[Federal Register Volume 64, Number 3 (Wednesday, January 6, 1999)]
[Proposed Rules]
[Pages 805-813]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-178]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-104072-97]
RIN 1545-AV07


Recharacterizing Financing Arrangements Involving Fast-pay Stock

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 that 
recharacterize, for tax purposes, financing arrangements involving 
fast-pay stock. The regulations are necessary to prevent taxpayers from 
using fast-pay stock to achieve inappropriate tax avoidance. The 
regulations affect corporations that issue fast-pay stock, holders of 
fast-pay stock, and other shareholders that may claim tax benefits 
purported to result from arrangements involving fast-pay stock. This 
document also provides notice of a public hearing on the proposed 
regulations.

DATES: Written and electronic comments must be received by April 6, 
1999. Outlines of topics to be discussed at the public hearing 
scheduled for April 8, 1999, at 10 a.m. must be received by March 18, 
1999.

ADDRESSES: Send submissions: to CC:DOM:CORP:R (REG-104072-97), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-
104072-97), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments via the Internet by selecting the ``Tax Regs'' option of the 
IRS Home Page or by submitting them directly to the IRS Internet site 
at http://www.irs.ustreas.gov/prod/tax__regs/comments.html. The public 
hearing will be held in room 2615, 1111 Constitution Avenue, NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jonathan Zelnik at (202) 622-3940; concerning submissions of comments, 
the hearing, and/or to be placed on the building access list to attend 
the hearing, LaNita VanDyke 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, OP:FS:FP, Washington, DC 
20224. Comments on the collection of information should be received by 
March 8, 1999. 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 services to provide information.
    The collection of information is in Sec. 1.7701(l)-3(f) and 
Sec. 1.7701(l)-3(g). The collection of information is mandatory. The 
likely respondents are individuals, businesses, and other 
organizations.
    Estimated total annual burden: 50 hours
    Estimated average annual burden per respondent: 1 hour
    Estimated number of respondents: 50
    Estimated annual frequency of responses: Annually
    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 assigned by the Office of 
Management and Budget.
    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

    On February 27, 1997, the IRS issued Notice 97-21, 1997-1 C.B. 407, 
which relates to financing arrangements involving fast-pay stock. Among 
other things, the notice informs the public that the IRS and Treasury 
Department expect to issue regulations recharacterizing these 
arrangements to prevent tax avoidance. Notice 97-21 requested comments, 
but none have been received.

Explanation of Provisions

A. Tax-Avoidance Arrangements Using Fast-Pay Stock

    Notice 97-21 addresses two-party financing arrangements that are 
structured as multi-party arrangements to let one or more of the 
parties avoid tax. Instead of one party directly providing financing to 
the other, they both acquire stock (with different characteristics) in 
a conduit entity. The arrangement is structured so that the party 
providing the financing has a decreasing claim on the conduit entity

[[Page 806]]

(and its assets) while the party receiving the financing has an 
increasing claim on the conduit entity (and its assets). Economically, 
both parties benefit from the conduit entity's income. For tax 
purposes, however, the entity's income is allocated almost entirely to 
the party providing the financing, allowing the other party to claim 
unwarranted tax benefits.
    Notice 97-21 describes in detail a typical fast-pay stock financing 
arrangement. The parties to the arrangement include: (1) a person 
seeking financing (the sponsor), (2) investors who are willing to 
provide financing and typically are not subject to federal income tax 
(the investors), and (3) a corporation that is generally subject to tax 
only at the shareholder level (a conduit entity). The conduit entity 
issues a class of self-amortizing stock (the fast-pay stock) to the 
investors and a class of other stock (the benefited stock) to the 
sponsor. The fast-pay stock is structured so that during an initial 
period, the dividends made with respect to the stock are substantial 
and relatively certain while the dividends made with respect to the 
benefited stock are insignificant. After the initial period, the 
dividend rate of the fast-pay stock, the stock's effective redemption 
value, or both, decline.
    Economically, the fast-pay stock is self-amortizing because the 
distributions made with respect to the fast-pay stock are in part a 
return on the investors' investment and in part a return of their 
investment. For tax purposes, however, the parties characterize the 
fast-pay stock distributions entirely as dividends (that is, entirely 
as a return on the investment). Consequently, the investors' reported 
taxable income -- overstated dividend income followed by an overstated 
capital loss on disposition of the fast-pay stock--fails to clearly 
reflect their economic income. (Investors that are tax-exempt suffer no 
disadvantage from this arrangement.)
    Characterizing the distributions made with respect to the fast-pay 
stock solely as dividends has the corresponding effect of understating 
the taxable income on the benefited stock (the stock held by the 
sponsor) during the initial period. Instead of receiving dividends 
attributable to its share of the conduit entity's income, the sponsor's 
economic income takes the form of an increasing ownership interest in 
the conduit entity. Because the fast-pay stock is economically self-
amortizing, each distribution reduces the investors' claim on the 
conduit entity (and its assets) and increases the sponsor's claim. By 
treating a fast-pay arrangement according to its form, the sponsor 
reports taxable income that fails to clearly reflect its economic 
income. An individual sponsor, for example, reports little or no 
dividend income. Instead, the individual reports gain on disposing of 
its benefited stock; thus, deferring tax on its economic income and 
converting that income from ordinary to capital. A corporate sponsor 
not only reports little or no dividend income, but can avoid reporting 
gain on the disposition of its benefited stock, thereby entirely 
eliminating tax on its economic income. (If a corporate sponsor has a 
sufficient interest in the conduit entity, the sponsor may succeed to 
the conduit entity's assets tax-free by liquidating or reorganizing the 
conduit entity; thus, avoiding a taxable disposition of the benefited 
stock).
    In substance, the investors (the fast-pay shareholders) are 
financing the sponsor's investment in the conduit entity. Although 
nominally shareholders in the conduit entity, the investors have a 
limited, diminishing claim to the entity (and its assets). The 
sponsor's claim, by contrast, is residual and long-term. Thus, a fast-
pay arrangement is effectively a leveraged arrangement in which the 
sponsor uses untaxed income from the conduit entity to repay the 
investors.

B. The Proposed Regulations

1. In General
    To prevent the avoidance of tax, the Secretary may issue 
regulations under section 7701(l) recharacterizing any multiple-party 
financing transaction as a transaction directly among any two or more 
of the parties. The proposed regulations exercise this authority by 
recharacterizing certain fast-pay arrangements. A fast-pay arrangement 
is any financing arrangement in which a corporation has outstanding two 
or more classes of stock, one of which is fast-pay stock. The 
regulations identify fast-pay arrangements and recharacterize certain 
of them as arrangements directly between the holders of the fast-pay 
stock and the other shareholders (the benefited shareholders) in the 
corporation. The regulations also impose reporting requirements on 
certain corporations with outstanding fast-pay stock and on certain 
shareholders that participate in fast-pay arrangements. These reporting 
requirements apply to all fast-pay arrangements, whether or not they 
are subject to recharacterization.
    Notice 97-21 describes specific models for recharacterizing fast-
pay arrangements. For purposes of determining the income of the 
shareholders of a corporation with outstanding fast-pay stock, these 
models ignore the separate existence of the corporation and treat the 
fast-pay shareholders and benefited shareholders as owning the 
corporation's underlying assets. Although this approach prevents tax 
avoidance, the IRS and Treasury Department have concluded that it may 
not best reflect the financing relationship between the fast-pay 
shareholders and the benefited shareholders. In addition, the approach 
of the notice may be difficult for taxpayers to apply if the 
corporation has a complex capital structure, multiple assets (including 
active businesses), or both.
    To address these concerns, the proposed regulations treat the fast-
pay shareholders as acquiring instruments issued by the benefited 
shareholders instead of acquiring interests in the assets of the 
corporation. This approach better reflects the financing relationship 
between the fast-pay shareholders and the benefited shareholders. It 
also removes the burden of determining each party's ownership interest 
in the assets of the corporation. Thus, the regulations provide an 
approach that is easier to apply and more narrowly tailored than the 
models described in Notice 97-21.
2. Fast-Pay Stock and Benefited Stock
    Under the proposed regulations, stock is fast-pay stock if it is 
structured to provide for dividends that economically represent a 
return (in whole or in part) of the holder's investment rather than 
only a return on the holder's investment. Stock is presumed to be fast-
pay stock if it has, by design, a dividend rate that is reasonably 
expected to decline, or an issue price that exceeds the amount at which 
the holder can be compelled to dispose of the stock. A taxpayer may 
rebut these presumptions only by clearly showing that no dividend 
represents an economic return (in whole or in part) of the holder's 
investment.
    Generally, whether stock is fast-pay stock must be determined based 
on all the facts and circumstances, including any related agreements 
such as options or forward contracts. A related agreement is any direct 
or indirect, oral or written, agreement between the holder of the stock 
and the issuing corporation, or between the holder of the stock and one 
or more other shareholders in the corporation. The determination that 
stock is fast-pay stock is made when the stock is issued, and whenever 
there is a significant modification in the terms of the stock or the 
related agreements, or a significant change in the relevant facts and 
circumstances.

[[Page 807]]

    The proposed regulations define benefited stock by reference to 
fast-pay stock. With respect to a class of fast-pay stock, all other 
stock in the corporation (including any other class of fast-pay stock) 
is benefited stock. For fast-pay arrangements in which there is more 
than one class of benefited stock, the parties must apply the general 
recharacterization rules among the different classes as appropriate to 
match the arrangement's economic substance.
3. Fast-Pay Arrangements Subject to Recharacterization
    Under the proposed regulations, if the corporation with outstanding 
fast-pay stock is either a regulated investment company (RIC) or a real 
estate investment trust (REIT), the fast-pay arrangement is 
automatically recharacterized. If the corporation is neither a RIC nor 
a REIT, the Commissioner may (at the Commissioner's discretion) 
recharacterize the fast-pay arrangement in cases where the Commissioner 
determines that a principal purpose for the structure of the fast-pay 
arrangement is the avoidance of tax. This rule applies to all parties 
to a fast-pay arrangement, without regard to whether such parties 
acquired their interests as part of an initial offering or later (by 
purchase or other transfer).
    By not automatically recharacterizing all fast-pay arrangements, 
the regulations prevent taxpayers from using the recharacterization 
rules for other tax avoidance purposes. For example, shareholders of a 
controlled foreign corporation cannot circumvent the purposes of United 
States tax law (including treaties) by using the recharacterization 
rules to exploit inconsistencies between the treatment of a fast-pay 
arrangement by the United States and foreign jurisdictions. It is 
expected that the Commissioner will closely scrutinize fast-pay 
arrangements in which the corporation with outstanding fast-pay stock 
is a foreign corporation.
4. Model for Recharacterizing Fast-Pay Arrangements
a. In General
    The proposed regulations treat the fast-pay shareholders as holding 
financing instruments issued by the benefited shareholders rather than 
as holding fast-pay stock in the corporation. The corporation is the 
paying agent on the financing instruments but has no other relationship 
to the fast-pay shareholders.
    Under the proposed regulations, the financing instruments have the 
same payment terms as the fast-pay stock. The timing and amount of 
payments made with respect to the financing instruments, therefore, 
match the timing and amount of distributions made with respect to the 
fast-pay stock. Nothing in the regulations characterizes the financing 
instruments. The character of the financing instruments (for example, 
stock or debt) must be determined under general tax principles and 
depends on all the facts and circumstances.
    The benefited shareholders are treated as first issuing the 
financing instruments in exchange for cash equal to the fair market 
value of the fast-pay stock (taking into account any related 
agreements), and then as contributing the cash to the corporation 
(thereby increasing their basis in the benefited stock). Distributions 
made with respect to the fast-pay stock are treated as first made with 
respect to the benefited stock, and then as used by the benefited 
shareholders to make payments on the financing instruments.
b. Rule for Multiple Classes of Benefited Stock
    The proposed regulations do not describe detailed rules for fast-
pay arrangements in which there is more than one class of benefited 
shareholders. Instead, as mentioned before, the regulations provide a 
general rule that requires recharacterization among the different 
classes as appropriate to match the economic substance of the fast-pay 
arrangement.
c. Rules for Disposition of Benefited Stock
    The proposed regulations provide special rules for dispositions of 
benefited stock. On the sale of benefited stock, in addition to any 
consideration actually received, the seller is treated as receiving the 
amount necessary to terminate its position with respect to the 
financing instruments at fair market value. Similarly, the buyer is 
treated as paying that amount and as issuing new financing instruments 
to the fast-pay shareholders.
d. Rule Preserving Pre-effective Date Gain
    The proposed regulations provide a special basis adjustment rule to 
ensure that unrealized gain on benefited stock is not inappropriately 
eliminated. Because the regulations do not apply to amounts accrued or 
paid in taxable years ending before February 27, 1997 (pre-effective 
years), a benefited shareholder will have economic income, but not 
taxable income, attributable to pre-effective years if the form of a 
fast-pay arrangement is respected for those years. This economic income 
is reflected as unrealized gain in the benefited stock.
    Absent a special basis adjustment rule, the general 
recharacterization rule would eliminate this unrealized gain. Although 
the regulations do not apply to amounts accrued or paid in pre-
effective years, the regulations recharacterize fast-pay arrangements 
from their inception. Thus, in cases in which the fast-pay arrangement 
was entered into in a pre-effective year, the general 
recharacterization rule increases a benefited shareholder's basis in 
its stock as of the inception of the transaction, even though the 
regulations do not require the benefited shareholder to include deemed 
dividend distributions attributable to the pre-effective years. 
Consequently, this increase in basis without corresponding dividend 
income eliminates the unrealized gain from the pre-effective years.
    To preserve the unrealized gain resulting from the economic income 
attributable to pre-effective years, the proposed regulations provide a 
special basis adjustment rule. After taking into account any basis 
increase under the general rule, a benefited shareholder must decrease 
its basis in its benefited stock by the amount (if any) that (1) its 
taxable income attributable to the fast-pay arrangement for pre-
effective years, computed by recharacterizing the fast-pay arrangement 
under the regulations, exceeds (2) its taxable income attributable to 
the fast-pay arrangement for pre-effective years, computed without 
applying the recharacterization rules of the regulations. In this way, 
a benefited shareholder's economic income attributable to taxable years 
before the effective date of the regulations is not eliminated by the 
basis provisions of the general recharacterization rules and may be 
realized when the benefited shareholder disposes of its benefited 
stock.
e. Rule Prohibiting the Affirmative Use of These Regulations To Avoid 
Tax Imposed by the Code
    The proposed regulations prohibit a taxpayer from affirmatively 
using the automatic recharacterization rules if a principal purpose for 
using such rules is the avoidance of any tax imposed by the Code. With 
respect to such a taxpayer, the Commissioner may depart from the 
automatic recharacterization rules and treat (for all purposes of the 
Code) the fast-pay arrangement in accordance with its form or its 
economic substance. This anti-abuse rule applies on a taxpayer-by-

[[Page 808]]

taxpayer basis. For example, if a foreign person acquires fast-pay 
stock in a REIT and a principal purpose for acquiring such stock is to 
reduce United States withholding taxes by applying the automatic 
recharacterization rules, the Commissioner may, for purposes of 
determining the foreign person's United States tax consequences 
(namely, withholding tax), depart from the automatic recharacterization 
rules and treat the foreign person as holding fast-pay stock in the 
REIT.
5. Withholding
    A corporation that issues fast-pay stock is a withholding agent for 
payments made (or deemed made) under a fast-pay arrangement. Generally, 
if a fast-pay arrangement is recharacterized under the automatic 
recharacterization rules, a withholding agent must withhold in 
accordance with the transaction as recharacterized. A different rule 
applies, however, if the withholding agent knows or has reason to know 
that any taxpayer entered into the fast-pay arrangement with a 
principal purpose of using the recharacterization rules to avoid tax 
under section 871(a) or section 881. In that case, for each payment 
made (or deemed made) to such taxpayer under the arrangement, the 
withholding agent must withhold under section 1441 or section 1442 the 
higher of (1) the amount of withholding that applies to such payment 
determined under the form of the arrangement, or (2) the amount of 
withholding that applies to such payment determined under the automatic 
recharacterization rules. Also, when the withholding agent knows or has 
reason to know that the Commissioner has exercised the discretion to 
depart from the automatic recharacterization rules for a taxpayer, the 
withholding agent must withhold on payments made (or deemed made) to 
that taxpayer in accordance with the characterization of the fast-pay 
arrangement imposed by the Commissioner.
    The withholding agent's liability to withhold on payments to 
foreign individuals is described in new proposed Sec. 1.1441-7(g). The 
same rules apply to payments (or deemed payments) to foreign 
corporations under Sec. 1.1442-1.
6. Reporting Requirements
    In general, a corporation that has fast-pay stock outstanding at 
any time during the taxable year must attach a statement to its federal 
income tax return. This rule does not apply to a corporation that is a 
controlled foreign corporation (CFC) as defined in section 957, a 
foreign personal holding company (FPHC) as defined in section 552, or a 
passive foreign investment company (PFIC) as defined in section 1297. 
Instead, certain shareholders (and officers and directors of FPHCs) of 
those corporations must attach a statement to their returns.
    The statement must identify the corporation that has outstanding 
fast-pay stock and must recite the terms of the fast-pay stock and the 
date on which the fast-pay stock was issued. In addition, to the extent 
the filing person knows or has reason to know such information, the 
statement must contain the names and the taxpayer identification 
numbers of the shareholders of any class of stock that is not traded on 
an established securities market as described in Sec. 1.7704-1(b).
7. Election To Limit Taxable Income Attributable to a Recharacterized 
Fast-Pay Arrangement for Taxable Years Ending After February 26, 1997, 
and Before the Date These Regulations Are Published as Final 
Regulations in the Federal Register
    The regulations are proposed to be effective February 27, 1997, and 
to cover all taxable years ending after February 26, 1997. Thus, the 
regulations will apply to all amounts accrued or paid on or after the 
first day of the first taxable year ending after February 26, 1997.
    Because the proposed effective date relates to the date Notice 97-
21 was issued to the public, and because the regulations adopt 
different recharacterization rules from the ones described in the 
notice, the regulations permit a shareholder of a recharacterized fast-
pay arrangement to limit its taxable income attributable to the 
arrangement for certain taxable years. Specifically, for taxable years 
ending after February 26, 1997, and before the date these regulations 
are finalized, a shareholder may limit its taxable income attributable 
to a fast-pay arrangement recharacterized under the regulations, to the 
taxable income that would result if the fast-pay arrangement were 
recharacterized under Notice 97-21. Any amount excluded under the limit 
must be included as an adjustment to taxable income in the 
shareholder's first taxable year that includes the date the regulations 
are finalized. Under the regulations, a shareholder that has elected to 
apply the limit must include a statement in its books and records 
identifying each fast-pay arrangement for which the election was made, 
and the amount excluded from taxable income under the election for each 
fast-pay arrangement.
    Shareholders who take advantage of the limit enjoy only a deferral 
of taxable income: Any amount excluded under the limit is later 
included as an adjustment. Thus, the sole benefit of making the 
election is a timing difference. This result is appropriate because 
over the life of a fast-pay arrangement a shareholder has the same 
amount of taxable income whether the fast-pay arrangement is 
recharacterized under Notice 97-21 or under the regulations. The IRS 
and Treasury Department invite comments concerning the limit and 
whether there are fast-pay arrangements in which any difference between 
a shareholder's taxable income determined under Notice 97-21 and the 
shareholder's taxable income determined under the regulations is other 
than a timing difference.
    Notice 97-21 describes two types of fast-pay arrangements. Hence, 
calculating the limit requires appropriately recharacterizing the fast-
pay arrangement under the notice. In the first type of fast-pay 
arrangement that the notice describes, the corporation with outstanding 
fast-pay stock holds income-producing assets issued by a third party. 
Notice 97-21 treats the benefited shareholders (one of which is called 
the ``sponsor'' in the notice) as acquiring the assets of the 
corporation directly from the sellers of those assets. The notice 
treats the fast-pay shareholders (called ``investors'' in the notice) 
as acquiring the assets of the corporation either from the sellers of 
those assets or from the benefited shareholders in an income 
``stripping'' transaction. Thus, both the fast-pay shareholders and 
benefited shareholders are regarded as owning directly the 
corporation's assets.
    In the second type of fast-pay arrangement that Notice 97-21 
describes, the corporation with outstanding fast-pay stock holds a debt 
instrument issued by the sponsor (a benefited shareholder). In this 
situation, the notice treats the sponsor as having issued one or more 
instruments directly to the holders of the fast-pay stock. Thus, for 
purposes of determining the sponsor's taxable income, the sponsor's 
obligation under any asset held by the corporation is ignored.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It is hereby certified that 
these regulations will not have a significant economic impact on a 
substantial number of small entities.

[[Page 809]]

This certification is based on the understanding of the IRS and 
Treasury Department that the total number of fast-pay arrangements is 
fewer than 100, that the number of entities engaging in transactions 
affected by these regulations is not substantial and, of those 
entities, few or none are small entities within the meaning of the 
Regulatory Flexibility Act (5 U.S.C. chapter 6). Therefore, a 
Regulatory Flexibility Analysis 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 electronic and 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. 
The IRS and Treasury Department specifically request comments on the 
clarity of the proposed rule and how it may be made easier to 
understand.
    A public hearing has been scheduled for April 8, 1999, beginning at 
10 a.m. in room 2615 of the Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 15 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments by April 6, 1999 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 March 18, 1999.
    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.

Proposed Effective Date

    These regulations are proposed to be effective February 27, 1997, 
and apply to taxable years ending after February 26, 1997. Thus, all 
amounts accrued or paid on or after the first day of the first taxable 
year ending after February 26, 1997, will be subject to the 
regulations, regardless of when a particular share of the stock or a 
particular debt instrument was issued.
    The statement required under Sec. 1.7701(l)-3(f) is proposed to 
apply to taxable years (of the taxpayer required to file the statement) 
ending after the date the regulations are published as final 
regulations in the Federal Register.

Drafting Information

    The principal authors of these regulations are Jonathan Zelnik and 
Marshall Feiring of the 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)-3 also issued under 26 U.S.C. 7701(l). * * *
    Par. 2. Section 1.1441-7 is amended as follows:
    1. Paragraph (g) is redesignated as paragraph (h) and revised.
    2. New paragraph (g) is added.
    The addition and revision read as follows:


Sec. 1.1441-7  General provisions relating to withholding agents.

* * * * *
    (g) Fast-pay arrangements--(1) In general. A corporation that 
issues fast-pay stock in a fast-pay arrangement described in 
Sec. 1.7701(l)-3(b)(1) is a withholding agent with respect to fast-pay 
dividends paid under the arrangement and any deemed payments with 
respect to the arrangement under the recharacterization rules of 
Sec. 1.7701(l)-3(c). Except as provided in this paragraph (g)(1) or in 
paragraph (g)(2) of this section, the withholding tax rules under 
section 1441 and section 1442 apply with respect to a fast-pay 
arrangement described in Sec. 1.7701(l)-3(c)(1)(i) in accordance with 
the recharacterization rules provided in Sec. 1.7701(l)-3(c). In all 
cases, notwithstanding paragraph (g)(2) of this section, if at any time 
the withholding agent knows or has reason to know that the Commissioner 
has exercised the discretion under Sec. 1.7701(l)-3(d) to depart from 
the recharacterization rules of Sec. 1.7701(l)-3(c) for a taxpayer, the 
withholding agent must withhold on payments made (or deemed made) to 
that taxpayer in accordance with the characterization of the fast-pay 
arrangement imposed by the Commissioner under Sec. 1.7701(l)-3(d).
    (2) Exception. If at any time the withholding agent knows or has 
reason to know that any taxpayer entered into a fast-pay arrangement 
with a principal purpose of applying the recharacterization rules of 
Sec. 1.7701(l)-3(c) to avoid tax under section 871(a) or section 881, 
then for each payment made or deemed made to such taxpayer under the 
arrangement, the withholding agent must withhold, under section 1441 or 
section 1442, the higher of--
    (i) The amount of withholding that would apply to such payment 
determined under the form of the arrangement; or
    (ii) The amount of withholding that would apply to deemed payments 
determined under the recharacterization rules of Sec. 1.7701(l)-3(c).
    (3) Liability. Any person required to deduct and withhold tax under 
this paragraph (g) is made liable for that tax by section 1461, and is 
also liable for applicable penalties and interest for failing to comply 
with section 1461.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (g):

    Example 1. REIT W issues shares of fast-pay stock to foreign 
individual A, a resident of Country C. United States source 
dividends paid to residents of C are subject to a 30 percent 
withholding tax. W issues all shares of benefited stock to foreign 
individuals who are residents of Country D. D's income tax 
convention with the United States reduces the United States 
withholding tax on dividends to 15 percent. Under Sec. 1.7701(l)-
3(c), the dividends paid by W to A are deemed to be paid by W to the 
benefited shareholders. W has reason to know that A entered into the 
fast-pay arrangement with a principal purpose of using the 
recharacterization rules of Sec. 1.7701(l)-3(c) to reduce United 
States withholding tax. W must withhold at the 30 percent rate on 
the dividends deemed paid to its benefited shareholders because the 
amount of withholding that applies to such payments

[[Page 810]]

determined under the form of the arrangement is higher than the 
amount of withholding that applies to such payments determined under 
Sec. 1.7701(l)-3(c).
    Example 2. The facts are the same as in Example 1 of this 
paragraph (g)(4) except that W does not know, or have reason to 
know, that A entered the arrangement with a principal purpose of 
using the recharacterization rules of Sec. 1.7701(l)-3(c) to reduce 
United States withholding tax. Further, the Commissioner has not 
exercised the discretion under Sec. 1.7701(l)-3(d) to depart from 
the recharacterization rules of Sec. 1.7701(l)-3(c). Accordingly, W 
must withhold tax at a 15 percent rate on the dividends deemed paid 
to the benefited shareholders.

    (5) Effective date. This paragraph (g) applies to payments made (or 
deemed made) on or after January 6, 1999.
    (h) Effective date. Except as otherwise provided in paragraph 
(f)(3) or (g)(5) of this section, this section applies to payments made 
after December 31, 1999.
    Par. 3. Section 1.7701(l)-3 is added to read as follows:


Sec. 1.7701(l)-3  Recharacterizing financing arrangements involving 
fast-pay stock.

    (a) Purpose and scope. This section is intended to prevent the 
avoidance of tax by persons participating in fast-pay arrangements (as 
defined in paragraph (b)(1) of this section) and should be interpreted 
in a manner consistent with this purpose. This section applies to all 
fast-pay arrangements. Paragraph (c) of this section recharacterizes 
certain fast-pay arrangements to ensure the participants are taxed in a 
manner reflecting the economic substance of the arrangements. Paragraph 
(f) of this section imposes reporting requirements on certain 
participants.
    (b) Definitions--(1) Fast-pay arrangement. A fast-pay arrangement 
is any arrangement in which a corporation has outstanding for any part 
of its taxable year two or more classes of stock, at least one of which 
is fast-pay stock.
    (2) Fast-pay stock--(i) Defined. Stock is fast-pay stock if it is 
structured so that dividends (as defined in section 316) paid by the 
corporation with respect to the stock are economically (in whole or in 
part) a return of the holder's investment (as opposed to only a return 
on the holder's investment). Unless clearly demonstrated otherwise, 
stock is presumed to be fast-pay stock if--
    (A) It is structured to have a dividend rate that is reasonably 
expected to decline (as opposed to a dividend rate that is reasonably 
expected to fluctuate or remain constant); or
    (B) It is issued for an amount that exceeds (by more than a de 
minimis amount, as determined under the principles of Sec. 1.1273-1(d)) 
the amount at which the holder can be compelled to dispose of the 
stock.
    (ii) Determination. The determination of whether stock is fast-pay 
stock is based on all the facts and circumstances, including any 
related agreements such as options or forward contracts. A related 
agreement is any direct or indirect agreement or understanding, oral or 
written, between the holder of the stock and the issuing corporation, 
or between the holder of the stock and one or more other shareholders 
in the corporation. The determination is made when the stock is issued 
and whenever there is a significant modification in the terms of the 
stock or the related agreements, or a significant change in the 
relevant facts and circumstances.
    (3) Benefited stock defined. With respect to a class of fast-pay 
stock, all other stock in the corporation (including any other class of 
fast-pay stock) is benefited stock.
    (c) Recharacterization of certain fast-pay arrangements--(1) Scope. 
This paragraph (c) applies to any fast-pay arrangement--
    (i) In which the corporation that has outstanding fast-pay stock is 
a regulated investment company (RIC) (as defined in section 851) or a 
real estate investment trust (REIT) (as defined in section 856); or
    (ii) If the Commissioner determines that a principal purpose for 
the structure of the fast-pay arrangement is the avoidance of any tax 
imposed by the Code. Application of this paragraph (c)(1)(ii) is at the 
Commissioner's discretion, and a determination under this paragraph 
(c)(1)(ii) applies to all parties to the fast-pay arrangement, 
including transferees.
    (2) Recharacterization. A fast-pay arrangement described in 
paragraph (c)(1) of this section is recharacterized as an arrangement 
directly between the benefited shareholders and the fast-pay 
shareholders. The inception and resulting relationships of the 
recharacterized arrangement are deemed to be as follows:
    (i) Relationship between benefited shareholders and fast-pay 
shareholders. The benefited shareholders issue financial instruments 
(the financing instruments) directly to the fast-pay shareholders in 
exchange for cash equal to the fair market value of the fast-pay stock 
at the time of issuance (taking into account any related agreements). 
The financing instruments have the same payment terms as the fast-pay 
stock. Thus, the timing and amount of the payments made with respect to 
the financing instruments always match the timing and amount of the 
distributions made with respect to the fast-pay stock.
    (ii) Relationship between benefited shareholders and corporation. 
The benefited shareholders contribute to the corporation the cash they 
receive for issuing the financing instruments. Distributions made with 
respect to the fast-pay stock are distributions made by the corporation 
with respect to the benefited shareholders' benefited stock.
    (iii) Relationship between fast-pay shareholders and corporation. 
For purposes of determining the relationship between the fast-pay 
shareholders and the corporation, the fast-pay stock is ignored. The 
corporation is the paying agent of the benefited shareholders with 
respect to the financing instruments.
    (3) Other rules--(i) Character of the financing instruments. The 
character of a financing instrument (for example, stock or debt) is 
determined under general tax principles and depends on all the facts 
and circumstances.
    (ii) Multiple classes of benefited stock. If there is more than one 
class of benefited stock, the recharacterization rules of this 
paragraph (c) apply among the different classes as appropriate to match 
the economic substance of the fast-pay arrangement.
    (iii) Sale of benefited stock. If one person sells benefited stock 
to another--
    (A) In addition to any consideration actually paid and received for 
the benefited stock, the buyer is deemed to pay and the seller is 
deemed to receive the amount necessary to terminate the seller's 
position in the financing instruments at fair market value; and
    (B) The buyer is deemed to issue financing instruments to the fast-
pay shareholders in exchange for the amount necessary to terminate the 
seller's position in the financing instruments.
    (iv) Adjustment to basis for amounts accrued or paid in taxable 
years ending before February 27, 1997. In the case of a fast-pay 
arrangement involving amounts accrued or paid in taxable years ending 
before February 27, 1997, and recharacterized under this paragraph (c), 
a benefited shareholder must decrease its basis in any benefited stock 
(as determined under paragraph (c)(2)(ii) of this section) by the 
amount (if any) that--
    (A) Its income attributable to the benefited stock (reduced by 
deductions attributable to financing instruments) for taxable years 
ending before February 27, 1997, computed by recharacterizing the fast-
pay arrangement this under this paragraph (c); exceeds

[[Page 811]]

    (B) Its income attributable to such stock for taxable years ending 
before February 27, 1997, computed without applying the rules of this 
paragraph (c).
    (d) Prohibition against affirmative use of recharacterization by 
taxpayers. A taxpayer may not use the rules of paragraph (c) of this 
section if a principal purpose for using such rules is the avoidance of 
any tax imposed by the Code. Thus, with respect to such taxpayer, the 
Commissioner may depart from the rules of this section and 
recharacterize (for all purposes of the Code) the fast-pay arrangement 
in accordance with its form or its economic substance. For example, if 
a foreign person acquires fast-pay stock in a REIT and a principal 
purpose for acquiring such stock is to reduce United States withholding 
taxes by applying the rules of paragraph (c) of this section, the 
Commissioner may, for purposes of determining the foreign person's 
United States tax consequences (namely, withholding tax), depart from 
the rules of paragraph (c) of this section and treat the foreign person 
as holding fast-pay stock in the REIT.
    (e) Examples. The following examples illustrate the rules of 
paragraph (c) of this section:

    Example 1. Decline in dividend rate. (i) Facts. Corporation X 
issues 100 shares of A Stock and 100 shares of B Stock for $1,000 
per share. By its terms, a share of B Stock is reasonably expected 
to pay a $110 dividend in years 1 through 10 and a $30 dividend each 
year thereafter. If X liquidates, the holder of a share of B Stock 
is entitled to a preference equal to the share's issue price. 
Otherwise, the B Stock cannot be redeemed at either X's or the 
shareholder's option.
    (ii) Analysis. When issued, the B Stock has a dividend rate that 
is reasonably expected to decline from an annual rate of 11 percent 
of its issue price to an annual rate of 3 percent of its issue 
price. Since the B Stock is structured to have a declining dividend 
rate, the B Stock is fast-pay stock, and the A Stock is benefited 
stock.
    Example 2. Issued at a premium. (i) Facts. The facts are the 
same as in Example 1 of this paragraph (e) except that a share of B 
Stock is reasonably expected to pay an annual $110 dividend as long 
as it is outstanding, and Corporation X has the right to redeem the 
B Stock for $400 a share at the end of year 10.
    (ii) Analysis. The B Stock is structured so that the issue price 
of the B Stock ($1,000) exceeds (by more than a de minimis amount) 
the price at which the holder can be compelled to dispose of the 
stock ($400). Thus, the B Stock is fast-pay stock, and the A Stock 
is benefited stock.
    Example 3. Recharacterization illustrated. (i) Facts. On 
formation, REIT Y issues 100 shares of C Stock and 100 shares of D 
Stock for $1,000 per share. By its terms, a share of D Stock is 
reasonably expected to pay a $110 dividend in years 1 through 10 and 
a $30 dividend each year thereafter. In years 1 through 10, persons 
holding a majority of the D Stock must consent before Y may take any 
action that would result in Y liquidating or dissolving, merging or 
consolidating, losing its REIT status, or selling substantially all 
of its assets. Thereafter, Y may take these actions without consent 
so long as the D Stock shareholders receive $400 in exchange for 
their D Stock.
    (ii) Analysis. When issued, the D Stock has a dividend rate that 
is reasonably expected to decline from an annual rate of 11 percent 
of its issue price to an annual rate of 3 percent of its issue 
price. In addition, the $1,000 issue price of a share of D Stock 
exceeds the price at which the shareholder can be compelled to 
dispose of the stock ($400). Thus, the D Stock is fast-pay stock, 
and the C Stock is benefited stock. Because Y is a REIT, the fast-
pay arrangement is recharacterized under paragraph (c) of this 
section.
    (iii) Recharacterization. The fast-pay arrangement is 
recharacterized as follows:
    (A) Under paragraph (c)(2)(i) of this section, the C Stock 
shareholders are treated as issuing financing instruments to the D 
Stock shareholders in exchange for $100,000 ($1,000, the fair market 
value of each share of D Stock, multiplied by 100, the number of 
shares).
    (B) Under paragraph (c)(2)(ii) of this section, the C Stock 
shareholders are treated as contributing $200,000 to Y (the $100,000 
received for the financing instruments, plus the $100,000 actually 
paid for the C Stock) in exchange for the C Stock.
    (C) Under paragraph (c)(2)(ii) of this section, each 
distribution with respect to the D Stock is treated as a 
distribution with respect to the C Stock.
    (D) Under paragraph (c)(2)(iii) of this section, the C Stock 
shareholders are treated as making payments with respect to the 
financing instruments, and Y is treated as the paying agent of the 
financing instruments for the C Stock shareholders.
    Example 4. Transfer of benefited stock illustrated. (i) Facts. 
The facts are the same as in Example 3 of this paragraph (e). Near 
the end of year 5, a person holding one share of C Stock sells it 
for $1,300. The buyer is unrelated to REIT Y or to any of the D 
Stock shareholders. At the time of the sale, the amount needed to 
terminate the seller's position in the financing instruments at fair 
market value is $747.
    (ii) Benefited shareholder's treatment on sale. Under paragraph 
(c)(3)(iii)(A) of this section, the seller's amount realized is 
$2,047 ($1,300, the amount actually received, plus $747, the amount 
necessary to terminate the seller's position in the financing 
instruments at fair market value). The seller's gain on the sale of 
the common stock is $47 ($2,047, the amount realized, minus $2,000, 
the seller's basis in the common stock). The seller has no income or 
deduction with respect to terminating its position in the financing 
instruments.
    (iii) Buyer's treatment on purchase. Under paragraph 
(c)(3)(iii)(A) of this section, the buyer's basis in the share of D 
Stock is $2,047 ($1,300, the amount actually paid, plus $747, the 
amount needed to terminate the seller's position in the financing 
instruments at fair market value). Under paragraph (c)(3)(iii)(B) of 
this section, simultaneous with the sale, the buyer is treated as 
issuing financing instruments to the fast-pay shareholders in 
exchange for $747, the amount necessary to terminate the seller's 
position in the financing instruments at fair market value.
    Example 5. Fast-pay arrangement involving amounts accrued or 
paid in a taxable year ending before February 27, 1997. (i) Facts. Y 
is a calendar year taxpayer. In June 1996, Y acquires shares of REIT 
T benefited stock for $15,000. In December 1996, Y receives 
dividends of $100. Under the recharacterization rules of paragraph 
(c)(2) of this section, Y's 1996 income attributable to the 
benefited stock is $1,200, Y's 1996 deduction attributable to 
financing instruments is $500, and Y's basis in the benefited stock 
is $25,000.
    (ii) Analysis. Under paragraph (c)(3)(iv) of this section, Y's 
basis in the benefited stock is reduced by $600. This is the amount 
by which Y's 1996 income from the fast-pay arrangement as 
recharacterized under this section ($1,200 of income attributable to 
the benefited stock less $500 of deductions attributable to the 
financing instruments), exceeds Y's 1996 income from the fast-pay 
arrangement as not recharacterized under this section ($100 of 
income attributable to the benefited stock). Thus, in 1997 when the 
fast-pay arrangement is recharacterized, Y's basis in the benefited 
stock is $24,400.

    (f) Reporting requirement--(1) Filing requirements--(i) In general. 
A corporation that has fast-pay stock outstanding at any time during 
the taxable year must attach the statement described in paragraph 
(f)(2) of this section to its federal income tax return for such 
taxable year. This paragraph (f)(1)(i) does not apply to a corporation 
described in paragraph (f)(1)(ii), (iii), or (iv) of this section.
    (ii) Controlled foreign corporation. In the case of a controlled 
foreign corporation (CFC), as defined in section 957, that has fast-pay 
stock outstanding at any time during its taxable year (during which 
time it was a CFC), each controlling United States shareholder (within 
the meaning of Sec. 1.964-1(c)(5)) must attach the statement described 
in paragraph (f)(2) of this section to the shareholder's Form 5471 for 
the CFC's taxable year. The provisions of section 6038 and the 
regulations under section 6038 apply to any statement required by this 
paragraph (f)(1)(ii).
    (iii) Foreign personal holding company. In the case of a foreign 
personal holding company (FPHC), as defined in section 552, that has 
fast-pay stock outstanding at any time during its taxable year (during 
which time it was a FPHC), each United States citizen or resident who 
is an officer, director, or 10-percent shareholder (within the meaning 
of section 6035(e)(1)) of such FPHC must attach the statement described 
in paragraph (f)(2) of this

[[Page 812]]

section to his or her Form 5471 for the FPHC's taxable year. The 
provisions of sections 6035 and 6679 and the regulations under sections 
6035 and 6679 apply to any statement required by this paragraph 
(f)(1)(iii).
    (iv) Passive foreign investment company. In the case of a passive 
foreign investment company (PFIC), as defined in section 1297, that has 
fast-pay stock outstanding at any time during its taxable year (during 
which time it was a PFIC), each shareholder that has elected (under 
section 1295) to treat the PFIC as a qualified electing fund and knows 
or has reason to know that the PFIC has outstanding fast-pay stock must 
attach the statement described in paragraph (f)(2) of this section to 
the shareholder's Form 8621 for the PFIC's taxable year. Each 
shareholder owning 10 percent or more of the shares of the PFIC (by 
vote or value) is presumed to know that the PFIC has issued fast-pay 
stock. The provisions of sections 1295(a)(2) and 1298(f) and the 
regulations under sections 1295(a)(2) and 1298(f) (including 
Sec. 1.1295-1T(f)(2)) apply to any statement required by this paragraph 
(f)(1)(iv).
    (2) Statement. The statement required under this paragraph (f) must 
say, ``This fast-pay stock disclosure statement is required by 
Sec. 1.7701(l)-3(f) of the income tax regulations.'' The statement must 
also identify the corporation that has outstanding fast-pay stock and 
must contain the date on which the fast-pay stock was issued, the terms 
of the fast-pay stock, and (to the extent the filing person knows or 
has reason to know such information) the names and taxpayer 
identification numbers of the shareholders of any class of stock that 
is not traded on an established securities market (as described in 
Sec. 1.7704-1(b)).
    (g) Effective date--(1) In general. Except as provided in paragraph 
(g)(4) of this section (relating to reporting requirements), this 
section applies to taxable years ending after February 26, 1997. Thus, 
all amounts accrued or paid during the first taxable year ending after 
February 26, 1997, are subject to this section.
    (2) Election to limit taxable income attributable to a 
recharacterized fast-pay arrangement for taxable years ending after 
February 26, 1997, and before the date these regulations are published 
as final regulations in the Federal Register--(i) Limit and adjustment. 
For taxable years ending after February 26, 1997, and before the date 
these regulations are published as final regulations in the Federal 
Register, a shareholder may limit its taxable income attributable to a 
fast-pay arrangement recharacterized under paragraph (c) of this 
section, to the taxable income that would result if the fast-pay 
arrangement were recharacterized under Notice 97-21, 1997-1 C.B. 407, 
see Sec. 601.601(d)(2) of this chapter. Any amount a shareholder 
excludes from taxable income under this paragraph (g)(2)(i) must be 
included as an adjustment to taxable income in the shareholder's first 
taxable year that includes the date these regulations are published as 
final regulations in the Federal Register. A shareholder that has 
elected to limit its taxable income under this paragraph (g)(2)(i) must 
include a statement in its books and records identifying each fast-pay 
arrangement to which the limit was applied and providing the amount 
excluded from taxable income for each such fast-pay arrangement.
    (ii) The following examples illustrate the rules of this paragraph 
(g)(2). For purposes of these examples, assume that the last year a 
shareholder may limit its taxable income under this paragraph (g)(2) is 
1998. The examples are as follows:

    Example 1. Fast-pay arrangement recharacterized under Notice 97-
21; REIT holds third-party debt--(i) Facts. (A) REIT Y is formed on 
January 1, 1998, at which time it issues 1,000 shares of fast-pay 
stock and 1,000 shares of benefited stock for $100 per share. Y and 
all of its shareholders have calendar taxable years. All 
shareholders of Y have elected to accrue market discount based on a 
constant interest rate, to include the market discount in income as 
it accrues, and to amortize bond premium.
    (B) For years 1 through 5, the fast-pay stock has an annual 
dividend rate of $17 per share ($17,000 for the class); in later 
years, the fast-pay stock has an annual dividend rate of $1 per 
share ($1,000 for the class). At the end of year 5, and thereafter, 
a share of fast-pay stock can be acquired by Y in exchange for $50 
($50,000 for the class).
    (C) On the day Y is formed, it acquires a five-year mortgage 
note (the note) issued by an unrelated third party for $200,000. The 
note provides for annual interest payments on December 31 of $18,000 
(a coupon interest rate of 9.0 percent, compounded annually), and 
one payment of principal at the end of 5 years. The note can be 
prepaid, in whole or in part, at any time.
    (ii) Recharacterization under Notice 97-21. (A) In general. One 
way to recharacterize the fast-pay arrangement under Notice 97-21 is 
to treat the fast-pay shareholders and the benefited shareholders as 
if they jointly purchased the note from the issuer with the 
understanding that over the five-year term of the note the benefited 
shareholders would use their share of the interest to buy (on a 
dollar-for-dollar basis) the fast-pay shareholders' portion of the 
note. The benefited shareholders' and the fast-pay shareholders' 
yearly taxable income under Notice 97-21 can then be calculated 
after determining their initial portions of the note and whether 
those initial portions are purchased at a discount or premium.
    (B) Determining initial portions of the debt instrument. The 
fast-pay shareholders' and the benefited shareholders' initial 
portions of the note can be determined by comparing the present 
values of their expected cash flows. As a class, the fast-pay 
shareholders expect to receive cash flows of $135,000 (five annual 
payments of $17,000, plus a final payment of $50,000). As a class, 
the benefited shareholders expect to receive cash flows of $155,000 
(five annual payments of $1,000, plus a final payment of $150,000). 
Using a discount rate equal to the yield to maturity (as determined 
under Sec. 1.1272-1(b)(1)(i)) of the mortgage note (9.0 percent, 
compounded annually), the present value of the fast-pay 
shareholders' cash flows is $98,620, and the present value of the 
benefited shareholders' cash flows is $101,380. Thus, the fast-pay 
shareholders initially acquire 49 percent of the note at a $1,380 
premium (that is, they paid $100,000 for $98,620 of principal in the 
note). The benefited shareholders initially acquire 51 percent of 
the note at a $1,380 discount (that is, they paid $100,000 for 
$101,380 of principal in the note). Under section 171, the fast-pay 
shareholders' premium is amortizable based on their yield in their 
initial portion of the note (8.57 percent, compounded annually). The 
benefited shareholders' discount accrues based on the yield in their 
initial portion of the note (9.35 percent, compounded annually).
    (C) Taxable income under Notice 97-21. Under Notice 97-21, the 
fast-pay shareholders' 1998 taxable income attributable to the fast-
pay arrangement is $8,574 ($8.57 per $100 invested), computed by 
subtracting the amortizable premium ($302) from the interest income 
from their portion of the note ($8,876). The benefited shareholders' 
1998 taxable income attributable to the fast-pay arrangement is 
$9,353 ($9.35 per $100 invested), computed by adding the accrued 
discount ($229) to the interest income from their portion of the 
note ($9,124).
    (iii) Taxable income under the recharacterization of this 
section. Assume the financing instruments are debt instruments. 
Under the recharacterization rules of paragraph (c) of this section, 
the fast-pay shareholders' 1998 taxable income attributable to the 
fast-pay arrangement is $8,574 ($8.57 per $100 invested), which is 
the interest income from the financing instruments. The benefited 
shareholders' 1998 taxable income attributable to the fast-pay 
arrangement is $9,426 ($9.43 per share of benefited stock), computed 
by subtracting the interest income accrued on the financing 
instruments ($8,574) from the dividend income actually and deemed 
paid on the benefited stock ($18,000).
    (iv) Limit on taxable income under this paragraph (g)(2). (A) 
Fast-pay shareholders. For 1998, the fast-pay shareholders have the 
same taxable income under the recharacterization of Notice 97-21 
($8,574) as they have under the recharacterization of paragraph (c) 
of this section ($8,574). Thus,

[[Page 813]]

the limit under paragraph (g)(2)(i) of this section is unavailable 
to the fast-pay shareholders.
    (B) Benefited shareholders. For 1998, the benefited shareholders 
have taxable income attributable to the fast-pay arrangement of 
$9,353 ($9.35 per $100 invested) under the recharacterization of 
Notice 97-21, and taxable income of $9,426 ($9.43 per share of 
benefited stock) under the recharacterization of paragraph (c) of 
this section. Thus, under paragraph (g)(2)(i) of this section, a 
benefited shareholder may elect to limit its taxable income 
attributable to the fast-pay arrangement to $9.35 for each share of 
benefited stock. Any amount an electing shareholder excludes from 
taxable income($0.08 per share of benefited stock) must later be 
included as an adjustment. (If all benefited shareholders elect the 
limit, then as a class the later adjustment to taxable income is 
$73.)
    Example 2. REIT holds debt issued by a benefited shareholder. 
(i) Facts. The facts are the same as in Example 1 of this paragraph 
(g)(2) except that corporation Z holds 800 shares (80 percent) of 
the benefited stock, and Z, instead of a third party, issues the 
mortgage note acquired by Y.
    (ii) Recharacterization under Notice 97-21. Because Y holds a 
debt instrument issued by Z, the fast-pay arrangement is 
recharacterized under Notice 97-21 as an arrangement in which Z 
issued one or more instruments directly to the fast-pay shareholders 
and the other benefited shareholders. Consistent with this 
recharacterization, Z is treated as issuing a debt instrument to the 
fast-pay shareholders for $100,000. The debt instrument provides for 
five annual payments of $17,000 and an additional payment of $50,000 
in year five. Thus, the debt instrument's yield to maturity is 8.57 
percent per annum, compounded annually. Z is also treated as issuing 
a debt instrument to the other benefited shareholders for $20,000 
(200 shares multiplied by $100, or 20 percent of the $100,000 paid 
to Y by the benefited shareholders as a class). This debt instrument 
provides for five annual payments of $200 and an additional payment 
of $30,000 in year five. The debt instrument's yield to maturity is 
9.30 percent per annum, compounded annually. For 1998, Z's interest 
expense is $10,435 ($8,574 attributable to the debt instruments held 
by the fast-pay shareholders, and $1,861 attributable to the debt 
instruments held by the other benefited shareholders).
    (iii) Recharacterization under this section. Assume the 
financing instruments are debt instruments. Under the 
recharacterization rules of paragraph (c) of this section, for 1998, 
Z has dividend income of $14,400 (800 shares multiplied by $18, or 
80 percent of $18,000), and total interest expense of $24,859 
($18,000 of interest accrued on the note held by Y, and $6,859 of 
interest accrued on the financing instruments).
    (iv) Limit on taxable income under this paragraph (g)(2). For 
1998, Z has a taxable loss attributable to the fast-pay arrangement 
of $10,435 under the recharacterization of Notice 97-21, and a 
taxable loss of $10,459 ($14,400 of dividends, minus $24,859 of 
total interest expense) under the recharacterization of paragraph 
(c) of this section. Thus, for 1998, Z's taxable loss attributable 
to the fast-pay arrangement is $10,459 (the amount determined under 
paragraph (c) of this section), and the limit of paragraph (g)(2)(i) 
of this section is unavailable to Z.

    (3) Rule to comply with this section. To comply with this section 
for each taxable year in which it failed to do so, a taxpayer should 
file an amended return. For taxable years ending before the date these 
regulations are published as final regulations, a taxpayer that has 
complied with Notice 97-21, 1997-1 C.B. 407 (see Sec. 601.601(d)(2) of 
this chapter), is considered to have complied with this section.
    (4) Reporting requirements. The reporting requirements of paragraph 
(f) of this section apply to taxable years (of the person required to 
file the statement) ending after the date these regulations are 
published as final regulations in the Federal Register.

John M. Dalrymple,
Deputy Commissioner of Internal Revenue.
[FR Doc. 99-178 Filed 1-5-99; 8:45 am]
BILLING CODE 4830-01-U