[Federal Register Volume 61, Number 250 (Friday, December 27, 1996)]
[Proposed Rules]
[Pages 68175-68184]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32670]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209817-96]
RIN 1545-AU19


Treatment of Obligation-Shifting Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
treatment of certain multiple-party financing transactions in which one 
party realizes income from leases or similar agreements and another 
party claims deductions related to that income. In order to prevent tax 
avoidance, the proposed regulations recharacterize these transactions 
in a manner that clearly reflects income. The proposed regulations 
affect only persons that engage in these transactions. The regulations 
generally do not apply to routine transactions lacking characteristics 
of tax avoidance. This document also provides notice of a public 
hearing on the proposed regulations.

DATES: Written comments, requests to appear, and outlines of topics to 
be discussed at the public hearing scheduled for April 29, 1997, at 10 
a.m. must be received by April 8, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209817-96), Room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209817-96), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue NW, 
Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option of 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in the IRS Auditorium, 
Internal Revenue Building,

[[Page 68176]]

7th Floor, 1111 Constitution Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jonathan Zelnik at (202) 622-3940; concerning submissions and the 
hearing, Christina Vasquez at (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC 
20224. Comments on the collection of information should be received by 
April 8, 1997. Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the collection will have a practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collection of information is in Sec. 1.7701(l)-2(j). This 
information is required by the IRS to verify pass-through entity 
compliance with Sec. 1.7701(l)-2. This information will be used to 
determine whether the amount of tax has been computed correctly. The 
collection of information is mandatory. The likely recordkeepers are 
businesses and other organizations. Estimated total annual 
recordkeeping burden: 500 hours. Estimated average annual burden per 
recordkeeper: 5 hours. Estimated number of recordkeepers: 100.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax information are confidential, as required by 26 U.S.C. 6103.

Background

    The IRS and Treasury Department have become aware of multiple-party 
financing transactions (``stripping transactions'') intended to allow 
one party to realize income from a lease or similar agreement and to 
allow another party to report deductions related to that income (for 
example, cost recovery or rental expenses). Notice 95-53, 1995-2 C.B. 
334, describes several examples of these transactions, including 
transferred basis transactions, transfers of partnership interests, and 
variations involving licenses, service contracts, and prepayment, 
front-loading, and retention of rights to receive future payments.
    Notice 95-53 states the position of the IRS that the claimed tax 
treatment of these transactions improperly separates income from 
related deductions and that the transactions do not produce the tax 
consequences desired by the parties. The notice also states that 
regulations will be issued under section 7701(l) of the Internal 
Revenue Code recharacterizing stripping transactions any significant 
element of which is entered into or undertaken on or after October 13, 
1995. The notice requested comments regarding those regulations.
    The IRS received only one set of comments in response to Notice 95-
53. Those comments recommended that the regulations under section 
7701(l) address a broader class of transactions than was described in 
the notice. Specifically, they recommended that the regulations defer 
the recognition of income in circumstances where there is an advance 
receipt or assignment of future income and there is the potential for 
the transactions to become stripping transactions. They also 
recommended that the regulations recharacterize these transactions 
without regard to whether there is a tax avoidance purpose. The 
comments reflected a desire for the regulations to produce an economic 
accrual of income and to enable taxpayers to determine the proper tax 
accounting for their transactions without regard to subsequent events.
    The proposed regulations generally follow the notice and do not 
expand the class of transactions subject to recharacterization. The 
regulations do not require taxpayers to make any assumptions as to 
subsequent events. They are intended to produce tax results that 
conform to the economic substance of the transactions that they 
address. Furthermore, the regulations generally apply to transactions 
whether or not the parties have a tax avoidance purpose.

Explanation of Provisions

1. General Approach

    Section 7701(l) authorizes the Secretary to ``prescribe regulations 
recharacterizing any multiple-party financing transaction as a 
transaction directly among any 2 or more of such parties where the 
Secretary determines that such recharacterization is appropriate to 
prevent avoidance of any tax imposed by [the Internal Revenue Code].'' 
The proposed regulations recharacterize transactions in which the 
transferee (``the assuming party'') assumes obligations or acquires 
property subject to obligations under an existing lease or similar 
agreement and the transferor (``the property provider'') or any other 
party has already received or retains the right to receive amounts that 
are allocable to periods after the transfer. The recharacterization 
reflects the general principle that a taxpayer who is treated for 
federal income tax purposes as the owner of rental property must 
recognize income that accrues during its period of ownership. , e.g., 
Steinway & Sons v. Commissioner, 46 T.C. 375 (1966), acq., 1967-2 C.B. 
3; Alstores Realty Corp. v. Commissioner, 46 T.C. 363 (1966), acq., 
1967-2 C.B. 1.
    For the period in which an assuming party in such a transaction is 
a party to the lease or similar agreement, the recharacterization 
requires the assuming party to report income on a level-rent basis 
calculated using the rules of the constant rental accrual method 
described in Sec. 1.467-3(d) as proposed on June 3, 1996 (IA-292-84, 61 
FR 27834, 27844). Thus, the assuming party is required to recognize 
rental income for the period in which it owns the property or leasehold 
interest. In addition, the transaction is recharacterized to include 
additional consideration in the form of a note provided by the assuming 
party to the property provider for the transfer of the property, 
resulting in interest income and expense for which the parties must 
account as appropriate. The property provider also must adjust its 
income for any differences between amounts it recognized and amounts it 
would have recognized if it had reported income on a level-rent basis 
for the periods that it owned the property or leasehold

[[Page 68177]]

interest. Finally, to account for any differences in timing or amount 
between payments the property provider actually receives after the 
transaction and payments treated as being made to the property provider 
under the note from the assuming party, the property provider is 
treated as an obligor or obligee under a second loan, for which the 
property provider must account accordingly.

2. Obligation-shifting Tsransactions

    The proposed regulations are not intended to recharacterize 
transactions with little potential for tax avoidance. Taken together, 
the definition of ``obligation-shifting transaction'' and the 
enumerated exceptions limit the scope of the regulations to 
transactions that are not routine and that involve shifting of 
substantial amounts of income away from the taxpayer that recognizes 
deductions related to the income.
    The proposed regulations apply to obligation-shifting transactions, 
which are defined as any transaction in which an assuming party assumes 
a property provider's obligations to a property user (or acquires 
property subject to a property provider's obligations to a property 
user) under a lease or similar agreement if the property provider or 
any other party has already received, or retains the right to receive, 
amounts that are allocable to periods after the transaction. The 
regulations define obligations under a lease or similar agreement as 
including a continuing obligation to make property available to the 
lessee or the ultimate user of the property. These obligations 
typically give rise to deductions, such as for cost recovery or, in the 
case of a master-lease/sublease arrangement, for payments under a 
master lease. The advance receipt of amounts that are allocable to 
periods after the obligation- shifting transaction often results in 
accelerated taxable income for the recipient. Thus, the definition 
describes transactions in which there is the potential for one party to 
recognize income but a different party to recognize deductions 
associated with that income.
    In some transactions identified in Notice 95-53, one party sells, 
assigns, or otherwise transfers to a third party the right to receive 
future payments under a lease and includes as current income the amount 
received as consideration for the transfer. The underlying property 
(subject to the lease) is later transferred in a transaction intended 
to qualify as a transferred basis transaction. These transactions are 
within the scope of the regulations because the property transferee 
assumes obligations or acquires the property subject to the obligation 
to make the property available to the lessee and the property 
transferor already received amounts that are allocable to periods after 
the transaction by reason of the assignment of rights to receive future 
payments. In other transactions, the property transferor does not 
assign the right to future rental amounts but instead receives 
prepayment from the lessee or retains the right to receive future 
amounts over time. Both variations likewise are within the scope of the 
regulations.
    The proposed regulations adopt an aggregate view of partnerships, 
treating each partner as having a proportionate share of the rights and 
obligations of the partnership. Thus, for example, if a partnership 
assigns its right to receive future amounts under a lease and allocates 
to its current partners the amount recognized, a later transfer of a 
partnership interest is an obligation-shifting transaction because the 
transferee partner assumes an allocable share of the partnership's 
obligation to make the property available to the lessee and because the 
transferor partner is treated as having already received amounts that 
are allocable to periods after the transaction. See Example 3 of the 
proposed regulations. In appropriate cases, the IRS may assert other 
authorities to prevent the use of a partnership to effect an improper 
separation of income from related deductions. See, e.g., Sec. 1.701-
2(d) (Example 7).
    The proposed regulations also generally treat an obligation-
shifting transaction as occurring if a subsidiary that is a member of a 
consolidated group becomes a nonmember at a time when the subsidiary 
has received payments under a lease or similar agreement that are 
allocable to periods after the transaction.

3. Lease or Similar Agreement

    Under the proposed regulations, an obligation-shifting transaction 
involves a lease or similar agreement. The regulations define this term 
broadly to include any contract for the use or enjoyment of tangible or 
intangible property, including leaseholds, licenses, other non-fee 
interests in property, and other contracts (including service 
contracts) involving the use or enjoyment of property if the value of 
that use or enjoyment is more than de minimis. The proposed 
regulations, therefore, do not apply to service contracts that do not 
involve the use or enjoyment of property. The definition of obligation-
shifting transaction, however, does not restrict the IRS's ability to 
challenge these transactions under other authorities. For instance, 
even if a transaction is not within the scope of the proposed 
regulation, the IRS may challenge it under one or more of the 
authorities identified in Notice 95-53.
    The IRS requests comments on whether additional guidance is needed 
on the definition of lease or similar agreement.

4. Exceptions

    The proposed regulations are not intended to recharacterize 
otherwise routine transactions, such as the incorporation of an entire 
line of business that does not involve significant shifting of income 
and deductions. See Rev. Rul. 80-198, 1980-2 C.B. 113, subject to the 
limitations described therein. Accordingly, the regulations provide a 
number of objective exceptions that generally will protect routine 
transactions from recharacterization. The regulations do not apply to 
transactions in which the amounts that are allocable to future periods 
but are not transferred are less than or equal to $100,000. The 
regulations do not apply to transactions in which total payments 
(including the aggregate expected future value of all contingent 
consideration) under the lease or similar agreement are not reasonably 
expected to exceed $250,000. The regulations do not apply to 
transactions in which the fair market value of the property that is 
subject to the lease or similar agreement and is transferred in the 
obligation-shifting transaction, plus the value of the amounts that are 
already received or retained by the property provider but are allocable 
to periods after the obligation-shifting transaction, is less than ten 
percent of the total assets (other than Class I and Class II assets as 
described in Sec. 1.1060-1T(d) and debt issued by the property 
provider) transferred by the property provider in the transaction. The 
regulations do not apply to transactions in which the lease or similar 
agreement is a disqualified leaseback or long-term agreement within the 
meaning of Sec. 1.467-3(b). The regulations do not apply to 
transactions described in section 381(a), unless the transaction is 
deemed to be an obligation-shifting transaction under proposed 
Sec. 1.7701(l)-2(k). Finally, the regulations provide that a 
transaction is exempt from recharacterization if the parties to the 
transaction establish to the satisfaction of the Commissioner that the 
transaction does not present a significant potential for tax avoidance.
    Because the purpose of recharacterization under section 7701(l) is 
to prevent tax avoidance, these objective exceptions are unavailable 
for

[[Page 68178]]

transactions entered into with a principal purpose of substantially 
reducing the present value of the aggregate tax liability of the 
property provider, the assuming party, and any other party whose 
taxable income is determined by reference to the taxable income of the 
property provider or the assuming party.

5. Recharacterization

    The proposed regulations recharacterize an obligation- shifting 
transaction in order to ensure that the property provider and the 
assuming party both report the income from the underlying property 
allocable to their respective periods of ownership.
    For purposes of determining the amounts that are allocable to 
periods under the lease or similar agreement, the proposed regulations 
apply a rent-leveling process based on the constant rental accrual 
method described in Sec. 1.467-3(d) to all amounts that are treated as 
payable under the lease or similar agreement. At the time of the 
obligation-shifting transaction, the level rental amount is determined 
for the entire term of the lease or similar agreement using 110 percent 
of the applicable Federal rate based on that term. The amounts that are 
treated as payable under the lease or similar agreement at the time of 
the obligation-shifting transaction are the amounts that have already 
been paid to the property provider and the future amounts that, 
immediately before the obligation-shifting transaction, are payable to 
the property provider. Thus, if the property provider assigns the right 
to receive payments to a third party in exchange for consideration, the 
consideration is treated as an amount received under the lease or 
similar agreement. Because the property provider no longer has the 
right to receive the payments assigned to the third party, those 
payments (whether past or future) are not treated as amounts that are 
payable to the property provider for purposes of calculating the level 
rental amount.
    The proposed regulations recharacterize an obligation- shifting 
transaction by treating the assuming party and the property provider as 
follows:
    The assuming party is treated as acquiring the right to receive all 
amounts that are allocable to periods after the obligation-shifting 
transaction. The assuming party includes these amounts in income for 
the periods that it owns the property.
    To reflect the amounts that the assuming party is treated as 
receiving under the recharacterization but that it does not actually 
receive, the assuming party also is treated as providing additional 
consideration to the property provider in the form of a note (a 
``section 7701(l) note''). The original principal balance of the 
section 7701(l) note equals the excess of the present value of the 
amounts that are allocable to periods after the obligation-shifting 
transaction over the present value of the amounts that are payable to 
the assuming party.
    The property provider must adjust its income to the extent that it 
accounted for income under the lease or similar agreement before the 
obligation-shifting transaction in a manner inconsistent with the 
level-rent method described above. The adjustment, which can increase 
or decrease the property provider's income, equals the principal 
balance of the section 467 loan that would have existed if the property 
provider had been using the constant rental accrual method to account 
for amounts under the lease or similar agreement that are allocable to 
periods before the obligation-shifting transaction, reduced by any 
existing section 467 loan if the lease or similar agreement is a 
section 467 rental agreement. The constant rental amount is calculated 
using the amounts that are treated as payable under the lease or 
similar agreement.
    Finally, to account for any differences in timing or amount between 
payments the property provider actually receives after the obligation-
shifting transaction and payments treated as being made to the property 
provider under the section 7701(l) note, the property provider is 
treated as a party to a loan (a ``section 7701(l) rent-leveling 
loan''). The section 7701(l) rent-leveling loan is created at the time 
of the obligation-shifting transaction. Its balance at that time equals 
the section 467 loan that would have existed if the property provider 
had been using the constant rental accrual method to account for 
amounts under the lease or similar agreement that are allocable to 
periods before the obligation-shifting transaction. Thus, in the 
periods after the obligation-shifting transaction, the property 
provider must account for any interest expense or income resulting from 
the section 7701(l) rent-leveling loan, in addition to any interest 
income or expense resulting from the section 7701(l) note.
    Although section 467 may not apply to an obligation-shifting 
transaction, the effect of the proposed regulations is to 
recharacterize the transaction to produce the constant rental amount 
and associated loans that the parties would have been treated as having 
if the lease or similar agreement had been a section 467 rental 
agreement (modified to reflect the amounts already received or payable 
to the property provider immediately before the obligation-shifting 
transaction) and had been subject to the constant rental accrual 
method. Thus, the assuming party is treated as if it had purchased the 
property in part with a note, had obtained the right to receive rental 
amounts on the constant rental accrual method during its ownership of 
the property, and had used those amounts to service the note. For the 
property provider, the proposed regulations provide a 
recharacterization that is similar (but not identical) to the treatment 
required when a lessor disposes of property subject to a section 467 
rental agreement that was accounted for under the constant rental 
accrual method.
    The proposed regulations provide the exclusive recharacterization 
of an obligation-shifting transaction for a property provider and an 
assuming party. Thus, if an obligation-shifting transaction is 
recharacterized under this section and the lease or similar agreement 
is a section 467 rental agreement, the rules of this section supersede 
the rules of Secs. 1.467-1 through 1.467-8 as proposed on June 3, 1996 
(IA-292-84, 61 FR 27834) for the property provider (the transferor) and 
the assuming party (the transferee). The assuming party's income after 
the obligation-shifting transaction is determined under this section 
and not under Sec. 1.467-7(e)(1). Similarly, the rules provided in 
Sec. 1.467-7(e)(2) for determining the amount of the section 467 loan 
for the period after the transfer, the amount realized by the property 
provider, and the assuming party's basis in the property do not apply 
to obligation-shifting transactions recharacterized by this section.
    The recharacterization does not affect the property user or rent 
factor (if any), because, even though they are parties to the multiple-
party financing transaction, no adjustment to their treatment of the 
transaction is necessary to prevent the avoidance of tax. Cf. 
Sec. 1.881-3(a)(3)(ii)(A) (limiting purposes for which conduit 
financing arrangements are recharacterized). Thus, if the lease or 
similar agreement is a section 467 rental agreement, the property user 
must continue to take section 467 rent and section 467 interest into 
account without regard to the obligation-shifting transaction and the 
recharacterization under this section. See Sec. 1.467-7(e)(1).

6. Issues Not Addressed

    The proposed regulations do not address transactions in which a 
taxpayer assigns rights to future income

[[Page 68179]]

but does not transfer the underlying property to another taxpayer, 
except as provided in the special rules regarding pass-through entities 
and consolidated groups.

7. Proposed Effective Date

    Notice 95-53 states that the regulations under section 7701(l) will 
be effective ``with respect to stripping transactions any significant 
element of which is entered into or undertaken on or after October 13, 
1995.'' The regulations are proposed to adopt the effective date stated 
in the notice.

Special Analyses

    It is hereby certified that these regulations do not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the understanding of the IRS that the 
total number of entities engaging in transactions affected by these 
regulations is not substantial and, of those entities, most are not 
small entities within the meaning of the Regulatory Flexibility Act (5 
U.S.C. chapter 6). Therefore, a Regulatory Flexibility Analysis is not 
required. It has been determined that this notice of proposed 
rulemaking is not a significant regulatory action as defined in E.O. 
12866. Therefore, a regulatory assessment is not required. Pursuant to 
section 7805(f) of the Internal Revenue Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comments on its impact on small 
businesses.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for April 29, 1997, at 10 a.m. 
in the IRS Auditorium, Internal Revenue Building, 7th Floor, 1111 
Constitution Avenue NW, Washington, DC. Because of access restrictions, 
visitors will not be admitted beyond the building lobby more than 15 
minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments and submit an outline of the topics to be 
discussed and the time to be devoted to each topic (a signed original 
and eight (8) copies) by April 8, 1997.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Jonathan R. Zelnik, 
Office of the Assistant Chief Counsel (Financial Institutions & 
Products). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

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

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

    Section 1.7701(l)-2 also issued under 26 U.S.C. 7701(l). * * *
    Par. 2. Section 1.7701(l)-1 is amended as follows:
    1. Paragraphs (b)(6) and (b)(7) are revised.
    2. Paragraph (b)(8) is added.
    The revisions and addition reads as follows:


Sec. 1.7701(l)-1  Conduit financing arrangements.

* * * * *
    (b) * * *
* * * * *
    (6) Section 1.6038A-3(b)(5);
    (7) Section 1.6038A-3(c)(2)(vii); and
    (8) Section 1.7701(l)-2.
    Par. 3. Section 1.7701(l)-2 is added under the center heading 
``General Actuarial Valuations'' to read as follows:


Sec. 1.7701(l)-2  Treatment of obligation-shifting transactions.

    (a) Purpose. The purpose of this section is to prevent avoidance of 
tax by parties participating in multiple-party financing transactions 
that involve an assumption of obligations under a lease or similar 
agreement. This section should be interpreted in a manner consistent 
with this purpose.
    (b) In general. Obligation-shifting transactions as defined in 
paragraph (h)(1) of this section are recharacterized in the manner 
described in paragraph (d) of this section unless an exception in 
paragraph (c) of this section applies.
    (c) Exceptions--(1) In general. Paragraph (d) of this section does 
not apply if any of the following is satisfied:
    (i) The aggregate amounts that have already been received by or are 
payable to the property provider but are allocable to periods 
(including partial periods) after the obligation-shifting transaction 
(as determined under paragraph (g) of this section) are less than or 
equal to $100,000.
    (ii) The sum of the aggregate payments (including contingent 
payments) under the lease or similar agreement and the aggregate value 
of other consideration (including contingent consideration) to be 
received under the lease or similar agreement is not reasonably 
expected to exceed $250,000. The rules of Sec. 1.467-1(c)(4)(ii) \1\ 
apply in determining the amount described in this paragraph (c)(1)(ii).
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    \1\ This section appears in proposed regulations published on 
June 3, 1996 (IA-292-84, 61 FR 27834, 27839).
---------------------------------------------------------------------------

    (iii) The fair market value of the leased property is less than ten 
percent of the aggregate fair market value of all of the property 
(excluding Class I assets as described in Sec. 1.1060-1T(d)(1), Class 
II assets as described in Sec. 1.1060-1T(d)(2)(i), and debt issued by 
the property provider) that the property provider transfers to the 
assuming party as part of the same transaction or series of related 
transactions. For this purpose, the fair market value of the leased 
property is the sum of--
    (A) The fair market value of the property subject to the lease or 
similar agreement and transferred in the obligation-shifting 
transaction, plus
    (B) The value of the amounts that have already been received under 
the lease or similar agreement or are retained by the property provider 
or any other party but are allocable to periods (including partial 
periods) after the obligation-shifting transaction.
    (iv) The agreement(s) between the property provider and the 
property user is a disqualified leaseback or long-term agreement within 
the meaning of Sec. 1.467-3(b).\2\
---------------------------------------------------------------------------

    \2\ This section appears in proposed regulations published on 
June 3, 1996 (IA-292-84, 61 FR 27834, 17844).
---------------------------------------------------------------------------

    (v) The transaction is described in section 381(a), unless the 
transaction is deemed to be an obligation-shifting transaction under 
paragraph (k) of this section.
    (vi) The Commissioner determines that the transaction does not

[[Page 68180]]

substantially reduce the present value of the tax liability of the 
assuming party or otherwise result in the avoidance of tax.
    (2) Limitation on exceptions. The exceptions listed in paragraph 
(c)(1) of this section do not apply to obligation-shifting transactions 
entered into with a principal purpose of substantially reducing the 
present value of the aggregate tax liability of the assuming party, the 
property provider, and any person whose taxable income is determined 
(in whole or in part) by reference to the taxable income of the 
property provider or the assuming party.
    (d) Recharacterization of obligation-shifting transaction--(1) In 
general. In order to clearly reflect the income of the assuming party 
and the property provider, an obligation-shifting transaction is 
recharacterized as follows:
    (i) Assuming party treated as receiving all allocable rents. The 
assuming party is treated as acquiring the right to receive (and as 
receiving when due) all amounts under the lease or similar agreement 
that are allocable (as determined under paragraph (g) of this section) 
to periods (including partial periods) after the obligation-shifting 
transaction. Thus, the assuming party must include these amounts in 
income in the periods to which they are allocable.
    (ii) Assuming party treated as issuing section 7701(l) note. The 
assuming party is treated as issuing to the property provider, as 
additional consideration in the obligation-shifting transaction, a 
section 7701(l) note, with terms as described in paragraph (e) of this 
section. Accordingly, the assuming party and the property provider must 
account for interest expense and income from the section 7701(l) note 
in the periods (including partial periods) following the obligation-
shifting transaction.
    (2) Section 7701(l) rent-leveling loan and adjustment to property 
provider's income--(i) Section 7701(l) rent-leveling loan. To account 
for any differences in timing or amount between payments actually 
received by the property provider after the obligation-shifting 
transaction and payments (as described in paragraph (e)(3) of this 
section) treated as being made under the section 7701(l) note, the 
property provider is treated as a party to a section 7701(l) rent-
leveling loan, with terms as described in paragraph (f) of this 
section. Accordingly, the property provider must account for interest 
expense or income (as appropriate) in the periods (including partial 
periods) following the obligation-shifting transaction.
    (ii) Adjustment to property provider's income. To account for any 
differences between amounts previously included by the property 
provider and amounts that are allocable to periods before the 
obligation-shifting transaction, on the date on which the obligation-
shifting transaction is consummated, the property provider must treat 
as an item of expense or income (as appropriate)--
    (A) The principal balance of the section 7701(l) rent-leveling 
loan, minus
    (B) The principal balance (plus interest not already included in 
the principal balance) of the property provider's section 467 loan (if 
any) as determined under the principles of Sec. 1.467-4(a)(4) \3\ and 
existing as of that date.
---------------------------------------------------------------------------

    \3\ This section appears in proposed regulation published on 
June 3, 1996 (IA-292-84, 61 FR 27834, 27845).
---------------------------------------------------------------------------

    (3) Exclusive recharacterization. If the lease or similar agreement 
is a section 467 rental agreement, the property provider and the 
assuming party must account for the recharacterized transaction under 
the provisions of this section and not under the provisions of 
Secs. 1.467-1 through 1.467-8.\4\
---------------------------------------------------------------------------

    \4\ These sections appear in proposed regulations published on 
June 3, 1996 (IA-292-84, 61 FR 27834).
---------------------------------------------------------------------------

    (e) Section 7701(l) note--(1) Principal. On the date on which the 
obligation-shifting transaction is consummated, the principal balance 
of the section 7701(l) note equals the excess of--
    (i) The present value of the amounts that are allocable to periods 
(including partial periods) after the obligation-shifting transaction, 
over
    (ii) The present value of the amounts that are payable to the 
assuming party.
    (2) Present value, yield, and compounding period. For purposes of 
paragraph (e)(1) of this section, present value is determined under the 
rules of Sec. 1.467-2(d)\5\. The yield of the section 7701(l) note 
equals 110 percent of the applicable Federal rate on the date on which 
the obligation-shifting transaction is consummated, based on the 
remaining term of the lease or similar agreement. The compounding 
period for determining both the original principal balance and the 
yield must equal the period used in determining the amounts that are 
allocable (as determined under paragraph (g) of this section) to 
periods under the lease or similar agreement.
---------------------------------------------------------------------------

    \5\ This section appears in proposed regulations published on 
June 3, 1996 (IA-292-84, 61 FR 27834, 27842).
---------------------------------------------------------------------------

    (3) Repayment schedule--(i) Amount. The payment for each period 
under the section 7701(l) note is--
    (A) The amount that is taken into account by the assuming party 
under paragraph (d)(1)(i) of this section, minus
    (B) The amount received by the assuming party for that period.
    (ii) Timing. The timing of section 7701(l) note payments, as 
determined under paragraph (e)(3)(i) of this section, is the same as 
the timing of the payments taken into account by the assuming party 
under paragraph (d)(1)(i) of this section.
    (4) Debt for all purposes. A section 7701(l) note is debt for all 
purposes of the Internal Revenue Code. The principal balance of the 
section 7701(l) note after the obligation-shifting transaction may be 
positive or negative. If the principal balance is positive, the note 
represents an amount owed by the assuming party to the property 
provider, and if the principal balance is negative, the note represents 
an amount owed by the property provider to the assuming party.
    (f) Section 7701(l) rent-leveling loan--(1) Principal. On the date 
on which the obligation-shifting transaction is consummated, the 
principal balance of the section 7701(l) rent-leveling loan equals the 
principal balance (plus any interest not already included in the 
principal balance) of the section 467 loan as determined under 
Sec. 1.467-4(b) that would have existed as of that date if--
    (i) The amounts payable under the lease or similar agreement were 
the amounts described in paragraphs (g)(1) and (g)(2) of this section, 
and
    (ii) The property provider had reported all items of income and 
expense with respect to the lease or similar agreement by applying the 
constant rental accrual method described in Sec. 1.467-3(d) and by 
determining the section 467 rent for each period in accordance with 
Sec. 1.467-1(d)(2)(i).
    (2) Yield and compounding period. The yield of the section 7701(l) 
rent-leveling loan equals 110 percent of the applicable Federal rate on 
the date on which the obligation-shifting transaction is consummated, 
based on the original term of the lease or similar agreement. The 
compounding period for determining the yield must equal the period used 
in determining the amounts that are allocable (as determined under 
paragraph (g) of this section) to periods under the lease or similar 
agreement.
    (3) Repayment schedule--(i) Amount. The property provider's payment 
(or receipt) for each period under the section 7701(l) rent-leveling 
loan is--
    (A) The amount (as described in paragraph (e)(3)(i) of this 
section)

[[Page 68181]]

treated as paid in satisfaction of the section 7701(l) note, minus
    (B) The amount received by the property provider under the lease or 
similar agreement for that period.
    (ii) Timing. The timing of section 7701(l) rent-leveling loan 
payments, as determined under paragraph (f)(3)(i) of this section, is 
governed by paragraph (g) of this section (and thus, is the same as the 
timing of the payments taken into account by the assuming party under 
paragraph (d)(1)(i) of this section).
    (4) Debt for all purposes. A section 7701(l) rent-leveling loan is 
debt for all purposes of the Internal Revenue Code. The principal 
balance of the section 7701(l) rent-leveling loan may be positive or 
negative. If the principal balance is positive, the amount represents a 
loan on which the property provider is the obligee, and if the 
principal balance is negative, the amount represents a loan on which 
the property provider is the obligor.
    (g) Determining amounts that are allocable to periods under the 
lease or similar agreement. The amounts that are allocable to periods 
under a lease or similar agreement are determined (immediately before 
the obligation-shifting transaction is consummated) by applying the 
constant rental accrual method described in Sec. 1.467-3(d) from the 
inception of the lease or similar agreement based on--
    (1) The amounts that have already been received under the lease or 
similar agreement, and
    (2) The amounts that are payable under the lease or similar 
agreement.
    (h) Definitions. The following definitions apply solely for 
purposes of this section.
    (1) An obligation-shifting transaction is any transaction in which 
an assuming party assumes a property provider's obligations to a 
property user (or acquires property subject to a property provider's 
obligations to a property user) under a lease or similar agreement if 
the property provider or any other party has already received, or 
retains the right to receive, amounts that are allocable to periods 
after the transaction.
    (2) A property user is any person with the right to use property 
under a lease or similar agreement.
    (3) A property provider is any person (other than an assuming party 
in its capacity as such) that is obligated to make property available 
to a property user on account of a lease or similar agreement.
    (4) An assuming party is any person that assumes obligations or 
acquires property subject to obligations under an existing lease or 
similar agreement with a property user.
    (5) A lease or similar agreement is any contract for the use or 
enjoyment of tangible or intangible property, including leaseholds, 
licenses, other non-fee interests in property, and other contracts 
(including service contracts) involving the use or enjoyment of 
property if the fair market value of that use or enjoyment is more than 
de minimis.
    (6) Obligations under a lease or similar agreement include the 
continuing obligation to make property subject to a lease or similar 
agreement available to a property user. To the extent that an assuming 
party assumes obligations of a property provider or acquires property 
subject to obligations of a property provider, the obligations shall 
not thereafter be treated as obligations of the property provider.
    (7) Amounts that have already been received under the lease or 
similar agreement include consideration received (as of the date on 
which the obligation-shifting transaction is consummated) for assigning 
the rights to receive payments under the lease or similar agreement.
    (8) Amounts that are payable under the lease or similar agreement 
do not include payments the rights to which have been assigned in an 
arm's-length transaction to an unrelated third person in exchange for 
consideration.
    (9) A section 7701(l) note is indebtedness arising from the 
recharacterization described in paragraph (d)(1)(ii) of this section. 
The terms of a section 7701(l) note are described in paragraph (e) of 
this section.
    (10) A section 7701(l) rent-leveling loan is indebtedness arising 
from the recharacterization described in paragraph (d)(2)(i) of this 
section. The terms of a section 7701(l) rent-leveling loan are 
described in paragraph (f) of this section.
    (i) Reserved.
    (j) Pass-through entity look-through rule. For purposes of 
determining whether any person is a property user, a property provider, 
or an assuming party, the person is treated as having the rights and 
obligations of any pass-through entity in which the person is a 
partner, shareholder, beneficiary, or other participant, but only to 
the extent of the person's allocable share of pass-through entity items 
relating to the property. The pass-through entity must reflect the 
required recharacterization on its books.
    (k) Consolidated group rule. For purposes of this section, if a 
subsidiary is a member of a consolidated group and the subsidiary or a 
successor becomes a nonmember (other than in a transaction described in 
Sec. 1.1502-13(j)(5)), the nonmember (whether or not a separate legal 
entity) will be treated as a separate corporation that acquires the 
assets and assumes the obligations of the subsidiary. For example, 
assume that P sells all the stock of S, previously a wholly-owned 
subsidiary of P and a member of the P consolidated group, and that, at 
the time of the sale, S already has received amounts under a lease that 
are allocable to periods after the sale. Under this paragraph (k), an 
obligation-shifting transaction occurs when S becomes a nonmember. S, 
as a nonmember, is treated as having assumed the obligations under the 
lease. Therefore, S must adjust its income as provided in paragraph 
(d)(2)(ii) of this section immediately before it becomes a nonmember of 
the consolidated group. After the sale, S is treated as both a property 
provider and an assuming party in the obligation-shifting transaction.
    (l) Reserved.
    (m) Examples. The following examples illustrate the rules of this 
section. Each example assumes that all taxpayers use the calendar year 
as the taxable year, all payment periods are the calendar year, and 
none of the rental agreements are disqualified leasebacks or long-term 
agreements under Sec. 1.467-3(b). Except as otherwise provided, none of 
the exceptions in paragraph (c)(1) of this section apply. The examples 
read as follows:

    Example 1. Retained rents; section 351 transfer--(i) Facts. (A) 
On January 1, 2001, A leases property to B for a five-year period. 
The lease provides for rent of $10,000,000 per year, payable 
annually on December 31.
    (B) On January 1, 2002, A transfers the leased property to D in 
exchange for D preferred stock. A retains the right to receive the 
remaining four years of rent from B. As part of the same 
transaction, C transfers $100,000,000 to D in exchange for D common 
stock. After the transaction, A and C own 100 percent of the stock 
of D. Assume the transaction meets all of the requirements of 
section 351. C and D are members of the same consolidated group as 
defined in Sec. 1.1502-1(h). One hundred ten percent of the 
applicable Federal rate based on annual compounding is 7 percent.
    (ii) Obligation-shifting transaction. B is a property user 
because B has the right to use the property under the lease with A. 
A is a property provider because A is obligated to make the property 
available to B on account of the lease. D is an assuming party 
because in the January 1, 2002, transaction D acquires the property 
subject to A's obligations under the lease to make the property 
available to B for the remaining four years of the lease. The 
transaction is an obligation-shifting transaction because D is an 
assuming party

[[Page 68182]]

and A retains the right to receive rent from B allocable to periods 
after the transaction.
    (iii) Recharacterization. As of January 1, 2002, the transaction 
is recharacterized as follows:
    (A) Under the constant rental accrual method described in 
Sec. 1.467-3(d), the amount accruing for each calendar year period 
under the lease is $10,000,000. D is treated as acquiring the right 
to receive the amounts allocable to the four periods after the 
obligation-shifting transaction. Thus, in 2002, 2003, 2004, and 
2005, D must recognize $10,000,000 rental income.
    (B) The principal balance of the section 7701(l) note equals 
$33,872,112.56, with a yield equal to 7 percent based on annual 
compounding. As part of the obligation-shifting transaction, D is 
treated as having given A the section 7701(l) note as additional 
consideration. The amount of the section 7701(l) note is treated as 
``other property'' transferred from D to A in the section 351 
exchange. D is treated as making section 7701(l) note payments to A. 
A has interest income on the section 7701(l) note. D has interest 
expense on the section 7701(l) note. A and D account for the section 
7701(l) note as follows:

                                              Section 7701(1) Note                                              
----------------------------------------------------------------------------------------------------------------
                                                   Beginning                                                    
              Taxable year ending                   balance          Payment         Interest        Principal  
----------------------------------------------------------------------------------------------------------------
12/31/02......................................   $33,872,112.56   $10,000,000.00   $2,371,047.88   $7,628,952.12
12/31/03......................................    26,243,160.44    10,000,000.00    1,837,021.23    8,162,978.77
12/31/04......................................    18,080,181.67    10,000,000.00    1,265,612.72    8,734,387.28
12/31/05......................................     9,345,794.39    10,000,000.00      654,205.61    9,345,794.39
----------------------------------------------------------------------------------------------------------------

    (C) Because the amount A recognized in the year before the 
obligation-shifting transaction equals the amount A would have 
recognized under the constant rental accrual method, A's adjustment 
to income on the consummation of the obligation-shifting transaction 
is $0.
    (D) At the time of the obligation-shifting transaction, the 
principal balance of the section 7701(l) rent-leveling loan equals 
$0. Furthermore, because the amounts A actually receives each year 
after the obligation-shifting transaction, $10,000,000, equal the 
amounts D is treated as paying A under the section 7701(l) note, 
$10,000,000, the balance of the section 7701(l) rent-leveling loan 
equals $0 for all periods after the obligation-shifting transaction. 
Thus, A has no interest income or expense arising from the section 
7701(l) rent-leveling loan.
    Example 2. Rents already received; section 351 transfer--(i) 
Facts. (A) On January 1, 2001, X leases property to Y for a seven-
year period. The XY lease provides for rent of $900,000 per year, 
payable annually on December 31. Also on January 1, 2001, Y leases 
the property to Z for a five-year period. The YZ lease provides for 
rent payable on December 31 of each year as follows: $800,000 in 
2001, $900,000 in 2002, $1,000,000 in 2003, $1,100,000 in 2004, and 
$1,200,000 in 2005.
    (B) On December 31, 2001, Y sells to F the right to receive all 
rents from Z for 2002 through 2005. F pays Y $3,146,345.27. Y 
includes the $3,146,345.27 as ordinary income.
    (C) On January 1, 2002, Y contributes to S cash of $2,500,000, 
Y's rights and obligations under the lease with X, and Y's rights 
and obligations under the lease with Z in exchange for S preferred 
stock. As part of the same transaction, P transfers cash of 
$7,500,000 to S in exchange for S common stock. After the 
transaction, Y and P own 100 percent of the stock of S. Assume the 
transaction meets all of the requirements of section 351. S and P 
are members of the same consolidated group as defined in 
Sec. 1.1502-1(h). One hundred ten percent of the applicable Federal 
rate based on annual compounding is 10 percent.
    (ii) Obligation-shifting transaction. Z is a property user 
because Z has the right to use the property under the YZ lease. Y is 
a property provider because Y is obligated to make the property 
available to Z. S is an assuming party because in the January 1, 
2002, transaction, S assumes Y's obligations under the YZ lease to 
make the property available for the remaining four years of the 
lease. The transaction is an obligation-shifting transaction because 
S is an assuming party and Y has already received amounts allocable 
to periods after the transaction (Y sold to F the right to receive 
rent payments under the YZ lease for 2002 through 2005).
    (iii) Recharacterization. As of January 1, 2002, the transaction 
is recharacterized as follows:
    (A) Under the constant rental accrual method described in 
Sec. 1.467-3(d), the amount accruing for each calendar year period 
under the YZ lease is $946,396.31, based on the $800,000 Y received 
from Z on December 31, 2001, and the $3,146,345.27 Y received from F 
on December 31, 2001. S is treated as acquiring the right to receive 
the amounts allocable to the four periods after the obligation-
shifting transaction. Thus, S must recognize $946,396.31 of rental 
income for each of the four periods following the obligation-
shifting transaction.
    (B) The principal balance of the section 7701(l) note equals 
$2,999,948.96, with a yield equal to 10 percent based on annual 
compounding. As part of the obligation-shifting transaction, S is 
treated as having given Y the section 7701(l) note as additional 
consideration. The amount of the section 7701(l) note is treated as 
``other property'' transferred from S to Y in the section 351 
exchange. S is treated as making section 7701(l) note payments to Y. 
Y has interest income on the section 7701(l) note. S has interest 
expense on the section 7701(l) note. S and Y account for the section 
7701(l) note as follows:

                                              Section 7701(l) Note                                              
----------------------------------------------------------------------------------------------------------------
                                                     Beginning                                                  
               Taxable year ending                    balance         Payment        Interest        Principal  
----------------------------------------------------------------------------------------------------------------
12/31/02........................................   $2,999,948.96     $946,396.31     $299,994.90     $646,401.41
12/31/03........................................    2,353,547.55      946,396.31      235,354.75      711,041.56
12/31/04........................................    1,642,505.99      946,396.31      164,250.60      782,145.71
12/31/05........................................      860,360.28      946,396.31       86,036.03      860,360.28
----------------------------------------------------------------------------------------------------------------

    (C) At the time of the obligation-shifting transaction, the 
principal balance of the section 467 loan that would have existed if 
Y had reported all items of income and expense by applying the 
constant rental accrual method equals negative $2,999,948.96. Thus, 
in computing its income on the consummation of the obligation-
shifting transaction, Y must take into account an expense equal to 
$2,999,948.96.
    (D) At the time of the obligation-shifting transaction, the 
principal balance of the section 7701(l) rent-leveling loan equals 
negative $2,999,948.96. Y must account for the section 7701(l) rent-
leveling loan as follows:

[[Page 68183]]



                                       Section 7701(l) Rent-Leveling Loan                                       
----------------------------------------------------------------------------------------------------------------
                                                    Beginning                                                   
              Taxable year ending                    balance          Payment        Interest        Principal  
----------------------------------------------------------------------------------------------------------------
12/31/02.......................................  ($2,999,948.96)   ($946,396.31)   ($299,994.90)   ($646,401.41)
12/31/03.......................................   (2,353,547.55)    (946,396.31)    (235,354.75)    (711,041.56)
12/31/04.......................................   (1,642,505.99)    (946,396.31)    (164,250.60)    (782,145.71)
12/31/05.......................................     (860,360.28)    (946,396.31)     (86,036.03)    (860,360.28)
----------------------------------------------------------------------------------------------------------------

    Example 3. Rents already received; sale of a partnership 
interest--(i) Facts. (A) On January 1, 2001, A, B, and C form 
partnership PRS by contributing $3,600,000, $396,000, and $4,000, 
respectively, for proportionate interests (90.0 percent, 9.9 
percent, and 0.1 percent, respectively) in the capital and profits 
of PRS. On the same day, PRS purchases property for $4,000,000 and 
leases the property to X for a five-year period. The lease provides 
for rent payable on December 31 of each year as follows: $800,000 in 
2001, $900,000 in 2002, $1,000,000 in 2003, $1,100,000 in 2004, and 
$1,200,000 in 2005.
    (B) On December 31, 2001, PRS sells to F the right to receive 
all rents from X for 2002 through 2005. F pays PRS $3,146,345.27. 
PRS treats the $3,146,345.27 as ordinary income allocated 
$2,831,710.74 to A, $311,488.18 to B, and $3,146.35 to C. One 
hundred ten percent of the applicable Federal rate based on annual 
compounding is 10 percent.
    (C) Immediately following the sale of the rents, A sells its 
entire partnership interest to D based on the fair market value of 
90 percent of PRS's assets. PRS does not have an election in effect 
under section 754.
    (ii) Obligation-shifting transaction. X is a property user 
because X has the right to use the property under the lease with 
PRS. A is a property provider as to its share of the partnership's 
obligations under the lease to make the property available to X. D 
is an assuming party because D acquires A's partnership interest 
subject to A's share of the partnership's obligations under the 
lease with X to make the property available for the remaining four 
years of the agreement. The transaction is an obligation-shifting 
transaction because D is an assuming party and A has already 
received income allocable to periods after the transaction (A 
received allocations of income from the sale of the right to receive 
rents under the lease in 2002 through 2005). Thus, D is treated as 
assuming 90 percent of the partnership's obligations under the 
lease.
    (iii) Recharacterization. As of January 1, 2002, the transaction 
is recharacterized as follows:
    (A) Under the constant rental accrual method described in 
Sec. 1.467-3(d), the amount accruing for each calendar year period 
under the lease is $946,396.31, based on the $800,000 PRS received 
from X and the $3,146,345.27 PRS received from F. A's share of the 
amount payable in each calendar year period under the lease is 
$851,756.68 (90 percent of $946,396.31). D is treated as acquiring 
the right to A's 90 percent share of the amounts allocable to the 
four periods after the obligation-shifting transaction. Thus, D must 
recognize $851,756.68 of rental income for each of the four periods 
following the obligation-shifting transaction.
    (B) The principal balance of the section 7701(l) note equals 
$2,699,954.06, with a yield equal to 10 percent based on annual 
compounding. As part of the obligation-shifting transaction, D is 
treated as having given A the section 7701(l) note as additional 
consideration. D is treated as making section 7701(l) note payments 
to A. A has interest income on the section 7701(l) note. D has 
interest expense on the section 7701(l) note. A and D account for 
the section 7701(l) note as follows:

                                              Section 7701(l) Note                                              
----------------------------------------------------------------------------------------------------------------
       Taxable year ending         Beginning balance        Payment            Interest            Principal    
----------------------------------------------------------------------------------------------------------------
12/31/02........................       $2,699,954.06         $851,756.68         $269,995.41         $581,761.27
12/31/03........................        2,118,192.79          851,756.68          211,819.28          639,937.40
12/31/04........................        1,478,255.39          851,756.68          147,825.54          703,931.14
12/31/05........................          774,324.25          851,756.68           77,432.42          774,324.26
----------------------------------------------------------------------------------------------------------------

    (C) At the time of the obligation-shifting transaction, the 
principal balance of the section 467 loan that would have existed if 
PRS had reported all items of income and expense by applying the 
constant rental accrual method equals negative $2,999,948.96. Thus, 
in computing its income on the consummation of the obligation-
shifting transaction, A must take into account an expense equal to 
$2,699,954.06 (90 percent of $2,999,948.96).
    (D) At the time of the obligation shifting transaction, the 
principal balance of the section 7701(l) rent-leveling loan equals 
negative $2,699,954.06. A must account for the section 7701(l) rent-
leveling loan as follows:

                                       Section 7701(l) Rent-leveling Loan                                       
----------------------------------------------------------------------------------------------------------------
       Taxable year ending         Beginning balance        Payment            Interest            Principal    
----------------------------------------------------------------------------------------------------------------
12/31/02........................     ($2,699,954.06)       ($851,756.68)       ($269,995.41)       ($581,761.27)
12/31/03........................      (2,118,192.79)        (851,756.68)        (211,819.28)        (639,937.40)
12/31/04........................      (1,478,255.39)        (851,756.68)        (147,825.54)        (703,931.14)
12/31/05........................        (774,324.25)        (851,756.68)         (77,432.42)        (774,324.26)
----------------------------------------------------------------------------------------------------------------

    Example 4. Exception where aggregate amounts retained or already 
received are less than or equal to $100,000; section 351 transfer--
(i) Facts. (A) On January 1, 2001, A leases property to B for a 
five-year period. The lease provides for rent of $1,000,000 for 
2001, and $875,000 for the each of the remaining four years of the 
lease. Rent is payable annually on December 31.
    (B) On January 1, 2002, A transfers the leased property along 
with the right to receive rent payments for 2002 through 2005 to D 
in exchange for D preferred stock. As part of the same transaction, 
C transfers $1,000,000 to D in exchange for D common stock. After 
the transaction, A and C own 100 percent of the stock of D. Assume 
that the transaction meets all of the requirements of

[[Page 68184]]

section 351. C and D are members of the same consolidated group as 
described in Sec. 1.1502-1(h). Assume that A, C, and D did not enter 
into the transaction with a principal purpose of substantially 
reducing the present value of their aggregate tax liabilities. One 
hundred ten percent of the applicable Federal rate based on annual 
compounding is 7 percent.
    (ii) Obligation-shifting transaction. A is a property provider 
because it is obligated to make property available to B on account 
of a lease or similar agreement. B is a property user because it has 
the right to use property under its lease with A. D is an assuming 
party because, in the January 1, 2002, transaction, it acquires the 
property subject to A's obligation to make the property available to 
B for the remaining term of the lease. The transaction between A and 
D is an obligation-shifting transaction because D is an assuming 
party and A retains the right to receive amounts from B allocable to 
periods after the transaction.
    (iii) Availability of exception. Even though the transaction 
between A and D is an obligation-shifting transaction, it is not 
recharacterized under this section. As of the date of the 
transaction, A has already received $1,000,000. Under the constant 
rental accrual method described in Sec. 1.467-3(d), the constant 
rental amount accruing for each calendar year during the lease is 
$903,491.90. The aggregate amount that has already been received by 
A but that is allocable to periods after the obligation-shifting 
transaction is $1,000,000 minus $903,491.90, or $96,508.10. Because 
this amount is less than $100,000, the transaction is excepted from 
recharacterization under paragraph (c)(1)(i) of this section.
    Example 5. Exception where fair market value of leased property 
is less than 10 percent of value of all property transferred; 
incorporation of existing business--(i) Facts. (A) On January 1, 
2001, A leases property to B for a five-year period. The lease 
provides for rent of $1,000,000 per year, payable annually on 
December 31.
    (B) On January 1, 2003, the fair market value of the leased 
property is $4,000,000. On that date, A transfers the property, 
together with $3,000,000 of Class I and Class II assets and other 
property with a fair market value of $39,000,000, in exchange for 
all of the common stock of C. A retains the right to receive the 
remaining three rent payments from B. The fair market value of the 
rent payments retained by A is $2,486,851.99 (based on a discount 
rate of 10 percent). The fair market value of the property subject 
to the lease and transferred to B, reflecting A's retention of the 
right to the remaining three rent payments, is $1,513,148.01. Assume 
that the transaction meets all of the requirements of section 351. 
Assume that A and C did not enter into the transaction with a 
principal purpose of substantially reducing the present value of 
their aggregate tax liabilities.
    (ii) Obligation-shifting transaction. A is a property provider 
because it is obligated to make property available to B on account 
of a lease or similar agreement. B is a property user because it has 
the right to use property under its lease with A. C is an assuming 
party because, in the January 1, 2003, transaction, it acquires the 
property subject to A's obligation to make the property available to 
B for the remaining three years of the lease. The transaction 
between A and C is an obligation-shifting transaction because C is 
an assuming party and A retains the right to receive amounts from B 
allocable to periods after the transaction.
    (iii) Availability of exception. Even though the transaction 
between A and C is an obligation-shifting transaction, it is not 
recharacterized under this section. The fair market value of the 
leased property equals $4,000,000. The fair market value of the 
property subject to the lease and transferred to B is $1,513,148.01, 
and the fair market value of the rents retained is $2,486,851.99. 
The aggregate fair market value of all of the property transferred, 
excluding Class I assets, Class II assets, and debt issued by the 
property provider, as part of the same transaction is $43,000,000 
($4,000,000 leased property plus $39,000,000 other property, 
excluding Class I assets, Class II assets, and debt issued by the 
property provider). Because the value of the leased property, 
$4,000,000, is less than 10 percent of $43,000,000, the transaction 
is excepted from recharacterization under paragraph (c)(1)(iii) of 
this section.

    (n) Effective date. This section applies to obligation-shifting 
transactions any significant element of which was entered into or 
undertaken on or after October 13, 1995.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-32670 Filed 12-26-96; 8:45 am]
BILLING CODE 4830-01-P