[Federal Register Volume 65, Number 6 (Monday, January 10, 2000)]
[Rules and Regulations]
[Pages 1310-1318]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-114]



[[Page 1310]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8853]
RIN 1545-AV07


Recharacterizing Financing Arrangements Involving Fast-Pay Stock

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final 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.

DATES: Effective Date: February 27, 1997.
    Applicability Dates: For dates of applicability, see Secs. 1.1441-
10(e) and 1.7701(l)-3(g) of these regulations.

FOR FURTHER INFORMATION CONTACT: Jonathan Zelnik, (202) 622-3920 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1642. Responses to this collection 
of information are mandatory.
    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.
    The estimated average annual burden hours per respondent/
recordkeeper: 1 hour.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, 
Washington, DC 20224, and 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.
    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 informed the public that the IRS and Treasury 
Department expected to issue regulations recharacterizing these 
arrangements to prevent tax avoidance. No comments were received in 
response to Notice 97-21.
    On January 6, 1999, the IRS published in the Federal Register a 
notice of proposed rulemaking (64 FR 805) providing rules for the 
recharacterization of certain fast-pay arrangements under section 
7701(l) of the Internal Revenue Code. Because no one requested to speak 
at the public hearing, the hearing was canceled. Four written comments 
responding to the notice of proposed rulemaking were received. The 
comments addressed neither (1) the accuracy of the estimate of the 
collection of information burden nor (2) the accuracy of the IRS's 
understanding that the total number of entities engaging in 
transactions affected by these regulations is not substantial and most 
are not small entities within the meaning of the Regulatory Flexibility 
Act (5 U.S.C. chapter 6). After considering the comments, the proposed 
regulations are adopted as final regulations with some changes.
    The preamble to the proposed regulations (64 FR 805) provides a 
detailed discussion of fast-pay arrangements and the proposed 
regulations.

Summary of Comments and Changes

In General

    Two commentators were generally favorable to the proposed 
regulations. One considered them a reasonable attempt to address 
abusive transactions. The other viewed them as consistent with section 
7701(l), but preferred, as a matter of tax policy, a legislative 
solution. One of these commentators also recommended narrowing the 
scope of the proposed regulations, asserting they might penalize 
shareholders who do not benefit from the fast-pay arrangement. 
Significantly, neither of these commentators recommended that the final 
regulations adopt a different approach, such as the one taken in Notice 
97-21.
    A third commentator criticized the proposed regulations as 
inconsistent with section 7701(l). This commentator viewed them as 
addressing not a conduit financing issue, but a tax accounting issue, 
namely, that the amount of dividend income under tax principles can 
exceed the economic income from the stock. Additionally, this 
commentator believed that regulations under section 7701(l) cannot 
operate if there is no back-to-back structure or if the corporation 
subject to recharacterization holds bona fide assets such as third-
party debt. Finally, the commentator questioned whether the grant of 
regulatory authority under section 7701(l) permits recharacterizing 
transactions subject to other, comprehensive statutory rules such as 
the rules governing the transactions of RICs and REITs.
    The IRS and Treasury Department have concluded that section 7701(l) 
authorizes recharacterization of any multiple-party financing 
transaction, including a fast-pay arrangement. The IRS and Treasury 
Department have also concluded (as did the other two commentators) that 
recharacterizing a fast-pay arrangement as an arrangement directly 
between the fast-pay shareholders and the benefited shareholders is 
consistent with the legislative mandate of section 7701(l). Thus, the 
final regulations retain the approach of the proposed regulations while 
making some changes to address other comments.

Definition of Fast-Pay Stock

    Under the proposed regulations, 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). To determine if it is fast-pay stock, 
stock is examined when issued, and, for stock that is not fast-pay 
stock when issued, when 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.
    Two commentators expressed concern about the interaction of section 
302 with the definition of fast-pay stock and the duty to retest stock. 
In particular, the commentators asked whether stock that is not fast-
pay stock when issued can become fast-pay stock solely because a 
redemption of the stock is treated as a dividend under section 302. 
This conversion is possible because section 302 treats certain 
redemptions as distributions of property to which

[[Page 1311]]

section 301 applies rather than as distributions in exchange for stock.
    The commentators gave different reasons why stock should not become 
fast-pay stock solely because a redemption is treated as a dividend. 
One reason was that section 302 and the provisions referring to it (for 
example, section 1059(e)) already recharacterize certain redemptions of 
stock, which indicates Congress has determined the appropriate tax 
treatment of these transactions. Another reason was that applying the 
fast-pay regulations to arrangements involving redemptions may have a 
chilling effect on common, non-abusive transactions. Finally, it was 
suggested that any changes affecting the application of section 302 
should be accomplished by issuing new regulations under that statute.
    The IRS and Treasury Department agree it is inappropriate to treat 
as a fast-pay arrangement every arrangement in which a redemption of 
stock produces dividend income under section 302. The IRS and Treasury 
Department, however, conclude that eliminating all such arrangements 
from the scope of the regulations would render the regulations 
meaningless. Little difference exists between a fast-pay arrangement 
resulting from redemptions structured to be dividends and a fast-pay 
arrangement resulting from dividends structured to be a return of the 
holder's investment.
    To balance the concerns of the commentators and the concerns of the 
IRS and Treasury Department, the final regulations add a new rule 
clarifying the effect of section 302 on the determination of whether 
stock is fast-pay stock. Under this rule, stock is not fast-pay stock 
solely because a redemption is treated as a dividend by section 302 
unless there is a principal purpose of achieving the same economic and 
tax effect as a fast-pay arrangement. In this way, only those 
arrangements in which redemptions are designed to return a 
shareholder's economic investment as dividends are recharacterized. 
Because the problem of stock redemptions may be common to many 
different fast-pay arrangements, regardless of how they are structured, 
the rule addressing such problem is placed within the regulations under 
section 7701(l) rather than under a different section.

Characterization of the Financing Instruments

    Under the proposed regulations, the fast-pay shareholders are 
treated as holding financing instruments issued by the benefited 
shareholders rather than as holding the fast-pay stock. The character 
of financing instruments (for example, stock or debt) is determined 
under general tax principles and depends on all the facts and 
circumstances.
    All three commentators were concerned by the failure of the 
proposed regulations to classify the financing instruments as debt. If 
the financing instruments are classified as stock, the benefited 
shareholders are subject to substantially greater tax liabilities: they 
must include in income all dividends paid by the corporation that 
issues the fast-pay stock, but cannot deduct amounts deemed paid with 
respect to the financing instruments. According to the commentators, 
this result distorts the benefited shareholders' economic income. 
Therefore, the regulations should classify the financing instruments as 
debt in all cases.
    After careful consideration of the comments, the IRS and Treasury 
Department have decided against characterizing the financing 
instruments in the final regulations. Although debt characterization 
may be appropriate in some cases, in other cases it will be more 
appropriate to characterize the financing instruments as equity or 
something else. Thus, the rule in the proposed regulations is retained. 
(As explained below, however, the final regulations permit taxpayers, 
for a limited period, to determine their taxable income attributable to 
a recharacterized fast-pay arrangement by treating the financing 
instruments as debt.)

Election to Limit Taxable Income Attributable to a Recharacterized 
Fast-Pay Arrangement for Periods Before April 1, 2000

    Because the regulations are effective February 27, 1997 (the date 
Notice 97-21 was issued to the public), the proposed regulations permit 
a shareholder of a recharacterized fast-pay arrangement to limit, for 
certain taxable years, its income from the arrangement. Specifically, a 
shareholder may limit its taxable income attributable to a 
recharacterized fast-pay arrangement to the taxable income that results 
if the fast-pay arrangement is recharacterized under Notice 97-21. This 
limit is available under the proposed regulations for taxable years 
ending after the effective date of the regulations and before the 
regulations are finalized. Any amount excluded under this 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. 
Thus, the sole benefit of limiting taxable income under the proposed 
regulations is a timing benefit. The preamble to the proposed 
regulations found this appropriate on the assumption that 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.
    One commentator criticized this assumption, and, therefore, the 
limit and later adjustment. In particular, the commentator pointed out 
that if the financing instruments are treated as equity under the 
regulations, a benefited shareholder would have had less taxable income 
over the life of the fast-pay arrangement under the recharacterization 
of Notice 97-21 (that is, a shareholder would have a permanent 
reduction to taxable income). Thus, the limit is without any 
substantive effect because any non-timing reduction in taxable income 
due to the limit is included in the year the regulations are finalized. 
To rectify this problem, the commentator asked that, if the final 
regulations do not classify the financing instruments as debt in all 
cases, they should at least classify the financing instruments as debt 
for the period starting after the effective date of the final 
regulations and ending before the final regulations are published.
    To address these concerns, the final regulations adopt a different 
rule from the one in the proposed regulations. As with the proposed 
regulations, a shareholder may limit its taxable income to either the 
amount determined under Notice 97-21 or the amount determined under the 
regulations. For purposes of this limit, a shareholder may assume the 
financing instruments are debt under the final regulations. A 
shareholder may also make this assumption to determine the amount of 
any later adjustment to income because of the limit. Thus, the later 
adjustment will not include any permanent reduction to taxable income a 
shareholder realizes by limiting its taxable income to the amount 
determined under Notice 97-21.
    The final regulations also adopt a longer period during which 
shareholders may limit their taxable income. Under the proposed 
regulation, a shareholder may limit its taxable income for taxable 
years ending after February 26, 1997, and before the date these 
regulations are published as final regulations in the Federal Register. 
The final regulations permit a shareholder to limit its taxable income 
for all periods before April 1, 2000. Thus, for all taxable years 
ending after February 26, 1997 and before April 1, 2000, and for that 
part of a shareholder's taxable year before April 1, 2000, a 
shareholder may

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limit its taxable income attributable to the fast-pay arrangement.
    In permitting shareholders to determine their taxable income under 
the regulations by assuming that the financing instruments are debt for 
periods before April 1, 2000, the IRS and Treasury Department intend no 
implication regarding the proper characterization of the financing 
instruments under general tax principles. Rather, the rule regarding 
the financing instruments is intended solely for the purpose of giving 
shareholders the benefit of the recharacterization described in Notice 
97-21 for periods before April 1, 2000.

Use of Derivatives To Avoid the Regulations

    One commentator recommended adding an explicit rule to prevent 
parties from using derivative contracts to create a fast-pay 
arrangement that escapes either the regulations or the effect of the 
recharacterization rules. To illustrate this point, the commentator 
posited a simplified transaction in which a corporation issues fast-pay 
stock to one tax-exempt entity and benefited stock to another tax-
exempt entity. The tax-exempt entity holding the benefited stock enters 
into a prepaid forward contract with a taxable person. Under the 
prepaid forward contract, the taxable person must buy the benefited 
stock in the future for an amount substantially below its expected 
value. According to the commentator, unless the taxable person is 
treated as owning the benefited stock, the parties have created a fast-
pay arrangement in which the recharacterization of the regulations 
fails to prevent tax avoidance. Without making a recommendation, the 
commentator offered a number of rules to correct this situation. (The 
commentator did not discuss whether the benefited holder would be 
subject to the ``debt-financing'' rules in section 514).
    The IRS and Treasury Department have concluded that there is no 
present need to modify the regulations to address this problem. First, 
the tax treatment of derivatives in general is outside of the scope of 
these regulations. Therefore, a rule specific to these regulations 
would only increase the complexity regarding the tax treatment of 
derivatives. Second, and more importantly, the IRS and Treasury 
Department have concluded that under existing law the party entitled to 
purchase the benefited stock under a prepaid forward contract such as 
the one described above is the owner of the benefited stock for federal 
income tax purposes. See Rev. Rul. 82-150, 1982-2 C.B. 110 (concluding 
that the holder of a deep-in-the-money option is the owner of the 
reference property). Finally, the regulations state they are to be 
interpreted in a manner consistent with preventing the avoidance of 
tax. Mechanically applying the regulations in a manner that does not 
prevent tax avoidance is clearly inconsistent with the purpose of the 
regulations and the Congressional mandate of section 7701(l).

Fast-Pay Arrangement Defined

    The proposed regulations define a fast-pay arrangement as 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. Some taxpayers assert that the regulations can be 
avoided by creating a fast-pay arrangement in which a corporation 
issues what is nominally a single class of shares, notwithstanding that 
some of the shares are subject to a related agreement. These taxpayers 
apparently rely on the formal meaning of ``class'' under state 
corporate law and ignore the direction in the proposed regulations to 
determine whether stock is fast-pay stock based on all the facts and 
circumstances.
    To remove any doubt that the regulations cover fast-pay 
arrangements no matter how contrived, the IRS and Treasury Department 
have simplified the definition of ``fast-pay arrangement'' in the final 
regulations. Under this definition, a fast-pay arrangement is any 
arrangement in which a corporation has fast-pay stock outstanding for 
any part of its taxable year. The regulations illustrate this point 
with an example.

Effective Date

    These regulations apply to taxable years ending after February 26, 
1997.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It is hereby 
certified that these regulations will not have a significant economic 
impact on a substantial number of small entities. 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, the 
notice of proposed rulemaking preceding these regulations was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comments on its impact on small businesses.

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

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are 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 in part 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 1.1441-10, is added to read as follows:


Sec. 1.1441-10  Withholding agents with respect to fast-pay 
arrangements.

    (a) 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 payments made on the fast-pay stock and payments 
deemed made under the recharacterization rules of Sec. 1.7701(l)-3. 
Except as provided in this paragraph (a) or in paragraph (b) 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 (b) of this section, if at any time the withholding agent 
knows or has reason to know that the Commissioner has exercised the 
discretion under either Sec. 1.7701(l)-3(c)(1)(ii) to apply the 
recharacterization rules of Sec. 1.7701(l)-

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3(c), or 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.
    (b) 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--
    (1) The amount of withholding that would apply to such payment 
determined under the form of the arrangement; or
    (2) The amount of withholding that would apply to deemed payments 
determined under the recharacterization rules of Sec. 1.7701(l)-3(c).
    (c) Liability. Any person required to deduct and withhold tax under 
this section 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.
    (d) Examples. The following examples illustrate the rules of this 
section:

    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 
because the amount of withholding that applies to the payments 
determined under the form of the arrangement is higher than the 
amount of withholding that applies to the payments determined under 
Sec. 1.7701(l)-3(c).
    Example 2. The facts are the same as in Example 1 of this 
paragraph (d) except that W does not know, or have reason to know, 
that A entered into 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.

    (e) Effective date. This section applies to payments made (or 
deemed made) on or after January 6, 1999.

    Par. 3. Section 1.7701(l)-0 is added to read as follows:


Sec. 1.7701(l)-0  Table of contents.

    This section lists captions that appear in Secs. 1.7701(l)-1 and 
1.7701(l)-3:

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

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

    (a) Purpose and scope.
    (b) Definitions.
    (1) Fast-pay arrangement.
    (2) Fast-pay stock.
    (i) Defined.
    (ii) Determination.
    (3) Benefited stock.
    (c) Recharacterization of certain fast-pay arrangements.
    (1) Scope.
    (2) Recharacterization.
    (i) Relationship between benefited shareholders and fast-pay 
shareholders.
    (ii) Relationship between benefited shareholders and 
corporation.
    (iii) Relationship between fast-pay shareholders and 
corporation.
    (3) Other rules.
    (i) Character of the financing instruments.
    (ii) Multiple types of benefited stock.
    (iii) Transactions affecting benefited stock.
    (A) Sale of benefited stock.
    (B) Transactions other than sales.
    (iv) Adjustment to basis for amounts accrued or paid in taxable 
years ending before February 27, 1997.
    (d) Prohibition against affirmative use of recharacterization by 
taxpayers.
    (e) Examples.
    (f) Reporting requirement.
    (1) Filing requirements.
    (i) In general.
    (ii) Controlled foreign corporation.
    (iii) Foreign personal holding company.
    (iv) Passive foreign investment company.
    (2) Statement.
    (g) Effective date.
    (1) In general.
    (2) Election to limit taxable income attributable to a 
recharacterized fast-pay arrangement for periods before April 1, 
2000.
    (i) Limit.
    (ii) Adjustment and statement.
    (iii) Examples.
    (3) Rule to comply with this section.
    (4) Reporting requirements.

    Par. 4. 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 fast-pay stock 
outstanding for any part of its taxable year.
    (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 includes 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. To determine if it is fast-pay stock, 
stock is examined when issued, and, for stock that is not fast-pay 
stock when issued, when 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. Stock is not fast-pay stock 
solely because a redemption is treated as a dividend as a result of 
section 302(d) unless there is a principal purpose of achieving the 
same economic and tax effect as a fast-pay arrangement.
    (3) Benefited stock. With respect to any fast-pay stock, all other 
stock in the corporation (including other fast-pay stock having any 
significantly different characteristics) is benefited stock.
    (c) Recharacterization of certain fast-pay arrangements--(1) Scope. 
This paragraph (c) applies to any fast-pay arrangement--

[[Page 1314]]

    (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 Internal Revenue 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 terms (other than issuer) as 
the fast-pay stock. Thus, for example, 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 types of benefited stock. If any benefited stock has 
any significantly different characteristics from any other benefited 
stock, the recharacterization rules of this paragraph (c) apply among 
the different types of benefited stock as appropriate to match the 
economic substance of the fast-pay arrangement.
    (iii) Transactions affecting benefited stock--(A) Sale of benefited 
stock. If one person sells benefited stock to another--
    (1) 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
    (2) 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.
    (B) Transactions other than sales. Except for transactions subject 
to paragraph (c)(3)(iii)(A) of this section, in the case of any 
transaction affecting benefited stock, the parties to the transaction 
must make appropriate adjustments to properly take into account the 
fast-pay arrangement as characterized under paragraph (c)(2) of this 
section.
    (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 the financing instruments) for taxable years 
ending before February 27, 1997, computed by recharacterizing the fast-
pay arrangement under this paragraph (c) and by treating the financing 
instruments as debt; exceeds
    (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 Internal Revenue Code. Thus, with respect to 
such taxpayer, the Commissioner may depart from the rules of this 
section and recharacterize (for all purposes of the Internal Revenue 
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 
(including 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. Planned section 302(d) redemptions--(i) Facts. 
Corporation L, a subchapter C corporation, issues 220 shares of 
common stock for $1,000 per share. No other stock is authorized, but 
L can issue warrants entitling the holder to acquire L common stock 
for $3,000 per share until such time as L adopts a plan of 
liquidation. L can adopt a plan of liquidation if approved by 90 
percent of its shareholders. Half of L's stock is purchased by 
Corporation M, and half by Organization N, which is tax exempt. At 
the time of purchase, M and N agree that for a period of ten years L 
will annually redeem (and N will tender) ten shares of stock in 
exchange for $12,100 and ten warrants. It is anticipated that, under 
sections 302 and 301, the annual payment to N will be a distribution 
of property that is a dividend.
    (ii) Analysis. Considering all the facts and circumstances, 
including the agreement between M and N, L's redemption of N's stock 
is undertaken with a principal purpose of achieving the same 
economic and tax

[[Page 1315]]

effect as a fast-pay arrangement. Thus, N's stock is fast-pay stock, 
M's stock is benefited stock, and the parties have entered into a 
fast-pay arrangement. Because L is neither a RIC nor a REIT, whether 
this fast-pay arrangement is recharacterized under paragraph (c) of 
this section depends on whether the Commissioner determines, under 
paragraph (c)(1)(ii) of this section, that a principal purpose for 
the structure of the fast-pay arrangement is the avoidance of any 
tax imposed by the Internal Revenue Code.
    Example 4. 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 5. Transfer of benefited stock illustrated--(i) Facts. 
The facts are the same as in Example 4 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 6. 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 the 
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 paragraphs (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 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 those sections (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 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

[[Page 1316]]

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 periods before April 1, 2000--
(i) Limit. For periods before April 1, 2000, provided the shareholder 
recharacterizes the fast-pay arrangement consistently for all such 
periods, 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 results if the fast-pay arrangement 
is recharacterized under either--
    (A) Notice 97-21, 1997-1 C.B. 407, see Sec. 601.601(d)(2) of this 
chapter; or
    (B) Paragraph (c) of this section, computed by assuming the 
financing instruments are debt.
    (ii) Adjustment and statement. A shareholder that limits its 
taxable income to the amount determined under paragraph (g)(2)(i)(A) of 
this section must include as an adjustment to taxable income the 
excess, if any, of the amount determined under paragraph (g)(2)(i)(B) 
of this section, over the amount determined under paragraph 
(g)(2)(i)(A) of this section. This adjustment to taxable income must be 
made in the shareholder's first taxable year that includes April 1, 
2000. A shareholder to which this paragraph (g)(2)(ii) applies must 
include a statement in its books and records identifying each fast-pay 
arrangement for which an adjustment must be made and providing the 
amount of the adjustment for each such fast-pay arrangement.
    (iii) Examples. The following examples illustrate the rules of this 
paragraph (g)(2). For purposes of these examples, assume that a 
shareholder may limit its taxable income under this paragraph (g)(2) 
for periods before January 1, 2000.

    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, 1997, 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 are U.S. persons and 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 all fast-pay stock); in 
later years, the fast-pay stock has an annual dividend rate of $1 
per share ($1,000 for all fast-pay stock). 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 all fast-pay stock).
    (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 9.00 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 group, 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 group, 
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 (9.00 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 (8.574 percent, compounded annually). 
The benefited shareholders' discount accrues based on the yield in 
their initial portion of the note (9.353 percent, compounded 
annually).
    (C) Taxable income under Notice 97-21--(1) Fast-pay 
shareholders. Under Notice 97-21, the fast-pay shareholders compute 
their taxable income attributable to the fast-pay arrangement for 
periods before January 1, 2000, by subtracting the amortizable 
premium from the accrued interest on the fast-pay shareholders' 
portion of the note. For purposes of paragraph (g)(2)(i)(A) of this 
section, the fast-pay shareholders' taxable income as a group is as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                   Interest       Amortizable
                        Taxable period                              income          premium      Taxable  income
----------------------------------------------------------------------------------------------------------------
1/1/97-12/31/97..............................................           $8,876           ($302)           $8,574
1/1/98-12/31/98..............................................            8,145            (293)            7,852
1/1/99-12/31/99..............................................            7,348            (281)            7,067
                                                              --------------------------------------------------
    Total....................................................           24,369            (876)           23,493
----------------------------------------------------------------------------------------------------------------

    (2) Benefited shareholders. Under Notice 97-21, the benefited 
shareholders compute their taxable income attributable to the fast-
pay arrangement for periods before January 1, 2000, by adding the 
accrued discount to the accrued interest on the benefited 
shareholders' portion of the note. For purposes of paragraph 
(g)(2)(i)(A) of this section, the benefited shareholders' taxable 
income as a group is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                   Interest       Amortizable
                        Taxable period                              income          premium      Taxable  income
----------------------------------------------------------------------------------------------------------------
1/1/97-12/31/97..............................................           $9,124             $229           $9,353
1/1/98-12/31/98..............................................            9,855              251           10,106
1/1/99-12/31/99..............................................           10,652              274           10,926
                                                              --------------------------------------------------
    Total....................................................           29,631              754           30,385
----------------------------------------------------------------------------------------------------------------


[[Page 1317]]

    (iii) Taxable income under the recharacterization of this 
section--(A) Fast-pay shareholders. Under paragraphs (c) and 
(g)(2)(i)(B) of this section, the fast-pay shareholders' taxable 
income attributable to the fast-pay arrangement for periods before 
January 1, 2000, is the interest deemed paid on the financing 
instruments. For purposes of paragraph (g)(2)(i)(B) of this section, 
the fast-pay shareholders' taxable income as a group is as follows:

------------------------------------------------------------------------
                                                                 Taxable
                        Taxable period                           income
------------------------------------------------------------------------
1/1/97-12/31/97...............................................    $8,574
1/1/98-12/31/98...............................................     7,852
1/1/99-12/31/99...............................................     7,067
 
  Total.......................................................    23,493
------------------------------------------------------------------------

    (B) Benefited shareholders. Under paragraphs (c) and 
(g)(2)(i)(B) of this section, the benefited shareholders compute 
their taxable income attributable to the fast-pay arrangement for 
periods before January 1, 2000, by subtracting the interest deemed 
paid on the financing instruments from the dividends actually and 
deemed paid on the benefited stock. For purposes of paragraph 
(g)(2)(i)(B) of this section, the benefited shareholders' taxable 
income as a group is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                Dividends paid   Interest paid
                        Taxable period                           on benefited     on financing   Taxable  income
                                                                    stock         instruments
----------------------------------------------------------------------------------------------------------------
1/1/97-12/31/97..............................................          $18,000         ($8,574)           $9,426
1/1/98-12/31/98..............................................           18,000          (7,852)           10,148
1/1/99-12/31/99..............................................           18,000          (7,067)           10,933
                                                              --------------------------------------------------
    Total....................................................           54,000         (23,493)           30,507
----------------------------------------------------------------------------------------------------------------

    (iv) Limit on taxable income under paragraph (g)(2)(i) of this 
section--(A) Fast-pay shareholders. For periods before January 1, 
2000, the fast-pay shareholders have the same taxable income under 
the recharacterization of Notice 97-21 and paragraph (g)(2)(i)(A) of 
this section ($23,493) as they have under the recharacterization of 
paragraphs (c) and (g)(2)(i)(B) of this section ($23,493). Thus, 
under paragraph (g)(2)(i) of this section, the fast-pay shareholders 
may limit their taxable income attributable to the fast-pay 
arrangement for periods before January 1, 2000, to $23,493 (as a 
group).
    (B) Benefited shareholders. For periods before January 1, 2000, 
the benefited shareholders have taxable income attributable to the 
fast-pay arrangement of $30,385 under the recharacterization of 
Notice 97-21 and paragraph (g)(2)(i)(A) of this section, and taxable 
income of $30,507 under the recharacterization of paragraphs (c) and 
(g)(2)(i)(B) of this section. Thus, under paragraph (g)(2)(i) of 
this section, the benefited shareholders may limit their taxable 
income attributable to the fast-pay arrangement for periods before 
January 1, 2000, to either $30,385 (as a group) or $30,507 (as a 
group).
    (v) Adjustment to taxable income under paragraph (g)(2)(ii) of 
this section. Under paragraph (g)(2)(ii) of this section, any 
benefited shareholder that limited its taxable income to the amount 
determined under paragraph (g)(2)(i)(A) of this section must include 
as an adjustment to taxable income the excess, if any, of the amount 
determined under paragraph (g)(2)(i)(B) of this section, over the 
amount determined under paragraph (g)(2)(i)(A) of this section. If 
all benefited shareholders limited their taxable income to the 
amount determined under paragraph (g)(2)(i)(A) of this section, then 
as a group their adjustment to income is $122 ($30,507, minus 
$30,385). Each shareholder must include its adjustment in income for 
the taxable year that includes January 1, 2000.
    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.
    (A) Fast-pay 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 8.574 
percent per annum, compounded annually.
    (B) Benefited shareholders. 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 group). 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 
9.304 percent per annum, compounded annually.
    (C) Issuer's interest expense under Notice 97-21. Under Notice 
97-21, Z's interest expense attributable to the fast-pay arrangement 
for periods before January 1, 2000, equals the interest accrued on 
the debt instrument held by the fast-pay shareholders, plus the 
interest accrued on the debt instrument held by the benefited 
shareholders other than Z. For purposes of paragraph (g)(2)(i)(A) of 
this section, Z's interest expense is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                   Accrued           Accrued
                                                                interest fast-   interest other   Total interest
                        Taxable period                               pay           benefited         expense
                                                                 shareholders     shareholders
----------------------------------------------------------------------------------------------------------------
1/1/97-12/31/97..............................................         ($8,574)         ($1,861)        ($10,435)
1/1/98-12/31/98..............................................          (7,852)          (2,015)          (9,867)
1/1/99-12/31/99..............................................          (7,067)          (2,184)          (9,251)
                                                              --------------------------------------------------
    Total....................................................         (23,493)          (6,060)         (29,553)
----------------------------------------------------------------------------------------------------------------

    (iii) Recharacterization under this section. Under paragraphs 
(c) and (g)(2)(i)(B) of this section, Z's taxable income 
attributable to the fast-pay arrangement for periods before January 
1, 2000, equals Z's share of the dividends actually and deemed paid 
on the benefited stock (80 percent of the outstanding benefited 
stock), reduced by the sum of the interest accrued on the note held 
by Y and the interest accrued on the financing instruments deemed to 
have been issued by Z. For purposes of paragraph (g)(2)(i)(B) of 
this section, Z's taxable income is as follows:

[[Page 1318]]



----------------------------------------------------------------------------------------------------------------
                                                                                      Accrued
                                                     Dividends        Accrued        interest         Taxable
                 Taxable period                      benefited      interest on      financing        expense
                                                       stock      debt held by Y    instruments
----------------------------------------------------------------------------------------------------------------
1/1/97-12/31/97.................................         $14,400       ($18,000)        ($6,859)       ($10,459)
1/1/98-12/31/98.................................          14,400        (18,000)         (6,281)         (9,881)
1/1/99-12/31/99.................................          14,400        (18,000)        ( 5,654)         (9,254)
                                                 ---------------------------------------------------------------
    Total.......................................          43,200        (54,000)        (18,794)        (29,594)
----------------------------------------------------------------------------------------------------------------

    (iv) Limit on taxable income under this paragraph (g)(2). For 
periods before January 1, 2000, Z has a taxable loss attributable to 
the fast-pay arrangement of $29,553 under the recharacterization of 
Notice 97-21 and paragraph (g)(2)(i)(A) of this section, and a 
taxable loss of $29,594 under the recharacterization of paragraphs 
(c) and (g)(2)(i)(B) of this section. Thus, under paragraph 
(g)(2)(i) of this section, Z may report a taxable loss attributable 
to the fast-pay arrangement for periods before January 1, 2000, of 
either $29,553 or $29,594. Under paragraph (g)(2)(ii), Z has no 
adjustment to its taxable income for its taxable year that includes 
January 1, 2000.
    (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 Janaury 10, 
2000, a taxpayer that has complied with Notice 97-21, 1997-1 C.B. 407 
(see Sec. 601.601(d)(2) of this chapter), for all such taxable years is 
considered to have complied with this section and limited its taxable 
income under paragraph (g)(2)(i)(A) of 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 Janaury 10, 2000.

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

    Par. 5. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 6. Section 602.101(b) is amended by adding an entry in 
numerical order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (6) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.7701(l)-3................................................    1545-1642
 
                  *        *        *        *        *
------------------------------------------------------------------------

    Approved: December 10, 1999.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
Robert Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 00-114 Filed 1-7-00; 8:45 am]
BILLING CODE 4830-01-P