Rev. Rul. 74-376

Advice has been requested whether, under the circumstances described below, the taxpayer can modify a group election under section 963(c)(3) of the Internal Revenue Code of 1954 in a taxable year subsequent to the election year.

On March 15, 1970, the taxpayer, a domestic corporation, filed a Federal income tax return for the calendar year 1969, in which it elected under section 963(c)(2) of the Code to exclude from its gross income the subpart F income of its foreign subsidiaries. The election was made with respect to a group composed of all of the foreign corporations includible under section 1.963-1(b) of the Income Tax Regulations, including X, a single first tier foreign subsidiary of the taxpayer.

At the time the election was filed, the taxpayer was involved in an unresolved dispute with the Internal Revenue Service concerning the treatment of certain royalty amounts received by X in 1967 and 1968. The Service had proposed to reallocate all of this royalty income from X to the taxpayer under section 482 of the Code.

The decision to file a group election for 1969 was based upon the taxpayer's assumption that no more than 50 percent of the 1967 and 1968 royalty amounts would be reallocated to the taxpayer and that the 1969 royalty amounts would be treated in the same manner. The taxpayer had determined that a first-tier election should be made for X if the settlement exceeded a 50 percent allocation. The taxpayer's assumption was based upon advice of counsel.

In late 1970 the taxpayer reached an agreement with the Service under which 70 percent of the royalty amounts at issue for 1967 and 1968 were reallocated to the taxpayer. In response to the Service's expressed intention to again seek a 100 percent reallocation in 1969, the taxpayer filed an application with the Service to modify the 1969 election by changing it from a group election to a first-tier election with respect to X.

Section 1.963-1(c)(3)(ii)(a) of the regulations provides, in part and in substance, that a United States shareholder must establish to the satisfaction of the Commissioner that reasonable cause exists for modification of an election under section 963 of the Code.

Section 1.963-1(c)(3)(ii)(b) of the regulations provides, in part, that reasonable cause shall be deemed to exist for the modification of an election only if, after the making of such election, a material and substantial change in circumstances affecting the election occurs which reasonably could not have been anticipated when the election was made and which, to a significant degree, was beyond the control of the electing United States shareholder.

In the instant case the ultimate royalty reallocation was a material and substantial circumstance affecting the election within the meaning of section 1.963-1(c)(3)(ii)(b) of the regulations. However, in light of the facts within its knowledge at the time of making its election, the taxpayer could have reasonably anticipated a reallocation of 50 percent or more of the royalties paid to X in 1969. Accordingly, reasonable cause, as defined in section 1.963-1(c)(3)(ii)(b), does not exist for the modification of the taxpayer's 1969 election.