[Federal Register Volume 69, Number 89 (Friday, May 7, 2004)]
[Proposed Rules]
[Pages 25534-25535]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-10476]



[[Page 25534]]

=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-128572-03]
RIN 1545-BC24


Application of Sections 265(a)(2) and 246A in Multi-Party 
Financing Arrangements; Request for Comments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Advance notice of proposed rulemaking.

-----------------------------------------------------------------------

SUMMARY: The IRS and Treasury Department are soliciting comments and 
suggestions regarding the scope and details of regulations that may be 
proposed under section 7701(f) of the Internal Revenue Code to address 
the application of sections 265(a)(2) and 246A in transactions 
involving related parties, pass-through entities, or other 
intermediaries.

DATES: Written or electronic comments must be submitted by August 5, 
2004.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-128572-03), room 5203, 
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 4 p.m. to: CC:PA:LPD:PR (REG-128572-
03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal 
at www.regulations.gov (IRS and REG-128572-03).

FOR FURTHER INFORMATION CONTACT: Concerning submissions, LaNita Van 
Dyke, (202) 622-7180; concerning the notice, Avital Grunhaus, (202) 
622-3930 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 163(a) generally allows a deduction for all interest paid 
or accrued within the taxable year on indebtedness. Section 265(a)(2), 
however, provides that no deduction shall be allowed for interest on 
indebtedness incurred or continued to purchase or carry obligations the 
interest on which is wholly exempt from Federal income taxes.
    Generally, section 246A reduces the dividends received deduction 
under section 243, 244, or 245(a) to the extent that the portfolio 
stock, with respect to which the dividends are received, is debt-
financed. Stock is treated as debt-financed if there is indebtedness 
directly attributable to the stock investment.
    Section 7701(f) provides that the Secretary shall prescribe such 
regulations as may be necessary or appropriate to prevent the avoidance 
of the provisions of the Internal Revenue Code that deal with (1) the 
linking of borrowing to investment, or (2) diminishing risk, through 
the use of related persons, pass-thru entities, or other 
intermediaries.
    Concurrent with the publication of this advance notice of proposed 
rulemaking in the Federal Register, the IRS and Treasury are issuing 
Rev. Rul. 2004-47 (2004-20 I.R.B.), which provides guidance on the 
application of section 265(a)(2) to disallow a portion of interest 
incurred by one member of an affiliated group when it transfers 
borrowed funds to another member of the group that is a dealer in tax-
exempt bonds. In the circumstances described in Situations 1 and 2 of 
that ruling, the funds borrowed by one member are directly traceable to 
the funds the borrowing member transfers to the dealer member. Under 
Rev. Proc. 72-18 (1972-1 C.B. 740), the application of section 
265(a)(2) to these facts requires a determination of the borrowing 
member's purpose for incurring or continuing each item of indebtedness. 
The revenue ruling holds that the purpose of the borrowing member is 
determined by reference to the use of the borrowed funds in the 
business of the dealer member to whom the funds are made available. 
This conclusion is based on H Enterprises International v. 
Commissioner, 75 T.C.M. 1948 (1998), aff'd per curiam, 183 F.3d 907 
(8th Cir. 1999). The result is a disallowance of the borrowing member's 
interest expense under section 265(a)(2).
    In H Enterprises, a parent and a subsidiary were members of the 
same consolidated group of corporations. The subsidiary declared a 
dividend and, a few days later, borrowed funds and immediately used 
part of those funds to make the dividend distribution to the parent. A 
portion of the distributed funds was disbursed to two investment 
divisions of the parent, which used the funds to acquire investments 
including tax-exempt obligations and corporate stock. The court held 
that a portion of the indebtedness was incurred to purchase and carry 
tax-exempt obligations for the purpose of section 265(a)(2) and that a 
portion of the indebtedness was directly attributable to the purchase 
and carry of portfolio stock for the purpose of section 246A.
    The transactions described in Situations 1 and 2 of Rev. Rul. 2004-
47 and the transaction before the court in H Enterprises all involve 
funds borrowed by one member of an affiliated group that can be 
directly traced to funds transferred to another member of the group.
    In contrast to the transactions described in Situations 1 and 2, in 
the transaction described in Situation 3 of Rev. Rul. 2004-47, the 
borrowed funds are not directly traceable to the funds transferred to 
the dealer member, and there is no other direct evidence linking the 
borrowed funds to the funds transferred to the dealer member. The 
revenue ruling holds that in these circumstances, section 265(a)(2) 
will not be applied to disallow interest expense of the borrowing 
member.
    Other situations may not be so clear. For example, funds may be 
transferred among the members of an affiliated or consolidated return 
group in a variety of ways that make it difficult to match borrowed 
funds with particular investments or other uses. Furthermore, certain 
taxpayers may affirmatively seek to avoid application of the rules of 
sections 265(a)(2) and 246A by using related parties, pass-thru 
entities, or other intermediaries in a manner that obscures the linkage 
between borrowing outside of the affiliated group and the purchase or 
carry of investments within the group.
    During the course of developing Rev. Rul. 2004-47, the IRS and 
Treasury began preliminary consideration of possible regulations that 
might be adopted under the authority granted by section 7701(f) to 
provide clearer rules for matching borrowings and investments and for 
administering more effectively the purposes of section 265(a)(2). For 
example, Treasury and IRS are considering a rule that would permit 
taxpayers to trace proceeds of borrowings to specific taxable 
investments or other specific uses but would apply a pro rata approach 
to determine the use of proceeds of borrowings that are not traceable 
to a specific use. This would differ from a general rule requiring a 
pro rata allocation of borrowings among all available uses, such as the 
rule in section 265(b) applicable to financial institutions.
    The IRS and Treasury also are considering whether to adopt 
regulations under section 7701(f) for purposes of section 246A (dealing 
with debt financing of portfolio stock).
    The IRS and Treasury are requesting comments on whether regulations 
should be adopted under section 7701(f) for purposes of applying 
section

[[Page 25535]]

265(a)(2) or section 246A and, if so, the approach that should be taken 
in such regulations. Specifically, the IRS and Treasury are inviting 
comments on the approach of supplementing a specific tracing rule with 
a pro rata allocation rule, as well as suggestions for alternative 
approaches. Comments addressing the possible adoption of regulations 
for purposes of section 246A should take into account any differences 
in approach that may be required under section 7701(f) because section 
246A defines portfolio indebtedness by reference to indebtedness 
``directly attributable to'' portfolio stock, while section 265(a)(2) 
refers to indebtedness ``incurred or continued to purchase or carry'' 
tax-exempt obligations. Persons making comments may also wish to 
address the mandate in section 246A(f) to adopt regulations providing 
for interest disallowance, rather than disallowance of the dividends 
received deduction, when indebtedness is incurred by a person other 
than the person receiving dividends.

Special Analysis

    This advance notice of proposed rulemaking is not a significant 
regulatory action for purposes of Executive Order 12866, ``Regulatory 
Planning and Review.''

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-10476 Filed 5-6-04; 8:45 am]
BILLING CODE 4830-01-P