Diversification Requirements for Certain Defined Contribution Plans, 421-428 [E7-25533]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 2 (Thursday, January 3, 2008)]
[Proposed Rules]
[Pages 421-428]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-25533]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-136701-07]
RIN1545-BH04


Diversification Requirements for Certain Defined Contribution 
Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under section 
401(a)(35) of the Internal Revenue Code (Code) relating to 
diversification requirements for certain defined contribution plans and 
to publicly traded employer securities. These regulations will affect 
administrators of, employers maintaining, participants in, and 
beneficiaries of defined contribution plans that are invested in 
employer securities.

DATES: Written or electronic comments and requests for a public hearing 
must be received by April 2, 2008.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (Reg-136701-07), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (Reg-
136701-07), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically via the Federal 
eRulemaking Portal at https://www.regulations.gov (IRS REG-136701-07).

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, R. Lisa 
Mojiri-Azad or Dana Barry at (202) 622-6060; concerning submission of 
comments or to request a public hearing, Kelly Banks at (202) 622-7180 
(not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed regulations under section 
401(a)(35) of the Code, which was added by section

[[Page 422]]

901 of the Pension Protection Act of 2006, Public Law 109-280, 120 
Stat. 780 (PPA '06).\1\
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    \1\ Section 901 of PPA '06 also added a parallel provision at 
section 204(j) of the Employee Retirement Income Security Act of 
1974, Public Law 93-406, 88 Stat. 829 (ERISA). Under section 101 of 
Reorganization Plan No. 4 of 1978 (43 FR 47713), the Secretary of 
Treasury has interpretative jurisdiction over the subject matter 
addressed in these proposed regulations for purposes of section 
204(j) of ERISA. Thus, the guidance provided in these proposed 
regulations with respect to section 401(a)(35) of the Code also 
applies for purposes of section 204(j) of ERISA.
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    Section 401(a)(35)(A) provides that a trust which is part of an 
applicable defined contribution plan is not a qualified trust under 
section 401(a) unless the plan satisfies the diversification 
requirements of sections 401(a)(35)(B), (C), and (D). Under section 
401(a)(35)(B), each individual must have the right to direct the plan 
to divest employer securities allocated to the individual's account 
that are attributable to employee contributions or elective deferrals 
and to reinvest an equivalent amount in other investment options 
meeting the requirements of section 401(a)(35)(D).\2\
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    \2\ Section 401(a)(28) provides certain diversification rights 
to participants in an employee stock ownership plan within the 
meaning of section 4975(e)(7) (ESOP). Section 401(a)(28)(B) also 
generally requires that the plan offer at least three alternative 
investment options. Section 401(a)(28)(B) permits a plan to satisfy 
these diversification requirements by distributing, within 90 days 
after the period during which the election may be made, the portion 
of the participant's account that is subject to section 
401(a)(28)(B). Section 401(a)(28)(B) was amended by section 
901(a)(2)(A) of PPA '06 not to apply to a plan to which section 
401(a)(35) applies.
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    Under section 401(a)(35)(C), each individual who is a participant 
who has completed at least three years of service, a beneficiary of a 
participant who has completed at least three years of service, or a 
beneficiary of a deceased participant must be permitted to elect to 
direct the plan to divest employer securities allocated to the 
individual's account and to reinvest an equivalent amount in other 
investment options meeting the requirements of section 401(a)(35)(D).
    Section 401(a)(35)(D)(i) requires an applicable defined 
contribution plan to offer individuals not less than three investment 
options, other than employer securities, to which the individuals may 
direct the proceeds from the divestment of employer securities, each of 
which is diversified and has materially different risk and return 
characteristics.
    Under section 401(a)(35)(D)(ii)(I), a plan does not fail to meet 
the requirements of section 401(a)(35)(D) if it allows individuals to 
divest employer securities and reinvest the proceeds at periodic, 
reasonable opportunities occurring no less frequently than quarterly.
    Under section 401(a)(35)(D)(ii)(II), a plan is not permitted to 
impose restrictions or conditions with respect to the investment of 
employer securities that are not imposed on the investment of other 
assets of the plan. However, this rule does not apply to restrictions 
or conditions imposed to comply with securities laws. The Secretary is 
authorized to issue regulations providing additional exceptions to the 
requirements of section 401(a)(35)(D)(ii)(II).
    An applicable defined contribution plan under section 401(a)(35) is 
a defined contribution plan that holds any publicly traded employer 
securities. A publicly traded employer security is defined as an 
employer security under section 407(d)(1) of the Employee Retirement 
Income Security Act of 1974, Public Law 93-406, 88 Stat. 829 (ERISA) 
which is readily tradable on an established securities market. Section 
401(a)(35)(F)(i) provides that a plan that does not hold publicly 
traded employer securities is nevertheless treated as holding publicly 
traded employer securities if any employer corporation or any member of 
a controlled group of corporations which includes the employer 
(determined by applying section 1563(a), except substituting 50 percent 
for 80 percent) has issued a class of stock that is a publicly traded 
employer security. However, section 401(a)(35)(F) does not apply to a 
plan if no employer corporation, or parent corporation (as defined in 
section 424(e)) of an employer corporation, has issued any publicly 
traded employer security and no employer or parent corporation has 
issued any special class of stock which grants particular rights to, or 
bears particular risks for, the holder or issuer with respect to any 
corporation described in section 401(a)(35)(F)(i) which has issued any 
publicly traded employer security.
    Section 401(a)(35)(E) provides that section 401(a)(35) does not 
apply to an employee stock ownership plan within the meaning of section 
4975(e)(7) (ESOP) that holds no contributions (or earnings thereunder) 
that are subject to section 401(k) or (m) (generally relating to 
elective deferrals and matching and employee after-tax contributions) 
and the ESOP is a separate plan for purposes of section 414(l) with 
respect to any other defined benefit plan or defined contribution plan 
maintained by the same employer or employers. Section 401(a)(35)(E) 
further provides that section 401(a)(35) does not apply to one-
participant retirement plans.
    Section 401(a)(35) is generally effective for plan years beginning 
after December 31, 2006. Section 401(a)(35)(H) generally provides a 
three year phase-in rule with respect to an individual's right to 
direct the divestment of employer securities attributable to employer 
contributions, except with respect to certain participants who have 
attained age 55. Section 901(c)(2) of PPA '06 includes a special rule 
for a plan maintained pursuant to one or more collective bargaining 
agreements between employee representatives and one or more employers 
that was ratified on or before August 17, 2006. Under this rule, 
section 401(a)(35) is not effective until plan years beginning after 
the earlier of (1) the later of (a) December 31, 2007 or (b) the date 
on which the last of such collective bargaining agreements terminates 
(determined without regard to any extension thereof after August 17, 
2006) or (2) December 31, 2008.
    Notice 2006-107 (2006-2 CB 1114 (December 18, 2006)) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), includes guidance and 
transitional rules with respect to the diversification requirements of 
section 401(a)(35).\3\ Notice 2006-107 provides that a plan (and an 
investment option described in section 401(a)(35)(D)(i)) is not treated 
as holding employer securities to which section 401(a)(35) applies with 
respect to any securities held through either an investment company 
registered under the Investment Company Act of 1940 or a similar pooled 
investment vehicle that is regulated and subject to periodic 
examination by a State or Federal agency and with respect to which 
investment in securities is made both in accordance with the stated 
investment objectives of the investment vehicle and independent of the 
employer and any affiliate thereof, but only if the holdings of the 
investment company or similar investment vehicle are diversified so as 
to minimize the risk of large losses. Notice 2006-107 also provides 
that investment options satisfy the requirement that investment options 
be diversified and have materially different risk and return 
characteristics under section 401(a)(35)(D)(i) if the investment 
options satisfy the requirements of section 2550.404c-1(b)(3) of the 
Department of Labor regulations.
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    \3\ Notice 2006-107 also includes guidance regarding the related 
notice requirements of section 101(m) of ERISA, including a model 
notice.
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    Notice 2006-107 further provides that, for purposes of section 
401(a)(35), the date on which a participant completes three years of 
service occurs immediately after the end of the third

[[Page 423]]

vesting computation period provided for under the plan that constitutes 
the completion of a third year of service under section 411(a)(5). For 
a plan using the elapsed time method of crediting service for vesting 
purposes (or a plan that provides for immediate vesting without using a 
vesting computation period or elapsed time method of determining 
vesting), the date on which a participant completes three years of 
service is the third anniversary of the participant's date of hire.
    Notice 2006-107 includes special rules regarding restrictions or 
conditions with respect to employer securities under section 
401(a)(35)(D)(ii)(II). An impermissible restriction or condition is 
either a restriction on an individual's right to divest an investment 
in employer securities that is not imposed on an investment that is not 
in employer securities or a benefit that is conditioned on an 
investment in employer securities. Examples of restrictions or 
conditions that are prohibited by section 401(a)(35)(D)(ii)(II) under 
Notice 2006-107 include: (1) A plan allows an individual the right to 
divest employer securities on a quarterly basis but permits divestiture 
of another investment on a more frequent basis; (2) a plan provides 
that a participant who divests his or her account of employer 
securities receives less favorable treatment (such as a lower rate of 
matching contributions) than a participant whose account remains 
invested in employer securities; and (3) a plan that provides if a 
participant divests his or her account balance with respect to 
investment in a class of employer securities, the participant is not 
permitted for a period of time to reinvest in that class of securities 
where that restriction is not imposed on other investments. Notice 
2006-107 also provided examples of restrictions or conditions that are 
not prohibited by section 401(a)(35)(D)(ii)(II): (1) A provision that 
limits the extent to which an individual's account balance can be 
invested in employer securities; (2) a provision under which an 
employer securities fund is closed; (3) a restriction imposed by reason 
of application of securities laws or a restriction that is reasonably 
designed to ensure compliance with such laws; (4) an imposition of fees 
on other investment options under the plan but not on investments in 
employer securities; and (5) a plan restriction on the availability of 
otherwise applicable diversification rights under the plan for up to 90 
days following an initial public offering of the employer's stock.
    Notice 2006-107 provides certain transition rules. For example, for 
the period prior to January 1, 2008, a plan does not impose a 
restriction or condition prohibited by section 401(a)(35)(D)(ii)(II) 
merely because the plan, as in effect on December 18, 2006, (1) does 
not impose an otherwise applicable restriction on a stable value fund 
or (2) allows individuals the right to divest employer securities on a 
periodic basis (at least quarterly), but permits divestiture of another 
investment on a more frequent basis, provided that the other investment 
is not a generally available investment.

Explanation of Provisions

Overview

    The proposed regulations would provide guidance with respect to the 
requirements of section 401(a)(35) that incorporate much of the 
guidance provided under Notice 2006-107. The regulations would clarify 
the scope of the rule in section 401(a)(35)(D)(ii)(II) that generally 
prohibits restrictions and conditions on investment in employer 
securities, but would specifically permit certain restrictions and 
conditions on such investment that are consistent with the statute, and 
would also define when employer securities are publicly traded on an 
established securities market under section 401(a)(35)(D).

Basic Diversification Rights

    The proposed regulations incorporate the guidance on the basic 
diversification rights of section 401(a)(35) that is contained in 
Notice 2006-107. Thus, if an applicable defined contribution plan holds 
employee contributions (including rollover contributions) or elective 
deferrals with respect to an individual that are invested in employer 
securities, the plan must provide that the individual is given the 
opportunity to divest the employer securities and reinvest an 
equivalent amount in another investment. These rights must be provided 
to each participant, to each alternate payee who has an account under 
the plan, and to each beneficiary of a deceased participant.
    If employer contributions (other than elective deferrals) are 
invested in employer securities under the plan, the divestment right 
must be provided to each participant who has completed at least three 
years of service, to each alternate payee who has an account under the 
plan with respect to a participant who has at least three years of 
service, and to each beneficiary of a deceased participant (regardless 
of whether the participant had completed at least three years of 
service). For this purpose, the regulations would provide that a 
participant has completed three years of service on the last day of the 
vesting computation period as determined under the plan that 
constitutes the completion of the third year of service (or the third 
anniversary of hire for a plan that either uses the elapsed time method 
or that does not define the vesting computation period because the plan 
provides for full and immediate vesting).
    The regulations would require a plan to provide individuals who 
have section 401(a)(35) diversification rights the opportunity to 
divest the employer securities and reinvest an equivalent amount in 
another investment at least quarterly. The individuals must be 
permitted to select among no less than three investment options, each 
of which is diversified and has materially different risk and return 
characteristics. For this purpose, investment options that constitute a 
broad range of investment alternatives within the meaning of Department 
of Labor Regulations section 2550.404c-1(b)(3) are treated as being 
diversified and having materially different risk and return 
characteristics.

Plans Subject to Section 401(a)(35)

    Under the proposed regulations, a defined contribution plan, which 
holds publicly traded employer securities (referred to as an applicable 
defined contribution plan), is subject to the diversification 
requirements of section 401(a)(35), unless it is exempted under section 
401(a)(35)(E) as a stand-alone ESOP or as a one-participant retirement 
plan. For this purpose, an employer security is defined by reference to 
section 407(d)(1) of ERISA.
    Under section 401(a)(35)(G)(v), an employer security is a publicly 
traded employer security if it is readily tradable on an established 
securities market. The regulations would provide separate rules for 
securities traded on domestic securities exchanges and foreign 
securities exchanges.
    If a security is traded on a securities exchange that is registered 
under section 6 of the Securities Exchange Act of 1934, then the 
security would be deemed to be readily tradable on an established 
securities market. This definition is consistent with the definition of 
publicly traded found in Sec.  54.4975-7(b)(1)(iv), but deletes the 
reference to a system sponsored by the National Association of 
Securities Dealers (NASDAQ) registered under section 15A(b) of the Act 
(15 U.S.C. 78o) because NASDAQ is now registered as

[[Page 424]]

a securities exchange under section 6 of the Securities Exchange Act of 
1934. Thus, if a security is not traded on a national securities 
exchange that is registered under section 6 of the Securities Exchange 
Act of 1934, then the security would not be publicly traded for 
purposes of section 401(a)(35) (unless it is traded on a foreign 
securities exchange and has a ``ready market'' as described in the next 
paragraph). This would apply to U.S. securities that are only traded on 
the ``Over-The-Counter Bulletin Board'' and the ``pink sheets.''
    Under the proposed regulations, if a security is not listed on a 
securities exchange that is registered under section 6 of the 
Securities Exchange Act of 1934, but is traded on a foreign national 
securities exchange that is officially recognized, sanctioned, or 
supervised by a governmental authority, then under the proposed 
regulations, the security would be traded on an established securities 
market. The proposed regulations would provide that such a security is 
readily tradable if the security is deemed by the Securities and 
Exchange Commission (SEC) as having a ``ready market'' under SEC Rule 
15c3-1 (17 CFR 240.15c3-1).\4\
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    \4\ Under the current SEC rules, a security is deemed to have a 
ready market if it is included on the FTSE Group (FTSE) World Index.
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    The proposed regulations would reflect section 401(a)(35)(F), 
which, subject to certain exceptions, treats a plan holding employer 
securities that are not publicly traded as nonetheless subject to the 
rules of section 401(a)(35) if any employer sponsoring the plan, or any 
member of the controlled group of corporations (determined by applying 
section 1563(a), except substituting 50 percent for 80 percent) has 
issued a class of stock which is publicly traded (as defined above).
    Section 401(a)(35)(E)(ii) provides that an ESOP that is a separate 
plan holding no contributions that are subject to section 401(k) or 
section 401(m) is not an applicable defined contribution plan. (As 
noted earlier in this preamble, such a plan is subject to the 
diversification requirements of section 401(a)(28)(B).) The proposed 
regulations would clarify that a plan does not lose this exemption 
merely because it receives rollover contributions of amounts from 
another plan that are held in a separate account, even if those amounts 
were attributable to contributions that were subject to section 401(k) 
or 401(m) in the other plan. In addition, the proposed regulations 
would reflect the exemption for one-participant retirement plans under 
section 401(a)(35)(E)(iv).
    Notice 2006-107 provides that employer securities held by an 
investment company registered under the Investment Company Act of 1940 
or similar pooled investment vehicle are not treated as being held by 
the plan. Some comments on Notice 2006-107 had recommended a broader 
rule, under which a commingled fund that holds employer securities and 
other securities would not be treated as holding employer securities 
that are subject to the section 401(a)(35) diversification requirement. 
The proposed regulations would not adopt this broad exemption from the 
diversification rules.
    The proposed regulations, however, clarify the types of pooled 
investment vehicles that are exempt from the diversification 
requirements. Under the proposed regulations, in order to be exempt 
from the diversification requirements, the pooled investment vehicle 
must be a common or collective trust fund or pooled investment fund 
maintained by a bank or trust company supervised by a State or Federal 
agency, a pooled investment fund of an insurance company that is 
qualified to do business in a State, or an investment fund designated 
by the Commissioner in revenue rulings, notices, or other guidance 
published in the Internal Revenue Bulletin. As under Notice 2006-107, 
the regulations would include the requirement that in order to be 
exempt from the diversification requirements the pooled investment fund 
that holds the employer securities must have stated investment 
objectives and the investment must be independent of the employer and 
any affiliate thereof. The proposed regulations would add a percentage 
limitation rule to ensure that the investment in the employer 
securities through a pooled fund is not an attempt to evade the rules 
of section 401(a)(35). Under this rule, if the employer securities held 
by such fund is more than 10 percent of the total value of all of the 
fund's investment, then the fund is not considered to be independent of 
the employer.

Prohibition on Restrictions or Conditions

    The proposed regulations would provide that the section 
401(a)(35)(D)(ii)(II) prohibition on restrictions or conditions with 
respect to the investment of employer securities which are not imposed 
on the investment of other assets of the plans applies to a direct or 
indirect restriction on an individual's rights to divest an investment 
in employer securities that is not imposed on an investment that is not 
employer securities as well as a direct or indirect benefit that is 
conditioned on investment in employer securities. However, like Notice 
2006-107, the regulations would not apply this prohibition to 
restrictions that are imposed by reason of the application of 
securities laws and in certain other situations described below.
    Like Notice 2006-107, the proposed regulations would allow a plan 
to impose a restriction on divestiture that is reasonably designed to 
comply with securities law, even if the restriction is broader than the 
minimum restriction needed to comply with securities laws. The proposed 
regulations incorporate the example of such a restriction from Notice 
2006-107. This is merely an example and broader restrictions on 
divestiture are permitted, provided they are reasonably designed to 
comply with securities law. For example, in some smaller entities a 
broad restriction allowing divestiture to occur only once a quarter 
might be a restriction that is reasonably designed to comply with 
securities law.
    Notice 2006-107 includes a rule that permits a plan to restrict the 
otherwise applicable diversification rights under section 401(a)(35) 
for a period of up to 90 days following an initial public offering of 
the employer's stock. The proposed regulations would extend this rule 
to apply to the first 90 days after the plan becomes an applicable 
defined contribution plan. This could happen, for example, when some 
other entity in the controlled group first issues stock which is 
publicly traded or when a stand-alone ESOP first provides for 
contributions that are subject to section 401(k) or section 401(m).
    Notice 2006-107 permits a plan to impose a restriction on an 
investment in employer securities that is not imposed on a stable value 
fund. The proposed regulations extend this rule to a fund that is 
similar to a stable value fund. Specifically, the proposed regulations 
would provide that in the case of a plan that has several investment 
funds, including a fund invested in employer securities, a fund which 
is a stable value or similar fund, and other funds which are not 
invested in employer securities, the plan does not impose a restriction 
prohibited under section 401(a)(35)(D)(ii)(II) merely because the plan 
permits transfers to be made into the stable value or similar fund more 
frequently than into the fund invested in employer securities (assuming 
the plan does not impose a restriction on transfers to or from the 
employer securities fund that it does not impose with respect to the 
other funds).
    While the proposed regulations would generally prohibit indirect 
restrictions

[[Page 425]]

on an individual's exercise of diversification rights (such as a plan 
provision that limits the right of an individual who diversifies out of 
employer securities by providing that such a participant is not 
permitted to reinvest in employer securities for a period of time), the 
rules would permit certain indirect restrictions, as well as certain 
indirect benefits that are conditioned on investment in employer 
securities. Under the proposed regulations, a plan would be permitted 
to limit the extent to which an individual's account balance can be 
invested in employer securities. For example, a plan would not be 
treated as imposing a restriction that violates section 
401(a)(35)(D)(ii)(II) merely because the plan prohibits a participant 
from investing additional amounts in employer securities if more than 
10 percent of that participant's account balance is (or would be after 
the change) invested in employer securities. In addition, an applicable 
defined contribution plan does not violate a prohibition against 
reinvestment in employer securities if the plan has terminated any 
further investment in employer securities.
    The proposed regulations would provide that a plan is not providing 
an indirect benefit that is conditioned on investment in employer 
securities merely because the plan imposes fees on other investment 
options that are not imposed on the investment in employer securities. 
In addition, a plan is not providing a restriction on the right to 
divest an investment in employer securities merely because the plan 
imposes a reasonable fee for the divestment of employer securities.
    The proposed regulations would permit a restriction on the 
frequency of investment elections that was not in Notice 2006-107. 
Under this rule, a plan would be permitted to impose reasonable 
restrictions on the timing and number of investment elections that an 
individual can make to invest in employer securities, provided that the 
restrictions are designed to limit short-term trading in the employer 
securities. For example, a fund could limit the purchase of employer 
securities if there has been a sale within a short period of time, such 
as 7 days. The regulations, however, would not permit a plan to limit 
an individual's right to divest employer securities.

Proposed Effective Date

    Section 401(a)(35) is applicable to plan years beginning on or 
after January 1, 2007, subject to certain deferred effective dates and 
transition rules. The proposed regulations would provide guidance on 
these effective dates and transition rules. In particular, the 
regulations would provide that a plan is eligible for the deferred 
effective date applicable to collectively bargained plans only if at 
least 25 percent of the participants in the plan are members of 
collective bargaining units for which the contributions under the plan 
are specified under a collective bargaining agreement.
    The regulations under section 401(a)(35) are proposed to be 
effective for plan years beginning on or after January 1, 2009. Until 
the regulations go into effect, Notice 2006-107 will continue to apply. 
For this purpose, the transitional relief provided for the period prior 
to January 1, 2008, in paragraph 4 of Section III.D. of Notice 2006-107 
will continue to apply after 2007 until the regulations go into 
effect.\5\ In addition, plans are also permitted to apply the proposed 
regulations for plan years before the regulations go into effect.
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    \5\ The Treasury and IRS are issuing a notice to reflect this 
extension. The notice is expected to be published as Notice 2008-7 
in the 2008-3 issue of the IRB on january 22, 2008 (see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
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Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and, because 
Sec.  1.401(a)(35)-1 would not impose a collection of information on 
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
does not apply. Pursuant to section 7805(f) of the Code, this notice of 
proposed rulemaking will be submitted to the Chief Counsel for Advocacy 
of the Small Business Administration for comment on its impact on small 
business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (one signed and eight (8) 
copies) or electronic comments that are submitted timely to the IRS. 
The IRS and the Treasury Department specifically request comments on 
the clarity of the proposed regulations and how they can be made easier 
to understand.
    In particular, the IRS and the Treasury Department request comments 
on whether the determination of when an employer security is readily 
tradable on an established securities market under these proposed 
regulations should also be applied for purposes of determining whether 
an employer security is readily tradable on an established securities 
market in applying other provisions relating to qualified plans, given 
that the same words used in interrelated provisions of the Code are 
presumed to have the same meaning. These interrelated provisions 
include section 401(a)(28)(C) (requiring the use of an independent 
appraiser for valuation of employer securities that are not readily 
tradable on an established securities market), section 409(h)(1)(B) 
(relating to put options for employer securities that are not readily 
tradable on an established market), the definition of employer 
securities under section 409(l)(1) (including regulations under section 
4975), and the special rules under section 1042 (providing 
nonrecognition treatment for certain sales to an ESOP).
    All comments will be available for public inspection and copying. A 
public hearing will be scheduled if requested in writing by any person 
who timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place of the public hearing will be 
published in the Federal Register.

Drafting Information

    The principal authors of these regulations are Dana A. Barry and 
Lisa Mojiri-Azad, Office of Division Counsel/Associate Chief Counsel 
(Tax Exempt and Government Entities). However, other personnel from the 
IRS and the Treasury participated in the development of these 
regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.401(a)(35)-1 is also issued under 26 U.S.C. 
401(a)(35).* * *

    Par. 2. Section 1.401(a)(35)-1 is added to read as follows:

[[Page 426]]

Sec.  1.401(a)(35)-1  Diversification Requirements for Certain Defined 
Contribution Plans.

    (a) General rule--(1) Diversification requirements. Section 
401(a)(35) imposes diversification requirements on applicable defined 
contribution plans. A trust that is part of an applicable defined 
contribution plan is not a qualified trust under section 401(a) unless 
the plan--
    (i) Satisfies the diversification election requirements for 
elective deferrals and employee contributions set forth in paragraph 
(b) of this section;
    (ii) Satisfies the diversification election requirements for 
employer nonelective contributions set forth in paragraph (c) of this 
section;
    (iii) Satisfies the investment option requirement set forth in 
paragraph (d) of this section; and
    (iv) Does not apply any restrictions or conditions on investments 
in employer securities that violate the requirements of paragraph (e) 
of this section.
    (2) Definitions, effective dates, and transition rules. The 
definitions of applicable defined contribution plan, employer security, 
parent corporation, and publicly traded are set forth in paragraph (f) 
of this section. Effective/applicability dates and transition rules are 
set forth in paragraph (g) of this section.
    (b) Diversification requirements for elective deferrals and 
employee contributions invested in employer securities--(1) General 
rule. With respect to any individual described in paragraph (b)(2) of 
this section, if any portion of the individual's account under an 
applicable defined contribution plan attributable to elective deferrals 
(as described in section 402(g)(3)(A)), after-tax employee 
contributions, or rollover contributions is invested in employer 
securities, then the plan satisfies the requirements of this paragraph 
(b) if the individual may elect to divest those employer securities and 
reinvest an equivalent amount in other investment options. The plan may 
limit the time for divestment and reinvestment to periodic, reasonable 
opportunities occurring no less frequently than quarterly.
    (2) Applicable individual with respect to elective deferrals and 
employee contributions. An individual is described in this paragraph 
(b)(2) if the individual is--
    (i) A participant;
    (ii) An alternate payee who has an account under the plan; or
    (iii) A beneficiary of a deceased participant.
    (c) Diversification requirements for employer nonelective 
contributions invested in employer securities--(1) General rule. With 
respect to any individual described in paragraph (c)(2) of this 
section, if a portion of the individual's account under an applicable 
defined contribution plan attributable to employer nonelective 
contributions, other than elective deferrals, is invested in employer 
securities, then the plan satisfies the requirements of this paragraph 
(c) if the individual may elect to divest those employer securities and 
reinvest an equivalent amount in other investment options. The plan may 
limit the time for divestment and reinvestment to periodic, reasonable 
opportunities occurring no less frequently than quarterly.
    (2) Applicable individual with respect to employer nonelective 
contributions. An individual is described in this paragraph (c)(2) if 
the individual is--
    (i) A participant who has completed at least three years of 
service;
    (ii) An alternate payee who has an account under the plan with 
respect to a participant who has completed at least three years of 
service; or
    (iii) A beneficiary of a deceased participant.
    (3) Completion of 3 years of service. For purposes of paragraph 
(c)(2) of this section, a participant completes three years of service 
on the last day of the vesting computation period provided for under 
the plan that constitutes the completion of the third year of service 
under section 411(a)(5). However, for a plan that uses the elapsed time 
method of crediting service for vesting purposes (or a plan that 
provides for immediate vesting without using a vesting computation 
period or the elapsed time method of determining vesting), a 
participant completes three years of service on the day immediately 
preceding the third anniversary of the participant's date of hire.
    (d) Investment option. An applicable defined contribution plan must 
offer not less than three investment options, other than employer 
securities, to which an individual who has the right to divest under 
paragraph (b)(1) or (c)(1) of this section may direct the proceeds from 
the divestment of employer securities. Each of the three investment 
options must be diversified and have materially different risk and 
return characteristics. For this purpose, investment options that 
constitute a broad range of investment alternatives within the meaning 
of Department of Labor Regulation section 2550.404c-1(b)(3) are treated 
as being diversified and having materially different risk and return 
characteristics.
    (e) Restrictions or conditions on investments in employer 
securities--(1) Impermissible restrictions or conditions--(i) General 
rule. Except as provided in paragraph (e)(2) of this section, an 
applicable defined contribution plan violates the requirements of this 
paragraph (e) if the plan imposes restrictions or conditions with 
respect to the investment of employer securities that are not imposed 
on the investment of other assets of the plan. A restriction or 
condition with respect to employer securities means--
    (A) A restriction on an individual's right to divest an investment 
in employer securities that is not imposed on an investment that is not 
employer securities; and
    (B) A benefit that is conditioned on investment in employer 
securities.
    (ii) Indirect restrictions or conditions. Except as provided in 
paragraph (e)(3) of this section, a plan violates the requirements of 
this paragraph (e) if the plan imposes a restriction or condition in 
paragraph (e)(1)(i)(A) or (B) of this section either directly or 
indirectly. For example, a plan imposes an indirect restriction on an 
individual's right to divest an investment in employer securities if 
the plan provides that a participant who divests his or her account 
balance with respect to investment in employer securities is not 
permitted for a period of time thereafter to reinvest in employer 
securities.
    (2) Permitted restrictions or conditions--(i) In general. An 
applicable defined contribution plan does not violate the requirements 
of this paragraph (e) merely because it imposes a restriction or a 
condition set forth in paragraph (e)(2)(ii) or (e)(2)(iii) of this 
section.
    (ii) Securities laws. A plan is permitted to impose a restriction 
or condition on the divestiture of employer securities that is either 
required in order to ensure compliance with applicable securities laws 
or is reasonably designed to ensure compliance with applicable 
securities laws. For example, it is permissible for a plan to limit 
divestiture rights for participants who are subject to section 16(b) of 
the Securities Exchange Act of 1934 to a reasonable period (such as 3 
to 12 days) following publication of the employer's quarterly earnings 
statements because it is reasonably designed to ensure compliance with 
Rule 10b-5 of the Securities and Exchange Commission.
    (iii) Deferred application of the diversification requirements. An 
applicable defined contribution plan is permitted to restrict the 
application of the diversification requirements of

[[Page 427]]

section 401(a)(35) and this section for up to 90 days after the plan 
becomes an applicable defined contribution plan (for example, the date 
on which the employer securities held under the plan become publicly 
traded).
    (3) Permitted indirect restrictions or conditions--(i) In general. 
An applicable defined contribution plan does not violate the 
requirements of this paragraph (e) merely because it imposes an 
indirect restriction or condition set forth in paragraphs (e)(3)(ii) 
through (e)(3)(v) of this section.
    (ii) Limitation on investment in employer securities. The plan is 
permitted to limit the extent to which an individual's account balance 
can be invested in employer securities, provided the limitation applies 
without regard to a prior exercise of rights to divest employer 
securities. For example, a plan does not impose a restriction that 
violates this paragraph (e) merely because the plan prohibits a 
participant from investing additional amounts in employer securities if 
more than 10 percent of that participant's account balance is invested 
in employer securities.
    (iii) Trading frequency. A plan is permitted to impose reasonable 
restrictions on the timing and number of investment elections that an 
individual can make to invest in employer securities, provided that the 
restrictions are designed to limit short-term trading in the employer 
securities. For example, a plan could provide that a participant may 
not elect to invest in employer securities if the employee has elected 
to divest employer securities within a short period of time, such as 
seven days.
    (iv) Frozen funds. A plan is permitted to prohibit any further 
investment in employer securities.
    (v) Fees. The plan has not provided an indirect benefit that is 
conditioned on investment in employer securities merely because the 
plan imposes fees on other investment options that are not imposed on 
the investment in employer securities. In addition, the plan has not 
provided a restriction on the right to divest an investment in employer 
securities merely because the plan imposes a reasonable fee for the 
divestment of employer securities.
    (vi) Transfers to stable value fund. In the case of a plan that has 
several investment funds, including one or more funds invested in 
employer securities, a fund which is a stable value or similar fund, 
and other funds which are not invested in employer securities, the plan 
does not impose a restriction prohibited under this paragraph (e) 
merely because the plan permits transfers to be made into the stable 
value or similar fund more frequently than other funds (including funds 
invested in employer securities).
    (f) Definitions--(1) Application of definitions. This paragraph (f) 
contains definitions that are applicable for purposes of this section.
    (2) Applicable defined contribution plan--(i) General rule. Except 
as provided in this paragraph (f)(2), an applicable defined 
contribution plan means any defined contribution plan which holds 
employer securities that are publicly traded. See paragraph (f)(2)(iv) 
of this section for a special rule that treats certain plans that hold 
employer securities that are not publicly traded as applicable defined 
contribution plans and paragraph (f)(3)(ii) of this section for a 
special rule that treats certain plans as not holding publicly traded 
employer securities for purposes of this section.
    (ii) Exception for certain ESOPs. An employee stock ownership plan 
(ESOP), as defined in section 4975(e)(7), is not an applicable defined 
contribution plan if the plan is a separate plan for purposes of 
section 414(l) with respect to any other defined benefit plan or 
defined contribution plan maintained by the same employer or employers 
and holds no contributions (or earnings thereunder) that are (or were 
ever) subject to section 401(k) or 401(m). Thus, an employee stock 
ownership plan is an applicable defined contribution plan if that ESOP 
is a portion of a larger plan (whether or not that larger plan includes 
contributions that are subject to section 401(k) or 401(m)). For 
purposes of this paragraph (f)(2)(ii), a plan is not considered to hold 
amounts ever subject to section 401(k) or 401(m) merely because the 
plan holds amounts attributable to rollover amounts in a separate 
account that were previously subject to section 401(k) or 401(m).
    (iii) Exception for one-participant plans. A one-participant plan, 
as defined in section 401(a)(35)(E)(iv), is not an applicable defined 
contribution plan.
    (iv) Certain defined contribution plans treated as holding publicly 
traded employer securities--(A) General rule. A defined contribution 
plan holding employer securities that are not publicly traded is 
treated as an applicable defined contribution plan if any employer 
maintaining the plan or any member of a controlled group of 
corporations that includes such employer has issued a class of stock 
which is publicly traded. For purposes of this paragraph (f)(2)(iv), a 
controlled group of corporation has the meaning given such term by 
section 1563(a), except that ``50 percent'' is substituted for ``80 
percent'' each place it appears.
    (B) Exception for certain plans. Paragraph (f)(2)(iv)(A) of this 
section does not apply to a plan if--
    (1) No employer maintaining the plan (or a parent corporation with 
respect to such employer) has issued stock that is publicly traded; and
    (2) No employer maintaining the plan (or parent corporation with 
respect to such employer) has issued any special class of stock which 
grants to the holder or issuer particular rights, or bears particular 
risks for the holder or issuer, with respect to any employer 
maintaining the plan (or any member of a controlled group of 
corporations that includes such employer) which has issued any stock 
that is publicly traded.
    (3) Employer security--(i) General rule. Employer security has the 
meaning given such term by section 407(d)(1) of the Employee Retirement 
Income Security Act of 1974, as amended.
    (ii) Certain defined contribution plans or investment funds not 
treated as holding employer securities--(A) Exception for certain flow-
through investments. Subject to paragraph (f)(3)(ii)(B) and (C) of this 
section, a plan (and an investment option described in paragraph (d) of 
this section) is not treated as holding employer securities for 
purposes of this section to the extent the employer securities are held 
indirectly through--
    (1) An investment company registered under the Investment Company 
Act of 1940;
    (2) A common or collective trust fund or pooled investment fund 
maintained by a bank or trust company supervised by a State or a 
Federal agency;
    (3) A pooled investment fund of an insurance company that is 
qualified to do business in a State; or
    (4) Any other investment fund designated by the Commissioner in 
revenue rulings, notices, or other guidance published in the Internal 
Revenue Bulletin.
    (B) Investment must be independent. The exception set forth in 
paragraph (f)(3)(ii)(A) of this section applies only if the investment 
in the employer securities are held in a fund under which--
    (1) There are stated investment objectives of the fund; and
    (2) The investment is independent of the employer and any affiliate 
thereof.
    (C) Percentage limitation rule. For purposes of paragraph 
(f)(3)(ii)(B)(2) of this section, an investment in employer securities 
in a fund is considered to be independent of the employer and any 
affiliate thereof only if the aggregate value of the employer 
securities held in

[[Page 428]]

the fund is not in excess of 10 percent of the total value of all of 
the fund's investments.
    (4) Parent corporation. Parent corporation has the meaning given 
such term by section 424(e).
    (5) Publicly traded--(i) In general. A security is publicly traded 
if it is readily tradable on an established securities market.
    (ii) Established securities market. For purposes of this paragraph 
(f)(5), a security is traded on an established securities market if--
    (A) The security is traded on a national securities exchange that 
is registered under section 6 of the Securities and Exchange Act of 
1934 (15 U.S.C. 78f); or
    (B) The security is traded on a foreign national securities 
exchange that is officially recognized, sanctioned, or supervised by a 
governmental authority.
    (iii) Readily tradable. For purposes of this paragraph (f)(5), 
except as provided by the Commissioner in revenue rulings, notices, or 
other guidance published in the Internal Revenue Bulletin, a security 
is readily tradable if--
    (A) The security is traded on a securities exchange that is 
described in paragraph (f)(5)(ii)(A) of this section; or
    (B) The security is traded on a securities exchange that is 
described in paragraph (f)(5)(ii)(B) of this section and the security 
is deemed by the Securities and Exchange Commission (SEC) as having a 
``ready market'' under SEC Rule 15c3-1 (17 CFR 240.15c3-1).
    (g) Effective date and transition rules--(1) Statutory effective 
date--(i) General rule. Except as otherwise provided in this paragraph 
(g), section 401(a)(35) is effective for plan years beginning after 
December 31, 2006.
    (ii) Collectively bargained plans--(A) Delayed effective date. In 
the case of a plan maintained pursuant to one or more collective 
bargaining agreements between employee representatives and one or more 
employers ratified on or before August 17, 2006, section 401(a)(35) is 
effective for plan years beginning after the earlier of
    (1) the later of--
    (i) December 31, 2007; or
    (ii) the date on which the last such collective bargaining 
agreement terminates (determined without regard to any extension 
thereof); or
    (2) December 31, 2008.
    (B) Definition of collectively bargained plans. For purposes of 
this paragraph (g)(1)(ii), in the case of a plan for which one or more 
collective bargaining agreements apply to some, but not all, of the 
plan participants, the plan is considered a collectively bargained plan 
if at least 25 percent of the participants in the plan are members of 
collective bargaining units for which the contributions under the plan 
are specified under a collective bargaining agreement.
    (iii) Special rule for certain employer securities held in an ESOP. 
Section 901(c)(3)(A) and (B) of the Pension Protection Act of 2006, 
Public Law 109-280, 120 Stat. 780 (PPA '06), provides a special 
effective date for an employee stock ownership plan that holds a class 
of preferred stock with a guaranteed minimum value, as described in 
that section.
    (2) Statutory transition rules--(i) General rule. Pursuant to 
section 401(a)(35)(H), in the case of the portion of an account to 
which paragraph (c) of this section applies and that consists of 
employer securities acquired in a plan year beginning before January 1, 
2007, the requirements of paragraph (c) of this section only apply to 
the applicable percentage of such securities.
    (ii) Applicable percentage--(A) Phase-in percentage. For purposes 
of this paragraph (g)(2), the applicable percentage is determined as 
follows--

------------------------------------------------------------------------
                                                                  The
                                                              applicable
  Plan year to which paragraph (c) of this section applies:   percentage
                                                                  is:
------------------------------------------------------------------------
1st.........................................................          33
2nd.........................................................          66
3rd and following...........................................         100
------------------------------------------------------------------------

    (B) Special rule. For a plan described in paragraph (g)(1)(iii) of 
this section for which the special effective date under section 
901(c)(3) of PPA '06 applies, the applicable percentage under this 
paragraph (g)(2)(ii) is determined without regard to the delayed 
effective date in section 901(c)(3)(A) and (B) of PPA '06.
    (iii) Nonapplication for participants age 55 with three years of 
service. Paragraph (g)(2)(i) of this section does not apply to an 
individual who is a participant who attained age 55 and had completed 
at least three years of service (as defined in paragraph (c)(3) of this 
section) before the first day of the first plan year beginning after 
December 31, 2005.
    (iv) Separate application by class of securities. This paragraph 
(g)(2) applies separately with respect to each class of securities.
    (3) Regulatory effective date. This section is effective for plan 
years beginning on or after January 1, 2009.

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E7-25533 Filed 1-2-08; 8:45 am]
BILLING CODE 4830-01-P