxpayer actually de-termines that the amount is uncollectibleand charges it off. If a taxpayer using anonaccrual-experience method determinesthat an amount that was not excluded fromincome is uncollectible and should becharged off (for example, a calendar-yeartaxpayer determines on November 1st thatan account receivable that was originatedon May 1st of the same taxable year is un-collectible and should be charged off), thetaxpayer may deduct the amount chargedoff when it is charged off, but must includeany subsequent recoveries in income. Thereasonableness of a taxpayer’s determi-nation that amounts are uncollectible andshould be charged off may be consideredon examination. See paragraph (g) Exam-ple 12 of this section for an example ofthis rule.

(3) Acquisitions and dispositions—(i)Acquisitions. If a taxpayer acquires themajor portion of a trade or business ofanother person (predecessor) or the majorportion of a separate unit of a trade or busi-ness of a predecessor, then, for purposes ofapplying this section for any taxable yearending on or after the acquisition, the ex-perience from preceding taxable years ofthe predecessor attributable to the portion

of the trade or business acquired, if avail-able, must be used in determining the tax-payer’s experience.

(ii) Dispositions. If a taxpayer disposesof a major portion of a trade or businessor the major portion of a separate unitof a trade or business, and the taxpayerfurnished the acquiring person the infor-mation necessary for the computations re-quired by this section, then, for purposes ofapplying this section for any taxable yearending on or after the disposition, the expe-rience from preceding taxable years attrib-utable to the portion of the trade or busi-ness disposed may not be used in determin-ing the taxpayer’s experience.

(iii) Meaning of terms. For the mean-ing of the terms acquisition, separate unit,and major portion, see paragraph (b) of§1.52–2. The term acquisition includes anincorporation or a liquidation.

(4) New taxpayers. The rules of thisparagraph (d)(4) apply to any newlyformed taxpayer to which the rules ofparagraph (d)(3)(i) of this section do notapply. Any newly formed taxpayer thatwants to use a safe harbor nonaccrual-ex-perience method of accounting describedin paragraph (f)(1), (f)(2), (f)(3), (f)(4),or (f)(5) of this section applies the meth-ods by using the experience of the actualnumber of taxable years available in theapplicable period. A newly formed tax-payer that wants to use one of the safeharbor nonaccrual-experience methods ofaccounting described in paragraph (f)(2),(f)(4), or (f)(5) of this section in its firsttaxable year and does not have any ac-counts receivable upon formation maynot exclude any portion of its year-endaccounts receivable from income for itsfirst taxable year. The taxpayer mustbegin creating its moving average in itssecond taxable year by tracking the ac-counts receivable as of the first day of itssecond taxable year. The use of one of thesafe harbor nonaccrual-experience meth-ods of accounting described in paragraph(f)(2), (f)(4), or (f)(5) of this section ina taxpayer’s second taxable year in thissituation is not a change in method ofaccounting. Although the taxpayer mustmaintain the books and records necessaryto perform the computations under theadopted safe harbor nonaccrual-experi-ence method, the taxpayer is not requiredto affirmatively elect the method on its

October 10, 2006 665 2006–41 I.R.B.

Federal income tax return for its first tax-able year.

(5) Recoveries. Regardless of thenonaccrual-experience method of ac-counting used by a taxpayer under thissection, the taxpayer must take recoveriesinto account. If, in a subsequent taxableyear, a taxpayer recovers an amount pre-viously excluded from income under anonaccrual-experience method or chargedoff, the taxpayer must include the recov-ered amount in income in that subsequenttaxable year. See paragraph (g) Example13 of this section for an example of thisrule.

(6) Request to exclude taxable yearsfrom applicable period. A period shorterthan the applicable period generally is per-missible only if the period consists of con-secutive taxable years and there is a changein the type of a substantial portion of theoutstanding accounts receivable such thatthe risk of loss is substantially increased.A decline in the general economic condi-tions in the area, which substantially in-creases the risk of loss, is a relevant fac-tor in determining whether a shorter pe-riod is appropriate. However, approval touse a shorter period will not be grantedunless the taxpayer supplies evidence thatthe accounts receivable outstanding at theclose of the taxable years for the shorterperiod requested are more comparable innature and risk to accounts receivable out-standing at the close of the current taxableyear. A substantial increase in a taxpayer’sbad debt experience is not, by itself, suffi-cient to justify the use of a shorter period.If approval is granted to use a shorter pe-riod, the experience for the excluded tax-able years may not be used for any subse-quent taxable year. A request for approvalto exclude the experience of a prior taxableyear must be made in accordance with theapplicable procedures for requesting a let-ter ruling and must include a statement ofthe reasons the experience should be ex-cluded. A request will not be consideredunless it is sent to the Commissioner atleast 30 days before the close of the firsttaxable year for which the approval is re-quested.

(7) Short taxable years. A taxpayerwith a short taxable year that uses a nonac-crual-experience method that comparesaccounts receivable balance to total baddebts during the taxable year should makeappropriate adjustments.

(8) Record keeping requirements—(i)A taxpayer using a nonaccrual-experiencemethod of accounting must keep sufficientbooks and records to establish the amountof any exclusion from gross income un-der section 448(d)(5) for the taxable year,including books and records demonstrat-ing—

(A) The nature of the taxpayer’s nonac-crual-experience method;

(B) Whether, for any particular tax-able year, the taxpayer qualifies to use itsnonaccrual-experience method (includingthe self-testing requirements of paragraph(e) of this section (if applicable));

(C) The taxpayer’s determination thatamounts are uncollectible;

(D) The proper amount that is exclud-able under the taxpayer’s nonaccrual-ex-perience method; and

(E) The taxpayer’s determination dateunder paragraph (c)(5) of this section (ifapplicable).

(ii) If a taxpayer does not maintainrecords of the data that are sufficient to es-tablish the amount of any exclusion fromgross income under section 448(d)(5)for the taxable year, the Internal Rev-enue Service may change the taxpayer’smethod of accounting on examination.See §1.6001–1 for rules regarding records.

(e) Requirements for nonaccrualmethod to clearly reflect experience—(1)In general. A nonaccrual-experiencemethod clearly reflects the taxpayer’s ex-perience if the taxpayer’s nonaccrual-ex-perience method meets the self-test re-quirements described in this paragraph(e). If a taxpayer is using one of the safeharbor nonaccrual-experience methodsdescribed in paragraphs (f)(1) through(f)(4) of this section, its method is deemedto clearly reflect its experience and is notsubject to the self-testing requirements inparagraphs (e)(2) and (e)(3) of this section.

(2) Requirement to self-test—(i) Ingeneral. A taxpayer using, or desiringto use, a nonaccrual-experience methodmust self-test its nonaccrual-experiencemethod for its first taxable year for whichthe taxpayer uses, or desires to use, thatnonaccrual-experience method (first-yearself-test) and every three taxable yearsthereafter (three-year self-test). Eachself-test must be performed by comparingthe uncollectible amount (under the tax-payer’s nonaccrual-experience method)with the taxpayer’s actual experience. A

taxpayer using the safe harbor under para-graph (f)(5) of this section must self-testusing the safe harbor comparison methodin paragraph (e)(3) of this section.

(ii) First-year self-test. The first-yearself-test must be performed by compar-ing the uncollectible amount with the tax-payer’s actual experience for its first tax-able year for which the taxpayer uses, ordesires to use, that nonaccrual-experiencemethod. If the uncollectible amount for thefirst-year self-test is less than or equal tothe taxpayer’s actual experience for its firsttaxable year for which the taxpayer uses, ordesires to use, that nonaccrual-experiencemethod, the taxpayer’s nonaccrual-experi-ence method is treated as clearly reflect-ing its experience for the first taxable year.If, as a result of the first-year self-test, theuncollectible amount for the test period isgreater than the taxpayer’s actual experi-ence, then—

(A) The taxpayer’s nonaccrual-experi-ence method is treated as not clearly re-flecting its experience;

(B) The taxpayer is not permitted to usethat nonaccrual-experience method in thattaxable year; and

(C) The taxpayer must change to (oradopt) for that taxable year either—

(1) Another nonaccrual-experiencemethod that clearly reflects experience,that is, a nonaccrual-experience methodthat meets the first-year self-test require-ment; or

(2) A safe harbor nonaccrual-experi-ence method described in paragraphs (f)(1)through (f)(5) of this section.

(iii) Three-year self-test—(A) In gen-eral. The three-year self-test must be per-formed by comparing the sum of the un-collectible amounts for the current taxableyear and prior two taxable years (cumu-lative uncollectible amount) with the sumof the taxpayer’s actual experience for thecurrent taxable year and prior two tax-able years (cumulative actual experienceamount).

(B) Recapture. If the cumulative un-collectible amount for the test period isgreater than the cumulative actual ex-perience amount for the test period, thetaxpayer’s uncollectible amount is lim-ited to the cumulative actual experienceamount for the test period. Any excessof the taxpayer’s cumulative uncollectibleamount over the taxpayer’s cumulativeactual nonaccrual-experience amount ex-

2006–41 I.R.B. 666 October 10, 2006

cluded from income during the test periodmust be recaptured into income in the thirdtaxable year of the three-year self-test pe-riod.

(C) Determination of whether methodis permissible or impermissible. If thecumulative uncollectible amount is lessthan 110 percent of the cumulative ac-tual experience amount, the taxpayer’snonaccrual-experience method is treatedas a permissible method and the tax-payer may continue to use its alternativenonaccrual-experience method, subjectto the three-year self-test requirementof this paragraph (e)(2)(iii). If the cu-mulative uncollectible amount is greaterthan or equal to 110 percent of the cu-mulative actual experience amount, thetaxpayer’s nonaccrual-experience methodis treated as impermissible in the taxableyear subsequent to the three-year self-testyear and does not clearly reflect its ex-perience. The taxpayer must change toanother nonaccrual-experience methodthat clearly reflects experience, includ-ing, for example, one of the safe harbornonaccrual-experience methods describedin paragraphs (f)(1) through (f)(5) ofthis section, for the subsequent taxableyear. A change in method of accountingfrom an impermissible method under thisparagraph (e)(2)(iii)(C) to a permissiblemethod in the taxable year subsequent tothe three-year self-test year is made on acut-off basis.

(iv) Determination of taxpayer’s actualexperience. Reserved.

(3) Safe harbor comparisonmethod—(i) In general. A taxpayerusing, or desiring to use, a nonaccrual-ex-perience method under the safe harborin paragraph (f)(5) of this section mustself-test its nonaccrual-experience methodfor its first taxable year for which thetaxpayer uses, or desires to use, thatnonaccrual-experience method (first-yearself-test) and every three taxable yearsthereafter (three-year self-test). A nonac-crual-experience method under the safeharbor in paragraph (f)(5) of this sectionis deemed to clearly reflect experienceprovided all the requirements of thesafe harbor comparison method of thisparagraph (e)(3) are met. Each self-testmust be performed by comparing the un-collectible amount (under the taxpayer’snonaccrual-experience method) with theuncollectible amount that would have

resulted from use of one of the safe harbormethods described in paragraph (f)(1),(f)(2), (f)(3), or (f)(4) of this section.A change from a nonaccrual-experi-ence method that uses the safe harborcomparison method for self-testing toa nonaccrual-experience method thatdoes not use the safe harbor comparisonmethod for self-testing, and vice versa,is a change in method of accounting towhich the provisions of sections 446and 481 and the regulations apply. Achange solely to use or discontinue useof the safe harbor comparison methodfor purposes of determining whether thenonaccrual-experience method clearlyreflects experience must be made on acut-off basis and without audit protection.

(ii) Requirements to use safe har-bor comparison method—(A) First-yearself-test. The first-year self-test must beperformed by comparing the uncollectibleamount with the uncollectible amountdetermined under any of the safe harbormethods described in paragraph (f)(1),(f)(2), (f)(3), or (f)(4) of this section (safeharbor uncollectible amount) for its firsttaxable year for which the taxpayer uses, ordesires to use, that nonaccrual-experiencemethod. If the uncollectible amount forthe first-year self-test is less than or equalto the safe harbor uncollectible amount,then the taxpayer’s nonaccrual-experiencemethod is treated as clearly reflecting itsexperience for the first taxable year. If,as a result of the first-year self-test, theuncollectible amount for the test period isgreater than the safe harbor uncollectibleamount, then—

(1) The taxpayer’s nonaccrual-experi-ence method is treated as not clearly re-flecting its experience;

(2) The taxpayer is not permitted to usethat nonaccrual-experience method in thattaxable year; and

(3) The taxpayer must change to (oradopt) for that taxable year either—

(i) Another nonaccrual-experiencemethod that clearly reflects experience,that is, a nonaccrual-experience methodthat meets the first-year self-test require-ment; or

(ii) A safe harbor nonaccrual-experi-ence method described in paragraphs (f)(1)through (f)(5) of this section.

(B) Three-year self-test. The three-yearself-test must be performed by compar-ing the sum of the uncollectible amounts

for the current taxable year and prior twotaxable years (cumulative uncollectibleamount) with the sum of the uncollectibleamount determined under any of the safeharbor methods described in paragraph(f)(1), (f)(2), (f)(3), or (f)(4) of this sec-tion for the current taxable year and priortwo taxable years (cumulative safe harboruncollectible amounts). If the cumulativeuncollectible amount for the three-yearself-test is less than or equal to the cu-mulative safe harbor uncollectible amountfor the test period, then the taxpayer’snonaccrual-experience method is treatedas clearly reflecting its experience for thetest period and the taxpayer may continueto use that nonaccrual-experience method,subject to a requirement to self-test againafter three taxable years. If the cumulativeuncollectible amount for the test period isgreater than the cumulative safe harbor un-collectible amount for the test period, thetaxpayer’s uncollectible amount is limitedto the cumulative safe harbor uncollectibleamount for the test period. Any excessof the taxpayer’s cumulative uncollectibleamount over the taxpayer’s cumulativesafe harbor uncollectible amount excludedfrom income during the test period mustbe recaptured into income in the third tax-able year of the three-year self-test period.If the cumulative uncollectible amountis less than 110 percent of the cumula-tive safe harbor uncollectible amount, thetaxpayer’s nonaccrual-experience methodis treated as a permissible method andthe taxpayer may continue to use its al-ternative nonaccrual-experience method,subject to the three-year self-test require-ment of this paragraph (e)(3)(ii)(B). If thecumulative uncollectible amount is greaterthan or equal to 110 percent of the cumula-tive safe harbor uncollectible amount, thetaxpayer’s nonaccrual-experience methodis treated as impermissible in the taxableyear subsequent to the three-year self-testyear and does not clearly reflect its ex-perience. The taxpayer must change toanother nonaccrual-experience methodthat clearly reflects experience, includ-ing, for example, one of the safe harbornonaccrual-experience methods describedin paragraphs (f)(1) through (f)(5) ofthis section, for the subsequent taxableyear. A change in method of accountingfrom an impermissible method under thisparagraph (e)(3)(ii)(B) to a permissiblemethod in the taxable year subsequent to

October 10, 2006 667 2006–41 I.R.B.

the three-year self-test year is made on acut-off basis.

(4) Methods that do not clearly reflectexperience. [Reserved.]

(5) Contemporaneous documentation.For purposes of this paragraph (e), includ-ing the safe harbor comparison method ofparagraph (e)(3) of this section, a taxpayermust document in its books and records, inthe taxable year any first-year or three-yearself-test is performed, the method used toconduct the self-test, including appro-priate documentation and computations

that resulted in the determination that thetaxpayer’s nonaccrual-experience methodclearly reflected the taxpayer’s nonac-crual-experience for the applicable testperiod.

(f) Safe harbors—(1) Safe harbor 1:revenue-based moving average method.A taxpayer may use a nonaccrual-expe-rience method under which the taxpayerdetermines the uncollectible amount bymultiplying its accounts receivable bal-ance at the end of the current taxable yearby a percentage (revenue-based moving

average percentage). The revenue-basedmoving average percentage is computedby dividing the total bad debts sustained,adjusted by recoveries received, through-out the applicable period by the totalrevenue resulting in accounts receivableearned throughout the applicable period.See paragraph (g) Example 4 of this sec-tion for an example of this method. Thus,the uncollectible amount under the rev-enue-based moving average method iscomputed:

Bad debts sustained, adjusted by recoveries received, during theapplicable period

Total revenue resulting in accounts receivable during theapplicable period

× Accounts receivable at end of current taxable year

(2) Safe harbor 2: actual experiencemethod—(i) Option A: single determina-tion date. A taxpayer may use a nonac-crual-experience method under whichthe taxpayer determines the uncollectibleamount by multiplying its accounts re-ceivable balance at the end of the currenttaxable year by a percentage (moving av-erage nonaccrual-experience percentage)and then increasing the resulting amount

by 5 percent. See paragraph (g) Example5 of this section for an example of safeharbor 2 in general, and paragraph (g)Example 6 of this section for an exampleof the single determination date optionof safe harbor 2. The taxpayer’s movingaverage nonaccrual-experience percent-age is computed by dividing the total baddebts sustained, adjusted by recoveriesthat are allocable to the bad debts, by the

determination date of the current taxableyear related to the taxpayer’s accounts re-ceivable balance at the beginning of eachtaxable year during the applicable periodby the sum of the accounts receivable atthe beginning of the each taxable yearduring the applicable period. Thus, theuncollectible amount under Option A ofthe actual experience method is computed:

Bad debts sustained, adjusted by recoveries receivedthat are allocable to the bad debts, by the determinationdate of the current taxable year related to the taxpayer’saccounts receivable balance at the beginning of eachtaxable year during the applicable period

Sum of accounts receivable at the beginning of eachtaxable year during the applicable period

×Accounts receivable at end

of current taxable year× 1.05

(ii) Option B: multiple determinationdates. Alternatively, in computing its baddebts related to the taxpayer’s accounts re-ceivable balance at the beginning of eachtaxable year during the applicable period,a taxpayer may use the original determina-tion date for each taxable year during the

applicable period. That is, the taxpayermay use bad debts sustained, adjusted byrecoveries received that are allocable tothe bad debts, by the determination date ofeach taxable year during the applicable pe-riod rather than the determination date ofthe current taxable year. See paragraph (g)

Example 7 of this section for an exampleof the multiple determination date optionof safe harbor 2. Thus, the uncollectibleamount under Option B of the actual expe-rience method is computed:

Sum of, for each taxable year during the applicableperiod, bad debts sustained, adjusted by recoveriesreceived that are allocable to the bad debts, by thattaxable year’s determination date and related to thetaxpayer’s accounts receivable balance at the beginningof the taxable year

Sum of accounts receivable at the beginning of eachtaxable year during the applicable period

×Accounts receivable at end

of current taxable year× 1.05

2006–41 I.R.B. 668 October 10, 2006

(iii) Tracing of recoveries—(A) In gen-eral. Bad debts related to the taxpayer’saccounts receivable balance at the begin-ning of each taxable year during the appli-cable period must be adjusted by the por-tion, if any, of recoveries received that areproperly allocable to the bad debts.

(B) Specific tracing. If a taxpayer, with-out undue burden, can trace all recoveriesto their corresponding charge-offs, the tax-payer must specifically trace all recover-ies.

(C) Recoveries cannot be traced with-out undue burden. If a taxpayer has anyrecoveries that cannot, without undue bur-den, be traced to corresponding charge-offs, the taxpayer may allocate those or allrecoveries between charge-offs of amountsin the relevant beginning accounts receiv-able balances and other charge-offs usingan allocation method that is reasonable un-der all of the facts and circumstances.

(1) Reasonable allocations. An allo-cation method is reasonable if there is acause and effect relationship between theallocation base or ratio and the recoveries.A taxpayer may elect to trace recoveriesthat are traceable and allocate all untrace-able recoveries to charge-offs of amountsin the relevant beginning accounts receiv-able balances. Such an allocation methodwill be deemed to be reasonable under allthe facts and circumstances.

(2) Allocations that are not reasonable.Allocation methods that generally will notbe considered reasonable include, for ex-ample, methods in which there is not acause and effect relationship between theallocation base or ratio and methods inwhich receivables for which the nonac-crual-experience method is not allowed tobe used are included in the allocation. Seeparagraph (c)(1)(ii) of this section for ex-amples of receivables for which the nonac-crual-experience method is not allowed.

(3) Safe harbor 3: modified Black Mo-tor method. A taxpayer may use a nonac-crual-experience method under whichthe taxpayer determines the uncollectibleamount by multiplying its accounts re-ceivable balance at the end of the currenttaxable year by a percentage (modifiedBlack Motor moving average percentage)and then reducing the resulting amountby the bad debts written off during thecurrent taxable year relating to accountsreceivable generated during the currenttaxable year. The modified Black Motormoving average percentage is computedby dividing the total bad debts sustained,adjusted by recoveries received, during theapplicable period by the sum of accountsreceivable at the end of each taxable yearduring the applicable period. See para-graph (g) Example 8 of this section for anexample of this method. Thus, the uncol-lectible amount under the modified BlackMotor method is computed:

Bad debts sustained, adjusted byrecoveries received, during theapplicable period

Sum of accounts receivable at theend of each taxable year during theapplicable period

×Accounts receivable at end of

current taxable year

Bad debts written off during thecurrent taxable year relating to

accounts receivable generated duringthe current taxable year

(4) Safe harbor 4: modified movingaverage method. A taxpayer may usea nonaccrual-experience method underwhich the taxpayer determines the un-collectible amount by multiplying itsaccounts receivable balance at the end ofthe current taxable year by a percentage

(modified moving average percentage).The modified moving average percentageis computed by dividing the total bad debtssustained, adjusted by recoveries received,during the applicable period other than baddebts that were written off in the same tax-able year the related accounts receivable

were generated by the sum of accountsreceivable at the beginning of each taxableyear during the applicable period. Seeparagraph (g) Example 9 of this sectionfor an example of this method. Thus, theuncollectible amount under the modifiedmoving average method is computed:

(Bad debts sustained, adjusted by recoveries received, duringthe applicable period Bad debts written off in same taxableyear accounts receivable generated)

Sum of accounts receivable at the beginning of each taxableyear during the applicable period

× Accounts receivable at end of current taxable year

(5) Safe harbor 5: alternative nonac-crual-experience method. A taxpayer mayuse an alternative nonaccrual-experiencemethod that clearly reflects the taxpayer’sactual nonaccrual-experience, providedthe taxpayer’s alternative nonaccrual-ex-perience method meets the self-test re-quirements described in paragraph (e)(3)of this section.

(g) Examples. The following examplesillustrate the provisions of this section. Ineach example, the taxpayer uses a calendaryear for Federal income tax purposes andan accrual method of accounting, does notrequire the payment of interest or penaltieswith respect to past due accounts receiv-able (except in the case of Example 3) and,in the case of Examples 5 through 7, selects

an appropriate determination date for eachtaxable year. The examples are as follows:

Example 1. Contractual allowance or adjust-ment. B, a healthcare provider, performs a medicalprocedure on individual C, who has health insurancecoverage with IC, an insurance company. B bills ICand C for $5,000, B’s standard charge for this med-ical procedure. However, B has a contract with ICthat obligates B to accept $3,500 as full payment forthe medical procedure if the procedure is providedto a patient insured by IC. Under the contract, only$3,500 of the $5,000 billed by B is legally collectible

October 10, 2006 669 2006–41 I.R.B.

from IC and C. The remaining $1,500 representsa contractual allowance or contractual adjustment.Under paragraph (c)(1)(i) of this section, the remain-ing $1,500 is not a contractually collectible amountfor purposes of this section and B may not use anonaccrual-experience method with respect to thisportion of the receivable.

Example 2. Charitable or pro bono services. D,a law firm, agrees to represent individual E in a le-gal matter and to provide services to E on a pro bonobasis. D normally charges $500 for these services.Because D provides its services to E pro bono, D’sservices are never billed or intended to result in rev-enue. Thus, under paragraph (c)(1)(i) of this section,

the $500 is not a collectible amount for purposes ofthis section and D may not use a nonaccrual-experi-ence method with respect to this portion of the receiv-able.

Example 3. Charging interest and/or penalties.Z has two billing methods for the amounts to be re-ceived from Z’s provision of services described inparagraph (a)(1) of this section. Under one method,for amounts that are more than 90 days past due, Zcharges interest at a market rate until the amounts(together with interest) are paid. Under the otherbilling method, Z charges no interest for amounts pastdue. Under paragraph (c)(1)(ii) of this section, A maynot use a nonaccrual-experience method of account-

ing with respect to any of the amounts billed underthe method that charges interest on amounts that aremore than 90 days past due. Z may, however, usethe nonaccrual-experience method with respect to theamounts billed under the method that does not chargeinterest for amounts past due.

Example 4. Safe harbor 1: Revenue-based mov-ing average method. (i) F uses the revenue-basedmoving average method described in paragraph (f)(1)of this section with an applicable period of six tax-able years. F’s total accounts receivable and bad debtexperience for the 2006 taxable year and the five im-mediately preceding consecutive taxable years are asfollows:

Taxableyear

Total accounts receivableearned during the taxable year

Bad debts(adjusted for recoveries)

2001 $40,000 $5,7002002 40,000 7,2002003 40,000 11,0002004 60,000 10,200

2005 70,000 14,0002006 80,000 16,800Total $330,000 $64,900

(ii) F’s revenue-based moving average percent-age is 19.67% ($64,900/$330,000). If $49,300 ofaccounts receivable remains outstanding as of theclose of that taxable year (2006), F’s uncollectibleamount using the revenue-based moving average safeharbor method is computed by multiplying $49,300by the revenue-based moving average percentage

of 19.67%, or $9,697. Thus, F may exclude $9,697from gross income for 2006.

Example 5. Safe harbor 2: Actual experiencemethod. (i) G is eligible to use a nonaccrual-expe-rience method and wishes to adopt the actual expe-rience method of paragraph (f)(2) of this section. Gelects to use a three-year applicable period consisting

of the current and two immediately preceding consec-utive taxable years. G determines that its actual ac-counts receivable collection experience is as follows:

Taxableyear

Total A/R balanceat beginning of taxable year

Bad debts, adjusted for recoveries,related to A/R balance at beginning

of taxable year

2006 $1,000,000 $35,0002007 760,000 75,0002008 1,975,000 65,000Total $3,735,000 $175,000

(ii) G’s ending A/R Balance on December 31,2008, is $880,000. In 2008, G computes its uncol-lectible amount by using a three-year moving averageunder paragraph (f)(2) of this section. G’s moving av-erage nonaccrual-experience percentage is 4.7%, de-termined by dividing the sum of the amount of G’s ac-counts receivable outstanding on January 1 of 2006,2007, and 2008, that were determined to be bad debts(adjusted for recoveries allocable to the bad debts)on or before the corresponding determination date(s),by the sum of the amount of G’s accounts receivableoutstanding on January 1 of 2006, 2007, and 2008($175,000/$3,735,000 or 4.7%). G’s uncollectibleamount for 2008 is determined by multiplying thispercentage by the balance of G’s accounts receivableon December 31, 2008 ($880,000 x 4.7% = $41,360),and increasing this amount by 105% ($41,360 x 105%= $43,428). G may exclude $43,428 from gross in-come for 2008.

Example 6. Safe harbor 2: Single determinationdate (Option A). H is eligible to use a nonaccrual-ex-perience method and wishes to adopt the actual expe-rience method of paragraph (f)(2) of this section. Helects to use a six-year applicable period consisting

of the current and five immediately preceding taxableyears. H also elects to use a single determination datein accordance with paragraph (f)(2)(i) of this section.H selects December 31, its taxable year-end, as itsdetermination date. Since H is using a single deter-mination date from the current taxable year, its deter-mination date for the 2001–2006 applicable period isDecember 31, 2006. H has a $800 charge-off in 2003of an account receivable in the 2003 beginning ac-counts receivable balance. In 2005, H has a recoveryof $100 which is traceable, without undue burden, tothe $800 charge-off in 2003. Since the $100 recoveryoccurred prior to H’s December 31, 2006, determina-tion date, it reduces the amount of H’s bad debts in thenumerator of the formula for purposes of determiningH’s moving average nonaccrual-experience percent-age. In addition, H must include the $100 recovery inincome in 2005 (see paragraph (d)(5) of this sectionregarding recoveries).

Example 7. Safe harbor 2: Multiple determina-tion dates (Option B). The facts are the same as inExample 6, except H elects to use multiple determi-nation dates in accordance with paragraph (f)(2)(ii) ofthis section. Consequently, H’s determination date is

December 31, 2001, for its calculations of the portionof the numerator relating to the 2001 taxable year, De-cember 31, 2002, for its calculations of the portion ofthe numerator relating to the 2002 taxable year, andso on through the final taxable year (2006), which hasa determination date of December 31, 2006. Sincethe $100 recovery did not occur until after Decem-ber 31, 2003 (the determination date for the 2003 tax-able year), it does not reduce the amount of H’s baddebts in the numerator of the formula for purposesof determining H’s moving average nonaccrual-ex-perience percentage. However, H still must includethe $100 recovery in income in 2005 (see paragraph(d)(5) of this section regarding recoveries).

Example 8. Safe harbor 3: Modified Black Motormethod. (i) J uses the modified Black Motor methoddescribed in paragraph (f)(3) of this section and a six-year applicable period. J’s total accounts receivableand bad debt experience for the 2006 taxable year andthe five immediately preceding consecutive taxableyears are as follows:

2006–41 I.R.B. 670 October 10, 2006

Taxableyear

Total accounts receivableearned during the taxable year

Bad debts(adjusted for recoveries)

2001 $130,000 $9,1002002 140,000 7,0002003 140,000 14,0002004 160,000 14,4002005 170,000 20,4002006 180,000 10,800Total $920,000 $75,700

(ii) J’s modified Black Motor moving averagepercentage is 8.228% ($75,700/$920,000). If theaccounts receivable generated and written off duringthe current taxable year are $3,600, J’s uncollectibleamount is $11,210, computed by multiplying J’s ac-counts receivable on December 31, 2006 ($180,000)by the modified Black Motor moving average per-centage of 8.228% and reducing the resulting amount

by $3,600 (J’s accounts receivable generated andwritten off during the 2006 taxable year). J mayexclude $11,210 from gross income for 2006.

Example 9. Safe harbor 4: Modified moving av-erage method. (i) The facts are the same as in Ex-ample 8, except that the balances represent accountsreceivable at the beginning of the taxable year, and Juses the modified moving average method described

in paragraph (f)(4) of this section and a six-year ap-plicable period. Furthermore, the accounts receivablethat were written off in the same taxable year theywere generated, adjusted for recoveries of bad debtsduring the period are as follows:

Taxableyear

Accounts receivable written offin same taxable year as generated

(adjusted for recoveries)

2001 $3,0332002 2,3332003 4,6672004 4,800

2005 6,8002006 3,600Total $25,233

(ii) J’s modified moving average percentageis 5.486% (($75,700 - $25,233)/$920,000). J’suncollectible amount is $9,875, computed by mul-tiplying J’s accounts receivable on December 31,2006 ($180,000) by the modified moving averagepercentage of 5.486%. J may exclude $9,875 fromgross income for 2006.

Example 10. First-year self-test. Beginning in2006, K is eligible to use a nonaccrual-experiencemethod and wants to adopt an alternative nonaccrual-experience method under paragraph (f)(5) of this sec-tion, and consequently is subject to the safe harborcomparison method of self-testing under paragraph(e)(3) of this section. K elects to self-test against safeharbor 1 for purposes of conducting its first-year self-test. K’s uncollectible amount for 2006 is $22,000.K’s safe harbor uncollectible amount under safe har-bor 1 is $21,000. Because K’s uncollectible amountfor 2006 ($22,000) is greater than the safe harbor un-collectible amount ($21,000), K’s alternative nonac-crual-experience method is treated as not clearly re-flecting its nonaccrual experience for 2006. Accord-ingly, K must adopt either another nonaccrual-experi-ence method that clearly reflects experience (subjectto the self-testing requirements of paragraph (e)(2)(ii)of this section, or a safe harbor nonaccrual-experiencemethod described in paragraph (f)(1) (revenue-basedmoving average), (f)(2) (actual experience method),(f)(3) (modified Black Motor method), (f)(4) (modi-fied moving average method) of this section, or an-other alternative nonaccrual-experience method un-der paragraph (f)(5) of this section that meets theself-testing requirements of paragraph (e)(3) of thissection.

Example 11. Three-year self-test. The facts arethe same as in Example 10, except that K’s safeharbor uncollectible amount under safe harbor 1for 2006 is also $22,000. Consequently, K meetsthe first-year self-test requirement and may use itsalternative nonaccrual-experience method. Subse-quently, K’s cumulative uncollectible amount for2007 through 2009 is $300,000. K’s safe harboruncollectible amount for 2007 through 2009 underits chosen safe harbor method for self-testing (safeharbor 1) is $295,000. Because K’s cumulativeuncollectible amount for the three-year test period(taxable years 2007 through 2009) is greater than itssafe harbor uncollectible amount for the three-yeartest period ($295,000), under paragraph (e)(3)(ii)(B)of this section, the $5,000 excess of K’s cumulativeuncollectible amount over K’s safe harbor uncol-lectible amount for the three-year test period must berecaptured into income in 2009 in accordance withparagraph (e)(3)(ii)(B) of this section. Since K’scumulative uncollectible amount for the three-yeartest period ($300,000) is less than 110% of its safeharbor uncollectible amount ($295,000 x 110% =$324,500), under paragraph (e)(3)(ii)(B) of thissection, K may continue to use its alternative nonac-crual-experience method, subject to the three-yearself-test requirement.

Example 12. Subsequent worthlessness of year-end receivable. The facts are the same as in Exam-ple 4, except that one of the accounts receivable out-standing at the end of 2002 was for $8,000, and in2003, under section 166, the entire amount of this re-ceivable becomes wholly worthless. Because F doesnot accrue as income $1,573 of this account receiv-

able ($8,000 x .1967) under the nonaccrual-experi-ence method in 2002, under paragraph (d)(2) of thissection F may not deduct this portion of the accountreceivable as a bad debt deduction under section 166in 2003. F may deduct the remaining balance of thereceivable in 2003 as a bad debt deduction under sec-tion 166 ($8,000 - $1,574 = $6,426).

Example 13. Subsequent collection of year-endreceivable. The facts are the same as in Example 4.In 2007, F collects in full an account receivable of$1,700 that was outstanding at the end of 2006. Underparagraph (d)(5) of this section, F must recognize ad-ditional gross income in 2007 equal to the portion ofthis receivable that F excluded from gross income inthe prior taxable year ($1,700 x .1967 = $334). Thatamount ($334) is a recovery under paragraph (d)(5)of this section.

(h) Effective date. This section is appli-cable for taxable years ending on or afterAugust 31, 2006.

§1.448–2T [Removed]

Par. 3. Section 1.448–2T is removed.

PART 602—OMB CONTROLNUMBERS UNDER THE PAPERWORKREDUCTION ACT

Par. 4. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.

October 10, 2006 671 2006–41 I.R.B.

Par. 5. In §602.101, paragraph (b) isamended by adding an entry in numericalorder to the table to read as follows:

§602.101 OMB Control numbers.

* * * * *

(b) * * *

CFR part or section whereidentified and described

Current OMBcontrol No.

* * * * *

1.448–2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–1855

* * * * *

Steven T. Miller,Acting Deputy Commissionerfor Services and Enforcement.

Approved August 30, 2006.

Eric Solomon,Acting Deputy Assistant Secretary

of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on August 31,2006, 1:53 p.m., and published in the issue of the FederalRegister for September 6, 2006, 71 F.R. 52430)

Section 467.—CertainPayments for the Use ofProperty or Services

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 468.—SpecialRules for Mining and SolidWaste Reclamation andClosing Costs

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 482.—Allocationof Income and DeductionsAmong Taxpayers

Federal short-term, mid-term, and long-term ratesare set forth for the month of October 2006. See Rev.Rul. 2006-50, page 672.

Section 483.—Interest onCertain Deferred Payments

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 642.—SpecialRules for Credits andDeductions

Federal short-term, mid-term, and long-term ratesare set forth for the month of October 2006. See Rev.Rul. 2006-50, page 672.

Section 807.—Rules forCertain Reserves

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 846.—DiscountedUnpaid Losses Defined

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 1274.—Determi-nation of Issue Price in theCase of Certain Debt Instru-ments Issued for Property(Also Sections 42, 280G, 382, 412, 467, 468, 482,483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates;adjusted federal long-term rate and the

long-term exempt rate. For purposes ofsections 382, 642, 1274, 1288, and othersections of the Code, tables set forth therates for October 2006.

Rev. Rul. 2006–50

This revenue ruling provides variousprescribed rates for federal income taxpurposes for October 2006 (the currentmonth). Table 1 contains the short-term,mid-term, and long-term applicable fed-eral rates (AFR) for the current monthfor purposes of section 1274(d) of theInternal Revenue Code. Table 2 containsthe short-term, mid-term, and long-termadjusted applicable federal rates (adjustedAFR) for the current month for purposesof section 1288(b). Table 3 sets forth theadjusted federal long-term rate and thelong-term tax-exempt rate described insection 382(f). Table 4 contains the ap-propriate percentages for determining thelow-income housing credit described insection 42(b)(2) for buildings placed inservice during the current month. Finally,Table 5 contains the federal rate for deter-mining the present value of an annuity, aninterest for life or for a term of years, ora remainder or a reversionary interest forpurposes of section 7520.

2006–41 I.R.B. 672 October 10, 2006

REV. RUL. 2006–50 TABLE 1

Applicable Federal Rates (AFR) for October 2006

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term

AFR 5.00% 4.94% 4.91% 4.89%110% AFR 5.50% 5.43% 5.39% 5.37%120% AFR 6.02% 5.93% 5.89% 5.86%130% AFR 6.52% 6.42% 6.37% 6.34%

Mid-term

AFR 4.82% 4.76% 4.73% 4.71%110% AFR 5.31% 5.24% 5.21% 5.18%120% AFR 5.79% 5.71% 5.67% 5.64%130% AFR 6.29% 6.19% 6.14% 6.11%150% AFR 7.27% 7.14% 7.08% 7.04%175% AFR 8.50% 8.33% 8.25% 8.19%

Long-term

AFR 5.02% 4.96% 4.93% 4.91%110% AFR 5.53% 5.46% 5.42% 5.40%120% AFR 6.04% 5.95% 5.91% 5.88%130% AFR 6.55% 6.45% 6.40% 6.36%

REV. RUL. 2006–50 TABLE 2

Adjusted AFR for October 2006

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term adjustedAFR

3.50% 3.47% 3.46% 3.45%

Mid-term adjusted AFR 3.69% 3.66% 3.64% 3.63%

Long-term adjustedAFR

4.22% 4.18% 4.16% 4.14%

REV. RUL. 2006–50 TABLE 3

Rates Under Section 382 for October 2006

Adjusted federal long-term rate for the current month 4.22%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjustedfederal long-term rates for the current month and the prior two months.) 4.52%

REV. RUL. 2006–50 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for October 2006Appropriate percentage for the 70% present value low-income housing credit 8.15%

Appropriate percentage for the 30% present value low-income housing credit 3.49%

October 10, 2006 673 2006–41 I.R.B.

REV. RUL. 2006–50 TABLE 5

Rate Under Section 7520 for October 2006

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years,or a remainder or reversionary interest 5.8%

Section 1288.—Treatmentof Original Issue Discounton Tax-Exempt Obligations

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 7520.—ValuationTables

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

Section 7872.—Treatmentof Loans With Below-MarketInterest Rates

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof October 2006. See Rev. Rul. 2006-50, page 672.

2006–41 I.R.B. 674 October 10, 2006

Part III. Administrative, Procedural, and MiscellaneousPhase-Out of Credit forNew Qualified Hybrid MotorVehicles and New AdvancedLean Burn Technology MotorVehicles

Notice 2006–78

SECTION 1. PURPOSE

This notice announces the credit phase-out schedule for advanced lean burn tech-nology motor vehicles and hybrid passen-ger automobiles and light trucks manufac-tured by Toyota Motor Corporation.

SECTION 2. BACKGROUND

Section 30B(a)(2) of the Internal Rev-enue Code provides for a credit determinedunder § 30B(c) for certain new advancedlean burn technology motor vehicles. Sec-tion 30B(a)(3) provides for a credit de-termined under § 30B(d) for certain newqualified hybrid motor vehicles. Both thenew advanced lean burn technology motorvehicle credit and the new qualified hybridmotor vehicle credit begin to phase out fora manufacturer’s passenger automobilesand light trucks in the second calendarquarter after the calendar quarter in whichat least 60,000 of the manufacturer’s pas-senger automobiles and light trucks thatqualify for either credit have been sold foruse or lease in the United States (deter-mined on a cumulative basis for sales afterDecember 31, 2005). Taxpayers purchas-ing the manufacturer’s vehicles during thefirst two calendar quarters of the phase-outperiod may claim only 50 percent of theotherwise allowable credit. Taxpayers pur-chasing the manufacturer’s vehicles dur-ing the third and fourth quarters of thephase-out period may claim only 25 per-cent of the otherwise allowable credit. Nocredit is available for vehicles purchasedafter the last day of the fourth quarter ofthe phase-out period.

Notice 2006–9, 2006–6 I.R.B. 413, pro-vides procedures for a vehicle manufac-turer (or, in the case of a foreign vehi-cle manufacturer, its domestic distributor)to certify to the Internal Revenue Service(Service) both (1) that a particular make,model, and model year of vehicle quali-fies for either the new advanced lean burntechnology motor vehicle credit or the newqualified hybrid motor vehicle credit and(2) the amount of the credit allowable withrespect to that vehicle.

Section 5.05 of Notice 2006–9 requiresa manufacturer (or, in the case of a foreignvehicle manufacturer, its domestic distrib-utor) that has received from the Service anacknowledgement of its certification for aparticular make, model, and model year ofvehicle to submit to the Service a reportof the number of qualified vehicles soldby the manufacturer (or, in the case of aforeign vehicle manufacturer, its domesticdistributor) to retail dealers during the cal-endar quarter. A qualified vehicle is de-fined for this purpose as any passenger au-tomobile or light truck that is a new ad-vanced lean burn technology motor vehi-cle or a new qualified hybrid motor vehi-cle.

In accordance with the section 5.05of Notice 2006–9, Toyota Motor Sales,U.S.A., Inc. has submitted quarterly re-ports that indicate that its cumulativesales of qualified vehicles to retail dealersreached the 60,000-vehicle limit dur-ing the calendar quarter ending June 30,2006. Accordingly, the credit for all newadvanced lean burn technology motor ve-hicles or new qualified hybrid passengerautomobiles or light trucks manufacturedby Toyota Motor Corporation will beginto phase out on October 1, 2006.

SECTION 3. SCOPE OF NOTICE

This notice applies to any make, model,or model year of new advanced lean burntechnology motor vehicle or new qualified

hybrid passenger automobile or light truckthat is—

(1) manufactured by Toyota Motor Cor-poration; and

(2) purchased for use or lease in theUnited States on or after October 1, 2006.

SECTION 4. Credit Amount

.01 In general. If a new advanced leanburn technology motor vehicle or newqualified hybrid passenger automobile orlight truck manufactured by Toyota MotorCorporation is purchased for use or leaseafter September 30, 2006, the allowablecredit is as follows:

(1) For vehicles purchased for use orlease on or after October 1, 2006, and on orbefore March 31, 2007, the credit is 50 per-cent of the otherwise allowable amount de-termined under § 30B(c) or (d) (whicheveris applicable);

(2) For vehicles purchased for use orlease on or after April 1, 2007, and onor before September 30, 2007, the creditis 25 percent of the otherwise allowableamount determined under § 30B(c) or (d)(whichever is applicable); and

(3) For vehicles purchased for use orlease on or after October 1, 2007, no creditis allowable.

.02 Certified Vehicles. The followingtables set forth the credit available on or af-ter October 1, 2006, for hybrid motor vehi-cles for which Toyota Motor Sales, U.S.A.,Inc. received an acknowledgement of itscertification from the Service on or beforeSeptember 19, 2006:

October 10, 2006 675 2006–41 I.R.B.

Table 1

October 1, 2006 — March 31, 2007

Model Year Model Credit Amount

2005 Prius $1,575

2006 Prius $1,575

2006 Highlander 4WD Hybrid $1,300

2006 Highlander 2WD Hybrid $1,300

2006 Lexus RX400h 2WD $1,100

2006 Lexus RX400h 4WD $1,100

2007 Camry Hybrid $1,300

2007 Lexus GS 450h $775

Table 2

April 1, 2007 — September 30, 2007

Model Year Model Credit Amount

2005 Prius $787.50

2006 Prius $787.50

2006 Highlander 4WD Hybrid $650

2006 Highlander 2WD Hybrid $650

2006 Lexus RX400h 2WD $550

2006 Lexus RX400h 4WD $550

2007 Camry Hybrid $650

2007 Lexus GS 450h $387.50

Table 3

On or after October 1, 2007

Model Year Model Credit Amount

2005 Prius $0.00

2006 Prius $0.00

2006 Highlander 4WD Hybrid $0.00

2006 Highlander 2WD Hybrid $0.00

2006 Lexus RX400h 2WD $0.00

2006 Lexus RX400h 4WD $0.00

2007 Camry Hybrid $0.00

2007 Lexus GS 450h $0.00

The principal author of this noticeis Nicole R. Cimino of the Office ofAssociate Chief Counsel (Passthroughs

and Special Industries). For further in-formation regarding this notice, contact

Ms. Cimino at (202) 622–3120 (not atoll-free call).

2006–41 I.R.B. 676 October 10, 2006

Guidance on the Application ofSection 911 to U.S. IndividualsWorking at Guantanamo Bay

Notice 2006–84

This notice provides guidance regard-ing the application of section 911 of the In-ternal Revenue Code to U.S. citizens andresidents earning income from performingservices at the U.S. Naval Base at Guan-tanamo Bay.

Section 911(a) of the Code allows aqualified individual to elect to excludefrom gross income his or her foreignearned income (as defined in section911(b)) and housing cost amount. Section911(d)(1) generally defines a “qualifiedindividual” as a U.S. citizen or residentwhose tax home is in a foreign countryand who meets certain requirements ofresidence or presence in a foreign coun-try. Section 1.911–3(a) of the IncomeTax Regulations defines foreign earnedincome as earned income from sourceswithin a foreign country (as defined insection 1.911–2(h) of the regulations)that is earned during a period for whichthe individual qualifies under section1.911–2(a) to make an election. Earnedincome is from sources within a foreigncountry if it is attributable to servicesperformed by an individual in a foreigncountry or countries. Section 1.911–2(h)provides, in part, that the term “foreigncountry” when used in a geographicalsense includes any territory under the sov-ereignty of a government other than thatof the United States. Section 911(b)(1)(B)excludes from the definition of foreignearned income certain amounts, includ-ing amounts paid by the United States oran agency thereof to an employee of theUnited States or an agency thereof.

Section 911(d)(8)(A) of the Code pro-vides, generally, that if travel (or anytransaction in connection with such travel)with respect to any foreign country is pro-scribed by certain regulations during anyperiod, then: (1) foreign earned incomedoes not include income from sourceswithin that country attributable to servicesperformed during that period; (2) housingexpenses do not include any expenses al-locable to such period for housing in thatcountry, or for housing of the taxpayer’sspouse or dependents in another countrywhile the taxpayer is present in that coun-

try; and (3) an individual is not treated asa bona fide resident of, or as present in, aforeign country for any day during whichthe individual was present in that countryduring that period. The regulations iden-tified in section 911(d)(8)(A) are thosepromulgated pursuant to the Trading Withthe Enemy Act (“TWEA”), 50 U.S.C.App. 1 et seq., or the International Emer-gency Economic Powers Act, 50 U.S.C.1701 et seq., that include provisions gener-ally prohibiting U.S. citizens and residentsfrom engaging in transactions related totravel to, from, or within certain foreigncountries. Section 911(d)(8)(B). Section911(d)(8)(C), however, provides that thelimitations of section 911(d)(8)(A) do notapply to any individual during any periodin which such individual’s activities arenot in violation of these regulations.

In 1963, the Department of the Trea-sury’s Office of Foreign Assets Control(“OFAC”) issued the Cuban Assets Con-trol Regulations (the “CACR”), 31 C.F.R.part 515. The CACR were issued pursuantto TWEA. Section 515.201(b)(1) of theCACR prohibits persons subject to UnitedStates jurisdiction from all dealings inany property in which Cuba or a Cubannational has or has had an interest sinceJuly 8, 1963, unless authorized by OFAC.OFAC interprets this prohibition to includea prohibition on all transactions related totravel to, from, and within Cuba. See, e.g.,§ 515.560 of the CACR, which authorizescertain transactions related to travel to,from, and within Cuba for participation incertain activities.

Section 911(d)(8) of the Code was en-acted as part of the Tax Reform Act of 1986(Pub. L. No. 99–514, 1986–3 C.B. 1, 481).The Report of the Senate Committee on Fi-nance (S. Rep. No. 99–313, 99th Cong.,2d Sess. 389 (1986)) listed Cuba as oneof the countries for which Treasury reg-ulations proscribed transactions related totravel of U.S. citizens and residents. Sec-tion 911(d)(8) continues to apply to Cuba.See, Rev. Rul. 2005–3, 2005–1 C.B. 334.

After consultations with OFAC, the IRSand Treasury have determined that for pur-poses of section 911(d)(8) of the Code, theCACR do not proscribe transactions re-lated to travel, to, from, or within the U.S.Naval Base at Guantanamo Bay. For pur-poses of determining whether an individ-ual’s earned income is from sources withina foreign country for the purpose of sec-

tion 911(b) and section 1.911–3(a) of theregulations, however, the individual whois performing services at the U.S. NavalBase at Guantanamo Bay is performingservices within a foreign country. See sec-tion 1.911–2(h).

Accordingly, under section 911(d)(8)(C) of the Code, the limitations of sec-tion 911(d)(8)(A) do not apply to qualifiedindividuals who are performing services atthe U.S. Naval Base at Guantanamo Bay.Therefore, such individuals are eligible forthe exclusion under section 911 providedthat they meet the other requirements ofthat section.

The principal author of this notice isKate Y. Hwa of the Office of AssociateChief Counsel (International). For furtherinformation regarding this notice, contactKate Y. Hwa at (202) 622–3840 (not a toll-free call).

Treatment Under Section367(b) of Property Usedto Purchase Parent Stockin Certain TriangularReorganizations

Notice 2006–85

SECTION 1. OVERVIEW

This notice announces that the InternalRevenue Service (IRS) and the TreasuryDepartment (Treasury) will issue regula-tions under section 367(b) of the InternalRevenue Code that address certain triangu-lar reorganizations under section 368(a) in-volving one or more foreign corporations.This notice is issued in response to com-ments and specific requests for guidanceregarding certain transactions that are de-signed to avoid U.S. income tax, includ-ing tax on the repatriation of a subsidiary’searnings. The transactions generally in-volve a subsidiary purchasing its parent’sstock for property and then transferring thestock in exchange for the stock or assetsof a corporation in a triangular reorganiza-tion under section 368(a). In general, andas described below, the regulations issuedpursuant to this notice will apply to trans-actions occurring on or after September 22,2006.

The IRS and Treasury recently finalized§1.367(b)–4(b)(1)(ii), which may apply to

October 10, 2006 677 2006–41 I.R.B.

certain (but not all) of the triangular reor-ganizations described in this notice. Thatfinal regulation under section 367(b) ap-propriately addressed the treatment of themajority of relevant triangular reorganiza-tions. While the IRS and Treasury wereaware of the transactions covered by thisnotice at that time, the decision was madeto address these transactions comprehen-sively in separate guidance.

The following definitions apply for pur-poses of this notice. A “triangular reorga-nization” is a forward triangular merger,a triangular C reorganization, a reversetriangular merger, or a triangular B re-organization, as those terms are definedin §1.358–6(b)(2)(i) through (iv), respec-tively, or a reorganization described in sec-tion 368(a)(1)(G) and (a)(2)(D). In addi-tion, P, S, and T are corporations describedin §1.358–6(b)(1)(i) through (iii), respec-tively. Finally, the term “property” meansmoney, securities, and any other property,except that the term does not include stockin S.

SECTION 2. TRANSACTIONS ATISSUE

The IRS and Treasury are aware thatcertain taxpayers are engaging in triangu-lar reorganizations involving foreign cor-porations that result in a tax-advantagedtransfer of property from S to P. The trans-action is often structured as a triangularB reorganization, but could also be struc-tured as a triangular C reorganization oranother type of triangular reorganization.For example, assume P, a domestic corpo-ration, owns 100 percent of S, a foreigncorporation, and S1, a domestic corpora-tion. S1 owns 100 percent of T, a foreigncorporation. S purchases P stock for eithercash or a note, and provides the P stock toS1 in exchange for all the T stock in a tri-angular B reorganization.

Taxpayers take the position that (i)when P sells its stock to S for cash ora note, P recognizes no gain or loss onthe sale under section 1032, (ii) S takesa cost basis in the P shares under section1012, and (iii) S recognizes no gain under§1.1032–2(c) upon the transfer of the Pshares immediately thereafter because thebasis and fair market value of the sharesare equal. Thus, taxpayers take the po-sition that the cash or note used by S toacquire the P stock does not result in a

distribution under section 301. Further-more, taxpayers do not include in incomeamounts under section 951(a)(1)(B) be-cause S acquires and disposes of the Pstock before the close of a quarter ofthe taxable year, which is the time atwhich to measure P’s share of the averageamount of United States property heldby S. See section 956(a)(1)(A). Finally,under §1.367(b)–4(b)(1)(ii), S1 does notinclude in income as a deemed dividendthe section 1248 amount attributable to theT stock that S1 exchanges.

The IRS and Treasury believe that thetaxpayers’ characterization of these trans-actions raises significant policy concerns,particularly when either P or S (or both)is a foreign corporation (regardless ofwhether T is related to P and S beforethe transaction). For example, when P isdomestic and S is foreign, as in the exam-ple described above, the transaction couldhave the effect of repatriating foreignearnings of S to P without a correspondingdividend to P that would be subject to U.S.income tax. Similarly, where P is foreignand S is domestic, the transaction couldhave the effect of repatriating S’s U.S.earnings to its foreign parent in a mannerthat is not subject to U.S. withholdingtax. This variation of the transaction alsoraises U.S. earnings stripping issues whereS uses a note to purchase all or a portionof the P stock. Moreover, where both Pand S are foreign, the transactions mayhave the effect of avoiding income in-clusions to certain U.S. shareholders ofP that would be subject to U.S. incometax under the subpart F provisions, absentthe application of an exception, such asunder section 954(c)(6). In addition, for-eign-to-foreign transactions of this typecan be used to facilitate the subsequentrepatriation of foreign earnings to U.S.shareholders without U.S. income tax.

SECTION 3. BACKGROUND

.01 Triangular reorganizations

Section 368 defines the term “re-organization.” Sections 368(a)(1)(B),368(a)(1)(C), 368(a)(1)(G), 368(a)(2)(D),and 368(a)(2)(E) describe certain reorga-nizations in which P stock may be used byS as the consideration issued in exchangefor T’s stock or assets, as applicable.

Section 1032 provides that no gain orloss will be recognized to a corporationon the receipt of money or other propertyin exchange for stock of such corporation.Section 1.1032–2(b) provides that in thecase of a forward triangular merger, a trian-gular C reorganization, or a triangular B re-organization, P stock provided by P to S, ordirectly to T or T’s shareholders on behalfof S, pursuant to the plan of reorganizationis treated as a disposition by P of sharesof its own stock. However, §1.1032–2(c)provides that S must recognize gain or lossin the above transactions on its exchangeof P stock for T stock or assets if S did notreceive the P stock from P pursuant to theplan of reorganization. Section 361 pro-vides that S does not recognize gain or losson the P stock that it exchanges for T stockin a reverse triangular merger.

Section 361(a) provides that no gainor loss shall be recognized by T if it ex-changes property in pursuance of the planof reorganization solely for stock or secu-rities in P. Section 361(c) provides that nogain or loss shall be recognized to T on thedistribution to its shareholders of P stockreceived from P in pursuance of the planof reorganization.

Section 354 provides that no gain orloss shall be recognized by T sharehold-ers if stock or securities in T are, in pur-suance of the plan of reorganization, ex-changed solely for stock or securities of P.Section 356 applies to T shareholders incases where they receive other property inaddition to the property permitted to be re-ceived under section 354.

Section 358 provides rules for deter-mining the T shareholders’ bases in their Pstock following triangular reorganizations.Sections 1.358–6 and 1.367(b)–13 providerules for determining P’s basis in its S or Tstock, as applicable. If P files a consoli-dated return with S or T, other basis rulesapply. See Treas. Reg. §1.1502–30 or1.1502–31.

.02 Section 367

Section 367(a)(1) provides that if, inconnection with any exchange describedin section 332, 351, 354, 356, or 361, aUnited States person transfers property toa foreign corporation, such foreign corpo-ration shall not, for purposes of determin-ing the extent to which gain shall be recog-nized on such transfer, be considered to be

2006–41 I.R.B. 678 October 10, 2006

a corporation. The Secretary has broad au-thority under section 367(a)(2), (3), and (6)to provide that section 367(a)(1) will notapply to certain transfers described therein.

In the case of any exchange describedin section 332, 351, 354, 355, 356, or361 in connection with which there is notransfer of property described in section367(a)(1), section 367(b)(1) provides thata foreign corporation shall be consideredto be a corporation except to the extent pro-vided in regulations prescribed by the Sec-retary which are necessary or appropriateto prevent the avoidance of Federal incometaxes.

Section 367(b)(2) provides that theregulations prescribed pursuant to section367(b)(1) shall include (but shall not belimited to) regulations dealing with thesale or exchange of stock or securities ina foreign corporation by a United Statesperson, including regulations providing,among other things, the circumstancesunder which gain is recognized, amountsare included in gross income as a divi-dend, adjustments are made to earningsand profits, or adjustments are made tobasis of stock or securities.

.03 Distributions of property

Section 301(c)(1) provides that a distri-bution of property by a corporation to itsshareholder with respect to its stock is in-cluded in the shareholder’s gross incometo the extent the distribution constitutes adividend under section 316. Section 316defines a dividend as a distribution out ofa corporation’s current and accumulatedearnings and profits. To the extent the dis-tribution is not a dividend, the shareholderreduces basis in the distributing corpora-tion’s stock, and any amount of the distri-bution in excess of the shareholder’s ba-sis is treated as gain from the sale or ex-change of the corporation’s stock. See sec-tion 301(c)(2) and (3).

Certain transactions that are exchangesin form can be treated as distributions fortax purposes. Section 304 generally pro-vides that when a shareholder transfersstock of a controlled corporation to an-other controlled corporation in exchangefor property, the two legs of the exchangeare bifurcated and the receipt of the prop-erty by the shareholder is treated as a dis-tribution. Section 304, by its terms, doesnot apply to the transfer by a shareholder

of its own stock to a controlled corpora-tion in exchange for property, even thoughthe economic effect of that transaction isessentially identical.

Other transactions may result indeemed distribution treatment in certaincircumstances. For example, a share-holder that exchanges common stock of acorporation for common stock and prop-erty pursuant to a recapitalization willbe treated as receiving a distribution ofproperty with respect to its stock undersection 301 if in substance the distributionis a separate transaction. See Treas. Reg.§1.301–1(l); see also, Bazley v. Comm’r,331 U.S. 737 (1947).

.04 Distributions involving foreigncorporations or foreign shareholders

The treatment of a distribution variesdepending upon whether the corporationor shareholder is domestic or foreign. Adistribution from a foreign corporation toa shareholder that is a U.S. person result-ing in a dividend under sections 301(c)(1)and 316, or gain from the sale or exchangeof property under section 301(c)(3), gen-erally is subject to U.S. income tax, withpotential offset by foreign tax credits.

A distribution from a domestic corpo-ration to a shareholder that is not a U.S.person resulting in a dividend is generallytaxable under section 871 or 881 at a rateof 30 percent, subject to reduction underan applicable treaty, and the domestic cor-poration is responsible for withholding taxunder section 1441 or 1442. To the ex-tent such a distribution results in gain fromthe sale or exchange of property to the for-eign shareholder under section 301(c)(3),such amounts are subject to U.S. incometax under section 897(a) if the distributingcorporation had been a United States realproperty holding corporation (as definedin section 897(c)(2)) within the past fiveyears. In such a case, the gain is subjectto U.S. income tax as income effectivelyconnected with the conduct of a trade orbusiness within the United States.

Finally, a distribution from a foreigncorporation to a shareholder that is a con-trolled foreign corporation, within themeaning of section 957, resulting in a div-idend or gain from the sale or exchangeof property to the foreign shareholder un-der section 301(c)(3) may also be subjectto U.S. income tax. For example, such

amounts may constitute subpart F incomeand therefore result in an income inclusionunder section 951(a)(1)(A) to U.S. share-holders, within the meaning of section951(b), of the controlled foreign corpo-ration, subject to certain exceptions. See,e.g., section 954(c)(6).

SECTION 4. APPLICATION OFSECTION 367(b)

Congress enacted section 367(b) to en-sure that international tax considerationsare adequately addressed when the sub-chapter C provisions apply to certain non-recognition exchanges involving foreigncorporations. This provision was neces-sary because the subchapter C provisionswere enacted largely to address transac-tions involving domestic corporations andshareholders that are United States per-sons. As a result, the subchapter C pro-visions do not fully account for interna-tional tax concerns that arise when the pro-visions apply to transactions involving for-eign corporations or shareholders that arenot U.S. persons.

In enacting section 367(b), Congressnoted that “it is essential to protect againsttax avoidance in transfers to foreign cor-porations and upon the repatriation ofpreviously untaxed foreign earnings....”H.R. Rep. No. 658, 94th Cong., 1st Sess.241 (1975). In addition, because determin-ing the proper interaction of the Code’sinternational and subchapter C provi-sions is “necessarily highly technical,”Congress granted the Secretary broad reg-ulatory authority to provide the “necessaryor appropriate” rules to prevent the avoid-ance of Federal income taxes, rather thanenacting a more comprehensive statutoryregime. Id. This broad grant of authorityhas been exercised on numerous occasionsto address a wide range of internationalpolicy concerns. See, e.g., Treas. Reg.§§1.367(b)–4(b)(1) (preserving section1248 amounts), (b)(2) (addressing traf-ficking in foreign tax credits by use ofpreferred stock), –5(b)(1)(ii) (ensuringsection 311(b) gain is recognized by adomestic corporation when it distributesstock of a controlled foreign corporationto an individual distributee under section355), and –7 (addressing the carryoverof tax attributes in a foreign-to-foreignsection 381 transaction).

October 10, 2006 679 2006–41 I.R.B.

In a triangular reorganization, the ex-change by the T shareholders of their Tstock for P stock is described in section354 or 356. As a result, a triangular reorga-nization involving a foreign corporation isdescribed in section 367(b) and, therefore,may be subject to regulations issued un-der the broad regulatory authority grantedtherein. It is on this basis that regulationswill be issued to address the triangular re-organizations covered by this notice.

SECTION 5. REGULATIONS TO BEISSUED UNDER SECTION 367(b)

The IRS and Treasury will issue regula-tions under section 367(b) to address cer-tain triangular reorganizations involvingforeign corporations. The regulations willapply to triangular reorganizations whereP or S (or both) is foreign and, pursuantto the reorganization, S acquires from P,in exchange for property, all or a portionof the P stock that is used to acquire thestock or assets of T (T could be either re-lated or unrelated to P and S before thetransaction). In such a case, the regula-tions under section 367(b) will make ad-justments with respect to P and S such thatthe property transferred from S to P in ex-change for P stock will have the effect ofa distribution of property from S to P un-der section 301(c) that is treated as sepa-rate from the transfer by P of the P stockto S pursuant to the reorganization. Theadjustments will be made notwithstandingthe fact that section 1032 otherwise appliesto the reorganization. Therefore, the regu-lations will require, as appropriate, an in-clusion in P’s gross income as a dividend,a reduction in P’s basis in its S or T stock,and the recognition of gain by P from thesale or exchange of property. The regula-tions will also provide for appropriate cor-responding adjustments to be made, suchas a reduction of S’s earnings and profits asa result of the distribution (consistent withthe principles of section 312). The regula-tions will also address similar transactionsin which S acquires the P stock used inthe reorganization from a related party thatpurchased the P stock in a related transac-tion.

SECTION 6. EFFECTIVE DATE

In general, the regulations to be issuedunder section 367(b) that are described in

section 5 of this notice will apply to trans-actions occurring on or after September22, 2006. The regulations described inthis notice will not, however, apply to atransaction that was completed on or afterSeptember 22, 2006, provided the transac-tion was entered into pursuant to a writtenagreement which was (subject to custom-ary conditions) binding before September22, 2006 and all times thereafter.

No inference is intended as to the treat-ment of transactions described hereinunder current law, and the IRS may, whereappropriate, challenge such transactionsunder applicable provisions or judicialdoctrines.

SECTION 7. COMMENTS

The IRS and Treasury request com-ments on the regulations to be issuedunder this notice. Specifically, commentsare requested as to whether in certain casesit is appropriate to provide an exceptionfrom the treatment described in this notice.In addition, comments are requested as tothe source and timing of the adjustmentsto be made with respect to P and S underthe regulations to be issued.

The IRS and Treasury also requestcomments regarding transactions that arenot described in section 5 of this notice.For example, comments are requested ontransactions where S or P is foreign and Spurchases P stock from a person unrelatedto P (for example, from the public on theopen market), or where S acquires the Pstock in a transaction that is unrelated tothe triangular reorganization. Finally, theIRS and Treasury request comments onthe treatment of transactions similar tothose described in this notice that do notqualify as reorganizations (for example,because S issues minimal considerationto T in a transaction that would other-wise qualify as a reorganization undersection 368(a)(1)(B)). Any regulationsissued to address transactions that are notdescribed in section 5 of this notice willapply prospectively.

SECTION 8. DRAFTINGINFORMATION

The principal authors of this noticeare Daniel McCall of the Office of As-sociate Chief Counsel (International) andSean McKeever of the Office of Associate

Chief Counsel (Corporate). However,other personnel from the IRS and Trea-sury participated in its development. Forfurther information regarding this notice,contact Mr. McCall at (202) 622–3860(not a toll-free call). For comments orquestions regarding subchapter C issues,contact Mr. McKeever at (202) 622–7750.

“Tie-breaking” Rule for Two orMore Taxpayers Claiming aChild as a Qualifying Child

Notice 2006–86

PURPOSE

This notice provides interim guidanceunder § 152(c)(4) of the Internal RevenueCode, the rule for determining which tax-payer may claim a qualifying child whentwo or more taxpayers claim the samechild under any of the following provi-sions: (1) head of household filing statusunder § 2(b), (2) the child and dependentcare credit under § 21, (3) the child taxcredit under § 24, (4) the earned incomecredit under § 32, (5) the exclusion fordependent care assistance under § 129(which incorporates by reference the def-inition of qualifying child or other quali-fying individual under § 21), and (6) thedependency deduction under § 151. Thisnotice clarifies that, unless the special rulein § 152(e) applies, the tie-breaking rule in§ 152(c)(4) applies to these provisions as agroup, rather than on a section-by-sectionbasis.

Section 152 was amended by § 201 ofthe Working Families Tax Relief Act of2004 (WFTRA), Pub. L. No. 108–311,118 Stat. 1169, effective for taxable yearsbeginning after December 31, 2004. TheInternal Revenue Service and TreasuryDepartment intend to issue regulationsconsistent with the guidance contained inthis notice. The guidance in this notice ap-plies until those regulations are effective.

BACKGROUND

Definition of a qualifying child

Section 151 allows a taxpayer a deduc-tion of the exemption amount for each in-dividual who is a dependent (as defined in§ 152) of the taxpayer for the taxable year.

2006–41 I.R.B. 680 October 10, 2006

Under § 152(a), a dependent is a qualify-ing child or qualifying relative.

Section 152(c)(1) defines a qualifyingchild as an individual who (A) bears acertain relationship to the taxpayer (child,brother, sister, stepbrother, stepsister or de-scendant of any of those relatives), (B) hasthe same principal place of abode as thetaxpayer for more than one-half of the tax-able year, (C) meets certain age require-ments, and (D) does not provide over one-half of the child’s own support for the cal-endar year in which the taxable year of thetaxpayer begins.

WFTRA establishes a uniform defini-tion of a qualifying child under § 152(c)for determining whether a taxpayer qual-ifies for head of household filing sta-tus, the child and dependent care credit,the child tax credit, the earned incomecredit, and the dependency deduction.See §§ 2(b)(1)(A)(i), 21(b)(1)(A), 24(c),32(c)(3), and 151, respectively, andH.R. Conf. Rep. No. 696, 108th Cong.,2d Sess. 55–65 (2004). The uniform defi-nition also applies in determining whethera taxpayer qualifies for the income ex-clusion under § 129, which defines de-pendent care assistance by reference toemployment-related expenses (as definedin § 21(b)(2)) for the care of a qualifyingchild or other qualifying individual.

“Tie-breaking” rule

Section 152(c)(4) provides a tie-break-ing rule for determining which taxpayermay claim a qualifying child as a quali-fying child when two or more taxpayersclaim the same child for a taxable year be-ginning in the same calendar year. Thegeneral rule of § 152(c)(4)(A) applies ifone or no taxpayer claiming the child isthe child’s parent. Under § 152(c)(4)(A),the child is treated as the qualifying childof (i) the taxpayer who is the child’s par-ent, or (ii) if none of the taxpayers is thechild’s parent, the taxpayer with the high-est adjusted gross income for that taxableyear.

The rule of § 152(c)(4)(B) applies ifboth taxpayers claiming the child as aqualifying child are the child’s parentswho do not file a joint return together.Under § 152(c)(4)(B), the child is treatedas the qualifying child of the parent withwhom the child resides for the longer pe-riod of time during the taxable year. If

the child resides with both parents for thesame amount of time during the taxableyear, the child is treated as the qualifyingchild of the parent with the higher adjustedgross income for that taxable year.

Special rule for certain noncustodialparents

Notwithstanding the rule of§152(c)(4)(B), a child may be treated asthe qualifying child of the noncustodialparent, for certain purposes, under thespecial rule of § 152(e). The noncustodialparent may claim the child as a qualifyingchild under § 152(e), if:

(1) the child is in the custody of one orboth parents for more than one-half of thecalendar year;

(2) the child receives over one-half ofthe child’s support during the calendaryear from the child’s parents;

(3) the parents—(a) are divorced or separated under a

decree of divorce or separate maintenance,(b) are separated under a written sepa-

ration agreement, or(c) live apart at all times during the last

6 months of the calendar year; and(4) the custodial parent releases the

claim to the exemption to the noncustodialparent in a written declaration that thenoncustodial parent attaches to the non-custodial parent’s tax return.

Section 152(e)(4) defines “custodialparent” as the parent having custody of thechild for the greater portion of the calen-dar year, and “noncustodial parent” as theparent who is not the custodial parent.

The special rule of § 152(e) allows anoncustodial parent to claim the child asa qualifying child only for purposes of thechild tax credit under § 24 and the de-pendency deduction under § 151. Sec-tion 152(e) does not apply to determina-tions under §§ 2(b), 21(b) and 129 (see§ 21(e)(5)), and 32(c)(3).

APPLICATION

Except to the extent that § 152(e) ap-plies, under § 152(c)(4), when more thanone taxpayer claims a child as a qualify-ing child, the child is treated as the quali-fying child of only one taxpayer for all theprovisions that employ the uniform defini-tion of a qualifying child (head of house-hold filing status under § 2(b), the childand dependent care credit under § 21, the

child tax credit under § 24, the earned in-come credit under § 32, the exclusion fordependent care assistance under § 129, andthe dependency deduction under § 151).This rule is applied to these provisions as agroup, rather than on a section-by-sectionbasis.

If § 152(e) applies, a child may betreated as the qualifying child of twotaxpayers. A noncustodial parent mayclaim the child as a qualifying child under§ 152(e) only for purposes of the childtax credit under § 24 and the dependencydeduction under § 151. However, the non-custodial parent may not claim the childas a qualifying child under § 152(e) indetermining head of household filing sta-tus under § 2(b), the earned income creditunder § 32, the child and dependent carecredit under § 21, or the exclusion from in-come for dependent care assistance under§ 129. Only the custodial parent (or othereligible taxpayer) may claim the child as aqualifying child for those purposes.

EXAMPLES

In the examples below, each individualis a citizen of the United States and usesa calendar taxable year, and the child is aqualifying child (as defined in § 152(c)) ofeach taxpayer. Unless otherwise indicated,these examples assume that each individ-ual meets the other requirements for claim-ing a benefit described in the example.

Example 1. (i) A child, mother, and grandmothershare the same principal place of abode. The motheris not married and is not the qualifying child of thegrandmother, and the grandmother is not the mother’sdependent.

(ii) The mother claims the child as a qualifyingchild for purposes of the earned income credit under§ 32.

(iii) The child is treated as the qualifying child ofthe mother for purposes of the earned income credit.Because the mother claims the child as a qualifyingchild for purposes of the earned income credit, under§ 152(c)(4)(A), the child may not be treated as thequalifying child of the grandmother for any purpose.

(iv) If, however, the mother does not claim thechild as a qualifying child for any purpose, the childmay be treated as the qualifying child of the grand-mother for purposes of the earned income credit un-der § 32 as well as head of household filing status un-der § 2(b), the dependency deduction under § 151, thechild tax credit under § 24, the child and dependentcare credit under § 21, and the exclusion from incomefor dependent care assistance under § 129, if applica-ble, assuming that no other taxpayer claims the childas a qualifying child.

Example 2. (i) The facts are the same as in Exam-ple 1, except that the mother and father of the childare divorced, the father is the noncustodial parent, the

October 10, 2006 681 2006–41 I.R.B.

mother has released the claim to the exemption to thefather in a written declaration under § 152(e), and thefather attaches the written declaration to his returnand claims the child as a qualifying child for purposesof the dependency deduction and the child tax credit.

(ii) Under § 152(e), the child is treated as the qual-ifying child of the father for purposes of the depen-dency deduction and the child tax credit. The childis treated as the qualifying child of the mother forpurposes of the earned income credit and, if appli-cable, head of household filing status, the child anddependent care credit, and the exclusion from incomefor dependent care assistance. The child may not betreated as the qualifying child of the grandmother forany purpose.

Example 3. (i) The father and mother of a childare married to each other. The father, mother, andchild share the same principal place of abode for thefirst 8 months of the year. For the last 4 months ofthe year, the parents live apart from each other, andthe mother and child share the same principal placeof abode. The parents file separate tax returns forthe taxable year. Consequently, neither parent mayclaim head of household filing status, an earned in-come credit, or a child and dependent care credit, be-cause in general § 2(b) applies only to unmarried in-dividuals, while §§ 32(d) and 21(e)(2), respectively,require married individuals to file a joint return.

(ii) The father claims the child as a qualifyingchild for purposes of the dependency deduction under§ 151 and the exclusion for dependent care assistanceunder § 129. The mother claims the child as a quali-fying child for purposes of the dependency deductionunder § 151, the child tax credit under § 24, and theexclusion for dependent care assistance under § 129.

(iii) Under the tie-breaking rule of § 152(c)(4)(B),the child is treated as the qualifying child of themother because the child resided with the motherfor the longer period of time during the taxable year.Therefore, the child is the qualifying child of themother for purposes of the dependency deduction,

the child tax credit, and the exclusion for depen-dent care assistance. Section 152(e) does not applybecause the mother and father are not divorced orseparated under a decree of separate maintenance orwritten separation agreement at the end of the taxableyear and did not live apart for the last 6 months ofthe calendar year. Therefore, the child may not betreated as the qualifying child of the father for anypurpose.

(iv) If, however, the mother does not claim thechild as a qualifying child for any purpose, the childis treated as the qualifying child of the father forpurposes of the dependency deduction under § 151and the exclusion for dependent care assistance un-der § 129.

Example 4. (i) The facts are the same as in Exam-ple 3, except that the mother and father are separatedunder a written separation agreement at the end of thetaxable year, the mother is the custodial parent andhas released the claim to the exemption to the fatherin a written declaration under § 152(e), and the fatherattaches the Form 8332 to his return and claims thechild as a qualifying child for purposes of the depen-dency deduction, the child tax credit, and the exclu-sion for dependent care assistance under § 129.

(ii) Because § 152(e) applies, the child is treatedas the qualifying child of the father for purposes of thedependency deduction and the child tax credit. Thechild is not treated as the qualifying child of the fatherfor purposes of the exclusion for dependent care as-sistance because the father is the noncustodial parentand, under § 21(e)(5), only the custodial parent mayclaim the child as a qualifying child for purposes ofthe exclusion for dependent care assistance. There-fore, the tie-breaking rule of § 152(c)(4)(B) applies,and the child is treated as the qualifying child of themother for purposes of the exclusion for dependentcare assistance.

Example 5. (i) The father and mother of two chil-dren are married to each other. The father, mother,and both children share the same principal place of

abode for the entire year. The father and motherfile separate tax returns for the taxable year. Conse-quently, neither parent may claim head of householdfiling status, an earned income credit, or a child anddependent care credit, because in general § 2(b) ap-plies only to unmarried individuals, while §§ 32(d)and 21(e)(2), respectively, require married individu-als to file a joint return.

(ii) The father claims the older child as a qualify-ing child for purposes of the child tax credit, depen-dency deduction, and exclusion for dependent careassistance. The mother claims the younger child asa qualifying child for purposes of the child tax credit,dependency deduction, and exclusion for dependentcare assistance.

(iii) The older child is treated as the qualifyingchild of the father and the younger child is treated asthe qualifying child of the mother. The tie-breakingrule of § 152(c)(4)(B) does not apply because no twotaxpayers are claiming the same child as a qualifyingchild for any of the benefits.

EFFECTIVE DATE

This notice applies to taxable years be-ginning after December 31, 2004.

DRAFTING INFORMATION

The principal author of this notice isVictoria Driscoll of the Office of AssociateChief Counsel (Income Tax & Account-ing). For further information regardingthis notice, contact Ms. Driscoll at (202)622–4920.

2006–41 I.R.B. 682 October 10, 2006

Part IV. Items of General InterestNotice of ProposedRulemaking and Notice ofPublic Hearing

Section 1221(a)(4) CapitalAsset Exclusion for Accountsand Notes Receivable

REG–109367–06

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemakingand notice of public hearing.

SUMMARY: This document contains pro-posed regulations that clarify the circum-stances in which accounts or notes receiv-able are “acquired . . . for servicesrendered” within the meaning of section1221(a)(4) of the Internal Revenue Code.This document also provides a notice ofpublic hearing on these proposed regula-tions.

DATES: Written or electronic commentsmust be received by November 6, 2006.Outlines of topics to be discussed at thepublic hearing scheduled for November 7,2006, must be received by October 17,2006.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–109367–06), room5203, Internal Revenue Service, POB7604, Ben Franklin Station, Washington,DC 20044. Submissions may be handdelivered Monday through Friday, be-tween the hours of 8 a.m. and 4 p.m.to CC:PA:LPD:PR (REG–109367–06),Courier’s Desk, Internal Revenue Ser-vice, 1111 Constitution Avenue, NW,Washington, DC. Alternatively, tax-payers may submit comments elec-tronically via the IRS Internet site atwww.irs.gov/regs or via the Federal eRule-making Portal at www.regulations.gov/(IRS–REG–109367–06). The public hear-ing will be held in the New CarrolltonAuditorium, 5000 Ellin Road, Lanham,Maryland.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposed reg-ulations, K. Scott Brown (202) 622–3920

(not a toll-free number); concerningsubmissions of comments, the hearing,and/or to be placed on the building ac-cess list to attend the hearing, email:Kelly.D.Banks@irscounsel.treas.gov.

SUPPLEMENTAL INFORMATION:

Background and Explanation ofProvisions

I. Section 1221(a)(4) Language,Legislative History, and Regulations

Section 1221 defines a capital assetas all property held by a taxpayer unlessspecifically excepted. Section 1221(a)(4)treats accounts or notes receivable ac-quired in the ordinary course of trade orbusiness for services rendered or fromthe sale of property described in section1221(a)(1) as ordinary assets.

Congress enacted section 1221(a)(4) in1954 to correct a character mismatch prob-lem. Before its enactment, the value ofaccounts or notes receivable acquired forrendering services or selling inventory wastaken into account by a taxpayer as ordi-nary income, but gain or loss on a later dis-position of the receivables was given capi-tal treatment. Section 1221(a)(4) correctedthis mismatch by treating the accounts ornotes receivable as ordinary assets.

The legislative history confirms thislimited focus by referring explicitly toaccounts and notes receivable acquired“in payment for” inventory or servicesrendered by the holder. The specific prob-lem being addressed by the enactment ofsection 1221(a)(4) was described in theHouse Report:

Paragraph (4) is a new provisionwhich excepts from the definition ofcapital assets accounts or notes receiv-able acquired in the ordinary course oftrade or business for services renderedor from the sale of property describedin paragraph (1), that is, stock in tradeor inventory or property held for saleto customers in the ordinary course oftrade or business. This will changepresent law treatment, for example, asfollows: If a taxpayer acquires a note oraccount receivable in payment for in-ventory or services rendered, reports itas income and sells it at a discount, then

this amendment will provide ordinaryloss treatment. Under present law suchloss treatment is only allowed if the tax-payer is also, in effect, a dealer in suchaccounts or notes. Alternatively, thetaxpayer may sell the account or notefor something more than the discountedvalue that was originally reported. Un-der present law this difference wouldbe capital gain unless the taxpayer issuch a dealer. The amendment willcause such gain to be ordinary income.

H. R. Rep. No. 1337, 83d Cong., 2d Sess.,A273–74 (1954).

The longstanding regulation interpret-ing section 1221(a)(4) also confirms thislimited focus. Section 1.1221–1(a) of theIncome Tax Regulations states that theterm capital assets includes all classesof property not specifically excluded bysection 1221. Section 1.1221–1(d), whichaddresses the section 1221(a)(4) exclu-sion, repeats the statutory language ofsection 1221(a)(4) and then interprets it toapply as follows:

Thus, if a taxpayer acquires a note re-ceivable for services rendered, reportsthe fair market value of the note as in-come, and later sells the note for lessthan the amount previously reported,the loss is an ordinary loss. On the otherhand, if the taxpayer later sells the notefor more than the amount originally re-ported, the excess is treated as ordinaryincome.

II. Expansion of Section 1221(a)(4)

Notwithstanding the above, section1221(a)(4) has been applied more expan-sively. The initial expansion occurred withrespect to notes obtained in loan origina-tions. In Burbank Liquidating Corp. v.Commissioner, 39 T.C. 999 (1963), acq.sub nom. United Assocs., Inc., 1965–1C.B. 3, aff’d. in part and rev’d. in parton other grounds, 335 F.2d 125 (9th Cir.1964), the Tax Court held that mortgageloans originated by a savings and loan as-sociation in the ordinary course of its busi-ness were, in the hands of that association,ordinary assets under section 1221(a)(4)because they were notes receivable ac-quired for the service of making loans. Inaddition to acquiescing to the decision, theService relied upon Burbank Liquidating

October 10, 2006 683 2006–41 I.R.B.

in a series of revenue rulings treating loansmade by commercial lenders (includingbanks and REITs) as ordinary assets undersection 1221(a)(4) when held by the origi-nal lender. See Rev. Rul. 72–238, 1972–1C.B. 65; Rev. Rul. 73–558, 1973–2 C.B.298; Rev. Rul. 80–56, 1980–1 C.B. 154;Rev. Rul. 80–57, 1980–1 C.B. 157. See§601.601(d)(2) of this chapter.

Historically, a lending transaction wassometimes thought of as rendering a ser-vice to the borrower. See Rev. Rul.70–540, 1970–2 C.B. 101; Rev. Rul.69–188, 1969–1 C.B. 54; Rev. Rul. 68–6,1968–1 C.B. 325. That characterization,however, does not justify treating notesacquired by an originator in a lendingtransaction as ordinary assets under sec-tion 1221(a)(4). That treatment strainsthe language of the statute because thenotes are not issued by borrowers solely oreven predominantly for services rendered.Rather, the notes are, for the most part,issued by the borrower to the lender inexchange for money.

Subsequently, the Tax Court fur-ther extended the application of section1221(a)(4) in Federal National MortgageAssociation v. Commissioner, 100 T.C.541 (1993) (FNMA), by applying thatprovision to notes that were purchasedin transactions that the court consideredclosely associated with the process oforigination. Although FNMA was notan originator, the court used the BurbankLiquidating analysis to extend section1221(a)(4) treatment to mortgages pur-chased by FNMA. The court justifiedthis result by pointing out that FNMA’spurchasing activity was undertaken inaccordance with its statutorily definedpurpose “to provide supplementary assis-tance to the secondary market for homemortgages by providing a degree of liq-uidity for mortgage investments.” FNMA,100 T.C. at 545 (quoting the Housing Actof 1954, ch. 649, title II, section 201, 12U.S.C. 1716(a)). Because of this purpose,the court concluded that the purchaseswere “a service to the mortgage lendingbusiness and the members thereof.” Id. at578.

The expansion of section 1221(a)(4)cannot be reconciled with Congress’stated purpose for enacting the statute.Acquisition of notes or mortgages usingconsideration other than services or sec-tion 1221(a)(1) property generally does

not trigger current ordinary income and sodoes not create a potential for the charactermismatch that concerned Congress whenit enacted section 1221(a)(4).

The proposed regulation reflects aconclusion by the Treasury Departmentand the IRS that the extension of sec-tion 1221(a)(4) to notes acquired by acreditor in a lending transaction or tonotes purchased in the secondary mar-ket is inconsistent with Congressionalintent and is unsound as a matter of taxpolicy. In addition, the interpretation ofsection 1221(a)(4) set forth in BurbankLiquidating and FNMA impedes effectiveadministration of the tax laws by caus-ing the status of the notes to hinge onjudgments as to whether the lending trans-action or a subsequent secondary marketpurchase of the notes provides a serviceto the borrower or the mortgage lendingindustry. Reliance on judgments such asthis fosters uncertainty and disputes.

Accordingly, the proposed regulationclarifies that an account or note receiv-able is not described in section 1221(a)(4)if, in exchange for the account or notereceivable, the taxpayer provides morethan de minimis consideration other thanservices or property described in section1221(a)(1), or if the account or note receiv-able is not issued by the party acquiringthe services or property described in sec-tion 1221(a)(1). In particular, a note is notacquired for services within the meaningof section 1221(a)(4) on the grounds thatthe taxpayer’s act of acquiring (includingoriginating) the account or note receivableconstitutes, or includes, the provision ofa service or services to the issuer of theaccount or note receivable, to the sec-ondary market in which accounts or notesreceivable of this sort may trade, or to theparticipants in that market.

Effect on Other Documents

Rev. Rul. 72–238 and Rev. Rul.73–558 are not determinative with respectto future transactions because these rul-ings apply to taxable years beginning be-fore July 12, 1969, and were supersededby section 582(c) of the Internal RevenueCode of 1986. Accordingly, simultane-ously with the publication of these pro-posed regulations, those rulings are be-ing declared obsolete. When final regu-lations are published, the IRS will deter-

mine whether Rev. Rul. 80–56 and 80–57should similarly be declared obsolete.

Proposed Effective Date

These regulations are proposed to applyto accounts or notes receivable acquiredafter the date the final regulations are pub-lished in the Federal Register.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a signifi-cant regulatory action as defined in Exec-utive Order 12866. Therefore, a regula-tory assessment is not required. It has alsobeen determined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to these regu-lations, and because the regulation doesnot impose a collection of information onsmall entitles, the Regulatory FlexibilityAct (5 U.S.C. chapter 6) does not apply.Pursuant to section 7805(f) of the Code,this notice of proposed rulemaking will besubmitted to the Chief Counsel for Advo-cacy of the Small Business Administrationfor comment on its impact on small busi-ness.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written comments(a signed original and eight (8) copies)or electronic comments that are submit-ted timely to the IRS. The Treasury De-partment and IRS invite comments on theproposed effective date, on the impact ofthe proposed regulation on hedging prac-tices of lending institutions or other tax-payers to which section 582(c) does not ap-ply, and on appropriate measures to dealwith that impact. Comments are specifi-cally requested from taxpayers in the ac-ceptance finance, debt collection, factor-ing and personal finance industries on anyimpact that the proposed regulation mayhave. The Treasury Department and theIRS also specifically request comments onthe clarity of the proposed rules and howthey can be made easier to understand. Allcomments will be available for public in-spection and copying.

A public hearing has been scheduled forNovember 7, 2006, beginning at 10 a.m.in the New Carrollton Auditorium, 5000

2006–41 I.R.B. 684 October 10, 2006

Ellin Road, Lanham, Maryland. All vis-itors must present photo identification toenter the building. Because of access re-strictions, visitors will not be admitted be-yond the immediate entrance area morethan 30 minutes before the hearing starts.For information about having your nameplaced on the building access list to attendthe hearing, see the “FOR FURTHER IN-FORMATION CONTACT” section of thispreamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit written or electronic comments andan outline of the topics to be discussedand the time to be devoted to each topic(a signed original and eight (8) copies) byOctober 17, 2006. A period of 10 minuteswill be allotted to each person for makingcomments. An agenda showing the sched-uling of the speakers will be prepared af-ter the deadline for receiving outlines haspassed. Copies of the agenda will be avail-able free of charge at the hearing.

Drafting Information

The principal author of these proposedregulations is K. Scott Brown, Officeof the Associate Chief Counsel (Finan-cial Institutions and Products). However,other personnel from the IRS and TreasuryDepartment participated in their develop-ment.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.1221–1 is amended as

follows:1. Paragraph (e) is redesignated as (f).2. A new paragraph (e) is added.The addition reads as follows:

§1.1221–1 Meaning of terms.

* * * * *(e)(1) An account or note receivable is

not described in section 1221(a)(4) if—(i) In acquiring the account or note

receivable, the taxpayer provides morethan de minimis consideration other thanservices or property described in section1221(a)(1); or

(ii) The obligor under the account ornote receivable is a person other than theperson acquiring the services or propertydescribed in section 1221(a)(1).

(2) In particular, an account or notereceivable is not described in section1221(a)(4) on the grounds that the tax-

payer’s act of acquiring (including orig-inating) the account or note receivableconstitutes, or includes, the provision ofa service or services to the issuer of theaccount or note receivable, to the sec-ondary market in which accounts or notesreceivable of this sort may trade, or to theparticipants in that market. If a lender,however, separately invoiced reasonablefees for services that the lender renderedto the borrower in connection with a lend-ing transaction and if the lender receivedas evidence of the obligation to makepayment of those fees an account or notereceivable that is separate from the debtinstrument that was originated in the lend-ing transaction, then this paragraph (e)(2)does not prevent the separate account ornote receivable from being described insection 1221(a)(4).

(3) This paragraph (e) applies to ac-counts or notes receivable acquired afterthe date the final regulations are publishedin the Federal Register.

* * * * *

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

(Filed by the Office of the Federal Register on August 4,2006, 8:45 a.m., and published in the issue of the FederalRegister for August 7, 2006, 71 F.R. 44600)

October 10, 2006 685 2006–41 I.R.B.

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling is be-ing made clear because the language hascaused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more than re-state the substance and situation of a previ-ously published ruling (or rulings). Thus,the term is used to republish under the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situationsto show that the previous published rul-ings will not be applied pending somefuture action such as the issuance of newor amended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.

PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

2006–41 I.R.B. i October 10, 2006

Numerical Finding List1

Bulletins 2006–27 through 2006–41

Announcements:

2006-42, 2006-27 I.R.B. 48

2006-43, 2006-27 I.R.B. 48

2006-44, 2006-27 I.R.B. 49

2006-45, 2006-31 I.R.B. 121

2006-46, 2006-28 I.R.B. 76

2006-47, 2006-28 I.R.B. 78

2006-48, 2006-31 I.R.B. 135

2006-49, 2006-29 I.R.B. 89

2006-50, 2006-34 I.R.B. 321

2006-51, 2006-32 I.R.B. 222

2006-52, 2006-33 I.R.B. 254

2006-53, 2006-33 I.R.B. 254

2006-54, 2006-33 I.R.B. 254

2006-55, 2006-35 I.R.B. 342

2006-56, 2006-35 I.R.B. 342

2006-57, 2006-35 I.R.B. 343

2006-58, 2006-36 I.R.B. 388

2006-59, 2006-36 I.R.B. 388

2006-60, 2006-36 I.R.B. 389

2006-61, 2006-36 I.R.B. 390

2006-62, 2006-37 I.R.B. 444

2006-63, 2006-37 I.R.B. 445

2006-64, 2006-37 I.R.B. 447

2006-65, 2006-37 I.R.B. 447

2006-66, 2006-37 I.R.B. 448

2006-67, 2006-38 I.R.B. 509

2006-68, 2006-38 I.R.B. 510

2006-69, 2006-37 I.R.B. 449

2006-70, 2006-40 I.R.B. 629

2006-71, 2006-40 I.R.B. 630

2006-72, 2006-40 I.R.B. 630

Notices:

2006-56, 2006-28 I.R.B. 58

2006-57, 2006-27 I.R.B. 13

2006-58, 2006-28 I.R.B. 59

2006-59, 2006-28 I.R.B. 60

2006-60, 2006-29 I.R.B. 82

2006-61, 2006-29 I.R.B. 85

2006-62, 2006-29 I.R.B. 86

2006-63, 2006-29 I.R.B. 87

2006-64, 2006-29 I.R.B. 88

2006-65, 2006-31 I.R.B. 102

2006-66, 2006-30 I.R.B. 99

2006-67, 2006-33 I.R.B. 248

2006-68, 2006-31 I.R.B. 105

2006-69, 2006-31 I.R.B. 107

2006-70, 2006-33 I.R.B. 252

2006-71, 2006-34 I.R.B. 316

2006-72, 2006-36 I.R.B. 363

2006-73, 2006-35 I.R.B. 339

Notices— Continued:

2006-74, 2006-35 I.R.B. 339

2006-75, 2006-36 I.R.B. 366

2006-76, 2006-38 I.R.B. 459

2006-77, 2006-40 I.R.B. 590

2006-78, 2006-41 I.R.B. 675

2006-80, 2006-40 I.R.B. 594

2006-81, 2006-40 I.R.B. 595

2006-82, 2006-39 I.R.B. 529

2006-83, 2006-40 I.R.B. 596

2006-84, 2006-41 I.R.B. 677

2006-85, 2006-41 I.R.B. 677

2006-86, 2006-41 I.R.B. 680

Proposed Regulations:

REG-121509-00, 2006-40 I.R.B. 602

REG-135866-02, 2006-27 I.R.B. 34

REG-146893-02, 2006-34 I.R.B. 317

REG-159929-02, 2006-35 I.R.B. 341

REG-148864-03, 2006-34 I.R.B. 320

REG-168745-03, 2006-39 I.R.B. 532

REG-109512-05, 2006-30 I.R.B. 100

REG-145154-05, 2006-39 I.R.B. 567

REG-148576-05, 2006-40 I.R.B. 627

REG-109367-06, 2006-41 I.R.B. 683

REG-112994-06, 2006-27 I.R.B. 47

REG-118775-06, 2006-28 I.R.B. 73

REG-118897-06, 2006-31 I.R.B. 120

REG-120509-06, 2006-39 I.R.B. 570

REG-124152-06, 2006-36 I.R.B. 368

REG-125071-06, 2006-36 I.R.B. 375

Revenue Procedures:

2006-29, 2006-27 I.R.B. 13

2006-30, 2006-31 I.R.B. 110

2006-31, 2006-27 I.R.B. 32

2006-32, 2006-28 I.R.B. 61

2006-33, 2006-32 I.R.B. 140

2006-34, 2006-38 I.R.B. 460

2006-35, 2006-37 I.R.B. 434

2006-36, 2006-38 I.R.B. 498

2006-37, 2006-38 I.R.B. 499

2006-38, 2006-39 I.R.B. 530

2006-39, 2006-40 I.R.B. 600

Revenue Rulings:

2006-35, 2006-28 I.R.B. 50

2006-36, 2006-36 I.R.B. 353

2006-37, 2006-30 I.R.B. 91

2006-38, 2006-29 I.R.B. 80

2006-39, 2006-32 I.R.B. 137

2006-40, 2006-32 I.R.B. 136

2006-41, 2006-35 I.R.B. 331

2006-42, 2006-35 I.R.B. 337

2006-43, 2006-35 I.R.B. 329

2006-44, 2006-36 I.R.B. 361

Revenue Rulings— Continued:

2006-45, 2006-37 I.R.B. 423

2006-46, 2006-39 I.R.B. 511

2006-47, 2006-39 I.R.B. 511

2006-48, 2006-39 I.R.B. 516

2006-49, 2006-40 I.R.B. 584

2006-50, 2006-41 I.R.B. 672

2006-51, 2006-41 I.R.B. 632

Treasury Decisions:

9265, 2006-27 I.R.B. 1

9266, 2006-28 I.R.B. 52

9267, 2006-34 I.R.B. 313

9268, 2006-30 I.R.B. 94

9269, 2006-30 I.R.B. 92

9270, 2006-33 I.R.B. 237

9271, 2006-33 I.R.B. 224

9272, 2006-35 I.R.B. 332

9273, 2006-37 I.R.B. 394

9274, 2006-33 I.R.B. 244

9275, 2006-35 I.R.B. 327

9276, 2006-37 I.R.B. 424

9277, 2006-33 I.R.B. 226

9278, 2006-34 I.R.B. 256

9279, 2006-36 I.R.B. 355

9280, 2006-38 I.R.B. 450

9281, 2006-39 I.R.B. 517

9282, 2006-39 I.R.B. 512

9283, 2006-41 I.R.B. 633

9284, 2006-40 I.R.B. 582

9285, 2006-41 I.R.B. 656

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin2006–26, dated June 26, 2006.

October 10, 2006 ii 2006–41 I.R.B.

Finding List of Current Actions onPreviously Published Items1

Bulletins 2006–27 through 2006–41

Announcements:

2005-59

Updated and superseded by

Ann. 2006-45, 2006-31 I.R.B. 121

Notices:

2002-45

Amplified by

Rev. Rul. 2006-36, 2006-36 I.R.B. 353

2006-20

Supplemented and modified by

Notice 2006-56, 2006-28 I.R.B. 58

2006-53

Modified by

Notice 2006-71, 2006-34 I.R.B. 316

2006-67

Modified and superseded by

Notice 2006-77, 2006-40 I.R.B. 590

Proposed Regulations:

REG-135866-02

Corrected by

Ann. 2006-64, 2006-37 I.R.B. 447Ann. 2006-65, 2006-37 I.R.B. 447

REG-134317-05

Corrected by

Ann. 2006-47, 2006-28 I.R.B. 78

REG-118775-06

Corrected by

Ann. 2006-71, 2006-40 I.R.B. 630

Revenue Procedures:

2002-9

Modified and amplified by

Notice 2006-67, 2006-33 I.R.B. 248Notice 2006-77, 2006-40 I.R.B. 590

2004-63

Superseded by

Rev. Proc. 2006-34, 2006-38 I.R.B. 460

2005-41

Superseded by

Rev. Proc. 2006-29, 2006-27 I.R.B. 13

2005-49

Superseded by

Rev. Proc. 2006-33, 2006-32 I.R.B. 140

2006-12

Modified by

Rev. Proc. 2006-37, 2006-38 I.R.B. 499

Revenue Rulings:

72-238

Obsoleted by

REG-109367-06, 2006-41 I.R.B. 683

73-558

Obsoleted by

REG-109367-06, 2006-41 I.R.B. 683

81-35

Amplified and modified by

Rev. Rul. 2006-43, 2006-35 I.R.B. 329

81-36

Amplified and modified by

Rev. Rul. 2006-43, 2006-35 I.R.B. 329

87-10

Amplified and modified by

Rev. Rul. 2006-43, 2006-35 I.R.B. 329

2002-41

Amplified by

Rev. Rul. 2006-36, 2006-36 I.R.B. 353

2003-43

Amplified by

Notice 2006-69, 2006-31 I.R.B. 107

2005-24

Amplified by

Rev. Rul. 2006-36, 2006-36 I.R.B. 353

Treasury Decisions:

9254

Corrected by

Ann. 2006-44, 2006-27 I.R.B. 49Ann. 2006-66, 2006-37 I.R.B. 448

9258

Corrected by

Ann. 2006-46, 2006-28 I.R.B. 76

9260

Corrected by

Ann. 2006-67, 2006-38 I.R.B. 509

9262

Corrected by

Ann. 2006-56, 2006-35 I.R.B. 342

9264

Corrected by

Ann. 2006-46, 2006-28 I.R.B. 76

9272

Corrected by

Ann. 2006-68, 2006-38 I.R.B. 510

9277

Corrected by

Ann. 2006-72, 2006-40 I.R.B. 630

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin 2006–26, dated June 26, 2006.

2006–41 I.R.B. iii October 10, 2006

October 10, 2006 2006–41 I.R.B.

INTERNAL REVENUE BULLETINThe Introduction at the beginning of this issue describes the purpose and content of this publication. The weekly Internal Revenue

Bulletin is sold on a yearly subscription basis by the Superintendent of Documents. Current subscribers are notified by the Superin-tendent of Documents when their subscriptions must be renewed.

CUMULATIVE BULLETINSThe contents of this weekly Bulletin are consolidated semiannually into a permanent, indexed, Cumulative Bulletin. These are

sold on a single copy basis and are not included as part of the subscription to the Internal Revenue Bulletin. Subscribers to the weeklyBulletin are notified when copies of the Cumulative Bulletin are available. Certain issues of Cumulative Bulletins are out of printand are not available. Persons desiring available Cumulative Bulletins, which are listed on the reverse, may purchase them from theSuperintendent of Documents.

ACCESS THE INTERNAL REVENUE BULLETIN ON THE INTERNETYou may view the Internal Revenue Bulletin on the Internet at www.irs.gov. Under information for: select Businesses. Under

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purchased from National Technical Information Service (NTIS) on the Internet at www.irs.gov/cdorders (discount for online orders)or by calling 1-877-233-6767. The first release is available in mid-December and the final release is available in late January.

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