Regs on Treatment of Options in Loss Corporation Context

 [4830-01U]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations under section 382 of the Internal Revenue Code of 1986. The final regulations provide rules regarding the treatment of options in determining whether a loss corporation has an ownership change, within the meaning of section 382. These rules are necessary to enable a loss corporation to determine whether it is subject to the annual limitation provided in section 382 on the use of certain losses.

 DATES: These regulations are effective November 5, 1992. For dates of applicability of these regulations, see "Effective date" paragraph in the "SUPPLEMENTARY INFORMATION" portion of the preamble.

 FOR FURTHER INFORMATION CONTACT: Annette M. Ahlers of the Office of Assistant Chief Counsel (Corporate), Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (Attention: CC:DOM:CORP:1), or telephone (202) 622-7750 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1120. The estimated annual burden per respondent varies from .1 hour to .5 hour, depending on individual circumstances, with an estimated average of .3 hour.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing the burden should be sent to the Internal Revenue Service, Attention: IRS Reports Clearance Officer, PC:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

 This document contains final regulations to be added to the Income Tax Regulations (26 CFR part 1) under section 382 of the Internal Revenue Code (Code). The final regulations provide rules regarding the treatment of options in determining whether a loss corporation has an ownership change within the meaning of that section.

 Proposed regulations on this subject were set forth in a notice of proposed rulemaking published in the Federal Register on November 5, 1992. See 57 FR 52743. The Internal Revenue Service (IRS) received comments on the proposed regulations and held a public hearing on February 2, 1993. Having considered the comments and the statements made at the hearing, the IRS and the Treasury Department adopt the proposed regulations as revised by this Treasury decision.

EXPLANATION OF PROVISIONS

 Section 382 of the Code limits the amount of income earned by a corporation after an ownership change that can be offset by losses incurred prior to the ownership change. In general, an ownership change is an increase of more than 50 percentage points in stock ownership by 5-percent shareholders over a three-year period.

 Section 382(l)(3)(A) states that, except as provided in regulations, an option to acquire stock is treated as exercised if the deemed exercise would result in an ownership change. That section also provides that a similar rule applies in the case of certain interests that are similar to options. These rules are implemented by section 1.382-2T(h)(4) of the temporary regulations.

 The IRS issued the proposed regulations in response to numerous comments regarding the practical difficulties of applying the option rules in the temporary regulations. The proposed regulations were intended to reduce these practical difficulties by narrowing the scope of the option rules and simplifying their application.

 The proposed regulations treat an option as exercised only if it is issued or transferred for an abusive principal purpose. The proposed regulations define an abusive principal purpose as a principal purpose of manipulating the timing of an owner shift to avoid, or ameliorate the impact of, an ownership change by one of two means. These two means are (1) providing the holder of the option, prior to its exercise, with a substantial portion of the attributes of ownership of the underlying stock, and (2) facilitating the creation of income to absorb the loss corporation's losses prior to the exercise of the option.

 The determination of whether an option is issued or transferred for an abusive principal purpose is based on all relevant facts and circumstances. The proposed regulations include a nonexclusive list of factors that evidence an abusive principal purpose. One factor, for example, is the receipt by the loss corporation of a capital contribution (in exchange for stock or otherwise) in connection with the issuance or transfer of an option.

 This Treasury Decision adopts the proposed regulations with several revisions. The following discussion describes the principal differences between the proposed and final regulations.

A. THE OWNERSHIP, CONTROL, AND INCOME TESTS

 The final regulations treat an option as exercised if it satisfies either an OWNERSHIP TEST, a CONTROL TEST, or an INCOME TEST.

 The ownership test is substantially the same as the first element of the abusive principal purpose test of the proposed regulations. An option satisfies the ownership test if a principal purpose of its issuance, transfer, or structuring is to avoid or ameliorate the impact of an ownership change by providing the holder of the option, prior to its exercise or transfer, with a substantial portion of the attributes of ownership of the underlying stock.

 The control test applies to an option held by a major shareholder or used in connection with a major corporate acquisition. An actual or constructive holder of more than 50 percent of a corporation's stock can generally exercise significant influence over the corporation prior to the exercise of the option. The rules of the proposed regulations, however, may not adequately take into account the relationship between a major shareholder or option holder and the loss corporation. In particular, the attributes of ownership element of the abusive principal purpose test of the proposed regulations focuses only on the attributes of ownership of the stock covered by an option. It does not take into account an option holder's influence over a corporation as a result of owning other stock or options. In addition, the proposed regulations imply (and, as described below, the final regulations explicitly state) that the ability of the holder of an option with a fixed exercise price to share in future appreciation of the underlying stock is not, by itself, a substantial portion of the attributes of ownership of the stock. However, the extent to which a fixed price option transfers an economic interest in the loss corporation to an option holder may be of particular concern when the option is held by a major shareholder or is used in connection with a major corporate acquisition.

 For the reasons described above, the final regulations adopt a control test that applies to options held by major shareholders or used in connection with major corporate acquisitions. An option satisfies the control test if (1) a principal purpose of its issuance, transfer, or structuring is to avoid or ameliorate the impact of an ownership change, and (2) the holder of the option and any persons related to the option holder have, in the aggregate, a direct and indirect ownership interest in the loss corporation of more than 50 percent (determined as if the increase in such persons' percentage ownership interest that would result from the exercise of the option in question and any other options to acquire stock held by such persons, and any other intended increases in such persons' percentage ownership interest, actually occurred on the date the option is issued or transferred).

 The control test will subject certain options to inquiry even if it is unlikely that the option holder (or a related person) will actually acquire (directly or indirectly) more than 50 percent of the stock of the loss corporation. The control test is not satisfied, however, unless a requisite purpose is present. For example, the control test will apply to a contingent option to acquire more than 50 percent of the stock of a loss corporation even though the option holder has no other relationship to the corporation. Nevertheless, in such a situation, the option would not be treated as exercised if it were not issued with a principal purpose to avoid or ameliorate the impact of an ownership change.

 The income test is substantially the same as the second element of the abusive principal purpose test of the proposed regulations. An option satisfies the income test if a principal purpose of its issuance, transfer, or structuring is to avoid or ameliorate the impact of an ownership change by facilitating the creation of income prior to its exercise or transfer. The final regulations clarify that the creation of income concept is a broad one, and refers not only to the creation of income, but to the creation of any value (e.g., unrealized built-in gains that would ameliorate the impact of an ownership change), and also to the acceleration of income or the deferral of deductions.

B. CLARIFICATION OF PRINCIPAL PURPOSE CONCEPT

 The proposed regulations treat an option as exercised if a PRINCIPAL PURPOSE of its issuance or transfer is abusive. Various forms of this purpose standard are employed throughout the Code and regulations. See, e.g., sections 306(b)(4) ("one of its principal purposes"); 336(d)(2)(B) ("a principal purpose"); 453(e)(7) ("one of its principal purposes"); 7872(c) ("1 of the principal purposes"); 1.707-6(b) ("a principal purpose"); 1.1275-2T(g) ("a principal purpose"); and 1.1504-4(g)(3)(iv)(B) ("a principal purpose"). The IRS and the Treasury Department considered other formulations of a purpose test in an effort to provide greater clarity on the application of the test. No appropriate substitute was identified. Accordingly, the final regulations retain the "a principal purpose" standard, but clarify that the relevant inquiry under this standard is not limited to the purposes for which an option is issued or transferred. The inquiry also focuses on the purposes of structuring the option, either alone or in combination with other arrangements. An abusive purpose can be a principal purpose even when it is outweighed by the non-tax reasons (taken together or separately) for the occurrence or structure of a transaction.

C. ELIMINATION OF ABUSE FACTORS AND DISCLOSURE REQUIREMENT

 As noted above, the proposed regulations provide a nonexclusive list of factors that evidence an abusive principal purpose. The proposed regulations require a loss corporation to disclose certain information to the IRS if it does not treat as exercised an option to which one of the specific abuse factors applies.

 The IRS and the Treasury Department have determined that the enforcement benefits that would be achieved by the disclosure requirement do not justify the administrative burden it would impose on taxpayers (in addition to the general disclosure requirement of the temporary regulations; see section 1.382-2T(a)(2)(ii)). Therefore, the final regulations do not retain the disclosure requirement of the proposed regulations. The accuracy- related penalty of section 6662 may apply, however, if a substantial underpayment results from a position that lacks substantial authority that is not adequately disclosed by the taxpayer.

 Because the promulgation of specific abuse factors in the proposed regulations related largely to the disclosure requirement, the final regulations do not retain the specific abuse factors. The elimination of the abuse factors also addresses commentators' concerns that these factors could have been viewed as creating a presumption that an option to which a factor applied was issued or transferred for an abusive principal purpose.

 Instead of providing specific abuse factors that are evidence of an abusive principal purpose, the final regulations merely identify a series of factors that exemplify circumstances that may be probative under the ownership, control, and income tests. The weight given to these factors depends on the facts and circumstances. The presence or absence of any of these factors does not create a presumption.

 Among the factors that are relevant in applying all three tests are any business purposes for the issuance, transfer, or structure of an option, the likelihood of exercise of the option (taking into account, for example, any contingencies to its exercise), transactions related to the issuance or transfer of the option, and the consequences of treating the option as exercised. An option is not treated as exercised under any of the tests, however, if a principal purpose of its issuance, transfer, or structuring is to avoid an ownership change by having it treated as exercised.

 The final regulations also provide examples of additional factors that are taken into account in applying each of the separate tests. Among the additional factors that are taken into account in applying the ownership test are the relationship between the exercise price of the option and the value of the underlying stock at the time of the issuance or transfer of the option, whether the option provides its holder with the right to participate in the management of the loss corporation or with other rights that ordinarily would be afforded to owners of the underlying stock, and the existence of reciprocal put and call options. The ability of the holder of an option with a fixed exercise price to share in future appreciation of the underlying stock is also a relevant factor, but is not sufficient, by itself, for the option to be treated as exercised. Conversely, the fact that the holder of such an option does not bear the risk of loss due to declines in value of the underlying stock does not preclude the option from satisfying the ownership test.

 Among the additional factors that are taken into account in applying the control test are the economic interests in the loss corporation of the option holder or related persons and the influence of those persons over the management of the loss corporation.

 Among the additional factors that are taken into account in applying the income test are whether, in connection with the issuance or transfer of the option, the loss corporation engages in income acceleration transactions or the holder of the option or a related person purchases stock from, or makes a capital contribution or loan to, the loss corporation that can reasonably be expected to avoid or ameliorate the impact of an ownership change. Examples of income acceleration transactions are those outside the ordinary course of the loss corporation's business that accelerate income or gain into the period prior to the exercise of the option or defer deductions to the period after the exercise of the option.

 Commentators on the proposed regulations asked for clarification of the definition of "capital contribution" and guidance on the relevance of capital contributions in determining whether an option is treated as exercised. The final regulations address these comments in two respects. First, as noted above, the final regulations eliminate the abuse factors of the proposed regulations, including the factor related to capital contributions. Therefore, although a capital contribution or similar transaction made in connection with the issuance or transfer of an option is relevant in applying the income test, it cannot be viewed as giving rise to a presumption that the option satisfies the test. In addition, the final regulations provide further guidance regarding the relevance of a capital contribution or similar transaction. The final regulations provide that a capital contribution or similar transaction is more probative toward an option satisfying the income test the larger the amount received by the loss corporation in the transaction or related transactions. Further, such a transaction is generally not taken into account in applying the income test if it is made to enable the loss corporation to continue the basic operations of its business for such purposes as meeting the monthly payroll or funding other operating expenses.

D. SAFE HARBORS

 In response to commentators' requests, the final regulations provide several safe harbors. The safe harbors apply to (i) typical contracts to acquire stock that are closed on a change date within one year after they are entered into, (ii) options that are part of security arrangements in typical lending transactions, (iii) certain compensatory options, (iv) certain options exercisable only upon death, disability, mental incompetency, or retirement, and (v) certain rights of first refusal. In addition, the final regulations authorize the IRS to promulgate additional safe harbors by publication in the Internal Revenue Bulletin.

 An option to which a safe harbor applies is generally not subject to the ownership, control, or income test. A contract to acquire stock, however, is not exempted from the income test regardless of whether it is described in the safe harbor applicable to contracts.

E. TREATMENT OF OPTIONS RELATED TO CERTAIN BANKRUPTCY REORGANIZATIONS

 Section 382(l)(5) provides rules that apply to ownership changes that occur while the loss corporation is under the jurisdiction of a court in a title 11 or similar case. A loss corporation that qualifies for these special rules can use its pre-change losses, after certain reductions, without regard to the annual limitation provided in section 382.

Section 1.382-9(o) of the regulations provides that the option attribution rules of the temporary regulations do not apply to certain options that arise as part of a plan of reorganization in a title 11 or similar case until the time that the plan becomes effective. This rule clarifies the timing of any ownership change that results from the plan. This Treasury decision amends section 1.382-9(o) to provide that neither the option attribution rules of the temporary regulations nor the new rules of the final regulations apply prior to the time the plan becomes effective.

 In general, the new option rules of the final regulations apply to determine whether an ownership change occurs at the time the plan becomes effective. As explained in Part F, below, however, a loss corporation that is subject to a title 11 or similar case filed on or before May 17, 1994 may elect to apply the option attribution rules of the temporary regulations up to the time that the plan of reorganization becomes effective.

 Section 1.382-9(e) of the regulations provides rules regarding the treatment of options for purposes of determining eligibility for the special rules of section 382(l)(5). The preamble of the proposed regulations requested comments on the desirability of changes to the rules of section 1.382-9(e) in light of the option rules of the proposed regulations. The IRS and the Treasury Department are considering the comments received in response to this request.

F. EFFECTIVE DATE

 The option rules of the proposed regulations were proposed to apply on any testing date on or after November 5, 1992. Many commentators asked that taxpayers be allowed to apply the new option rules retroactively. These commentators observed that many of the options that were treated as exercised under the temporary regulations (and thus resulted in ownership changes) would not be treated as exercised under the rules of the proposed regulations. Thus, if the same options had been issued after the effective date of the proposed regulations, they would not necessarily have caused an ownership change. The commentators argued that the application of the section 382 limitation should not depend on the timing of the issuance of certain options.

 The IRS and the Treasury Department have declined to allow taxpayers to apply the new option rules retroactively because the results of retroactive application of these rules would be inappropriate. The results would be largely the same as if no option attribution rules had been in effect prior to November 5, 1992, except cases in which attribution favored the taxpayer. A taxpayer could argue that the options in question could not have had an abusive principal purpose because the temporary regulations treated an option as exercised whenever an ownership change would result. Accordingly, a taxpayer who had an ownership change under the prior rules could reverse the ownership change by electing to apply the new rules retroactively -- an election the taxpayer would presumably make unless, in retrospect, the application of the temporary regulations had proved to be favorable.

 In light of the foregoing, the final regulations retain the general effective date of the proposed regulations; the option rules of the final regulations generally apply on testing dates on or after November 5, 1992.

 Although the option rules of the final regulations, and not those of the temporary regulations, generally apply on testing dates on or after November 5, 1992, the final regulations allow a loss corporation to elect to apply the option rules of the temporary regulations for an extended period. For most loss corporations, the election applies to all testing dates that occur before May 17, 1994. If, however, the loss corporation is subject to a title 11 or similar case filed on or before May 17, 1994, the election applies to all testing dates on or before the time the plan of reorganization becomes effective.

 The final regulations provide an exception to the general effective date for the control test. The test generally does not apply to an option issued on or before March 17, 1994, or issued within 60 days after that date pursuant to a plan existing before that date. The control test will apply to such an option, however, on testing dates on or after the date of a transfer of the option that would itself cause the option to satisfy the control test.

SPECIAL ANALYSES

 It has been determined that this Treasury Decision is not a significant regulatory action, as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Annette M. Ahlers, Office of Assistant Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR part 1

 Income taxes, Reporting and recordkeeping requirements.

26 CFR part 602

 Reporting and recordkeeping requirements.

AMENDMENTS TO THE REGULATIONS

PART 1 -- INCOME TAXES

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

Paragraph 1. The authority citation for part 1 is amended by removing the current citations for sections 1.382-2, 1.382-4, and 1.382-9 and by adding the following citations to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.382-2 also issued 26 U.S.C. 382(k)(6)(B)(ii) and 26 U.S.C. 382(m). * * * Section 1.382-4 also issued under 26 U.S.C. 382(l)(3) and 382(m). * * * Section 1.382-9 also issued under 26 U.S.C. 382(l)(3) and 382(m). * * *

Authority 26 U.S.C. 7805.

Par. 2. Section 1.382-1 is amended as follows:

1. Entries for section 1.382-2, paragraphs (a)(3) through (b)(3) are added.

2. Entries for section 1.382-2T are amended by:

a. Revising the entry for paragraph (a)(2)(i).

b. Adding an entry for paragraph (h)(4)(xiii).

c. Removing the entry for paragraph (h)(4)(x)(Z).

d. Adding entries for paragraphs (m)(4)(vi) and (m)(4)(vii).

3. The entries for section 1.382-4 are revised.

4. The additions and revisions read as follows:

SECTION 1.382-1 TABLE OF CONTENTS.

* * * * *

SECTION 1.382-2 GENERAL RULES FOR OWNERSHIP CHANGE.

(a) * * *

(3) Stock.

(i) In general. [Reserved]

(ii) Convertible stock.

(4) Testing date.

(i) In general.

(ii) Exceptions.

(b) Effective dates.

(1) In general. [Reserved]

(2) Rules provided in paragraph (a)(3)(ii) of this section.

(i) In general.

(ii) Certain convertible preferred stock.

(3) Rules provided in paragraph (a)(4) of this section.

SECTION 1.382-2T DEFINITION OF OWNERSHIP CHANGE UNDER SECTION 382, AS AMENDED BY THE TAX REFORM ACT OF 1986 (TEMPORARY).

(a) * * *

(2) * * *

(i) Testing dates prior to November 5, 1992.

* * * * *

(h) * * *

(4) * * *

(xiii) Effective date.

* * * * *

(m) * * *

(4) * * *

(vi) Rules provided in paragraph (h)(4) of this section.

(vii) Rules provided in paragraph (a)(2)(i) of this section.

* * * * *

SECTION 1.382-4 CONSTRUCTIVE OWNERSHIP OF STOCK.

 (a) In general. [Reserved]

Par. 3. Section 1.382-2 is amended as follows:

1. By revising paragraph (a)(1)(i)(B).

2. By adding paragraphs (a)(3), (a)(4), and (b).

3. The revision and additions read as follows.

SECTION 1.382-2 GENERAL RULES FOR OWNERSHIP CHANGE.

(a) * * *

(1) * * *

(i) * * *

(B) for the taxable year that includes a testing date, as defined in paragraph (a)(4) of this section or section 1.382-2T(a)(2)(i), whichever is applicable (determined for purposes of this paragraph (a)(1) without regard to whether the corporation is a loss corporation), has a net operating loss, a net capital loss, excess foreign taxes under section 904(c), unused general business credits under section 38, or an unused minimum tax credit under section 53, or * * * * *

(3) STOCK -- (i) IN GENERAL. [Reserved]

(ii) CONVERTIBLE STOCK. The term "stock" includes any convertible stock. For rules regarding the treatment of certain convertible stock as an option, see section 1.382-4(d)(9)(ii).

(4) TESTING DATE -- (i) IN GENERAL. Except as provided in paragraph (a)(4)(ii) of this section, a loss corporation is required to determine whether an ownership change has occurred immediately after any owner shift, or issuance or transfer (including an issuance or transfer described in section 1.382-4(d)(8)(i) or (ii)) of an option with respect to stock of the loss corporation that is treated as exercised under section 1.382-4(d)(2). Each date on which a loss corporation is required to make a determination of whether an ownership change has occurred is referred to as a testing date. All computations of increases in percentage ownership are to be made as of the close of the testing date and any transactions described in this paragraph (a)(4) that occur on that date are treated as occurring simultaneously at the close of the testing date. See section 1.382-2T(e)(1) for the definition of owner shift. The term OPTION, as used in this paragraph (a)(4), includes interests that are treated as options under section 1.382-4(d)(9). For rules regarding the determination of whether dates prior to November 5, 1992, are testing dates, see section 1.382-2T(a)(2)(i).

(ii) EXCEPTIONS. A loss corporation is not required to determine whether an ownership change has occurred immediately after --

(A) Any transfer of stock, or an option with respect to stock, of the loss corporation in any of the circumstances described in section 382(l)(3)(B) (death, gift, divorce, etc.); or

(B) The transfer of an option described in section 1.382-4(d)(11)(i) or (ii) (relating to transfers between persons who are not 5-percent shareholders or between members of certain public groups).

(b) EFFECTIVE DATES -- (1) IN GENERAL. [Reserved]

(2) RULES PROVIDED IN PARAGRAPH (A)(3)(II) OF THIS SECTION -- (i) IN GENERAL. Except as provided in paragraph (b)(2)(ii) of this section, the rules provided in paragraph (a)(3)(ii) of this section apply with respect to any convertible stock.

(ii) CERTAIN CONVERTIBLE PREFERRED STOCK. Convertible stock that, when issued, would be described in section 1504(a)(4) by disregarding subparagraph (D) thereof and by ignoring the potential participation in corporate growth that the conversion feature may offer is treated as stock described in that section (and thus is not treated as stock for the purpose of determining whether an ownership change occurs, but is taken into account for the purpose of determining the value of the loss corporation immediately before an ownership change; see sections 382(e)(1) and 382(k)(6)(A)) if --

(A) The stock was issued on or after July 20, 1988, and prior to November 5, 1992; or

(B) The stock was issued prior to July 20, 1988, and the loss corporation makes the election described in Notice 88-67, 1988-1 C.B. 555, (see section 601.601(d)(2)(ii)(b) of this chapter for availability of Cumulative Bulletins (C.B.)) on or before the earlier of the date prescribed in the Notice or December 7, 1992.

(3) RULES PROVIDED IN PARAGRAPH (a)(4) OF THIS SECTION. The rules provided in paragraph (a)(4) of this section apply to determine whether dates on or after November 5, 1992, are testing dates.

Par. 4. Section 1.382-2T is amended as follows:

1. The paragraph heading for paragraph (a)(2)(i) is revised.

2. A sentence is added at the end of paragraph (a)(2)(i)(B).

3. Paragraph (f)(18)(iii) is amended by adding a sentence at the end of the concluding text.

4. Paragraph (h)(4)(x)(Z) is removed.

5. Paragraph (h)(4)(xiii) is added.

6. Paragraphs (m)(4)(vi) and (m)(4)(vii) are added.

7. The revisions and additions read as follows:

SECTION 1.382-2T DEFINITION OF OWNERSHIP CHANGE UNDER SECTION 382, AS AMENDED BY THE TAX REFORM ACT OF 1986 (TEMPORARY).

(a) * * *

(2) * * *

(i) TESTING DATES PRIOR TO NOVEMBER 5, 1992. * * *

(B) * * * See paragraph (m)(4)(vii) of this section for special rules regarding the effective date of the provisions of this paragraph (a)(2)(i).

* * * * *

(f) * * *

(18) * * *

(iii) TREATING INTERESTS NOT CONSTITUTING STOCK AS STOCK. * * * See section 1.382-4(d)(12) for rules that apply with respect to options and this paragraph (f)(18)(iii).

* * * * *

(h) * * *

(4) * * *

(xiii) EFFECTIVE DATE. See paragraph (m)(4)(vi) of this section for special rules regarding the effective date of the provisions of this paragraph (h)(4). * * * * *

(m) * * *

(4) * * *

(vi) RULES PROVIDED IN PARAGRAPH (h)(4) OF THIS SECTION. The rules provided in paragraph (h)(4) of this section do not apply on any testing date on or after November 5, 1992. The rule provided in paragraph (h)(4)(viii) of this section applies to the lapse or forfeiture of any option treated as exercised under paragraph (h)(4)(i) of this section. If an option is treated as exercised under paragraph (h)(4)(i) of this section, and the option is actually exercised on a day that is within 120 days after the date on which the option is treated as exercised, the rule provided in paragraph (h)(4)(vi)(B) of this section applies (even if the actual exercise of the option occurs on a date on which the rules of paragraph (h)(4) of this section would not otherwise apply). Thus, in such a case, the loss corporation may elect to treat paragraphs (h)(4)(i) and (vi)(A) of this section as not applying to the option and take into account only the acquisition of loss corporation stock resulting from the actual exercise of the option.

(vii) RULES PROVIDED IN PARAGRAPH (a)(2)(i) OF THIS SECTION. The rules provided in paragraph (a)(2)(i) of this section apply to determine whether dates prior to November 5, 1992, are testing dates. For rules regarding the determination of whether dates on or after November 5, 1992, are testing dates, see section 1.382-2(a)(4).

* * * * *

Par. 5. Section 1.382-4 is revised to read as follows:

SECTION 1.382-4 CONSTRUCTIVE OWNERSHIP OF STOCK.

(a) IN GENERAL. [Reserved]

(b) ATTRIBUTION FROM CORPORATIONS, PARTNERSHIPS, ESTATES AND TRUSTS. [Reserved]

(c) ATTRIBUTION TO CORPORATIONS, PARTNERSHIPS, ESTATES AND TRUSTS. [Reserved]

(d) TREATMENT OF OPTIONS AS EXERCISED -- (1) GENERAL RULE. Except as provided in paragraph (d)(2) of this section, an option is not treated as exercised under section 382(l)(3)(A).

(2) OPTIONS TREATED AS EXERCISED -- (i) ISSUANCE OR TRANSFER. For purposes of determining whether an ownership change occurs, an option is treated as exercised on the date of its issuance or transfer if, on that date, the option satisfies --

(A) The OWNERSHIP TEST of paragraph (d)(3) of this section,

(B) The CONTROL TEST of paragraph (d)(4) of this section, or

(C) The INCOME TEST of paragraph (d)(5) of this section.

(ii) SUBSEQUENT TESTING DATES. Except as provided in paragraph (d)(10) of this section, an option that is treated as exercised on the date of its issuance or transfer is treated as exercised on any subsequent testing date (as defined in section 1.382-2(a)(4)) for purposes of determining whether an ownership change occurs.

(3) THE OWNERSHIP TEST. An option satisfies the ownership test if a principal purpose of the issuance, transfer, or structuring of the option (alone or in combination with other arrangements) is to avoid or ameliorate the impact of an ownership change of the loss corporation by providing the holder of the option, prior to its exercise or transfer, with a substantial portion of the attributes of ownership of the underlying stock.

(4) THE CONTROL TEST -- (i) IN GENERAL. An option satisfies the control test if --

(A) A principal purpose of the issuance, transfer, or structuring of the option (alone or in combination with other arrangements) is to avoid or ameliorate the impact of an ownership change of the loss corporation, and

(B) The holder of the option and any persons related to the option holder have, in the aggregate, a direct and indirect ownership interest in the loss corporation of more than 50 percent (determined as if the increase in such persons' percentage ownership interest that would result from the exercise of the option in question and any other options to acquire stock held by such persons, and any other intended increases in such persons' percentage ownership interest, actually occurred on the date the option is issued or transferred).

(ii) OPERATING RULES -- (A) PERSON AND RELATED PERSONS. For purposes of this paragraph (d)(4) --

(1) The term person includes an individual or entity, but not a public group, as defined in section 1.382-2T(f)(13), and

(2) Persons are related if they bear a relationship specified in section 267(b) or 707(b) or if they have a formal or informal understanding among themselves to make a coordinated acquisition of stock, within the meaning of section 1.382-3(a)(1)(i).

(B) INDIRECT OWNERSHIP INTEREST. The indirect ownership interest that the holder of the option and any persons related to the holder have in the loss corporation is determined by applying the constructive ownership rules of section 1.382-2T(h), other than section 1.382-2T(h)(2)(i)(A) (which treats stock attributed pursuant to section 318(a)(2) as no longer being owned by the entity from which it is attributed) and section 1.382-2T(h)(4) (which treats options as exercised in certain circumstances). If, however, the application of such constructive ownership rules without regard to section 1.382-2T(h)(2)(i)(A) would result in the same stock of the loss corporation being owned by two or more such persons, appropriate adjustments must be made so that such stock is not counted more than once in computing the aggregate ownership interests of such persons.

(5) THE INCOME TEST. An option satisfies the income test if a principal purpose of the issuance, transfer, or structuring of the option (alone or in combination with other arrangements) is to avoid or ameliorate the impact of an ownership change of the loss corporation by facilitating the creation of income (including accelerating income or deferring deductions) or value (including unrealized built-in gains) prior to the exercise or transfer of the option.

(6) APPLICATION OF THE OWNERSHIP, CONTROL, AND INCOME TESTS -- (i) IN GENERAL. Whether an option satisfies the ownership, control, or income test depends on all the relevant facts and circumstances. Among the factors that are relevant in applying all three tests are any business purposes for the issuance, transfer, or structure of the option, the likelihood of exercise of the option (taking into account, for example, any contingencies to its exercise), transactions related to the issuance or transfer of the option, and the consequences of treating the option as exercised. An option is not treated as exercised under any of the three tests, however, if a principal purpose of its issuance, transfer, or structuring is to avoid an ownership change by having it treated as exercised. Paragraphs (d)(6)(ii), (iii) and (iv) of this section describe additional examples of factors that are relevant in applying each test. The weight given to any factor depends on all the facts and circumstances. The presence or absence of any factor described in this paragraph (d)(6) does not create a presumption.

(ii) APPLICATION OF OWNERSHIP TEST. Among the additional factors that are taken into account in applying the ownership test are the relationship, at the time of issuance or transfer of the option, between the exercise price of the option and the value of the underlying stock, whether the option provides its holder or a related person with the right to participate in the management of the loss corporation or with other rights that ordinarily would be afforded to owners of the underlying stock, and the existence of reciprocal options (e.g., a call option held by the prospective purchaser and a corresponding put option held by the prospective seller). The ability of the holder of an option with a fixed exercise price to share in future appreciation of the underlying stock is also a relevant factor, but is not sufficient, by itself, for the option to satisfy the ownership test. Conversely, the fact that the holder of such an option does not bear the risk of loss due to declines in value of the underlying stock does not preclude the option from satisfying the ownership test.

(iii) APPLICATION OF CONTROL TEST. Among the additional factors that are taken into account in applying the control test are the economic interests in the loss corporation of the option holder or related persons and the influence of those persons over the management of the loss corporation (in either case, through the option or a related arrangement, or through rights in stock).

(iv) APPLICATION OF INCOME TEST. Among the additional factors that are taken into account in applying the income test are whether, in connection with the issuance or transfer of the option, the loss corporation engages in income acceleration transactions or the holder of the option or a related person purchases stock (including section 1504(a)(4) stock) from, or makes a capital contribution or loan to, the loss corporation that can reasonably be expected to avoid or ameliorate the impact of an ownership change. Examples of income acceleration transactions are those outside the ordinary course of the loss corporation's business that accelerate income or gain into the period prior to the exercise of the option (or defer deductions to the period after the exercise of the option). A stock purchase, capital contribution, or loan is more probative toward an option satisfying the income test the larger the amount received by the loss corporation in the transaction or related transactions. A stock purchase, capital contribution, or loan is generally not taken into account in applying the income test if it is made to enable the loss corporation to continue basic operations of its business (e.g., to meet the monthly payroll or fund other operating expenses of the loss corporation).

(7) SAFE HARBORS. Except as provided in paragraph (d)(7)(i) of this section, an option described in this paragraph (d)(7) is not treated as exercised pursuant to the ownership, control, or income test. The failure of an option to be described in this paragraph (d)(7) does not affect the determination of whether the option satisfies the ownership, income, or control test. The following options are described in this paragraph (d)(7):

(i) CONTRACTS TO ACQUIRE STOCK. A stock purchase agreement or a similar arrangement, the terms of which are commercially reasonable, in which the parties' obligations to complete the transaction are subject only to reasonable closing conditions, and which is closed on a change date within one year after it is entered into. An option is not exempt from the income test of paragraph (d)(5) of this section solely by reason of its description in this paragraph (d)(7)(i).

(ii) ESCROW, PLEDGE, OR OTHER SECURITY AGREEMENTS. An option that is part of a security arrangement in a typical lending transaction (including a purchase money loan), if the arrangement is subject to customary commercial conditions. For this purpose, a security arrangement includes, for example, an agreement for holding stock in escrow or under a pledge or other security agreement, or an option to acquire stock contingent upon a default under a loan.

(iii) COMPENSATORY OPTIONS. An option to acquire stock in a corporation with customary terms and conditions provided to an employee, director, or independent contractor in connection with the performance of services for the corporation or a related person (and that is not excessive by reference to the services performed) and which --

(A) Is nontransferable within the meaning of section 1.83-3(d); and

(B) Does not have a readily ascertainable fair market value as defined in section 1.83-7(b) on the date the option is issued.

(iv) OPTIONS EXERCISABLE ONLY UPON DEATH, DISABILITY, MENTAL INCOMPETENCY, OR RETIREMENT. An option entered into between stockholders of a corporation (or a stockholder and the corporation) with respect to stock of either stockholder, that is exercisable only upon the death, disability, mental incompetency of the stockholder, or, in the case of stock acquired in connection with the performance of services for the corporation or a related person (and that is not excessive by reference to the services performed), the stockholder's retirement.

(v) RIGHTS OF FIRST REFUSAL. A bona fide right of first refusal with customary terms, entered into between stockholders of a corporation (or between the corporation and a stockholder), and regarding the corporation's stock.

(vi) OPTIONS DESIGNATED IN THE INTERNAL REVENUE BULLETIN. An option designated by the Internal Revenue Service in the Internal Revenue Bulletin as being exempt from one or more of the ownership, control, or income tests. See section 601.601(d)(2)(ii) of this chapter (relating to the Internal Revenue Bulletin).

(8) ADDITIONAL RULES -- (i) CONTRACTS TO ACQUIRE STOCK. For purposes of this paragraph (d), a contract is considered to be issued or transferred on the date it is entered into or assigned, respectively.

(ii) INDIRECT TRANSFER OF AN OPTION. If an entity is formed or availed of for a principal purpose of facilitating an indirect transfer of an option by issuing or transferring interests in the entity, an issuance or transfer of an interest in the entity will be treated as a transfer of the option for purposes of applying the ownership, control, and income tests of paragraphs (d)(3) through (5) of this section.

(iii) OPTIONS RELATED TO INTERESTS IN NON-CORPORATE ENTITIES. The rules of this paragraph (d) apply, with appropriate adjustments, to options to acquire or transfer interests in non- corporate entities.

(iv) PUTS. In applying the rules of this section to puts, appropriate adjustments must be made to take into account that the put provides its holder with a right to transfer, instead of acquire, stock.

(9) DEFINITION OF OPTION -- (i) IN GENERAL. Any contingent purchase, warrant, convertible debt, put, stock subject to a risk of forfeiture, contract to acquire stock, or similar interest is treated as an option for purposes of this paragraph (d), regardless of whether it is contingent or otherwise not currently exercisable.

(ii) CONVERTIBLE STOCK. Convertible stock is treated as an option for purposes of this paragraph (d) (in addition to being treated as stock under section 1.382-2(a)(3)(ii)) only if the terms of the conversion feature permit or require consideration other than the stock being converted.

(iii) SERIES OF OPTIONS. For purposes of this paragraph (d), an option to acquire an option with respect to the stock of the loss corporation, and each one of a series of such options, is treated as an option to acquire such stock.

(iv) GENERAL PRINCIPLES OF TAX LAW. This paragraph (d) does not affect the determination under general principles of tax law (such as substance over form) of whether an instrument is an option or stock.

(10) SUBSEQUENT TREATMENT OF OPTIONS TREATED AS EXERCISED ON A CHANGE DATE -- (i) IN GENERAL. The following rules apply to options that are treated as exercised under paragraph (d)(2) of this section on a change date:

(A) The option is not treated as exercised under paragraph (d)(2) of this section on any testing date after the change date and prior to a transfer of the option that would itself (i.e., without regard to the purposes for the issuance or any prior transfers of the option) cause the option to satisfy the ownership test of paragraph (d)(3) of this section, the control test of paragraph (d)(4) of this section, or the income test of paragraph (d)(5) of this section; and

(B) The exercise of the option, if by the person who owned the option immediately after the ownership change (or by a transferee of the option who acquired the option, directly or indirectly, from that person in one or more transfers described in paragraph (d)(11) of this section), does not contribute to another ownership change on any testing date on or after the date of exercise.

(ii) ALTERNATIVE LOOK-BACK RULE FOR OPTIONS EXERCISED WITHIN 3 YEARS AFTER CHANGE DATE. If a loss corporation, on its return, as originally filed, for a taxable year that includes a change date, properly treats an option as exercised under paragraph (d)(2) of this section on the change date, and the option is actually exercised within three years after the change date, the loss corporation may treat the rules of paragraph (d)(10)(i) of this section as inapplicable to the option and instead treat the option as having been exercised on the change date for the purpose of determining whether an ownership change occurs on any and all testing dates after the change date (filing such amended returns as may be necessary for taxable years ending after the change date and before the date of exercise of the option). A transfer after the change date of an option to which this paragraph (d)(10)(ii) applies is treated as a transfer of the stock subject to the option. The exercise of an option to which this paragraph (d)(10)(ii) applies is not taken into account for the purpose of determining whether an ownership change occurs on or after the date of exercise.

(11) TRANSFERS NOT SUBJECT TO DEEMED EXERCISE. Paragraph (d)(2) of this section does not apply to the transfer of an option (including a transfer described in paragraph (d)(8)(i) or (ii) of this section), if --

(i) Neither the transferor nor the transferee is a 5-percent shareholder and neither person would be a 5-percent shareholder if all options held by that person to acquire stock were treated as exercised;

(ii) The transfer is between members of separate public groups resulting from the application of the segregation rules of section 1.382-2T(j)(2) and (3)(iii); or

(iii) The transfer occurs in any of the circumstances described in section 382(l)(3)(B) (relating to stock acquired by reason of death, gift, divorce, separation, etc.).

(12) CERTAIN RULES REGARDING NON-STOCK INTERESTS AS STOCK. Section 1.382-2T(f)(18)(iii) does not apply to treat an option (whether or not treated as exercised under this paragraph (d)) as stock.

(e) STOCK TRANSFERRED UNDER CERTAIN AGREEMENTS. [Reserved]

(f) FAMILY ATTRIBUTION. [Reserved]

(g) DEFINITIONS. The terms and nomenclature used in this section, and not otherwise defined herein, have the same meaning as in section 382 and the regulations thereunder.

(h) EFFECTIVE DATE -- (1) IN GENERAL. [Reserved]

(2) OPTION ATTRIBUTION RULES -- (i) GENERAL RULE. The rules of paragraph (d) of this section apply, instead of the rules of section 1.382-2T(h)(4), on any testing date on or after November 5, 1992. See paragraph (h)(2)(vi) of this section for an election relating to the effective date.

(ii) SPECIAL RULE FOR CONTROL TEST. An option issued on or before March 17, 1994, or an option issued within 60 days after that date pursuant to a plan existing before that date, is not treated as exercised under the control test provided in paragraph (d)(4) of this section on any testing date prior to a transfer of the option after March 17, 1994, that would itself cause the option to satisfy the control test.

(iii) CONVERTIBLE STOCK ISSUED PRIOR TO JULY 20, 1988 -- (A) IN GENERAL. Except as provided in paragraph (h)(2)(iii)(B) of this section, convertible stock issued prior to July 20, 1988, is not treated as an option subject to the rules of section 1.382-2T(h)(4) or paragraph (d)(2) of this section.

(B) EXCEPTIONS -- (1) NONVOTING CONVERTIBLE PREFERRED STOCK. Convertible stock issued prior to July 20, 1988, is treated as an option subject to the rules of section 1.382-2T(h)(4) or paragraph (d)(2) of this section if --

(i) The stock, when issued, would be described in section 1504(a)(4) by disregarding subparagraph (D) thereof and by ignoring the potential participation in corporate growth that the conversion feature may offer; and

(ii) The loss corporation makes the election described in Notice 88-67, 1988-1 C.B. 555 (see section 601.601(d)(2)(ii)(b) of this chapter for availability of Cumulative Bulletins (C.B.)), on or before the earlier of the date prescribed in Notice 88-67 or December 7, 1992.

(2) OTHER CONVERTIBLE STOCK. Convertible stock issued prior to July 20, 1988, is treated as an option subject to the rules of section 1.382-2T(h)(4) or paragraph (d)(2) of this section if --

(i) The terms of the conversion feature permit or require the tender of consideration other than the stock being converted; and

(ii) The loss corporation makes the election described in Notice 88-67 on or before the date prescribed in the Notice.

(iv) CONVERTIBLE STOCK ISSUED ON OR AFTER JULY 20, 1988, AND BEFORE NOVEMBER 5, 1992. Convertible stock issued on or after July 20, 1988, and before November 5, 1992, is treated as an option subject to the rules of section 1.382-2T(h)(4) or paragraph (d) of this section only if --

(A) The stock, when issued, would be described in section 1504(a)(4) by disregarding subparagraph (D) thereof and by ignoring the potential participation in corporate growth that the conversion feature may offer; or

(B) The terms of the conversion feature permit or require the tender of consideration other than the stock being converted.

(v) CERTAIN OPTIONS IN EXISTENCE IMMEDIATELY BEFORE AND AFTER AN OWNERSHIP CHANGE. If an option existed immediately before and after an ownership change occurring on a testing date to which section 1.382-2T(h)(4) applies --

(A) The option is not treated as exercised under paragraph (d)(2) of this section on any testing date after the change date and prior to a transfer of the option that would itself cause the option to satisfy the ownership test of paragraph (d)(3) of this section, the control test of paragraph (d)(4) of this section, or the income test of paragraph (d)(5) of this section; and

(B) Except as provided in section 1.382-2T(m)(4)(vi) (which relates to the effective date of the rules provided in section 1.382-2T(h)(4) and includes a special rule related to options that are actually exercised within 120 days after they are treated as exercised under that section), the actual exercise of the option, if by the person who owned the option immediately after the ownership change (or by a transferee of the option who acquired the option, directly or indirectly, from that person in one or more transfers described in paragraph (d)(11) of this section), will not contribute to an ownership change on any testing date on or after the date of exercise.

(vi) ELECTION TO APPLY SECTION 1.382-2T(h)(4) -- (A) IN GENERAL. If a loss corporation makes an election under this paragraph (h)(2)(vi), sections 1.382-2T(a)(2)(i) and (h)(4) (relating to testing dates and option attribution) apply (instead of the definition of testing date in section 1.382-2(a)(4) and paragraph (d) of this section) for the purpose of determining whether an ownership change occurs --

(1) On any testing date on or before May 17, 1994; or

(2) In the case of a loss corporation that is under the jurisdiction of a court in a title 11 or similar case filed on or before May 17, 1994, subject to section 1.382-9(o)(1), on any testing date at or before the time the plan of reorganization becomes effective.

(B) ADDITIONAL CONSEQUENCES OF ELECTION. If a loss corporation makes an election under this paragraph (h)(2)(vi) --

(1) In determining whether any convertible preferred stock issued by the loss corporation during the period that the election is in effect is treated as stock or as an option, the convertible preferred stock is treated as if it were issued on November 4, 1992, and

(2) The special effective date for the control test provided in paragraph (h)(2)(ii) of this section does not apply to any option with respect to stock of the loss corporation.

(C) TIME AND MANNER OF MAKING THE ELECTION. The election described in paragraph (h)(2)(vi)(A) of this section is made by attaching a statement to the loss corporation's income tax return for the first taxable year ending after November 4, 1992, in which a testing date (within the meaning of section 1.382-2T(a)(2)(i)) occurs, or if such return is filed on or before May 17, 1994, with its first return filed after May 17, 1994. However, a loss corporation that is under the jurisdiction of a court in a title 11 or similar case filed on or before May 17, 1994, may make the election described in paragraph (h)(2)(vi)(A) by attaching a statement to its tax return for its first taxable year ending after that date. The statement must say "THIS IS AN ELECTION UNDER SECTION 1.382-4(h)(2)(vi) TO APPLY SECTION 1.382-2T(h)(4) ON OR AFTER NOVEMBER 5, 1992." Any amended returns required by paragraph (h)(2)(vi)(D) of this section must accompany the return with which the election is made. An election under paragraph (h)(2)(vi)(A) of this section is irrevocable.

(D) AMENDED RETURNS. If an election under this paragraph (h)(2)(vi) affects the amount of taxable income or loss for a prior taxable year, the loss corporation (or the common parent of any consolidated group of which the loss corporation was a member for the year) must file an amended return for the year that reflects the effect of the election.

(3) SPECIAL RULE FOR OPTIONS SUBJECT TO ATTRIBUTION UNDER SECTION 1.382-2T(h)(4). Section 1.382-2T(h)(4)(i) does not apply to any option designated by the Internal Revenue Service in the Internal Revenue Bulletin as being excepted from the operation of section 1.382-2T(h)(4)(i).

Par. 6. Section 1.382-9(o)(1) is revised to read as follows:

SECTION 1.382-9. SPECIAL RULES UNDER SECTION 382 FOR CORPORATIONS UNDER THE JURISDICTION OF A COURT IN A TITLE 11 OR SIMILAR CASE.

* * * * *

(o) TREATMENT OF CERTAIN OPTIONS FOR OWNERSHIP CHANGE PURPOSES -- (1) Neither section 1.382-2T(h)(4)(i) nor section 1.382-4(d) (relating to the treatment of options as exercised) applies to the following options to acquire stock of a loss corporation reorganized pursuant to a plan of reorganization that is confirmed in a title 11 or similar case (within the meaning of section 368(a)(3)(A)) but only until the time the plan becomes effective --

(i) Any option created by the solicitation or receipt of acceptances to the plan;

(ii) The option created by the confirmation of the plan; and

(iii) Any option created under the plan.

* * * * *

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

Par. 7. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805

Par. 8. Section 602.101(c) is amended by adding the entry for "1.382-4" in the table to read as follows:

SECTION 602.101 OMB CONTROL NUMBERS.

* * * * *

(c) * * *

 CFR part or section where                              Current OMB