[Federal Register Volume 81, Number 68 (Friday, April 8, 2016)]
[Proposed Rules]
[Pages 20912-20943]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-07425]
[[Page 20911]]
Vol. 81
Friday,
No. 68
April 8, 2016
Part IV
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Treatment of Certain Interests in Corporations as Stock or
Indebtedness; Proposed Rule
Federal Register / Vol. 81 , No. 68 / Friday, April 8, 2016 /
Proposed Rules
[[Page 20912]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-108060-15]
RIN 1545-BN40
Treatment of Certain Interests in Corporations as Stock or
Indebtedness
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed regulations under section 385
of the Internal Revenue Code (Code) that would authorize the
Commissioner to treat certain related-party interests in a corporation
as indebtedness in part and stock in part for federal tax purposes, and
establish threshold documentation requirements that must be satisfied
in order for certain related-party interests in a corporation to be
treated as indebtedness for federal tax purposes. The proposed
regulations also would treat as stock certain related-party interests
that otherwise would be treated as indebtedness for federal tax
purposes. The proposed regulations generally affect corporations that
issue purported indebtedness to related corporations or partnerships.
DATES: Written or electronic comments and requests for a public hearing
must be received by July 7, 2016.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-108060-15), Room
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
108060-15), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue NW., Washington, DC 20224 or sent electronically via the Federal
eRulemaking Portal at http://www.regulations.gov (IRS REG-108060-15).
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations
under Sec. Sec. 1.385-1 and 1.385-2, Eric D. Brauer, (202) 317-5348;
concerning the proposed regulations under Sec. Sec. 1.385-3 and 1.385-
4, Raymond J. Stahl, (202) 317-6938; concerning submissions of comments
or requests for a public hearing, Regina Johnson, (202) 317-5177 (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 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, SE:W:CAR:MP:T:T:SP,
Washington, DC 20224. Comments on the collection of information should
be received by June 7, 2016. Comments are specifically requested
concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether the
information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information;
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 in this proposed regulation is in
Sec. 1.385-2(b)(2). This collection of information is necessary to
determine whether certain interests between members of an expanded
affiliated group are to be treated as stock or indebtedness for federal
tax purposes. The likely respondents are entities that are affiliates
of publicly traded entities or meet certain thresholds on their
financial statements.
Estimated total annual reporting burden: 735,000 hours.
Estimated average annual burden per respondent: 35 hours.
Estimated number of respondents: 21,000.
Estimated frequency of responses: Monthly.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Background
As described further in this preamble, courts historically have
analyzed whether an interest in a corporation should be treated as
stock or indebtedness for federal tax purposes by applying various sets
of factors to the facts of a particular case. In 1969, Congress enacted
section 385 to authorize the Secretary of the Treasury (Secretary) to
prescribe such regulations as may be necessary or appropriate to
determine whether an interest in a corporation is to be treated as
stock or indebtedness for purposes of the Code. Because no regulations
are currently in effect under section 385, the case law that developed
before the enactment of section 385 has continued to evolve and to
control the characterization of an interest in a corporation as debt or
equity.
I. Section 385 Statute and Legislative History
A. Original Enactment of Section 385
Section 385(a), as originally enacted as part of the Tax Reform Act
of 1969 (Pub. L. 91-172, 83 Stat. 487), authorizes the Secretary to
prescribe such regulations as may be necessary or appropriate to
determine whether an interest in a corporation is treated as stock or
indebtedness for purposes of the Code.
Section 385(b) provides that the regulations prescribed under
section 385 shall set forth factors that are to be taken into account
in determining in a particular factual situation whether a debtor-
creditor relationship exists or a corporation-shareholder relationship
exists. Under section 385(b), those factors may include, among other
factors, the following: (1) Whether there is a written unconditional
promise to pay on demand or on a specified date a sum certain in money
in return for an adequate consideration in money or money's worth, and
to pay a fixed rate of interest; (2) whether there is subordination to
or preference over any indebtedness of the corporation; (3) the ratio
of debt to equity of the corporation; (4) whether there is
convertibility into the stock of the corporation; and (5) the
relationship between holdings of stock in the corporation and holdings
of the interest in question.
In enacting section 385(a) and (b), Congress authorized the
Secretary to prescribe targeted rules to address particular factual
situations, stating:
In view of the uncertainties and difficulties which the
distinction between debt and equity has produced in numerous
situations . . . the committee further believes that it would be
desirable to provide rules for distinguishing debt from equity in
the variety of contexts in which this problem can arise. The
differing circumstances which characterize these situations,
however, would
[[Page 20913]]
make it difficult for the committee to provide comprehensive and
specific statutory rules of universal and equal applicability. In
view of this, the committee believes it is appropriate to
specifically authorize the Secretary of the Treasury to prescribe
the appropriate rules for distinguishing debt from equity in these
different situations.
S. Rep. No. 91-552, at 138 (1969). The legislative history further
explains that regulations applicable to a particular factual situation
need not rely on the factors set forth in section 385(b):
The provision also specifies certain factors which may be taken
into account in these [regulatory] guidelines. It is not intended
that only these factors be included in the guidelines or that, with
respect to a particular situation, any of these factors must be
included in the guidelines, or that any of the factors which are
included by statute must necessarily be given any more weight than
other factors added by regulations.
Id. Accordingly, section 385(b) provides the Secretary with discretion
to establish specific rules for determining whether an interest is
treated as stock or indebtedness for federal tax purposes in a
particular factual situation.
B. 1989 and 1992 Amendments to Section 385
Congress amended section 385 in 1989 and 1992. In 1989, the Omnibus
Budget Reconciliation Act of 1989 (Pub. L. 101-239, 103 Stat. 2106)
amended section 385(a) to expressly authorize the Secretary to issue
regulations under which an interest in a corporation is to be treated
as in part stock and in part indebtedness. This amendment also provides
that any regulations so issued may apply only with respect to
instruments issued after the date on which the Secretary or the
Secretary's delegate provides public guidance as to the
characterization of such instruments (whether by regulation, ruling, or
otherwise). See Public Law 101-239, sec. 7208(a)(2). The legislative
history to the 1989 amendment notes that, while ``[t]he
characterization of an investment in a corporation as debt or equity
for Federal income tax purposes generally is determined by reference to
numerous factors, . . . there has been a tendency by the courts to
characterize an instrument entirely as debt or entirely as equity.''
H.R. Rep. No. 101-386, at 3165-66 (1989) (Conf. Rep.).
In 1992, Congress added section 385(c) to the Code as part of the
Energy Policy Act of 1992 (Pub. L. 102-486, 106 Stat. 2776). Section
385(c)(1) provides that the issuer's characterization (as of the time
of issuance) as to whether an interest in a corporation is stock or
indebtedness shall be binding on such issuer and on all holders of such
interest (but shall not be binding on the Secretary). Section 385(c)(2)
provides that, except as provided in regulations, section 385(c)(1)
shall not apply to any holder of an interest if such holder on his
return discloses that he is treating such interest in a manner
inconsistent with the initial characterization of the issuer. Section
385(c)(3) authorizes the Secretary to require such information as the
Secretary determines to be necessary to carry out the provisions of
section 385(c), including the information necessary for the Secretary
to determine how the issuer characterized an interest as of the time of
issuance.
Congress added section 385(c) in response to issuers and holders
characterizing a corporate instrument inconsistently. H.R. Rep. No.
102-716, at 3 (1992). For example, a corporate issuer may designate an
instrument as indebtedness for federal tax purposes and deduct as
interest the amounts paid on the instrument, while a corporate holder
may treat the instrument as stock for federal tax purposes and claim a
dividends received deduction with respect to the amounts paid on the
instrument. See id.
II. Regulations
There are no regulations currently in effect under section 385. On
March 24, 1980, the Department of the Treasury (Treasury Department)
and the IRS published a notice of proposed rulemaking (LR-1661) in the
Federal Register (45 FR 18959) under section 385 relating to the
treatment of certain interests in corporations as stock or
indebtedness. Final regulations (TD 7747) were published in the Federal
Register (45 FR 86438) on December 31, 1980. Subsequent revisions of
the final regulations were published in the Federal Register on May 4,
1981, January 5, 1982, and July 2, 1982 (46 FR 24945, 47 FR 147, and 47
FR 28915, respectively). The Treasury Department and the IRS published
a notice of proposed withdrawal of TD 7747 in the Federal Register on
July 6, 1983 (48 FR 31053), and in TD 7920, published in the Federal
Register (48 FR 50711) on November 3, 1983, the Treasury Department and
the IRS withdrew TD 7747.
The Treasury Department and the IRS have not previously published
any regulations regarding the 1989 amendment to section 385(a), which
authorizes the Secretary to issue regulations that treat an interest in
a corporation as indebtedness in part or as stock in part. In addition,
no regulations have been published with respect to the 1992 addition of
section 385(c) authorizing the Secretary to require information related
to an issuer's initial characterization of an interest for federal tax
purposes or to affect the ability of a holder to treat an interest
inconsistent with the initial treatment of the issuer.
III. Case Law
In the absence of regulations under section 385, the pre-1969 case
law has continued to evolve and control the characterization of an
interest as debt or equity for federal tax purposes. Under that case
law, courts apply inconsistent sets of factors to determine if an
interest should be treated as stock or indebtedness, subjecting
substantially similar fact patterns to differing analyses. The result
has been a body of case law that perpetuates the ``uncertainties and
difficulties which the distinction between debt and equity has
produced'' and with which Congress expressed concern when enacting
section 385. See S. Rep. No. 91-552, at 138. For example, in Fin Hay
Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), the U.S.
Court of Appeals for the Third Circuit identified sixteen factors
relevant for distinguishing between indebtedness and stock:
(1) the intent of the parties; (2) the identity between
creditors and shareholders; (3) the extent of participation in
management by the holder of the instrument; (4) the ability of the
corporation to obtain funds from outside sources; (5) the `thinness'
of the capital structure in relation to debt; (6) the risk involved;
(7) the formal indicia of the arrangement; (8) the relative position
of the obligees as to other creditors regarding the payment of
interest and principal; (9) the voting power of the holder of the
instrument; (10) the provision of a fixed rate of interest; (11) a
contingency on the obligation to repay; (12) the source of the
interest payments; (13) the presence or absence of a fixed maturity
date; (14) a provision for redemption by the corporation; (15) a
provision for redemption at the option of the holder; and (16) the
timing of the advance with reference to the organization of the
corporation.
Id. at 696. By contrast, in Estate of Mixon v. United States, 464 F.2d
394 (5th Cir. 1972), the U.S. Court of Appeals for the Fifth Circuit
identified thirteen factors that are similar to, but not the same as,
those used in Fin Hay to distinguish between indebtedness and stock:
(1) the names given to the certificates evidencing the
indebtedness; (2) The presence or absence of a fixed maturity date;
(3) The source of payments; (4) The right to enforce payment of
principal and interest; (5) participation in management flowing as a
result; (6) the status of the contribution in relation to regular
corporate creditors; (7) the intent of the parties; (8) `thin' or
adequate capitalization; (9) identity of interest between creditor
and stockholder; (10) source of interest payments; (11) the ability
of the
[[Page 20914]]
corporation to obtain loans from outside lending institutions; (12)
the extent to which the advance was used to acquire capital assets;
and (13) the failure of the debtor to repay on the due date or to
seek a postponement.
Id. at 402. The weight given to the various factors in a particular
case also differs, and is highly dependent upon the relevant facts and
circumstances. See, e.g., J.S. Biritz Construction Co. v. Commissioner,
387 F.2d 451, 456-57 (8th Cir. 1967) (stating that the factors ``have
varying degrees of relevancy, depending on the particular factual
situation and are generally not all applicable to any given case'').
Under this facts-and-circumstances analysis, as developed in the
case law, no single fact or circumstance is sufficient to establish
that an interest should be treated as stock or indebtedness. See, e.g.,
John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946) (``[N]o one
characteristic . . . can be said to be decisive in the determination of
whether the obligations are risk investments in the corporations or
debts.''); Fin Hay, 398 F.2d at 697 (``[N]either any single criterion
nor any series of criteria can provide a conclusive answer in the
kaleidoscopic circumstances which individual cases present.''). It was
this emphasis on particular taxpayer facts and circumstances, coupled
with inconsistent analysis of the relevant factors by different courts,
that led Congress to delegate to the Secretary the authority to provide
regulations under section 385 for distinguishing debt from equity that
could depart from the factors developed in case law or enumerated in
the statute. See S. Rep. No. 91-552, at 138.
IV. Other Relevant Statutory Provisions
Section 701 provides that a partnership as such shall not be
subject to federal income tax, but that persons carrying on business as
partners shall be liable for federal income tax only in their separate
or individual capacities.
Section 1502 provides that the Secretary shall prescribe such
regulations as the Secretary deems necessary in order that the federal
tax liability of any affiliated group of corporations making a
consolidated return and of each corporation in the group, both during
and after the period of affiliation, may be returned, determined,
computed, assessed, collected, and adjusted, in such manner as clearly
to reflect the federal income tax liability and the various factors
necessary for the determination of such liability, and in order to
prevent avoidance of such tax liability. In prescribing such
regulations, section 1502 authorizes the Secretary to prescribe rules
that are different from the provisions of chapter 1 of subtitle A of
the Code that would apply if such corporations filed separate returns.
Section 7701(l) provides that the Secretary may prescribe
regulations recharacterizing any multiple-party financing transaction
as a transaction directly among any two or more of such parties where
the Secretary determines that such recharacterization is appropriate to
prevent avoidance of any tax imposed by the Code.
V. Earnings Stripping Guidance Described in Notice 2014-52 and Notice
2015-79
Notice 2014-52, 2014-42 IRB 712 (Oct. 14, 2014), and Notice 2015-
79, 2015-49 IRB 775 (Dec. 7, 2015), described regulations that the
Treasury Department and the IRS intend to issue with respect to
corporate inversions and related transactions. Notice 2014-52 and
Notice 2015-79 also provided that the Treasury Department and the IRS
expect to issue additional guidance to further limit the benefits of
post-inversion tax avoidance transactions. The notices stated, in
particular, that the Treasury Department and the IRS are considering
guidance to address strategies that avoid U.S. tax on U.S. operations
by shifting or ``stripping'' U.S.-source earnings to lower-tax
jurisdictions, including through intercompany debt.
VI. Purpose of the Proposed Regulations
These proposed regulations under section 385 address whether an
interest in a related corporation is treated as stock or indebtedness,
or as in part stock or in part indebtedness, for purposes of the Code.
While these proposed regulations are motivated in part by the enhanced
incentives for related parties to engage in transactions that result in
excessive indebtedness in the cross-border context, federal income tax
liability can also be reduced or eliminated with excessive indebtedness
between domestic related parties. Thus, the proposed rules apply to
purported indebtedness issued to certain related parties, without
regard to whether the parties are domestic or foreign. Nonetheless, the
Treasury Department and the IRS also have determined that the proposed
regulations should not apply to issuances of interests and related
transactions among members of a consolidated group because the concerns
addressed in the proposed regulations generally are not present when
the issuer's deduction for interest expense and the holder's
corresponding interest income offset on the group's consolidated
federal income tax return.
Section A of this Part VI addresses bifurcation of interests that
are indebtedness in part but not in whole. Section B of this Part VI
addresses documentation requirements for related-party indebtedness.
Section C of this Part VI addresses distributions of debt instruments
and similar transactions.
A. Interests That Are Indebtedness in Part but Not in Whole
As previously noted, Congress amended section 385(a) in 1989 to
authorize the issuance of regulations permitting an interest in a
corporation to be treated as in part indebtedness and in part stock.
The legislative history to the 1989 amendment explained that ``there
has been a tendency by the courts to characterize an instrument
entirely as debt or entirely as equity.'' H.R. Rep. No. 101-386, at 562
(1989) (Conf. Rep.). No regulations have been promulgated under the
amendment, however, and this tendency by the courts has continued to
the present day. Consequently, the Commissioner generally is required
to treat an interest in a corporation as either wholly indebtedness or
wholly equity.
This all-or-nothing approach is particularly problematic in cases
where the facts and circumstances surrounding a purported debt
instrument provide only slightly more support for characterization of
the entire interest as indebtedness than for equity characterization, a
situation that is increasingly common in the related-party context. The
Treasury Department and the IRS have determined that the all-or-nothing
approach frequently fails to reflect the economic substance of related-
party interests that are in form indebtedness and gives rise to
inappropriate federal tax consequences. Accordingly, the Treasury
Department and the IRS have determined that the interests of tax
administration would best be served if the Commissioner were able to
depart from the all-or-nothing approach where appropriate to ensure
that the provisions of the Code are applied in a manner that clearly
reflects the income of related taxpayers. To that end, these proposed
regulations would exercise the authority granted by section 385(a) to
permit the Commissioner to treat a purported debt instrument issued
between related parties as in part indebtedness and in part stock for
federal tax purposes. However, the proposed regulations would not
permit issuers and related holders to treat such an instrument in a
manner inconsistent with the issuer's initial characterization. The
proposed regulations described in
[[Page 20915]]
Part IV.B.2 of the Explanation of Provisions section of this preamble
also rely in part on the authority granted under section 385(a) to
treat interests as in part indebtedness and in part stock for federal
tax purposes.
The proposed rule applies with respect to parties that meet a lower
50-percent threshold for relatedness than the threshold applicable with
respect to other rules contained in these proposed regulations. This is
because, as noted in Part VI of the Background section of this
preamble, federal income tax liability can be reduced or eliminated by
the introduction of excessive indebtedness between related parties, and
this can be accomplished without special cooperation among the related
parties and regardless of other transactions undertaken by the issuer
or holder after issuance. In addition, a 50-percent relatedness
threshold is consistent with other provisions used in subchapter C of
the Code to identify a level of control or ownership that can warrant
different federal tax consequences than those for less-related parties.
The proposed rule merely permits the Commissioner to treat a
purported debt instrument as in part indebtedness and in part stock
consistent with its substance. Moreover, the proposed regulations would
not affect the authority of the Commissioner to disregard a purported
debt instrument as indebtedness or stock, to treat a purported debt
instrument as indebtedness or equity of another entity, or otherwise to
treat a purported debt instrument in accordance with its substance.
See, e.g., Plantation Patterns v. Commissioner, 462 F.2d 712 (5th Cir.
1972).
The Treasury Department and the IRS recognize that authorizing the
Commissioner to treat purported debt instruments issued among unrelated
parties as indebtedness in part and stock in part could result in
unnecessary uncertainty in the capital markets in the absence of
detailed standards for the exercise of that authority. Similarly, any
exercise of this authority with respect to related-party interests that
are denominated as other than indebtedness would require more detailed
guidance. Thus, the proposed rule does not apply in those contexts.
B. Related-Party Indebtedness
1. Background
Related-party indebtedness, like indebtedness between unrelated
persons, may be respected as indebtedness for federal tax purposes, but
only if there is intent to create a true debtor-creditor relationship
that results in bona fide indebtedness. While still subject to the same
multifactor analysis used for characterizing interests issued between
third parties, ``courts have consistently recognized that transactional
forms between related parties are susceptible of manipulation and,
accordingly, warrant a more thorough and discerning examination for tax
characterization purposes.'' PepsiCo Puerto Rico, Inc. v. Commissioner,
T.C. Memo 2012-269, at 51, citing United States v. Uneco, Inc., 532
F.2d 1204, 1207 (8th Cir. 1976); Cuyuna Realty Co. v. United States,
382 F.2d 298, 301 (Ct. Cl. 1967) (stating that an advance between a
parent corporation and a subsidiary or other affiliate under common
control must be subject to particular scrutiny ``because the control
element suggests the opportunity to contrive a fictional debt, an
opportunity less present in an arms-length transaction between
strangers.'').
This scrutiny is warranted because there is typically less economic
incentive for a related-party lender to impose discipline on the legal
documentation and economic analysis supporting the characterization of
an interest as indebtedness for federal tax purposes. While a lender
typically carefully documents a loan to a third party borrower and
decides whether and how much to lend based on that documentation and
objective financial criteria, a related-party lender, especially one
that directly or indirectly controls the borrower, may require only
simple (or even no) legal documentation and may forgo any economic
analysis that would inform the lender of the amount that the borrower
could reasonably be expected to repay.
The absence of reasonable diligence by related-party lenders can
have the effect of limiting the factual record that is available for
additional scrutiny and thorough examination. Nonetheless, courts do
not always require related parties to engage in reasonable financial
analysis and legal documentation similar to that which business
exigencies would incent third-parties in connection with lending to
unrelated borrowers. See, e.g., C.M. Gooch Lumber Sales Co. v.
Commissioner, 49 T.C. 649 (1968) at 656 (noting that in the case of
related-party debt, ``the absence of a written debt instrument,
security, or provision for the payment of interest is not controlling;
formal evidences of indebtedness are at best clues to proof of the
ultimate fact''); see also Byerlite Corp. v. Williams, 286 F.2d 285,
290-91 (6th Cir. 1960), citing Ewing v. Commissioner, 5 T.C. Memo 908
(1946) (``The fact that advancements to a corporation are made without
requiring any evidence of indebtedness . . . was not a controlling
consideration . . .'').
Historically, the absence of clear guidance regarding the
documentation and information necessary to support debt
characterization in the related-party context did not pose a
significant obstacle, because the transactions presented by cases such
as Mixon, Fin Hay, and their progeny were not factually complex.
Typically, the earlier cases involved direct advances between
individual U.S. taxpayers and their closely held domestic corporations.
The relevant documentation was readily identifiable, available on hand,
and able to be analyzed by the Commissioner in due course. Further,
when the case law was developing, the dollar amounts at stake were
comparatively modest. In Fin Hay, the shareholder advances gave rise to
a total federal tax liability of $3,241; in Mixon, the shareholder
advances gave rise to a total federal tax liability of $126,964.
Increasingly, this is no longer the case. Over time, the Treasury
Department and the IRS have observed that business practices,
structures, and activities between related parties have changed
considerably. The Treasury Department and the IRS acknowledge that the
size, activities, and financial complexity of corporations and their
group structures have grown exponentially, and understand that these
groups routinely include foreign entities, sometimes from multiple
foreign jurisdictions, as well as federal tax-indifferent domestic
members. The scope and complexity of intragroup transactions has grown
commensurately. Examples include the transactions at issue in PepsiCo
Puerto Rico, Inc. v. Commissioner and NA General Partnership &
Subsidiaries v. Commissioner, T.C. Memo 2012-172, both involving the
global restructuring of multinational corporate groups.
As a result of these developments, it is increasingly problematic
that there is a lack of guidance prescribing the information and
documentation necessary to support the characterization of a purported
debt instrument as indebtedness in the related-party context. The lack
of such guidance, combined with the sheer volume of financial records
taxpayers produce in the ordinary course of business, makes it
difficult to identify the documents that will ultimately be required to
support such a characterization, particularly with respect to whether a
reasonable expectation of repayment is present at the time an interest
is issued. The result can be either the inadvertent omission of
necessary documents from disclosure
[[Page 20916]]
to the IRS or the provision of vast amounts of irrelevant documents and
material, such that forensic accounting expertise is required to
isolate and evaluate relevant information. In either case, the ability
of the Commissioner to administer the Code efficiently with respect to
related-party interests is impeded. In addition, the absence of
guidance makes it difficult for U.S. taxpayers to determine timely what
steps they must take to ensure that essential records are not only
prepared, but also maintained in a manner that will facilitate their
being made available upon request, particularly regarding transactions
with related parties whose books and records are located in foreign
jurisdictions.
Finally, the dollar amounts at stake have often become increasingly
significant. For example, the federal tax liability at issue in PepsiCo
was $363,056,012; the federal tax liability at issue in NA General
Partnership was $188,000,000. As a result, it has become increasingly
important to prescribe rules that identify the types of documentation
and information necessary to support the characterization of a related-
party interest as indebtedness for federal tax purposes.
2. Proposed Regulations Addressing Documentation Requirements
To address these concerns, the Treasury Department and the IRS are
proposing rules, under the authority granted in section 385(a) to
prescribe regulations to determine whether an interest in a corporation
is stock or indebtedness, that prescribe the nature of the
documentation and information that must be prepared and maintained for
a purported debt instrument issued by a corporation to a related party
to be treated as indebtedness for federal tax purposes. The proposed
regulations are intended to impose discipline on related parties by
requiring timely documentation and financial analysis that is similar
to the documentation and analysis created when indebtedness is issued
to third parties. This requirement also serves to help demonstrate
whether there was intent to create a true debtor-creditor relationship
that results in bona fide indebtedness and also to help ensure that the
documentation necessary to perform an analysis of a purported debt
instrument is prepared and maintained. This approach is consistent with
the long-standing view held by courts that the taxpayer has the burden
of substantiating its treatment of an arrangement as indebtedness for
federal tax purposes. Hollenbeck v. Commissioner, 422 F.2d 2, 4 (9th
Cir. 1970).
In general, the Treasury Department and the IRS have determined
that timely preparation of documentation and financial analysis
evidencing four essential characteristics of indebtedness are a
necessary factor in the characterization of a covered interest as
indebtedness for federal tax purposes. Those characteristics are: a
legally binding obligation to pay, creditors' rights to enforce the
obligation, a reasonable expectation of repayment at the time the
interest is created, and an ongoing relationship during the life of the
interest consistent with arms-length relationships between unrelated
debtors and creditors. These characteristics are drawn from the case
law and are consistent with the text of section 385(b)(1) and (5).
While the proposed regulations do not intend to alter the general case
law view of the importance of these essential characteristics of
indebtedness, the proposed regulations do require a degree of
discipline in the creation of necessary documentation, and in the
conduct of reasonable financial diligence indicative of a true debtor-
creditor relationship, that exceeds what is required under current law.
See, e.g., C.M. Gooch Lumber Sales Co., 49 T.C. 649; Byerlite Corp.,
286 F.2d 285.
The proposed regulations make clear that the preparation and
maintenance of this documentation and information are not dispositive
in establishing that a purported debt instrument is indebtedness for
federal tax purposes. Rather, these requirements are necessary to the
conduct of the multi-factor analysis used in the Mixon and Fin Hay line
of cases to determine the nature of an interest as indebtedness for
federal tax purposes.
C. Certain Distributions of Debt Instruments and Similar Transactions
1. In General
The Treasury Department and the IRS have identified three types of
transactions between affiliates that raise significant policy concerns
and that should be addressed under the Secretary's authority to
prescribe rules for particular factual situations: (1) distributions of
debt instruments by corporations to their related corporate
shareholders; (2) issuances of debt instruments by corporations in
exchange for stock of an affiliate (including ``hook stock'' issued by
their related corporate shareholders); and (3) certain issuances of
debt instruments as consideration in an exchange pursuant to an
internal asset reorganization. Similar policy concerns arise when a
related-party debt instrument is issued in a separate transaction to
fund (1) a distribution of cash or other property to a related
corporate shareholder; (2) an acquisition of affiliate stock from an
affiliate; or (3) certain acquisitions of property from an affiliate
pursuant to an internal asset reorganization. Accordingly, the proposed
regulations treat related-party debt instruments issued in any of the
foregoing transactions as stock, subject to certain exceptions.
Sections C.2 through C.5 of this Part VI describe in greater detail
the purposes of the proposed regulations that apply to these types of
transactions. Part IV of the Explanation of Provisions section of this
preamble describes in detail the proposed regulations.
2. Debt Instrument Issued in a Distribution
In Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956),
the U.S. Court of Appeals for Second Circuit addressed a situation in
which a domestic corporate subsidiary issued indebtedness in the form
of debentures to its sole shareholder, also a domestic corporation, in
payment of a dividend. The parent and subsidiary were required to file
separate returns under the Code in effect during the years at issue,
and, before taking into account the interest income and deductions on
the distributed indebtedness, the parent corporation had losses and the
subsidiary was profitable.
The court considered arguments by the government that the parent-
subsidiary relationship warranted additional scrutiny in determining
whether a debtor-creditor relationship was established in substance. In
particular, the Commissioner argued that, because the issuer subsidiary
was wholly-owned, ``the sole stockholder [could] deal as it please[d]
with the corporate entity it control[led]'' and, as a result, the
transaction could have been a sham. Id. at 123. The Commissioner also
argued that the debentures should be treated as stock because no new
capital was introduced into the subsidiary in connection with the
issuance of the debentures, see id. at 126-27, and because the taxpayer
conceded that the issuance of the debentures in payment of the dividend
lacked a business purpose other than tax minimization. See id. at 127-
28.
In holding for the taxpayer, the Second Circuit determined that the
debentures should be respected as indebtedness because the debentures
were unambiguously denominated as debt, were issued by and to real
taxable entities, and created real legal rights and duties between the
parties. See id. at
[[Page 20917]]
127-28. In a dissenting opinion, Chief Judge Clark supported
``test[ing] the genuineness of the intercorporate indebtedness by
objective standards'' that would disregard indebtedness issued in this
circumstance, and warned that the majority opinion would open ``a large
leak . . . operable merely by denominating an intercorporate allocation
of surplus a debt'' and would ``[s]urely . . . stimulate imitators.''
Id. at 129.
Other courts have not given the same level of deference to the form
of a transaction that the Second Circuit did in Kraft and have treated
purported indebtedness as stock in similar circumstances. For example,
some courts have closely scrutinized situations in which indebtedness
is owed in proportion to stock ownership to determine whether a debtor-
creditor relationship exists in substance. See, e.g., Uneco, Inc. v.
United States, 532 F.2d 1204, 1207 (8th Cir. 1976) (``Advances between
a parent corporation and a subsidiary or other affiliate are subject to
particular scrutiny . . . .''); Arlington Park Jockey Club, Inc. v.
Sauber, 262 F.2d 902, 906 (7th Cir. 1959) (``It has been held that [a
cash advance made in proportion to stock ownership] gives rise to a
strong inference that the advances represent additional capital
investment and not loans.'' (citing Schnitzer v. Commissioner, 13 T.C.
43, aff'd 183 F.2d 70 (9th Cir. 1950))). Consistent with those
decisions, section 385(b)(5) specifically authorizes the Secretary, in
issuing regulations distinguishing between stock and indebtedness, to
take into account ``the relationship between holdings of stock in the
corporation and holdings of the interest in question.''
Courts also have given weight to the lack of new capital investment
when a closely-held corporation issues indebtedness to a controlling
shareholder but receives no new investment in exchange. See, e.g.,
Talbot Mills v. Commissioner, 146 F.2d 809 (1st Cir. 1944) (emphasizing
that a transaction involved no new investment, did not affect
proportionate ownership, and was motivated primarily by tax benefits in
holding that a closely-held corporation's participating notes should be
treated as stock when each stockholder exchanged four-fifths of its
existing stock for notes with a face amount equal to the par value of
the stock surrendered), aff'd sub nom, John Kelley Co. v. Commissioner,
326 U.S. 521 (1946); Sayles Finishing Plants, Inc. v. United States,
399 F.2d 214 (Ct. Cl. 1968) (noting that a ``lack of new money can be a
significant factor in holding a purported indebtedness to be a capital
transaction, particularly when the facts otherwise show that the
purported indebtedness was merely a continuation of the stock interests
allegedly converted'').
In many contexts, a distribution of a debt instrument similar to
the one at issue in Kraft lacks meaningful non-tax significance, such
that respecting the distributed instrument as indebtedness for federal
tax purposes produces inappropriate results. For example, inverted
groups and other foreign-parented groups use these types of
transactions to create interest deductions that reduce U.S. source
income without investing any new capital in the U.S. operations. In
addition, U.S.-parented groups obtain distortive results by, for
example, using these types of transactions to create interest
deductions that reduce the earnings and profits of controlled foreign
corporations (CFCs) and to facilitate the repatriation of untaxed
earnings without recognizing dividend income. An example of the latter
type of transaction could involve the distribution of a note from a
first-tier CFC to its United States shareholder in a taxable year when
the distributing CFC has no earnings and profits (although lower-tier
CFCs may) and the United States shareholder has basis in the CFC stock.
In a later taxable year, when the distributing CFC had untaxed earnings
and profits (such as by reason of intervening distributions from lower-
tier CFCs), the CFC could use cash attributable to the earnings and
profits to repay the note owed to its United States shareholder. The
taxpayer takes the position that the note should be respected as
indebtedness and, therefore, that the repayment of the note does not
result in any of the untaxed earnings and profits of the CFC being
taxed as a dividend to the United States shareholder.
In light of these policy concerns, the proposed regulations treat a
debt instrument issued in fact patterns similar to that in Kraft as
stock. The factors discussed in Kraft and Talbot Mills, including the
parent-subsidiary relationship, the fact that no new capital is
introduced in connection with a distribution of debentures, and the
typical lack of a substantial non-tax business purpose, support the
conclusion that the issuance of a debt instrument in a distribution is
a transaction that frequently has minimal or nonexistent non-tax
effects. Moreover, although the holder of a debt instrument has
different legal rights than a holder of stock, the distinction between
those rights usually has limited significance when the parties are
related. Subsidiaries often do not have significant amounts of debt
financing from unrelated lenders (other than trade payables) and, to
the extent they do, they may minimize any potential impact of related-
party debt on unrelated creditors, for example, by subordinating the
related-party debt instrument.
Thus, any non-tax effects of a distribution of a debt instrument to
an affiliate are often minimized or eliminated, allowing the related
parties to obtain significant federal tax benefits at little or no
cost. Accordingly, based on these considerations, the Treasury
Department and the IRS have determined that in fact patterns similar to
Kraft it is appropriate to treat a debt instrument as stock.
3. Debt Instrument Issued in Exchange for Affiliate Stock
The Treasury Department and the IRS have determined that the
issuance of a related-party debt instrument to acquire stock of a
related person is similar in many respects to a distribution of a debt
instrument and implicates similar policy considerations. Recognizing
the economic similarities between purchases of affiliate stock and
distributions, Congress enacted section 304 and its predecessors to
prevent taxpayers from acquiring affiliate stock to convert what
otherwise would be a taxable dividend into a sale or exchange
transaction. See S. Rep. No. 83-1622 at 46 (1954) (noting that, under
section 304, ``where the effect of the sale [of related-party stock] is
in reality the distribution of a dividend, it will be taxed as such'').
Similarly, if the proposed regulations addressed only debt instruments
issued in a distribution, and not acquisitions of affiliate stock that
have the effect of a distribution, taxpayers would readily substitute
the latter transaction for the former in order to produce the
inappropriate tax result that the proposed regulations are intended to
prevent.
Like distributions of debt instruments, issuances of debt
instruments to acquire affiliate stock frequently have limited non-tax
significance, particularly in relation to the significant federal tax
benefits that are generated in the transaction. Such transactions do
not change the ultimate ownership of the affiliate, and introduce no
new operating capital to either affiliate. While the change in the
direct ownership of the affiliate's stock may have some non-tax
significance in certain circumstances, such as the harmonization of a
group's corporate structure following an acquisition, other
[[Page 20918]]
purchases of affiliate stock, including purchases of ``hook stock''
from a parent in exchange for a debt instrument, typically possess
almost no non-tax significance.
Accordingly, the proposed regulations generally treat a debt
instrument issued in exchange for affiliate stock as stock.
4. Debt Instrument Issued Pursuant to an Internal Asset Reorganization
The proposed regulations also address certain debt instruments
issued by an acquiring corporation as consideration in an exchange
pursuant to an internal asset reorganization. Internal asset
reorganizations can operate in a similar manner to section 304
transactions as a device to convert what otherwise would be a
distribution into a sale or exchange transaction without having any
meaningful non-tax effect. Congress noted this similarity in 1984 when
it harmonized the control requirement for section 368(a)(1)(D)
reorganizations with the control requirement in section 304. See Staff
of Joint Comm. on Taxation, 98th Cong., General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984 193 (Comm.
Print 1984) (``The D reorganization provisions address the bail-out
problem in the context of a transfer of assets by 1 corporation to
another. Section 304 deals with the problem in the context of a
transfer of stock by shareholders to a corporation they control.'').
Consider the following example: A foreign parent corporation
(Parent) owns all of the stock of two U.S. subsidiaries, S1 and S2. In
a transaction qualifying as a reorganization described in section
368(a)(1)(D), Parent transfers its stock in S1 to S2 in exchange for a
note issued by S2, and S1 converts to a limited liability company. For
federal tax purposes, S1 is treated as selling all of its assets to S2
in exchange for a debt instrument, and under section 356, Parent is
treated as receiving the S2 debt instrument from S1 in a liquidating
distribution with respect to Parent's S1 stock. This transaction has a
similar effect (and tax treatment) as a section 304 transaction in
which S2 issues a debt instrument to Parent in exchange for S1 stock,
with the only difference being that S2 acquired the assets of S1
instead of the S1 stock and that Parent received the debt instrument as
a result of the liquidation of S1.
This transaction introduces no new capital into the P group, and
does not affect the ultimate ownership of the assets held by S1 or S2.
Furthermore, S1 generally would not be required to recognize any built-
in gain on the transfer of its assets to S2. Although this transaction
entails a transfer of assets from S1 to S2, the tax costs (if any) and
the non-tax consequences that result from this type of transaction
among related parties are typically insignificant relative to the
federal tax benefits obtained through the introduction of a related-
party debt instrument. Accordingly, the proposed regulations treat a
debt instrument issued by an acquiring corporation as consideration in
an exchange pursuant to an internal asset reorganization as stock,
consistent with the treatment of a debt instrument issued in a
distribution or in exchange for affiliate stock.
5. Debt Instrument Issued With a Principal Purpose of Funding Certain
Distributions and Acquisitions
The Treasury Department and the IRS have determined that the policy
concerns implicated by the transactions described in Sections C.2
through C.4 of this Part VI are also present when a corporation issues
a debt instrument with a principal purpose of funding certain related-
party transactions. Specifically, the proposed regulations treat a debt
instrument issued for property, including cash, as stock when the debt
instrument is issued to an affiliate with a principal purpose of
funding (1) a distribution of cash or other property to a related
corporate shareholder, (2) an acquisition of affiliate stock from an
affiliate, or (3) certain acquisitions of property from an affiliate
pursuant to an internal asset reorganization.
Without these funding provisions, taxpayers that otherwise would
have issued a debt instrument in a one-step transaction described in
Sections C.2 through C.4 of this Part VI would be able to use multi-
step transactions to avoid the application of these proposed
regulations while achieving economically similar outcomes. For example,
a wholly-owned subsidiary that otherwise would have distributed a debt
instrument to its parent corporation in a distribution could, absent
these rules, borrow cash from its parent and later distribute that cash
to its parent in a transaction that is purported to be independent from
the borrowing. Like the distribution of a note, this transaction, if
respected, would result in an increase of related-party debt, but no
new net investment in the operations of the subsidiary. The parent
corporation would have effectively reshuffled its subsidiary's capital
structure to obtain more favorable federal tax treatment for the
subsidiary without affecting its control over the subsidiary. The
similarity between these transactions indicates that they should be
subject to similar tax treatment.
The Treasury Department and the IRS also have determined that a
debt instrument should be subject to these funding rules regardless of
whether the funding affiliate (the lender) is a party to the funded
transaction. Otherwise, a corporation could, for example, borrow funds
from a sister corporation and immediately distribute those funds to the
common parent corporation. Issuances of debt instruments to an
affiliate in order to fund a distribution of property, an acquisition
of affiliate stock, or an acquisition of an affiliate's assets in a
reorganization often would confer significant federal tax benefits
without having a significant non-tax impact, regardless of whether the
lender is also a party to the funded transaction. Accordingly, the
proposed regulations treat as stock a debt instrument issued to an
affiliate to fund one of the specified transactions regardless of
whether the lender is a party to the funded transaction.
Explanation of Provisions
I. Overview
The proposed regulations provide guidance regarding substantiation
of the treatment of certain interests issued between related parties as
indebtedness for federal tax purposes, the treatment of certain
interests in a corporation as in part indebtedness and in part stock,
and the treatment of distributions of debt instruments and similar
transactions that frequently have only limited non-tax effects. More
specifically, the proposed regulations are set forth in four sections.
First, proposed Sec. 1.385-1 prescribes definitions and operating
rules applicable to the regulations under section 385 generally,
including a rule treating members of a consolidated group, as defined
in Sec. 1.1502-1(h), as one corporation. Proposed Sec. 1.385-1(d)
also provides that the Commissioner has the discretion to treat certain
interests in a corporation for federal tax purposes as indebtedness in
part and stock in part. Second, proposed Sec. 1.385-2 addresses the
documentation and information that taxpayers must prepare and maintain
within required timeframes to substantiate the treatment of an interest
issued between related parties as indebtedness for federal tax
purposes. Such substantiation is necessary, but not sufficient, for a
purported debt interest that is within the scope of these rules to be
characterized as indebtedness; general federal income tax principles
also apply in making such a determination. Third, if the application of
proposed Sec. 1.385-2 and
[[Page 20919]]
general federal income tax principles otherwise would result in
treating an interest issued to a related party as indebtedness for
federal tax purposes, proposed Sec. 1.385-3 provides additional rules
that may treat the interest, in whole or in part, as stock for federal
tax purposes if it is issued in a distribution or other transaction
that is identified as frequently having only limited non-tax effect, or
is issued to fund such a transaction. Finally, proposed Sec. 1.385-4
provides operating rules for applying proposed Sec. 1.385-3 to
interests that cease to be between members of the same consolidated
group or interests that become interests between members of the same
consolidated group.
II. Generally Applicable Definitions and Special Rules
A. Definition of Expanded Group
As previously discussed, the concerns addressed by the proposed
regulations arise with respect to interests issued among related
parties. The scope of the proposed regulations is therefore generally
limited to purported indebtedness between members of an expanded group.
Proposed Sec. 1.385-1, which sets forth definitions generally
applicable to the regulations proposed under section 385, defines the
term expanded group by reference to the term affiliated group in
section 1504(a). However, the proposed regulations broaden the
definition in several ways. Unlike an affiliated group, an expanded
group includes foreign and tax-exempt corporations, as well as
corporations held indirectly, for example, through partnerships.
Further, in determining relatedness, the proposed regulations adopt the
attribution rules of section 304(c)(3). The proposed regulations also
modify the definition of affiliated group to treat a corporation as a
member of an expanded group if 80 percent of the vote or value is owned
by expanded group members (instead of 80 percent of the vote and value,
as generally required under section 1504(a)).
Through this definition of an expanded group, the application of
the proposed regulations is limited to transactions between highly-
related parties. Other rules, discussed in Section III.A (limiting the
application of proposed Sec. 1.385-2 to large taxpayers) and Section
IV.C ($50 million threshold exception for proposed Sec. 1.385-3) of
this Explanation of Provisions limit the application of the proposed
regulations to large taxpayers.
B. Treatment of Deemed Exchanges
Proposed Sec. 1.385-1 includes rules that prescribe the effects
under the Code generally of an exchange of purported indebtedness for
stock that is deemed to occur under the proposed regulations. Under
those rules, on the date the indebtedness is recharacterized as stock,
the indebtedness is deemed to be exchanged, in whole or in part, for
stock with a value that is equal to the holder's adjusted basis in the
portion of the indebtedness that is treated as equity under the
regulations, and the issuer of the indebtedness is deemed to retire the
same portion of the indebtedness for an amount equal to its adjusted
issue price as of that date. This rule generally will prevent both the
holder and issuer from realizing gain or loss from the deemed exchange
other than foreign exchange gain or loss recognized by the issuer or
the holder under section 988.
C. Treatment of Certain Instruments as in Part Indebtedness and as in
Part Stock
Proposed Sec. 1.385-1 implements the statutory authority under
section 385(a) to treat an instrument as part indebtedness and part
stock by authorizing the Commissioner to treat certain instruments
issued between related parties in this manner. Any such treatment will
occur only in the event that the substance of the instrument is
regarded for federal tax purposes and the instrument has met the
documentation and information requirements in proposed Sec. 1.385-2
(described subsequently in Section III), if applicable. In addition,
the Commissioner is not required to treat such an interest as
indebtedness in part and stock in part. For example, under the proposed
regulations, if an analysis of a related-party interest that is
documented as a $5 million debt instrument demonstrates that the issuer
cannot reasonably be expected to repay more than $3 million of the
principal amount as of the issuance of the interest, the Commissioner
may treat the interest as part indebtedness ($3 million) and part stock
($2 million). The type of stock (for example, common stock or preferred
stock, section 306 stock, stock described in section 1504(a)(4)) that
the instrument will be treated as for federal tax purposes is
determined by taking into account the terms of the instrument (for
example, voting and conversion rights and rights relating to dividends,
redemption, liquidation, and other distributions).
The Treasury Department and the IRS believe that this approach will
facilitate the treatment of purported debt instruments issued between
related parties in a manner that is more consistent with the substance
of the underlying transaction.
Pursuant to section 385(c) and the regulatory authority granted the
Secretary under section 385(c)(2), the issuer of the interest, the
holder of the interest, and any other person relying on the
characterization of the interest as indebtedness for federal tax
purposes are all required to treat the interest consistent with the
issuer's initial characterization. Thus, for example, a holder may not
disclose on its return under section 385(c)(2) that it is treating an
EGI, as later defined in Section III.A of this Explanation of
Provisions, as indebtedness in part or stock in part if the issuer of
the EGI treats the EGI as indebtedness. This approach eliminates cases
in which members of the same expanded group take contrary positions as
to the treatment of an EGI as indebtedness, stock, or indebtedness in
part and stock in part.
The proposed regulations authorize the treatment of an interest as
indebtedness in part and stock in part in the case of instruments
issued in the form of debt between parties that are related, but at a
lesser degree of relatedness than that required to include them in an
expanded group. Under the proposed regulations, treatment as
indebtedness in part and stock in part can apply to purported
indebtedness between members of modified expanded groups (which are
defined in the same manner as expanded groups, but adopting a 50-
percent ownership test and including certain partnerships and other
persons). The 50-percent relatedness threshold contained in the
definition of modified expanded group is consistent with other
provisions used in subchapter C of the Code to identify a level of
control or ownership that can warrant different federal tax
consequences than those of less-related parties. For example, a similar
threshold applies in determining whether (i) control exists under
section 304(c), (ii) attribution to and from corporations is applicable
under section 318, (iii) persons are related under section 267(b),
which is incorporated into numerous provisions of the Code, (iv) a
redemption is substantially disproportionate under section 302(b)(2),
(v) a disqualified distribution has occurred under section 355(d), (vi)
a distribution is subject to section 355(e), and (vii) corporations are
under common control for purposes of section 334. The Treasury
Department and the IRS request comments on whether it would be helpful
or appropriate to have this rule apply more generally.
D. Consolidated Groups
As described in Part VI of the Background section of this preamble,
[[Page 20920]]
many of the concerns regarding related-party indebtedness are not
present in the case of indebtedness between members of a consolidated
group. Accordingly, the proposed regulations under section 385 do not
apply to interests between members of a consolidated group, although
general federal tax principles continue to apply. Proposed Sec. 1.385-
1(e) achieves this result by treating a consolidated group as one
corporation. See Section III.A and Section IV.F of this Part for
additional rules affecting consolidated groups.
III. Substantiation of Related-Party Indebtedness: Proposed Sec.
1.385-2
A. In General
Proposed Sec. 1.385-2 reflects the importance of contemporaneous
documentation in identifying the rights, obligations, and intent of the
parties to an instrument that is purported to be indebtedness for
federal tax purposes. Such documentation is particularly important to
the analysis of instruments issued between related parties. In
recognition of this importance, the Treasury Department and the IRS are
exercising authority granted under section 385(a) to treat the timely
preparation and maintenance of such documentation as necessary factors
to be taken into account in determining whether certain interests are
properly characterized as stock or indebtedness. Accordingly, the
proposed regulations first prescribe the nature of the documentation
necessary to substantiate the treatment of related-party instruments as
indebtedness and, second, require that such documentation be timely
prepared and maintained. The proposed regulations further provide that,
if the specified documentation is not provided to the Commissioner upon
request, the Commissioner will treat the preparation and maintenance
requirements as not satisfied and will treat the instrument as stock
for federal tax purposes. The type of stock (for example, common stock
or preferred stock, section 306 stock, stock described in section
1504(a)(4)) that the instrument will be treated as for federal tax
purposes is determined by taking into account the terms of the
instrument (for example, voting and conversion rights and rights
relating to dividends, redemption, liquidation, and other
distributions).
Satisfaction of the requirements of the proposed regulations does
not establish that a related-party instrument is indebtedness. Rather,
satisfaction of the proposed regulations acts as a threshold test for
allowing the possibility of indebtedness treatment after the
determination of an instrument's character is made under federal tax
principles developed under applicable case law. If the requirements of
the proposed regulations are not satisfied, the purported indebtedness
would be recharacterized as stock. In such a case, any federal tax
benefit claimed by the taxpayer with respect to the treatment of the
interest as indebtedness will be disallowed.
Judicial doctrines that disregard transactions as having no
substance continue to be applicable and are not affected by the
proposed regulations. Accordingly, proposed Sec. 1.385-2 applies only
to interests the substance of which is potentially regarded as
indebtedness for federal tax purposes. In addition, proposed Sec.
1.385-2 does not limit the ability of the IRS to request information
under any existing authorities, such as the rules under section 7602.
As discussed previously, these proposed regulations apply only to
purported indebtedness issued among entities that are highly related.
Several provisions of the proposed regulations combine to effect this
limitation.
First, proposed Sec. 1.385-2 provides rules only with respect to
applicable instruments, that is, interests issued in the form of debt.
Thus, these proposed regulations do not apply to any interest or
arrangement that is not, in form, indebtedness. The documentation and
other rules in proposed Sec. 1.385-2(b) are tailored to arrangements
that in form are traditional debt instruments and do not address other
arrangements that may be treated as indebtedness under general federal
tax principles. The proposed regulations under Sec. 1.385-2 reserve
with respect to documentation of interests that are not in form
indebtedness. Because there are a large number of ways to document
these arrangements, rules that provide sufficient information about
these arrangements will need to contain specific documentation and
timing requirements depending on the type of arrangement. Accordingly,
the Treasury Department and the IRS request comments regarding the
appropriate documentation and timing requirements for the various forms
that these arrangements can take.
Second, proposed Sec. 1.385-2 only applies to applicable interests
that are issued and held by members of an expanded group (expanded
group instruments, or EGI). For purposes of Sec. 1.385-2, controlled
partnerships are treated as members of the expanded group, and the term
controlled partnership is defined as any partnership the capital or
profits interest in which is 80-percent owned by members of the
expanded group. Proposed Sec. 1.385-2 provides that, solely for
purposes of Sec. 1.385-2, the term issuer means a person that is
obligated to satisfy any material payment obligations created under the
terms of an EGI. For this purpose, a disregarded entity can be treated
as the issuer. A person can be an issuer if that person is expected to
satisfy a material obligation under an EGI, even if that person is not
the primary obligor. A guarantor, however, is not an issuer unless the
guarantor is treated as the primary obligor under federal tax
principles. See, e.g., Plantation Patterns, Inc. v. Commissioner, 462
F.2d 712 (5th Cir. 1972).
Third, proposed Sec. 1.385-2 is intended to apply only to large
taxpayer groups. Accordingly, an EGI is not subject to proposed Sec.
1.385-2 unless the stock of any member of the expanded group is
publicly traded, all or any portion of the expanded group's financial
results are reported on financial statements with total assets
exceeding $100 million, or the expanded group's financial results are
reported on financial statements that reflect annual total revenue that
exceeds $50 million. The proposed regulations provide guidance
regarding the financial statement or statements that are to be used for
purposes of determining the expanded group's assets and liabilities. In
general, this determination is made by reference to a financial
statement required to be filed with the Securities and Exchange
Commission, a certified audited financial statement that is accompanied
by the report of an independent certified public accountant (or in the
case of a foreign entity, by the report of a similarly qualified
independent professional) that is used for certain purposes, or a
financial statement (other than a tax return) required to be provided
to the federal, state, or foreign government or any federal, state, or
foreign agency. Because this list represents a set of financial
statements created for other purposes for persons outside the expanded
group, these financial statements are expected to be sufficiently
reliable for this purpose. In addition, to prevent the use of stale
financial information, only applicable financial statements prepared
within the three years of the EGI becoming subject to the proposed
regulations are relevant for determining whether an EGI is subject to
the proposed regulations under Sec. 1.385-2.
B. Types of Documentation and Other Information Required
The core of proposed Sec. 1.385-2 is the guidance regarding the
nature of the
[[Page 20921]]
documentation and information that must be prepared and maintained to
support the characterization of an EGI as indebtedness for federal tax
purposes. The regulations organize the requirement into four
categories, each reflecting an essential characteristic of indebtedness
for federal tax purposes: a binding obligation to repay the funds
advanced, creditor's rights to enforce the terms of the EGI, a
reasonable expectation that the advanced funds can be repaid, and
actions evidencing a genuine debtor-creditor relationship. Together
these categories represent a distillation of case law principles
established for determining that an instrument is genuine indebtedness
for federal tax purposes.
The proposed regulations require that the prescribed documentation
and information must be provided with respect to each category. Failure
to provide the documentation and information upon request by the
Commissioner will result in the Commissioner treating the requirements
of this section as not satisfied. The four categories are more
specifically described in the following four paragraphs.
1. Binding Obligation to Repay. The threshold requirement for
indebtedness is a binding legal obligation to repay the funds advanced.
The proposed regulations require evidence of such obligation in the
form of timely prepared written documentation executed by the parties.
2. Creditor's Rights to Enforce Terms. The documents establishing
the issuer's obligation to repay must also establish that the creditor/
holder has the legal rights of a creditor to enforce the terms of the
EGI. The proposed regulations give examples of such rights that
creditor/holder typically has, including the right to trigger a default
and the right to accelerate payments. The proposed regulations also
give an example of one right that a creditor/holder must have, which is
a superior right to shareholders to share in the assets of the issuer
in the event that the issuer is dissolved or liquidated.
3. Reasonable Expectation of Repayment. The proposed regulations
also require the taxpayer to provide timely prepared documentation
evidencing a reasonable expectation that the issuer could in fact repay
the amount of a purported loan. The proposed regulations give examples
of such documentation, including cash flow projections, financial
statements, business forecasts, asset appraisals, determination of
debt-to-equity and other relevant financial ratios of the issuer
(compared to industry averages). Special rules are provided to address
disregarded entities that issue an EGI.
4. Genuine Debtor-Creditor Relationship. Finally, the taxpayer
asserting indebtedness treatment must prepare and maintain timely
evidence of an ongoing debtor-creditor relationship. This documentation
can take two forms. In the case of an issuer that complied with the
terms of the EGI, the documentation must include timely prepared
documentation of any payments on which the taxpayer relies to establish
such treatment under general federal tax principles. Alternatively, if
the issuer failed to comply with the terms of the EGI, either by
failing to make required payments or by otherwise suffering an event of
default under the terms of the EGI, the documentation must include
evidence of the holder's reasonable exercise of the diligence and
judgment of a creditor. The proposed regulations give examples of such
documentation, including evidence of the holder's efforts to enforce
the terms of the EGI, as well as any efforts to renegotiate the EGI.
In general, the documentation must be prepared no later than 30
calendar days after the date of the relevant event, which is generally
the later of the date that the instrument becomes an EGI or the date
that an expanded group member becomes an issuer with respect to an EGI.
However, in the case of documentation of the debtor-creditor
relationship, the regulations allow the documentation to be prepared up
to 120 calendar days after the payment or relevant event occurred. This
extended period is intended to avoid inadvertent failures to comply
with the regulations that may be more likely in the case of events that
occur during the life of an EGI. If an applicable instrument is not an
EGI when issued, no documentation is required under the proposed
regulations for any date before the date the applicable instrument
becomes an EGI.
The proposed regulations provide special rules for determining the
timeliness of documentation preparation in the case of certain
revolving credit agreements and similar arrangements and cash pooling
arrangements, generally looking to the documents pursuant to which the
arrangements were established.
C. Maintenance Requirement
Under proposed Sec. 1.385-2, the documentation and information in
the four categories previously described must be maintained for all
taxable years that the EGI is outstanding and until the period of
limitations expires for any return with respect to which the federal
tax treatment of the EGI is relevant. The proposed regulations do not
otherwise specify where or in what manner such records must be kept.
The Treasury Department and the IRS intend that taxpayers have
flexibility to determine the manner in which the requirements of the
proposed regulations are satisfied.
D. Timing of Application of Rule
In general, proposed Sec. 1.385-2 will apply to an applicable
instrument at the time it becomes an EGI and thereafter. If an EGI that
was characterized as stock under the rules of Sec. 1.385-2 ceases to
be an EGI, general federal tax principles will apply to determine its
character at the time it ceases to be an EGI; if, under general federal
tax principles, it is treated as indebtedness, the issuer is treated as
issuing a new debt instrument to the holder in exchange for the EGI
immediately before the transaction that causes the instrument to cease
to qualify as an EGI.
If an applicable instrument is an EGI when issued, determinations
under proposed Sec. 1.385-2 are generally effective from the issuance
date. If an applicable instrument was not an EGI when issued, proposed
Sec. 1.385-2 applies, and any resulting determination is generally
effective, when the applicable instrument becomes an EGI. However, if
an EGI originally treated as debt is later recharacterized as stock
because the documentation and information cease to evidence an ongoing
debtor-creditor relationship, the recharacterization will be effective
as of the time that the facts and circumstances cease to evidence a
debtor-creditor relationship.
E. Consolidated Groups
Proposed Sec. 1.385-1(e) provides that members of a consolidated
group are treated as one corporation. Proposed Sec. 1.385-2(c)(4)(ii)
further provides that if an applicable instrument ceases to be an
intercompany obligation and, as a result, becomes an EGI subject to the
rules of proposed Sec. 1.385-2, the applicable instrument is treated
as becoming an EGI immediately after it ceases to be an intercompany
obligation.
F. Modifications to General Operation of Proposed Sec. 1.385-2
The proposed regulation includes a number of provisions that modify
the general rules of Sec. 1.385-2 in order to provide flexibility in
appropriate circumstances or to prevent abuse. First, the requirements
of proposed Sec. 1.385-2 may be modified if a taxpayer's failure to
comply with the requirements is attributable to reasonable cause. The
principles of Sec. 301.6724-1 (relating to
[[Page 20922]]
waivers of penalty if failure due to reasonable cause) apply for
purposes of determining whether reasonable cause exists in any
particular case.
Second, to prevent abuse, proposed Sec. 1.385-2 prohibits the
affirmative use of the rules in the proposed regulations to support a
particular characterization of an instrument. Thus, if a taxpayer fails
to satisfy the requirements of proposed Sec. 1.385-2 with a principal
purpose of reducing the federal tax liability of any member of the
expanded group, the rules of the proposed regulations do not apply.
Third, if an applicable instrument that is not an EGI is issued
with a principal purpose of avoiding the purposes of proposed Sec.
1.385-2, the applicable instrument is treated as an EGI and will be
subject to the provisions of the proposed regulations. Such a situation
could occur if, for example, an applicable interest was issued by an
expanded group member to a trust held by members of the same expanded
group.
G. Effective Date of Proposed Sec. 1.385-2
The provisions of Sec. 1.385-2 are proposed to be generally
effective when the regulations are published as final regulations.
Proposed Sec. 1.385-2 would apply to any applicable instrument issued
on or after that date, as well as to any applicable instrument treated
as issued as a result of an entity classification election under Sec.
301.7701-3 made on or after the date the regulations are issued as
final regulations.
IV. Certain Distributions of Debt Instruments and Similar Transactions
A. In General
Proposed Sec. Sec. 1.385-3 and 1.385-4 provide rules that treat as
stock certain interests that otherwise would be treated as indebtedness
for federal income tax purposes. Proposed Sec. 1.385-3 applies to debt
instruments that are within the meaning of section 1275(a) and Sec.
1.1275-1(d), as determined without regard to the application of
proposed Sec. 1.385-3. Section 1275(a) and Sec. 1.1275-1(d) generally
define a debt instrument as any instrument or contractual arrangement
that constitutes indebtedness under general principles of federal
income tax law. Thus, the term debt instrument for purposes of proposed
Sec. Sec. 1.385-3 and 1.385-4 means an instrument that satisfies the
requirements of proposed Sec. Sec. 1.385-1 and 1.385-2 and that is
indebtedness under general principles of federal income tax law. The
Treasury Department and the IRS plan to amend Sec. 1.1275-1(d) to
coordinate Sec. 1.1275-1(d) with the regulations under section 385
when the proposed regulations are finalized.
Specifically, proposed Sec. 1.385-3 treats as stock certain debt
instruments issued by one member of an expanded group to another member
of the same group (expanded group debt instrument) in the circumstances
described in Section B of this Part IV, unless an exception described
in Section C of this Part IV applies. Detailed operating rules
regarding the recharacterization (including with respect to
partnerships) are discussed in Section D of this Part IV. A rule to
prevent taxpayers from affirmatively using proposed Sec. Sec. 1.385-3
and 1.385-4 is discussed in Section E of this Part IV. Section F of
this Part IV discusses proposed Sec. 1.385-4, which provides special
rules to address the treatment of consolidated groups. The effective
date of proposed Sec. Sec. 1.385-3 and 1.385-4 is discussed in Section
G of this Part IV.
To the extent proposed Sec. 1.385-3 treats an interest as stock,
the interest is treated as stock for all federal tax purposes.
Consistent with the traditional case law debt-equity analysis, when a
debt instrument is treated as stock under proposed Sec. 1.385-3, the
terms of the debt instrument (for example, voting rights or conversion
features) are taken into account for purposes of determining the type
of stock resulting from the recharacterization, including whether such
stock is preferred stock or common stock.
B. Debt Instruments Treated as Stock
Proposed Sec. 1.385-3 provides three rules that treat an expanded
group debt instrument as stock: a general rule, a funding rule, and an
anti-abuse rule.
1. The General Rule
The general rule treats an expanded group debt instrument as stock
to the extent it is issued by a corporation to a member of the
corporation's expanded group (1) in a distribution; (2) in exchange for
expanded group stock, other than in an exempt exchange (as defined
later in this Section 1); or (3) in exchange for property in an asset
reorganization, but only to the extent that, pursuant to the plan of
reorganization, a shareholder that is a member of the issuer's expanded
group immediately before the reorganization receives the debt
instrument with respect to its stock in the transferor corporation. All
or a portion of an issuance of a debt instrument may be described in
more than one prong of the general rule without changing the result
that follows from being described in a single prong.
For purposes of the first prong of the general rule, the term
distribution is broadly defined as any distribution by a corporation to
a member of the corporation's expanded group with respect to the
distributing corporation's stock, regardless of whether the
distribution is treated as a dividend within the meaning of section
316. Thus, a debt instrument issued in exchange for stock of the issuer
of the debt instrument (that is, in a redemption under corporate law)
is a distribution that is covered by the first prong of the general
rule and an acquisition of expanded group stock covered by the second
prong of the general rule.
The second prong of the general rule--addressing debt instruments
issued in exchange for expanded group stock--applies regardless of
whether the expanded group stock is acquired from a shareholder of the
issuer of the expanded group stock, or directly from the issuer. For an
illustration of this rule in a context where stock is not formally
issued because it would be a ``meaningless gesture,'' see Example 11 in
Sec. 1.385-3(g)(3) of the proposed regulations.
For purposes of the second prong of the general rule, the term
exempt exchange means an acquisition of expanded group stock in which
the transferor and transferee of the stock are parties to a
reorganization that is an asset reorganization, and either (i) section
361(a) or (b) applies to the transferor of the expanded group stock and
the stock is not transferred by issuance; or (ii) section 1032 or Sec.
1.1032-2 applies to the transferor of the expanded group stock and the
stock is distributed by the transferee pursuant to the plan of
reorganization. As a result, the second prong of the general rule
generally does not apply to a debt instrument that is issued in
exchange for expanded group stock when section 361(a) or (b) applies to
the transferor of such stock. This limitation has the effect of causing
exchanges of expanded group stock that are part of an asset
reorganization to be covered only by the third prong of the general
rule, which, as discussed in the next paragraph, imposes limitations on
the application of the general rule to exchanges that are part of an
asset reorganization.
The third prong of the general rule applies to asset
reorganizations among corporations that are members of the same
expanded group. An asset reorganization is a reorganization within the
meaning of section 368(a)(1)(A), (C), (D), (F), or (G). Specifically,
the third prong of the
[[Page 20923]]
general rule applies to a debt instrument issued in exchange for
property in an asset reorganization, but only to the extent that,
pursuant to the plan of reorganization, a shareholder that is a member
of the issuer's expanded group immediately before the reorganization
receives the debt instrument with respect to its stock in the
transferor corporation. The second step receipt of the debt instrument
by the expanded group shareholder could be in the form of a
distribution of the debt instrument to shareholders of the distributing
corporation in a divisive asset reorganization, or in redemption of the
shareholder's stock in the transferor corporation in an acquisitive
asset reorganization. Because the third prong of the general rule
applies only to a debt instrument that is received by a shareholder
with respect to its stock in the transferor corporation, that debt
instrument would, absent the application of Sec. 1.385-3, be treated
as ``other property'' within the meaning of section 356.
The third prong of the general rule is limited to debt instruments
distributed to shareholders pursuant to the reorganization, and does
not apply to debt instruments exchanged for securities or other debt
interests because, in that latter case, the newly issued debt
instrument is exchanged for existing debt interests and thus no
additional debt is incurred by the parties to the reorganization.
2. The Funding Rule
a. Funded Transactions
The funding rule treats as stock an expanded group debt instrument
that is issued with a principal purpose of funding a transaction
described in the general rule (principal purpose debt instrument).
Specifically, a principal purpose debt instrument is a debt instrument
issued by a corporation (funded member) to another member of the funded
member's expanded group in exchange for property with a principal
purpose of funding (1) a distribution of property by the funded member
to a member of the funded member's expanded group, other than a
distribution of stock pursuant to an asset reorganization that is
permitted to be received without the recognition of gain or income
under section 354(a)(1) or 355(a)(1) or, when section 356 applies, that
is not treated as ``other property'' or money described in section 356;
(2) an acquisition of expanded group stock, other than in an exempt
exchange, by the funded member from a member of the funded member's
expanded group in exchange for property other than expanded group
stock; or (3) the acquisition of property by the funded member in an
asset reorganization but only to the extent that, pursuant to the plan
of reorganization, a shareholder that is a member of the funded
member's expanded group immediately before the reorganization receives
``other property'' or money within the meaning of section 356 with
respect to its stock in the transferor corporation.
Prongs (1) through (3) of the funding rule are referred to in this
Section 2 as ``distributions or acquisitions.'' Proposed Sec. 1.385-
3(b)(3)(iii) provides that, if all or a portion of a distribution or
acquisition by a funded member is described in more than one prong of
the funding rule, the funded member is treated as engaging in only a
single distribution or acquisition for purposes of applying the funding
rule. The funding rule addresses transactions that, when viewed
together, present similar policy concerns as the transactions that are
subject to the general rule.
The first prong of the funding rule--addressing a distribution by a
funded member--excludes a distribution of stock permitted to be
received without the recognition of gain under section 355(a)(1) when
the distribution is pursuant to an asset reorganization (that is, a
divisive reorganization qualifying under section 368(a)(1)(D)), but
does not exclude a distribution of stock that is permitted to be
received without the recognition of gain under section 355(a)(1) when
the transaction qualifies under section 355 without also qualifying as
a reorganization (that is, a distribution of the stock of a controlled
corporation without a related transfer of property by the distributing
corporation to the controlled corporation pursuant to the plan of
reorganization). The reason for this distinction is that the controlled
corporation in a divisive reorganization described in section
368(a)(1)(D) acquires assets of the distributing corporation and, as
described in Section B.2.b.v of this Part IV, is treated as a successor
of the distributing corporation (and the distributing corporation is
treated as a predecessor of the controlled corporation) for purposes of
the funding rule. In contrast, when a distribution transaction
qualifies under section 355 without also qualifying as a
reorganization, the controlled corporation does not acquire assets from
the distributing corporation as part of the transaction and the
corporations are not treated as predecessor and successor of each other
for purposes of the funding rule. Consistent with this approach,
proposed Sec. 1.385-3 does not treat a section 355 distribution that
is part of a divisive reorganization as a distribution for purposes of
the funding rule because the distributing corporation and the
controlled corporation are both parties to the reorganization and are
both treated as funded members to the extent of any prior debt
instrument issued by the distributing corporation. For a further
illustration of this rule, see Example 10 in Sec. 1.385-3(g)(3) of the
proposed regulations.
b. Determining Whether a Debt Instrument Is Issued With a Principal
Purpose of Funding a Distribution or Acquisition
The determination as to whether a debt instrument is issued with a
principal purpose of funding a distribution or acquisition is based on
all of the facts and circumstances. A debt instrument may be treated as
issued with such a principal purpose whether it is issued before or
after a distribution or acquisition.
i. Non-Rebuttable Presumption During the 72-Month Period
Proposed Sec. 1.385-3 also establishes a non-rebuttable
presumption that certain expanded group debt instruments are issued
with a principal purpose of funding a distribution or acquisition by
the funded member. Specifically, such a principal purpose is deemed to
exist if the expanded group debt instrument is issued by the funded
member during the period beginning 36 months before the funded member
makes a distribution or acquisition and ending 36 months after the
distribution or acquisition (the 72-month period). This per se rule
does not create a safe harbor. Accordingly, a debt instrument issued
outside the 72-month period may be treated as having a principal
purpose of funding a distribution or acquisition, based on the facts
and circumstances.
The Treasury Department and the IRS have determined that this non-
rebuttable presumption is appropriate because money is fungible and
because it is difficult for the IRS to establish the principal purposes
of internal transactions. In the absence of a per se rule, taxpayers
could assert that free cash flow generated from operations funded any
distributions and acquisitions, while any debt instrument was incurred
to finance the capital needs of those operations. Because taxpayers
would be able to document the purposes of funding transactions
accordingly, it would be difficult for the IRS to establish that any
particular debt instrument was incurred with a principal purpose of
funding a
[[Page 20924]]
distribution or acquisition. The exception discussed in Section C of
this Part IV for distributions and acquisitions that do not exceed
current year earnings and profits would accommodate many ordinary
course distributions and acquisitions, providing significant
flexibility to avoid the application of this per se rule. The Treasury
Department and the IRS have determined that this exception, together
with the exception for a tainted debt instrument that does not exceed
$50 million, also discussed in Section C of this Part IV, appropriately
balance between preventing tax-motivated transactions among members of
an expanded group and accommodating ordinary course transactions.
ii. Exception to Non-Rebuttable Presumption for Ordinary Course Debt
Instruments
An exception to this per se rule applies to ordinary course debt
instruments. Proposed Sec. 1.385-3(b)(3)(iv)(B)(2) defines an ordinary
course debt instrument as a debt instrument that arises in the ordinary
course of the issuer's trade or business in connection with the
purchase of property or the receipt of services to the extent that it
reflects an obligation to pay an amount that is currently deductible by
the issuer under section 162 or currently included in the issuer's cost
of goods sold or inventory, provided that the amount of the obligation
outstanding at no time exceeds the amount that would be ordinary and
necessary to carry on the trade or business of the issuer if it was
unrelated to the lender. This exception is intended to apply to debt
instruments that arise in connection with the purchase of property or
the receipt of services between members of the same expanded group in
the ordinary course of the purchaser's or recipient's trade or
business, and is not intended to apply to intercompany financing or
treasury center activities or to capital expenditures. An ordinary
course debt instrument is not subject to the per se rule; however, it
may be treated as having a principal purpose of funding a distribution
or acquisition by the issuer, based on the facts and circumstances.
iii. Ordering Rules
For purposes of applying the per se rule, proposed Sec. 1.385-
3(b)(3)(iv)(B)(3) includes an ordering rule that provides that, when
two or more debt instruments may be treated as potentially funding the
same acquisition or distribution, the debt instruments are tested based
on the order in which they were issued. Thus, for example, if a company
issues an expanded group debt instrument of $100x in each of years 1
and 2, and then makes a distribution of $150x in year 3, the
distribution will result in a recharacterization as of the date of the
distribution of $100x of the year 1 debt instrument and $50x of the
year 2 debt instrument. For a further illustration of this rule, see
Example 6 in Sec. 1.385-3(g)(3) of the proposed regulations.
A second ordering rule in proposed Sec. 1.385-3(b)(3)(iv)(B)(4)
provides that, when a debt instrument may be treated as funding more
than one distribution or acquisition, the earliest distribution or
acquisition is treated as the first distribution or acquisition that
was funded.
An exception to these ordering rules applies when an acquisition of
expanded group stock by issuance ceases to qualify for the exception
from the funding rule described in Section C.3 of this Part IV. In that
case, the acquisition of expanded group stock is treated as an
acquisition that is subject to the funding rule on the date that the
acquisition actually occurred, but debt instruments issued, and other
distributions and acquisitions that occurred, prior to the date that
the acquirer ceases to qualify for the exception are ordered without
regard to the acquisition of expanded group stock that previously was
excepted from the funding rule.
iv. Transition Rule
For a rule preventing the funding rule from treating a debt
instrument issued on or after April 4, 2016 from being treated as
funding a distribution or acquisition that occurred before April 4,
2016, see Section G of this Part IV.
v. Predecessor and Successor Rules
Finally, the funding rule provides that references in the funding
rule to the funded member include any predecessor or successor of such
member. A predecessor is defined to include the distributor or
transferor corporation in a transaction described in section 381(a) in
which a member of the expanded group is the acquiring corporation, but
also includes the transferor corporation in a divisive reorganization
described in section 368(a)(1)(D) or (G). The term predecessor does not
include, with respect to a controlled corporation, a distributing
corporation that distributed the stock of the controlled corporation
pursuant to section 355(c). Similarly, a successor is defined to
include the acquiring corporation in a transaction described in section
381(a) in which a member of the expanded group is the distributor or
transferor corporation, but also includes the acquiring corporation in
a divisive reorganization described in section 368(a)(1)(D) or (G). The
term successor does not include, with respect to a distributing
corporation, a controlled corporation the stock of which was
distributed by the distributing corporation pursuant to section 355(c).
In addition, Section C.3 of this Part IV, which sets forth an exception
to the funding rule for certain acquisitions of expanded group stock by
issuance, provides that the funded member is treated as a predecessor
of the issuer and the issuer is treated as a successor of the funded
member to the extent of the value of the acquired stock. For an
illustration of these rules, see Examples 9, 10, and 12 in proposed
Sec. 1.385-3(g)(3).
3. The Anti-Abuse Rule
Proposed Sec. 1.385-3(b)(4) also provides that a debt instrument
is treated as stock if it is issued with a principal purpose of
avoiding the application of the proposed regulations. In addition,
other interests that are not debt instruments for purposes of proposed
Sec. Sec. 1.385-3 and 1.385-4 (for example, contracts to which section
483 applies or nonperiodic swap payments) are treated as stock if
issued with a principal purpose of avoiding the application of proposed
Sec. Sec. 1.385-3 or 1.385-4.
Proposed Sec. 1.385-3(b)(4) includes a non-exhaustive list of
examples illustrating situations where the anti-abuse rule might apply.
The anti-abuse rule may apply, for example, if a debt instrument is
issued to, and later acquired from, a person that is not a member of
the issuer's expanded group with a principal purpose of avoiding the
application of the proposed regulations. In that situation, factors
that may be taken into account in determining the presence or absence
of a principal purpose of avoiding the application of the proposed
regulations include the time period between the issuance of the debt
instrument to the non-member and the acquisition of the debt instrument
by a member of the issuer's expanded group, and whether there was a
significant change in circumstances during that time period. For
example, a change of control of the issuer group (for example, a cash
acquisition of all of the stock of the ultimate parent company of the
issuer) after the issuance and before the acquisition of the debt
instrument that was not foreseeable when the debt instrument was issued
to the non-member could indicate that the debt instrument was not
issued with a principal purpose of avoiding the
[[Page 20925]]
application of the proposed regulations. In contrast, the issuance of a
debt instrument to a non-member after discussions were underway
regarding the change-of-control transaction could indicate that the
debt instrument was issued with a principal purpose of avoiding the
application of the proposed regulations.
Other examples of when the anti-abuse rule could apply include
situations where, with a principal purpose of avoiding the application
of proposed Sec. 1.385-3: (i) A Debt instrument is issued to a person
that is not a member of the issuer's expanded group and that person
later becomes a member of the issuer's expanded group; (ii) a debt
instrument is issued to an entity that is not taxable as a corporation
for federal tax purposes (for example, a trust that is beneficially
owned by an expanded group member); or (iii) a member of the issuer's
expanded group is substituted as a new obligor or added as a co-obligor
on an existing debt instrument. The anti-abuse rule also could apply to
a debt instrument that is issued or transferred in connection with a
reorganization or similar transaction with a principal purpose of
avoiding the application of the proposed regulations. For a further
illustration of this rule, see Example 18 in Sec. 1.385-3(g)(3) of the
proposed regulations.
4. Coordination Between General Rule and Funding Rule
Proposed Sec. 1.385-3(b)(5) includes a rule to address a potential
overlap between the general rule and the funding rule. This
coordination rule provides that, to the extent all or a portion of a
debt instrument issued in an asset reorganization is treated as stock
under the third prong of the general rule (relating to a debt
instrument issued for property in an asset reorganization), the
distribution of the deemed stock to a shareholder in the asset
reorganization is not also treated as a distribution or acquisition by
the transferor corporation for purposes of the funding rule. This
coordination rule addresses a specific potential overlap situation
where a debt instrument is distributed to a shareholder pursuant to an
asset reorganization and is characterized under the third prong of the
general rule as an issuance of stock. When the issuance of the debt
instrument is characterized under the general rule as an issuance of
stock, the stock may be treated as non-qualified preferred stock for
purposes of section 356. Nonqualified preferred stock received by a
shareholder in a distribution is itself treated as ``other property''
for purposes of section 356. This overlap rule provides that, if the
shareholder is deemed to receive nonqualified preferred stock in the
asset reorganization, the distribution of the nonqualified preferred
stock in the asset reorganization is not treated as a distribution or
acquisition for purposes of the funding rule. For an illustration of
this rule, see Example 8 in Sec. 1.385-3(g)(3) of the proposed
regulations.
C. Exceptions
Proposed Sec. 1.385-3(c) provides three exceptions from the
application of proposed Sec. 1.385-3(b) for transactions that
otherwise could result in a debt instrument being treated as stock.
1. Exception for Current Year Earnings and Profits
As noted in Section B.2 of this Part IV, proposed Sec. 1.385-
3(c)(1) includes an exception pursuant to which distributions and
acquisitions described in proposed Sec. 1.385-3(b)(2) (the general
rule) or proposed Sec. 1.385-3(b)(3)(ii) (the funding rule) that do
not exceed current year earnings and profits (as described in section
316(a)(2)) of the distributing or acquiring corporation are not treated
as distributions or acquisitions for purposes of the general rule or
the funding rule. For this purpose, distributions and acquisitions are
attributed to current year earnings and profits in the order in which
they occur.
2. Threshold Exception
A second exception provides that an expanded group debt instrument
will not be treated as stock if, when the debt instrument is issued,
the aggregate issue price of all expanded group debt instruments that
otherwise would be treated as stock under the proposed regulations does
not exceed $50 million (the threshold exception). If the expanded
group's debt instruments that otherwise would be treated as stock later
exceed $50 million, then all expanded group debt instruments that, but
for the threshold exception, would have been treated as stock are
treated as stock, rather than only the amount that exceeds $50 million.
Thus, the threshold exception is not an exemption of the first $50
million of expanded group debt instruments that otherwise would be
treated as stock under the proposed regulations, but rather is only
intended to provide an exception from the application of proposed Sec.
1.385-3 for taxpayers that have not exceeded the $50 million threshold.
If the $50 million threshold subsequently is exceeded, the timing of
the recharacterization of the relevant debt instrument as stock depends
on when the debt instrument was issued. If the debt instrument ceases
to qualify for the threshold exception after the taxable year of its
issuance, the recharacterization is treated as occurring on the date
that the threshold exception ceases to apply. If, on the other hand,
the debt instrument ceases to qualify for the threshold exception
during the same taxable year that the debt instrument is issued, the
debt instrument is treated as stock as of the day that the debt
instrument is issued. Once the $50 million threshold is exceeded, the
threshold exception will not apply to any debt instrument issued by
members of the expanded group for so long as any instrument that
previously was treated as indebtedness solely because of the threshold
exception remains outstanding, in order to prevent the $50 million
limitation from refreshing after those instruments are treated as
stock.
The threshold exception is applied after applying the exception for
current year earnings and profits. For an illustration of the
interaction of the threshold exception and the exception for current
year earnings and profits, see Example 17 in Sec. 1.385-3(g)(3) of the
proposed regulations.
3. Exception for Funded Acquisitions of Subsidiary Stock by Issuance
An acquisition of expanded group stock will not be treated as an
acquisition described in the second prong of the funding rule if (i)
the acquisition results from a transfer of property by a funded member
(the transferor) to an issuer in exchange for stock of the issuer, and
(ii) for the 36-month period following the issuance, the transferor
holds, directly or indirectly, more than 50 percent of the total
combined voting power of all classes of stock of the issuer entitled to
vote and more than 50 percent of the total value of the stock of the
issuer. For purposes of this exception, a transferor's indirect stock
ownership is determined by applying the principles of section 958(a)
without regard to whether an intermediate entity is foreign or
domestic.
If the transferor ceases to meet the ownership requirement at any
time during the 36-month period, the acquisition of expanded group
stock will no longer qualify for the exception and will be treated as
an acquisition described in the second prong of the funding rule. In
this case, for purposes of applying the per se rule, the acquisition
may be treated as having been funded by a debt instrument issued during
the 72-month period determined with respect to the date of the
acquisition (rather than the date that
[[Page 20926]]
the exception ceased to apply (the cessation date)), but, in the case
of a debt instrument issued prior to the cessation date, only to the
extent that such debt instrument is treated as indebtedness as of the
cessation date (that is, a debt instrument not already treated as
stock).
The proposed regulations treat an issuer and a transferor as a
successor and predecessor, respectively, for purposes of the funding
rule to the extent of the value of the expanded group stock acquired
from the issuer. However, for purposes of the per se rule, the issuer
and transferor are only treated as successor and predecessor,
respectively, with respect to a debt instrument issued by the
transferor during the period beginning 36 months before the relevant
issuance of expanded group stock and ending 36 months after such
issuance. Proposed Sec. 1.385-3(f)(11) further limits the effect of
treating the issuer and transferor as successor and predecessor by
providing that a distribution made by the issuer directly to the
transferor is not treated as a distribution made by the transferor for
purposes of applying the funding rule to a debt instrument of the
transferor.
For an illustration of this exception, see Example 12 in Sec.
1.385-3(g)(3) of the proposed regulations.
D. Operating Rules
Proposed Sec. 1.385-3(d) includes operating rules for determining
when a debt instrument is treated as stock and for certain deemed
exchanges required under the proposed regulations.
1. Timing of Stock Treatment
a. Timing Under the General Rule
A debt instrument treated as stock under the general rule is
treated as stock from the time when the debt instrument is issued. In
addition, and in contrast to the funding rule, the treatment of a debt
instrument as stock pursuant to the general rule may affect other
aspects of the tax treatment of the transaction in which the debt
instrument is issued. For example, a distribution of a debt instrument
is treated as a distribution of stock for all federal tax purposes and,
accordingly, is subject to section 305. Similarly, a debt instrument
issued in exchange for expanded group stock is treated as an
acquisition of expanded group stock in exchange for stock of the
issuing corporation. Because stock of the issuing corporation is not
treated as ``property'' within the meaning of section 317, such
transactions would not, for example, be described in section 304(a)(1)
or be subject to Sec. 1.367(b)-10, both of which only apply to certain
acquisitions of stock for property.
b. Timing Under the Funding Rule
When the funding rule applies, a principal purpose debt instrument
also is treated as stock from the time when the debt instrument is
issued, but only to the extent it is issued in the same or a subsequent
taxable year as the distribution or acquisition that the debt
instrument is treated as funding. To the extent that a principal
purpose debt instrument is issued in a taxable year preceding the
taxable year in which the distribution or acquisition that it is
treated as funding occurs, the debt instrument is respected as
indebtedness until the date such distribution or acquisition occurs, at
which time it is deemed to be exchanged (as described in Section D.2 of
this Part IV) for stock. For these purposes, the relevant taxable year
is the taxable year of the funded member. See Section C.3 of this Part
IV for a discussion of the timing rule when the exception for funded
acquisitions of subsidiary stock by issuance ceases to apply.
In contrast to transactions that are characterized under the
general rule, when the funding rule applies, the tax treatment of the
distribution or acquisition that the principal purpose debt instrument
is treated as funding is never recharacterized under the proposed
regulations. Accordingly, in the case of a section 301 distribution
that triggers the application of the funding rule, section 301 will
continue to apply to the distribution without regard to the fact that
the debt instrument that is treated as funding the distribution is
recharacterized as stock. Similarly, the application of section 304 to
a funded acquisition of expanded group stock would not be affected by
the fact that the debt instrument that is treated as funding the
acquisition is recharacterized as stock under the funding rule.
c. Transitional Timing Rule
For an additional timing rule addressing certain debt instruments
issued on or after April 4, 2016 and before the date of publication in
the Federal Register of the Treasury decision adopting proposed Sec.
1.385-3 as a final regulation, see section G of this Part IV.
2. Deemed Exchange
As described in Section D.1 of this Part IV, the funding rule can
apply to treat a debt instrument as stock in a taxable year that is
subsequent to the taxable year in which the debt instrument is issued.
In addition, as described in Section C of this Part IV, when the $50
million threshold exception ceases to apply, all debt instruments of
the expanded group issued in a prior taxable year that previously was
treated as indebtedness because of the threshold exception is treated
as stock on the date that the threshold exception ceases to apply. In
those situations the deemed exchange rule described in Section B of
Part II applies. This deemed exchange rule does not apply when a debt
instrument that is treated as stock under proposed Sec. 1.385-3 leaves
the expanded group, as described in Section D.3 of this Part IV.
3. Debt Instrument That Leaves the Expanded Group
When a debt instrument that is treated as stock under proposed
Sec. 1.385-3 is transferred to a person that is not a member of the
expanded group, or when the obligor with respect to such debt
instrument ceases to be a member of the expanded group that includes
the issuer, the interest ceases to be treated as stock. This is because
proposed Sec. 1.385-3 generally applies only to a debt instrument that
is held by a member of an expanded group. For purposes of this rule, it
should be noted that a debt instrument held by a partnership is
considered held by its partners, as described in Section D.4 of this
Part IV.
The proposed regulations provide that, immediately before a debt
instrument that is treated as stock under proposed Sec. 1.385-3 ceases
to be held by a member of the expanded group, the expanded group issuer
is deemed to issue a new debt instrument to the expanded group holder
in exchange for the debt instrument that was treated as stock. The
proposed regulations provide that this deemed issuance of the debt
instrument is not itself subject to the general rule.
When a debt instrument treated as stock pursuant to the funding
rule ceases to be treated as stock because it is no longer an expanded
group debt instrument, all other debt instruments of the issuer that
are not currently treated as stock are re-tested to determine whether
other debt instruments are treated as funding the distribution or
acquisition that previously was treated as funded by the debt
instrument that ceases to be treated as stock pursuant to this rule.
For an illustration of this rule, see Example 7 in Sec. 1.385-3(g)(3)
of the proposed regulations.
4. Treatment of Partnerships
To prevent avoidance of these rules through the use of
partnerships, proposed Sec. 1.385-3(d)(5) takes an
[[Page 20927]]
aggregate approach to controlled partnerships for purposes of the
proposed regulations. The legislative history of subchapter K of
chapter 1 of the Code provides that, for purposes of interpreting Code
provisions outside of that subchapter, a partnership may be treated as
either an entity separate from its partners or an aggregate of its
partners, depending on which characterization is more appropriate to
carry out the purpose of the particular section under consideration.
H.R. Conf. Rep. No. 2543, 83rd Cong. 2d. Sess. 59 (1954). Thus, for
example, when a member of an expanded group becomes a partner in a
partnership that is a controlled partnership with respect to the
expanded group, the member is treated as acquiring its proportionate
share of the controlled partnership's assets. In addition, each
expanded group partner in a controlled partnership is treated as (i)
issuing its proportionate share of any debt instrument issued by the
controlled partnership, (ii) acquiring its proportionate share of any
expanded group stock acquired by the controlled partnership, and (iii)
receiving its proportionate share of any ``other property'' received by
the partnership in a transaction described in section 356. For this
purpose, a partner's proportionate share is determined in accordance
with the partner's share of partnership profits. A partnership is a
controlled partnership if 80 percent or more of the interests in the
capital or profits of the partnership are owned, directly or
indirectly, by one or more members of an expanded group. For this
purpose, indirect ownership of a partnership interest is determined
based on the indirect ownership rules of section 304(c)(3).
If a debt instrument issued by a controlled partnership were to be
recharacterized as equity in the controlled partnership, the resulting
equity could give rise to guaranteed payments that may be deductible or
gross income allocations to partners that would reduce the taxable
income of the other partners that did not receive such allocations.
Therefore, under the authority of section 7701(l) to recharacterize
multiple-party financing transactions, proposed Sec. 1.385-3(d)(5)(ii)
provides that, when a debt instrument issued by a partnership is
recharacterized, in whole or in part, under proposed Sec. 1.385-3, the
holder of the recharacterized debt instrument is treated as holding
stock in the expanded group partner or partners rather than as holding
a partnership interest in the controlled partnership. The partnership
and its partners must make appropriate conforming adjustments to
reflect the expanded group partner's treatment under the proposed
regulations. Any such adjustments must be consistent with the purposes
of these proposed regulations and must be made in a manner that avoids
the creation of, or increase in, a disparity between the controlled
partnership's aggregate basis in its assets and the aggregate bases of
the partners' respective interests in the partnership. For an
illustration of the rules applicable to controlled partnerships, see
Examples 13, 14, and 15 in Sec. 1.385-3(g)(3) of the proposed
regulations.
5. Notification of Inconsistent Treatment Waived
Section 385(c)(1) provides that an issuer's characterization as of
the time of issuance of an interest as debt or stock is binding on the
issuer and on all holders of the interest. Section 385(c)(2) provides
an exception to that rule if the holder discloses on its return that
the holder is treating such interest in a manner that is inconsistent
with such characterization. Section 385(c)(3) provides that the
Secretary is authorized to require such information as the Secretary
determines to be necessary to carry out the provisions of section
385(c). Under proposed Sec. 1.385-3, a holder may be required to treat
an interest as stock even though the issuer treated it as debt when it
was issued. For example, a debt instrument may first be treated as a
principal purpose debt instrument in a year that follows the year in
which the debt instrument was issued. In that case, absent a regulatory
provision to the contrary, the holder would be subject to the reporting
requirement described in section 385(c)(2).
The Treasury Department and the IRS have determined that the
characterization and reporting requirements in section 385(c) were not
intended to apply when regulations under section 385 require an
interest to be recharacterized after the issuer's initial
characterization of that interest. Accordingly, the proposed
regulations provide that section 385(c)(1) does not apply to a debt
instrument to the extent that it is treated as stock under the proposed
regulations.
6. Obligations of Disregarded Entities
Proposed Sec. 1.385-3(d)(6) provides that a debt instrument issued
by a disregarded entity that is treated as stock under proposed Sec.
1.385-3 is treated as stock in the disregarded entity's owner rather
than as an equity interest in the disregarded entity. Ordinarily, when
a disregarded entity becomes an entity with more than one equity owner,
the disregarded entity converts to a partnership. See, e.g., Sec.
301.7701-3(f)(2); Rev. Rul. 99-5, 1999-1 C.B. 434. Under these
circumstances, the Treasury Department and the IRS have determined that
treating a debt instrument issued by a disregarded entity that is
treated as stock under proposed Sec. 1.385-3 as stock in its owner,
rather than as an equity interest in the disregarded entity, is
consistent with, and addresses similar policy concerns as, the rules
applicable to a debt instrument issued by a controlled partnership,
which are described in Section D.4 of this Part IV.
E. No Affirmative Use
Under proposed Sec. 1.385-3(e), proposed Sec. Sec. 1.385-3 and
1.385-4 do not apply to the extent a person enters into a transaction
that otherwise would be subject to the proposed regulations with a
principal purpose of reducing its federal tax liability or the federal
tax liability of another person by disregarding the treatment of the
debt instrument that would occur without regard to the proposed
regulations.
F. Treatment of Consolidated Groups
As noted previously, the Treasury Department and the IRS have
determined that a debt instrument between members of the same
consolidated group does not raise the same federal tax concerns as a
debt instrument between members of the same expanded (but not
consolidated) group. Accordingly, proposed Sec. 1.385-4 includes
special rules, issued under the authority of section 1502, for applying
Sec. 1.385-3 to consolidated groups, including rules addressing the
treatment of a debt instrument issued by one member of a consolidated
group to another member of the same consolidated group (consolidated
group debt instrument) and rules regarding the treatment of a debt
instrument when it ceases to be a consolidated group debt instrument.
1. Consolidated Groups Treated as One Corporation
For purposes of proposed Sec. 1.385-3, all members of a
consolidated group are treated as one corporation. Accordingly,
proposed Sec. 1.385-3 does not apply to a consolidated group debt
instrument. Thus, for example, the proposed regulations do not treat as
stock a debt instrument that is issued by one member of a consolidated
group to another member of the consolidated group in a distribution.
The proposed regulations define a consolidated group
[[Page 20928]]
in the same manner as the consolidated return regulations. See Sec.
1.1502-1(h).
As a result of treating all members of a consolidated group as one
corporation for purposes of applying proposed Sec. 1.385-3, a debt
instrument issued to or by one member of a consolidated group generally
is treated as issued to or by all members of the same consolidated
group. Thus, a debt instrument issued by one consolidated group member
to a member of its expanded group that is not a member of its
consolidated group may be treated under the funding rule as funding a
distribution or acquisition by another member of that consolidated
group, even though that other consolidated group member was not the
issuer and thus was not funded directly. Similarly, a debt instrument
issued by one consolidated group member to another consolidated group
member is treated as stock under the general rule when the debt
instrument is distributed by the holder to a member of the expanded
group that is not a member of the same consolidated group, regardless
of whether the issuer itself distributed the debt instrument. For an
illustration of this rule, see Example 1 in proposed Sec. 1.385-
4(d)(3).
2. Debt Instrument That Ceases To Be a Consolidated Group Debt
Instrument but Continues To Be an Expanded Group Debt Instrument
Proposed Sec. 1.385-4 includes rules addressing debt held or
issued by a consolidated group member that leaves a consolidated group,
but continues to be a member of the expanded group (such corporation, a
departing member).
Generally, any consolidated group debt instrument that is issued or
held by the departing member and that is not treated as stock solely by
reason of the rule treating all members of a consolidated group as one
corporation (exempt consolidated group debt instrument) is deemed to be
exchanged for stock immediately after the departing member leaves the
group. Any consolidated group debt instrument issued or held by a
departing member that is not an exempt consolidated group debt
instrument (non-exempt consolidated group debt instrument) is treated
as indebtedness unless and until the non-exempt consolidated group debt
instrument is treated as a principal purpose debt instrument under
proposed Sec. Sec. 1.385-3(b)(3)(ii) and 1.385-3(d)(1) as a result of
a distribution or acquisition described in proposed Sec. 1.385-
3(b)(3)(ii) that occurs after the departure. However, solely for
purposes of applying the 72-month period under the per se funding rule,
the debt instrument is treated as having been issued when it was first
treated as a consolidated group debt instrument.
When a member of a consolidated group transfers a consolidated
group debt instrument to an expanded group member that is not a member
of the consolidated group, the debt instrument is treated as issued by
the issuer of the debt instrument (which is treated as one corporation
with the transferor of the debt instrument) to the transferee expanded
group member on the date of the transfer. For purposes of proposed
Sec. 1.385-3, the consequences of the transfer are determined in a
manner that is consistent with treating a consolidated group as one
corporation. Thus, for example, the sale of a consolidated group debt
instrument to an expanded group member that is not a member of the
consolidated group is treated as an issuance of the debt instrument to
the transferee expanded group member in exchange for property. To the
extent the debt instrument is treated as stock upon being transferred,
the debt instrument is deemed to be exchanged for stock immediately
after the debt instrument is transferred outside of the consolidated
group. For an illustration of this rule, see Examples 1 and 2 in Sec.
1.385-4(d)(3) of the proposed regulations.
G. Proposed Effective/Applicability Date and Transition Rules
Sections 1.385-3 and 1.385-4 are proposed to apply to any debt
instrument issued on or after April 4, 2016 and to any debt instrument
issued before April 4, 2016 as a result of an entity classification
election made under Sec. 301.7701-3 that is filed on or after April 4,
2016. However, when Sec. Sec. 1.385-3(b) and 1.385-3(d)(1)(i) through
(d)(1)(v), or Sec. 1.385-4 of the proposed regulations, otherwise
would treat a debt instrument as stock prior to the date of publication
in the Federal Register of the Treasury decision adopting this rule as
a final regulation, the debt instrument is treated as indebtedness
until the date that is 90 days after the date of publication in the
Federal Register of the Treasury decision adopting this rule as a final
regulation. To the extent that the debt instrument described in the
preceding sentence is held by a member of the issuer's expanded group
on the date that is 90 days after the date of publication in the
Federal Register of the Treasury decision adopting this rule as a final
regulation, the debt instrument is deemed to be exchanged for stock on
the date that is 90 days after the date of publication in the Federal
Register of the Treasury decision adopting this rule as a final
regulation.
In addition, for purposes of determining whether a debt instrument
is a principal purpose debt instrument described in proposed Sec.
1.385-3(b)(3)(iv), a distribution or acquisition described in proposed
Sec. 1.385-3(b)(3)(ii) that occurs before April 4, 2016, other than a
distribution or acquisition that is treated as occurring before April
4, 2016 as a result of an entity classification election made under
Sec. 301.7701-3 that is filed on or after April 4, 2016, is not taken
into account.
Statement of Availability of IRS Documents
IRS Revenue Procedures, Revenue Rulings notices, and other guidance
cited in this document are published in the Internal Revenue Bulletin
(or Cumulative Bulletin) and are available from the Superintendent of
Documents, U.S. Government Printing Office, Washington, DC 20402, or by
visiting the IRS Web site at http://www.irs.gov.
Special Analyses
Executive Orders 13563 and 12866 direct agencies to assess costs
and benefits of available regulatory alternatives and, if regulation is
necessary, to select regulatory approaches that maximize net benefits
(including potential economic, environmental, public health and safety
effects, distributive impacts, and equity). Executive Order 13563
emphasizes the importance of quantifying both costs and benefits, of
reducing costs, of harmonizing rules, and of promoting flexibility.
This rule has been designated a ``significant regulatory action'' under
section 3(f) of Executive Order 12866 and designated as economically
significant. Accordingly, the rule has been reviewed by the Office of
Management and Budget. A regulatory assessment for this proposed rule
is available in the docket for this rulemaking on www.regulations.gov.
Pursuant to the Regulatory Flexibility Act (5 U.S.C. Chapter 6), it
is hereby certified that the proposed regulations will not have a
significant economic impact on a substantial number of small entities.
Accordingly, an initial regulatory flexibility analysis is not
required. The Commissioner and the courts historically have analyzed
whether an interest in a corporation should be treated as stock or
indebtedness for federal tax purposes by applying various sets of
factors to the facts of a particular case. Proposed Sec. 1.385-1
provides that in connection with determining whether an interest in a
corporation should be treated as stock or indebtedness for federal tax
purposes,
[[Page 20929]]
the Commissioner has the discretion to treat certain interests in a
corporation for federal tax purposes as indebtedness in part and stock
in part. Proposed Sec. 1.385-1 does not require taxpayers to take any
additional actions or to engage in any new procedures or documentation.
Because proposed Sec. 1.385-1 contains no such requirements, it does
not have an effect on small entities.
To facilitate the federal tax analysis of an interest in a
corporation, taxpayers are required to substantiate their
classification of an interest as stock or indebtedness for federal tax
purposes. Proposed Sec. 1.385-2 provides documentation requirements to
substantiate the treatment of certain related-party instruments as
indebtedness. First, these rules apply only to debt instruments in form
issued within expanded groups of corporations and other entities.
Second, proposed Sec. 1.385-2 only applies to expanded groups if the
stock of a member of the expanded group is publicly traded, or
financial statements of the expanded group or its members show total
assets exceeding $100 million or annual total revenue exceeding $50
million. Because the rules are limited to large expanded groups, they
will not affect a substantial number of small entities.
Proposed Sec. 1.385-3 provides rules that treat as stock certain
interests in a corporation that are held by a member of the
corporation's expanded group and that otherwise would be treated as
indebtedness for federal tax purposes. Proposed Sec. 1.385-4 provides
rules regarding the application of proposed Sec. 1.385-3 to members of
a consolidated group. Proposed Sec. 1.385-3 includes multiple
exceptions that limit its application. In particular, the threshold
exception provides that an expanded group debt instrument will not be
treated as stock under proposed Sec. 1.385-3 if, when the debt
instrument is issued, the aggregate issue price of all expanded group
debt instruments that otherwise would be treated as stock under
proposed Sec. 1.385-3 does not exceed $50 million. The threshold
exception also governs the application of proposed Sec. 1.385-3 rules
to members of a consolidated group described in proposed Sec. 1.385-4.
Although it is possible that the classification rules in proposed
Sec. Sec. 1.385-3 and 1.385-4 could have an effect on small entities,
the threshold exception makes it unlikely that a substantial number of
small entities will be affected by proposed Sec. Sec. 1.385-3 and
1.385-4. Pursuant to section 7805(f) of the Code, these regulations
have been submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on their impact on small business.
Comments and Public Hearing
Before the proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and eight
copies) or electronic comments that are submitted timely to the IRS.
The Treasury Department and the IRS request comments on all aspects of
the proposed rules, including comments on the clarity of the proposed
rules and how they can be made more administrable. In addition,
comments are requested on: (1) Other instruments that should be subject
to the proposed regulations, including other types of applicable
instruments that are not indebtedness in form that should be subject to
proposed Sec. 1.385-2 and the documentation requirements that should
apply to such applicable instruments; (2) whether special rules are
warranted for cash pools, cash sweeps, and similar arrangements for
managing cash of an expanded group; (3) the rule addressing deemed
exchanges of an EGI and a debt instrument; (4) the application of these
rules to any entity with respect to a year in which the entity is not a
U.S. person (as defined in section 7701(a)(30)), is not required to
file a U.S. tax return, and is not a CFC or a controlled foreign
partnership, but in a later year becomes one of the foregoing; (5)
whether certain indebtedness commonly used by investment partnerships,
including indebtedness issued by certain ``blocker'' entities,
implicate similar policy concerns as those motivating the proposed
regulations, such that the scope of the proposed regulations should be
broadened; (6) whether guidance is needed under section 909 to the
extent a U.S. equity hybrid instrument arises solely by reason of the
application of proposed Sec. 1.385-3; and (7) the treatment of
controlled partnerships in proposed Sec. 1.385-3 and the collateral
consequences of the recharacterization and any corresponding
adjustments, including the treatment of a partner's proportionate share
of partnership assets or debt instruments, of treating a debt
instrument issued by a controlled partnership as stock in its expanded
group partners, including a situation in which a recharacterization
results in a partnership owning stock of an expanded group partner.
Specifically, the Treasury Department and the IRS request comments on
how to apply proposed Sec. 1.385-3 when expanded group partners make
distributions subject to the funding rule with respect to some, but not
all, partnership debt instruments; when one or more, but not all,
expanded group partners make a distribution subject to the funding rule
with respect to part or all of their share of the partnership debt
instrument; and how to address such distributions when a controlled
partnership has one or more partners that are not expanded group
members. The Treasury Department and the IRS also request comments on
whether the objective rules in proposed Sec. 1.385-3(d)(5) have the
potential to be manipulated, including by selectively locating debt
instruments in order to achieve results that are contrary to the
purposes of these regulations, and, if so, whether the anti-abuse rule
in proposed Sec. 1.385-3(b)(4) or the rule prohibiting the affirmative
use of these rules by taxpayers in proposed Sec. 1.385-3(e) are
sufficient to address these concerns.
More generally, the Treasury Department and the IRS request
comments on whether additional guidance is necessary regarding the
manner by which issuers and holders notify the Secretary of the
intended federal tax treatment of an interest in a corporation.
The Treasury Department and the IRS are aware that the issuance of
preferred equity by a controlled partnership to an expanded group
member may give rise to similar concerns as debt instruments of a
controlled partnership issued to an expanded group member, and that
controlled partnerships may, in some cases, issue preferred equity with
a principal purpose of avoiding the application of Sec. 1.385-3 of the
proposed regulations. The Treasury Department and the IRS are
considering rules that would treat preferred equity in a controlled
partnership as equity in the expanded group partners, based on the
principles of the aggregate approach used in proposed Sec. 1.385-
3(d)(5). Comments are requested regarding the recharacterization of
preferred equity in those circumstances. Until any such guidance is
issued, the IRS intends to closely scrutinize, and may challenge when
the regulations become effective, transactions in which a controlled
partnership issues preferred equity to an expanded group member and,
within the relevant 72-month period, one or more expanded group
partners in the controlled partnership engage in a transaction
described in Sec. 1.385-3(b)(3)(ii) of the proposed regulations.
Finally, regarding the request for comments on whether guidance is
needed under section 909 when a U.S. equity hybrid instrument arises
solely by reason of the application of Sec. 1.385-3: the application
of proposed Sec. 1.385-
[[Page 20930]]
3 may give rise to a U.S. equity hybrid instrument splitter arrangement
under Sec. 1.909-2(b)(3)(i) (for example when indebtedness issued by
one CFC to another CFC is treated as equity under proposed Sec. 1.385-
3). When this occurs, payments made pursuant to the instrument
generally would result in distributions out of earnings and profits
attributable pro rata to related income and other income, as described
in Sec. Sec. 1.909-3 and 1.909-6(d). Given that these section 385
regulations may give rise to a proliferation of U.S. hybrid equity
instrument splitter arrangements, the Treasury Department and the IRS
request comments on whether additional guidance is needed under section
909, including to address any uncertainty with respect to how U.S.
hybrid equity instrument splitter arrangements are treated. All
comments will be available for public inspection and copying at
www.regulations.gov or upon request.
Drafting Information
The principal authors of these regulations are Eric D. Brauer of
the Office of Associate Chief Counsel (Corporate) and Raymond J. Stahl
of the Office of Associate Chief Counsel (International). However,
other personnel from the Treasury Department and the IRS participated
in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendment to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART I--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Section 1.385-1 also issued under 26 U.S.C. 385.
0
Section 1.385-2 also issued under 26 U.S.C. 385 and 26 U.S.C. 1502.
0
Section 1.385-3 also issued under 26 U.S.C. 385, 26 U.S.C. 701, and
7701(l).
0
Section 1.385-4 also issued under 26 U.S.C. 385 and 26 U.S.C. 1502.
0
Par. 2. Section 1.385-1 is added to read as follows:
Sec. 1.385-1 General provisions.
(a) Overview. This section provides definitions applicable to the
regulations under section 385 and operating rules regarding the
treatment of certain direct and indirect interests in corporations as
stock or indebtedness for federal tax purposes. Section 1.385-2
provides documentation and information requirements necessary for
certain interests issued between members of an expanded group (as
defined in paragraph (b)(3) of this section) to be treated as
indebtedness for federal tax purposes. Section 1.385-3 provides rules
that treat as stock certain interests in a corporation issued between
members of an expanded group in connection with certain purported
distributions of debt instruments and similar transactions. Section
1.385-4 provides special rules regarding the transactions described in
Sec. 1.385-3 as they relate to consolidated groups.
(b) Definitions. The definitions in this paragraph (b) apply for
purposes of the regulations under section 385. For additional
definitions that apply for purposes of Sec. 1.385-2, see Sec. 1.385-
2(a)(4). For additional definitions that apply for purposes of
Sec. Sec. 1.385-3 and 1.385-4, see Sec. 1.385-3(f).
(1) Controlled partnership. The term controlled partnership means a
partnership with respect to which at least 80 percent of the interests
in partnership capital or profits are owned, directly or indirectly, by
one or more members of an expanded group. For this purpose, indirect
ownership of a partnership interest is determined by applying the
principles of paragraph (b)(3)(ii) of this section.
(2) Disregarded entity. The term disregarded entity means a
business entity (as defined in Sec. 301.7701-2(a) of this chapter)
that is disregarded as an entity separate from its owner for federal
tax purposes under Sec. Sec. 301.7701-1 through 301.7701-3 of this
chapter.
(3) Expanded group--(i) In general. The term expanded group means
an affiliated group as defined in section 1504(a), determined:
(A) Without regard to paragraphs (1) through (8) of section
1504(b);
(B) By substituting ``directly or indirectly'' for ``directly'' in
section 1504(a)(1)(B)(i); and
(C) By substituting ``or'' for ``and'' in section 1504(a)(2)(A).
(ii) Indirect stock ownership. For purposes of this paragraph
(b)(3), indirect stock ownership is determined by applying the rules of
section 304(c)(3).
(4) Modified controlled partnership. The term modified controlled
partnership means a partnership with respect to which at least 50
percent of the interests in partnership capital or profits are owned,
directly or indirectly, by one or more members of a modified expanded
group. For this purpose, indirect ownership of a partnership interest
is determined by applying the principles of paragraph (b)(3)(ii) of
this section.
(5) Modified expanded group. The term modified expanded group means
an expanded group, as defined in this section, determined by
substituting ``50'' for ``80'' in sections 1504(a)(2)(A) and (B). If
one or more members of a modified expanded group own, directly or
indirectly, 50 percent of the interests in partnership capital or
profits of a modified controlled partnership, the modified controlled
partnership is treated as a member of the modified expanded group. In
addition, if a person (as defined in section 7701(a)(1)) is treated,
under the rules of section 318, as owning at least 50 percent of the
value of the stock of a modified expanded group member, the person is
treated as a member of the modified expanded group.
(c) Treatment of deemed exchange. If a debt instrument (as defined
in Sec. 1.385-3(f)(3)) or an EGI (as defined in Sec. 1.385-
2(a)(4)(ii)) is deemed to be exchanged, in whole or in part, for stock
pursuant to Sec. 1.385-2(c)(3)(ii), Sec. 1.385-3(d)(1)(ii), Sec.
1.385-3(d)(1)(iii), Sec. 1.385-3(d)(1)(iv), Sec. 1.385-3(d)(1)(v),
Sec. 1.385-3(h)(3), or Sec. 1.385-4(e)(3), the holder is treated as
having realized an amount equal to the holder's adjusted basis in that
portion of the indebtedness or EGI as of the date of the deemed
exchange (and as having basis in the stock deemed to be received equal
to that amount), and the issuer is treated as having retired that
portion of the debt instrument or EGI for an amount equal to its
adjusted issue price as of the date of the deemed exchange. In
addition, neither party accounts for any accrued but unpaid qualified
stated interest on the debt instrument or EGI or any foreign exchange
gain or loss with respect to that accrued but unpaid qualified stated
interest (if any) as of the deemed exchange. Notwithstanding the first
sentence of this paragraph (c), the rules of Sec. 1.988-2(b)(13) apply
to require the holder and the issuer of a debt instrument or an EGI
that is deemed to be exchanged in whole or in part for stock pursuant
to Sec. 1.385-2(c)(3)(ii), Sec. 1.385-3(d)(1)(ii), Sec. 1.385-
3(d)(1)(iii), Sec. 1.385-3(d)(1)(iv), Sec. 1.385-3(d)(1)(v), Sec.
1.385-3(h)(3), or Sec. 1.385-4(e)(3) to recognize any exchange gain or
loss, other than any exchange gain or loss with respect to accrued but
unpaid qualified stated interest that is not taken into account under
this paragraph (c) at the time of the deemed exchange. For purposes of
this paragraph (c), in applying Sec. 1.988-2(b)(13) the exchange
[[Page 20931]]
gain or loss under section 988 is treated as the total gain or loss on
the exchange.
(d) Treatment as indebtedness in part--(1) In general. The
Commissioner may treat an EGI (as defined in Sec. 1.385-2(a)(4)(ii)
and described in paragraph (d)(2) of this section) as in part
indebtedness and in part stock to the extent that an analysis, as of
the issuance of the EGI, of the relevant facts and circumstances
concerning the EGI (taking into account any application of Sec. 1.385-
2) under general federal tax principles results in a determination that
the EGI is properly treated for federal tax purposes as indebtedness in
part and stock in part. For example, if the Commissioner's analysis
supports a reasonable expectation that, as of the issuance of the EGI,
only a portion of the principal amount of an EGI will be repaid and the
Commissioner determines that the EGI should be treated as indebtedness
in part and stock in part, the EGI may be treated as indebtedness in
part and stock in part in accordance with such determination, provided
the requirements of Sec. 1.385-2, if applicable, are otherwise
satisfied and the application of federal tax principles supports this
treatment. The issuer of an EGI, the holder of an EGI, and any other
person relying on the characterization of an EGI as indebtedness for
federal tax purposes are required to treat the EGI consistent with the
issuer's initial characterization. Thus, for example, a holder may not
disclose on its return under section 385(c)(2) that it is treating an
EGI as indebtedness in part or stock in part if the issuer of the EGI
treats the EGI as indebtedness.
(2) EGI described in this paragraph (d)(2). An EGI is described in
this paragraph (d)(2) if it is an applicable instrument (as defined in
Sec. 1.385-2(a)(4)(i)) an issuer of which is one member of a modified
expanded group and the holder of which is another member of the same
modified expanded group.
(e) Treatment of consolidated groups. For purposes of the
regulations under section 385, all members of a consolidated group (as
defined in Sec. 1.1502-1(h)) are treated as one corporation.
(f) Effective/applicability date. This section applies to any
applicable instrument issued or deemed issued on or after the date
these regulations are published as final regulations in the Federal
Register, and to any applicable instrument treated as indebtedness
issued or deemed issued before the date these regulations are issued as
final regulations if and to the extent it was deemed issued as a result
of an entity classification election made under Sec. 301.7701-3 of
this chapter that is filed on or after the date these regulations are
issued as final regulations in the Federal Register. For purposes of
Sec. Sec. 1.385-3 and 1.385-4, this section applies to any debt
instrument issued on or after April 4, 2016, and to any debt instrument
treated as issued before April 4, 2016 as a result of an entity
classification election made under Sec. 301.7701-3 of this chapter
that is filed on or after April 4, 2016.
0
Par. 3. Section 1.385-2 is added to read as follows:
Sec. 1.385-2 Treatment of certain interests between members of an
expanded group.
(a) General--(1) Scope. This section prescribes threshold
requirements that must be satisfied regarding the preparation and
maintenance of documentation and information with respect to an
expanded group instrument (an EGI, as defined in paragraph (a)(4)(ii)
of this section). The purpose of preparing and maintaining the
documentation and information required by this section is to enable an
analysis to be made whether an EGI is appropriately treated as stock or
indebtedness for federal tax purposes. Satisfying the requirements of
this section does not establish that an interest is indebtedness; such
satisfaction serves as a minimum standard that enables this
determination to be made under general federal tax principles. The
rules of this section must be interpreted and applied in a manner that
is consistent with and reasonably carries out the purposes of this
section. Moreover, nothing in this section prevents the Commissioner
from asserting that the substance of a transaction involving an EGI (or
the EGI itself) is different from the form of the transaction (or the
EGI) or disregarding the transaction (or the EGI) or treating the
transaction (or the EGI) in accordance with its substance for federal
tax purposes. Such an assertion may be made based on the documentation
or information received pursuant to a request under this section or a
request for information under section 7602. If, and only if, the
requirements of this section are satisfied, the determination of the
federal tax treatment of the EGI is made based on an analysis of the
documentation and information prepared and maintained, other facts and
circumstances relating to the EGI, and general federal tax principles.
If the requirements of this section are not satisfied with respect to
an EGI the substance of which is regarded for federal tax purposes, the
EGI will be treated as stock. This section does not otherwise affect
the authority of the Commissioner under section 7602 to request and
obtain documentation and information regarding transactions and
instruments that purport to create an interest in a corporation. If the
requirements of this section are satisfied or otherwise do not apply,
see Sec. Sec. 1.385-3 and 1.385-4 for additional rules for determining
whether and the extent to which an interest otherwise treated as
indebtedness under general federal tax principles is recharacterized as
stock for federal tax purposes.
(2) Application--(i) In general. This section applies to an EGI
only if--
(A) The stock of any member of the expanded group is traded on (or
subject to the rules of) an established financial market within the
meaning of Sec. 1.1092(d)-1(b);
(B) On the date that an applicable instrument first becomes an EGI,
total assets exceed $100 million on any applicable financial statement,
or
(C) On the date that an applicable instrument first becomes an EGI,
annual total revenue exceeds $50 million on any applicable financial
statement.
(ii) Non-U.S. dollar applicable financial statements. If an
applicable financial statement is denominated in a currency other than
the U.S. dollar, the total assets and annual total revenue are
translated into U.S. dollars at the spot rate (as defined in Sec.
1.988-1(d)) as of the date of the applicable financial statement.
(3) Consistency rule. If an issuer characterizes an EGI as
indebtedness, the EGI will be respected as indebtedness only if the
requirements of Sec. 1.385-2(b) are met with respect to the EGI. If
the issuer of an EGI characterizes that EGI as indebtedness, the
issuer, the holder, and any other person relying on the
characterization of an EGI as indebtedness for federal tax purposes is
required to treat the EGI as indebtedness for all federal tax purposes.
The Commissioner is not bound by the issuer's characterization of an
EGI.
(4) Definitions. The definitions in this paragraph (a)(4) apply for
purposes of this section.
(i) Applicable instrument--(A) In general. The term applicable
instrument means any interest issued or deemed issued that is in form a
debt instrument. See paragraph (a)(4)(i)(B) of this section for rules
regarding an interest that is not in form a debt instrument.
(B) [Reserved]
(ii) Expanded group instrument. The term expanded group instrument
(EGI) means an applicable instrument an issuer of which is one member
of an expanded group and the holder of
[[Page 20932]]
which is another member of the same expanded group.
(iii) Issuer. Solely for purposes of this section, the term issuer
means a person (including a disregarded entity defined in Sec. 1.385-
1(b)(2)) that is obligated to satisfy any material obligations created
under the terms of an EGI. A person can be an issuer if that person is
expected to satisfy a material obligation under an EGI, even if that
person is not the primary obligor. A guarantor, however, is not an
issuer unless the guarantor is expected to be the primary obligor.
(iv) Applicable financial statement. For purposes of this section,
the term applicable financial statement means a financial statement,
listed in paragraphs (a)(4)(iv)(A) through (C) of this section, that
includes the assets, portion of the assets or annual total revenue of
any member of the expanded group and that is prepared as of any date
within 3 years prior to the date the applicable instrument at issue
first becomes an EGI. A financial statement that includes the assets or
annual total revenue of a member of an expanded group may be a separate
company financial statement of any member of the expanded group or any
consolidated financial statement that includes the assets, portion of
the assets, or annual total revenue of any member of the expanded
group. A financial statement includes--
(A) A financial statement required to be filed with the Securities
and Exchange Commission (the Form 10-K or the Annual Report to
Shareholders);
(B) A certified audited financial statement that is accompanied by
the report of an independent certified public accountant (or in the
case of a foreign entity, by the report of a similarly qualified
independent professional) that is used for--
(1) Credit purposes;
(2) Reporting to shareholders, partners, or similar persons; or
(3) Any other substantial non-tax purpose; or
(C) A financial statement (other than a tax return) required to be
provided to the Federal, state, or foreign government or any Federal,
state, or foreign agency.
(b) Documentation and information required to determine treatment--
(1) Preparation and maintenance of documentation and information--(i)
In general. Except as otherwise provided in this section, an EGI is
treated for federal tax purposes as stock if the documentation and
information described in paragraph (b)(2) of this section are not
prepared, or the maintenance requirements of paragraph (b)(4) of this
section are not satisfied. If the requirements of this section are
satisfied, general federal tax principles apply to determine whether,
or the extent to which, the EGI is treated as indebtedness for federal
tax purposes. This determination will take into account the
documentation and information prepared, maintained, and provided in
accordance with this section, as well as any additional facts and
circumstances. This section applies to each EGI separately, but the
same documentation and information may satisfy the requirements of this
section for more than one EGI.
(ii) Failure to provide documentation and information described in
paragraph (b)(2) of this section. If a taxpayer characterizes an EGI as
indebtedness and fails to provide the documentation and information
described in paragraph (b)(2) of this section upon request by the
Commissioner, the Commissioner will treat the requirements of this
section as not satisfied.
(2) Documentation and other information required. This paragraph
(b)(2) describes the documentation and information that must be
prepared and maintained to satisfy the requirements of this section. In
each case, the documentation must include complete and (if relevant)
executed copies of all instruments, agreements and other documents
evidencing the material rights and obligations of the issuer and the
holder relating to the EGI, and any associated rights and obligations
of other parties, such as guarantees and subordination agreements.
Additional documentation and information may be provided to supplement,
but not substitute for, the documentation and information required
under this section. The documentation and information must satisfy the
following requirements:
(i) Unconditional obligation to pay a sum certain. There must be
written documentation prepared by the time required in paragraph (b)(3)
of this section establishing that the issuer has entered into an
unconditional and legally binding obligation to pay a sum certain on
demand or at one or more fixed dates.
(ii) Creditor's rights. The written documentation described in
paragraph (b)(2)(i) of this section must establish that the holder has
the rights of a creditor to enforce the obligation. The rights of a
creditor typically include, but are not limited to, the right to cause
or trigger an event of default or acceleration of the EGI (when the
event of default or acceleration is not automatic) for non-payment of
interest or principal when due under the terms of the EGI and the right
to sue the issuer to enforce payment. The rights of a creditor must
include a superior right to shareholders to share in the assets of the
issuer in case of dissolution.
(iii) Reasonable expectation of ability to repay EGI. There must be
written documentation prepared containing information establishing
that, as of the date of issuance of the applicable instrument and
taking into account all relevant circumstances (including all other
obligations incurred by the issuer as of the date of issuance of the
applicable instrument or reasonably anticipated to be incurred after
the date of issuance of the applicable instrument), the issuer's
financial position supported a reasonable expectation that the issuer
intended to, and would be able to, meet its obligations pursuant to the
terms of the applicable instrument. For this purpose, if a disregarded
entity is treated as the issuer of an EGI, and the owner of the
disregarded entity has limited liability within the meaning of Sec.
301.7701-3(b)(2)(ii) of this chapter, only the assets and financial
position of the disregarded entity are relevant for purposes of this
paragraph (b)(2)(iii). If the owner of such a disregarded entity does
not have limited liability within the meaning of Sec. 301.7701-
3(b)(2)(ii), all of the assets and the financial position of the
disregarded entity and the owner are relevant for purposes of this
paragraph (b)(2)(iii). The documentation may include cash flow
projections, financial statements, business forecasts, asset
appraisals, determination of debt-to-equity and other relevant
financial ratios of the issuer in relation to industry averages, and
other information regarding the sources of funds enabling the issuer to
meet its obligations pursuant to the terms of the applicable
instrument. If any member of an expanded group relied on any report or
analysis prepared by a third party in analyzing whether the issuer
would be able to meet its obligations pursuant to the terms of the EGI,
the documentation must include the report or analysis. If the report or
analysis is protected or privileged under law governing an inquiry or
proceeding with respect to the EGI and the protection or privilege is
asserted, neither the existence nor the contents of the report or
analysis is taken into account in determining whether the requirements
of this section are satisfied.
(iv) Actions evidencing debtor-creditor relationship--(A) Payments
of principal and interest. If an issuer made any payment of interest or
principal with respect to the EGI (whether in accordance with the terms
and conditions of the EGI or otherwise, including prepayments), and
such payment is claimed to support the
[[Page 20933]]
treatment of the EGI as indebtedness under general federal tax
principles, documentation must include written evidence of such payment
that is prepared by the time required in paragraph (b)(3) of this
section. Such evidence could include, for example, a wire transfer
record or a bank statement reflecting the payment.
(B) Events of default and similar events. If the issuer did not
make a payment of interest or principal that was due and payable under
the terms and conditions of the EGI, or if any other event of default
or similar event has occurred, there must be written documentation,
prepared, by the time required in paragraph (b)(3) of this section,
evidencing the holder's reasonable exercise of the diligence and
judgment of a creditor. Such documentation may include evidence of the
holder's efforts to assert its rights under the terms of the EGI,
including the parties' efforts to renegotiate the EGI or to mitigate
the breach of an obligation under the EGI, or any change in material
terms and conditions of the EGI, such as maturity date, interest rate,
or obligation to pay interest or principal, and any documentation
detailing the holder's decision to refrain from pursuing any actions to
enforce payment.
(v) Additional information with respect to an EGI evidenced by
documentation that does not in form reflect indebtedness. This
paragraph (b)(1)(v) describes additional information with respect to an
EGI evidenced by documentation that does not in form reflect
indebtedness.
(A)-(B) [Reserved]
(3) Timely preparation requirement--(i) General rule. For purposes
of this section, the documentation described in paragraphs (b)(2)(i),
(ii) and (iii) of this section will be treated as satisfying the timely
preparation requirement of this paragraph (b)(3) if it is prepared no
later than 30 calendar days after the relevant date, as defined in
paragraph (b)(3)(ii) of this section. The documentation described in
paragraph (b)(2)(iv) of this section will be treated as satisfying the
timely preparation requirement of this paragraph (b)(3) if it is
prepared no later than 120 calendar days after the relevant date, as
defined in paragraph (b)(3)(ii) of this section, as applicable.
(ii) Relevant date. Subject to the special rules in paragraph
(b)(3)(iii) of this section (relating to certain financial arrangements
not evidenced by an instrument) and paragraph (c)(1) of this section
(relating to modifications to certain requirements of this section),
the relevant date is as follows:
(A) For documentation and information described in paragraphs
(b)(2)(i) and (b)(2)(ii) of this section (relating to issuer's
unconditional obligation to repay and establishment of holder's
creditor's rights), the relevant date is the date on which a member of
the expanded group becomes an issuer of a new or existing EGI, without
regard to any subsequent deemed issuance of the EGI under Sec. 1.1001-
3. In the case of an applicable instrument that becomes an EGI
subsequent to issuance, including an intercompany obligation, as
defined in Sec. 1.1502-13(g)(2)(ii), that ceases to be an intercompany
obligation, the relevant date is the day on which the applicable
instrument becomes an EGI.
(B) For documentation and information described in paragraph
(b)(2)(iii) of this section (relating to reasonable expectation of
issuer's repayment), the relevant dates are the dates on which a member
of the expanded group becomes an issuer with respect to an EGI and any
later date on which an issuance is deemed to occur under Sec. 1.1001-3
and any subsequent relevant date that occurs under the special rules in
paragraph (b)(3)(iii) of this section. In the case of an applicable
instrument that becomes an EGI subsequent to issuance, the relevant
date is the day on which the applicable instrument becomes an EGI and
any relevant date after the date that the applicable instrument becomes
an EGI.
(C) For documentation and information described in paragraph
(b)(2)(iv)(A) of this section (relating to payments of principal and
interest), each date on which a payment of interest or principal is
due, taking into account all additional time permitted under the terms
of the EGI before there is (or holder can declare) an event of default
for nonpayment, is a relevant date.
(D) For documentation and information described in paragraph
(b)(2)(iv)(B) of this section (relating to events of default and
similar events), each date on which an event of default, acceleration
event or similar event occurs under the terms of the EGI is a relevant
date. For example, if the terms of the EGI require the issuer to
maintain certain financial ratios, any date on which the issuer fails
to maintain the specified financial ratio (and such failure results in
an event of default under the terms of the EGI) is a relevant date.
(E) In the case of an applicable instrument that becomes an EGI
subsequent to issuance, no date before the applicable instrument
becomes an EGI is a relevant date.
(iii) Special rules for determining relevant dates with respect to
certain financial arrangements. The relevant dates with respect to the
arrangements described in this paragraph (b)(3)(iii) include the date
of the execution of the legal documents governing the EGI and the date
of any amendment to those documents that provides for an increase in
the permitted maximum amount of principal. In addition--
(A) Revolving credit agreements and similar agreements.
Notwithstanding paragraph (b)(2)(i) of this section, if an EGI is not
evidenced by a separate note or other writing executed with respect to
the initial principal balance or any increase in principal balance (for
example, an EGI documented as a revolving credit agreement or an
omnibus agreement that governs open account obligations), the EGI
satisfies the requirements of paragraph (b)(2)(i) of this section only
if the material documentation associated with the EGI, including all
relevant enabling documents, is prepared, maintained, and provided in
accordance with the requirements of this section. Relevant enabling
documents may include board of directors' resolutions, credit
agreements, omnibus agreements, security agreements, or agreements
prepared in connection with the execution of the legal documents
governing the EGI as well as any relevant documentation executed with
respect to an initial principal balance or increase in the principal
balance of the EGI.
(B) Cash pooling arrangements. Notwithstanding paragraph (b)(2)(i)
of this section, if an EGI is issued pursuant to a cash pooling
arrangement or internal banking service that involves account sweeps,
revolving cash advance facilities, overdraft set-off facilities,
operational facilities, or similar features, the EGI satisfies the
requirements of paragraph (b)(2)(i) of this section only if the
material documentation governing the ongoing operations of the cash
pooling arrangement or internal banking service, including any
agreements with entities that are not members of the expanded group, is
prepared, maintained, and provided in accordance with the requirements
of this section. Such documentation must contain the relevant legal
rights and responsibilities of any members of the expanded group and
any entities that are not members of the expanded group in conducting
the operation of the cash pooling arrangement or internal banking
service.
(4) Maintenance requirements. The documentation and information
described in paragraph (b)(2) of this section must be maintained for
all taxable years that the EGI is outstanding and until the period of
limitations
[[Page 20934]]
expires for any return with respect to which the treatment of the EGI
is relevant. See section 6001 (requirement to keep books and records).
(c) Operating rules--(1) Reasonable cause exception. If the person
characterizing an EGI as indebtedness for federal tax purposes
establishes that a failure to satisfy the requirements of this section
is due to reasonable cause, appropriate modifications may be made to
the requirements of this section in determining whether the
requirements of this section have been satisfied. The principles of
Sec. 301.6724-1 of this chapter apply in interpreting whether
reasonable cause exists in any particular case.
(2) General application of section to applicable instrument
becoming or ceasing to be an EGI--(i) Applicable instrument becomes an
EGI. If an applicable instrument that is not an EGI when issued
subsequently becomes an EGI, this section applies to the applicable
instrument immediately after it becomes an EGI and thereafter.
(ii) EGI treated as stock ceases to be an EGI. When an EGI treated
as stock due to the application of this section ceases to be an EGI,
the applicable instrument is characterized at that time under general
federal tax principles. If, under general federal tax principles, the
applicable instrument is treated as indebtedness, the issuer is treated
as issuing a new instrument to the holder in exchange for the EGI
immediately before the transaction that causes the EGI treated as stock
due to the application of this section to cease to be treated as an
EGI. See Sec. 1.385-1(c).
(3) Effective date for treatment of EGI as stock under this
section--(i) In general. If an applicable instrument is an EGI when
issued and is determined to be stock, in whole or in part, due to the
application of this section, the applicable instrument or relevant
portion thereof is treated as stock from the date it was issued.
However, if an applicable instrument is issued prior to the time it
becomes an EGI and is determined to be stock, at the time it becomes an
EGI due to the application of this section, it is treated as stock from
the date it becomes an EGI. See Sec. 1.385-2(c)(4) regarding
intercompany obligations (deemed issued immediately after ceasing to be
an intercompany obligation for purposes of this section and Sec.
1.385-3).
(ii) EGI recharacterized as stock based on behavior of issuer or
holder after issuance. Notwithstanding paragraph (c)(3)(i) of this
section, if an EGI initially treated as indebtedness is recharacterized
as stock as a result of failing to satisfy paragraph (b)(2)(iv) of this
section (actions evidencing debtor-creditor relationship), the EGI will
cease to be treated as indebtedness as of the time the facts and
circumstances regarding the behavior of the issuer or the holder with
respect to the EGI cease to evidence a debtor-creditor relationship.
For purposes of determining whether an EGI originally treated as
indebtedness ceases to be treated as indebtedness by reason of
paragraph (b)(2)(iv) of this section, the rules of this section apply
before the rules of Sec. 1.1001-3, such that an EGI initially treated
as indebtedness may be recharacterized as stock regardless of whether
the indebtedness is altered or modified (as defined in Sec. 1.1001-
3(c)) and, in determining whether indebtedness is recharacterized as
stock, Sec. 1.1001-3(f)(7)(ii)(A) does not apply.
(4) Applicable instruments issued and held by members of
consolidated groups--(i) Consolidated group treated as one corporation.
Section 1.385-1(e) provides that members of a consolidated group are
treated as one corporation. Thus, during the time that the issuer and
the holder of an applicable instrument are members of the same
consolidated group, the applicable instrument is treated as not
outstanding for purposes of this section. As a result, this section
does not apply to any applicable instrument that is an intercompany
obligation as defined in Sec. 1.1502-13(g)(2)(ii).
(ii) Applicable instrument that ceases to be an intercompany
obligation. If an applicable instrument ceases to be an intercompany
obligation and, as a result, becomes an EGI, the applicable instrument
is treated as becoming an EGI immediately after it ceases to be an
intercompany obligation. This paragraph (c)(4)(i) does not affect the
application of the rules under Sec. 1.1502-13(g).
(5) Treatment of disregarded entities. If a disregarded entity is
the issuer of an EGI and that EGI is treated as equity under this
section, the EGI is treated as an equity interest in the disregarded
entity rather than stock in the disregarded entity's owner. See Sec.
1.385-2(c)(6)(ii) for rules regarding the treatment of an EGI issued by
a controlled partnership.
(6) Applicable instruments issued or held by controlled
partnerships--(i) Controlled partnerships included in expanded group.
For purposes of this section, a controlled partnership (as defined in
Sec. 1.385-1(b)(1)) is treated as a member of an expanded group if one
or more members of the expanded group own, directly or indirectly, 80
percent of the interests in partnership capital or profits of the
controlled partnership.
(ii) Treatment of EGI issued by a controlled partnership that is
recharacterized under this section. If an EGI that is issued by a
controlled partnership is recharacterized as stock under this section,
the EGI is treated as an equity interest in the controlled partnership.
(d) No affirmative use. The rules of this section do not apply if
there is a failure to satisfy the requirements of paragraph (b) of this
section with a principal purpose of reducing the federal tax liability
of any member or members of the expanded group of the issuer and holder
of the EGI or any other person relying on the characterization of an
EGI as indebtedness for federal tax purposes.
(e) Anti-avoidance. If an applicable instrument that is not an EGI
is issued with a principal purpose of avoiding the purposes of this
section, the applicable instrument is treated as an EGI subject to this
section.
(f) Effective/applicability date. This section applies to any
applicable instrument issued or deemed issued on or after the date
these regulations are published as final regulations in the Federal
Register, and to any applicable instrument treated as indebtedness
issued or deemed issued before the date these regulations are issued as
final regulations if and to the extent it was deemed issued as a result
of an entity classification election made under Sec. 301.7701-3 of
this chapter that is filed on or after the date these regulations are
issued as final regulations in the Federal Register.
0
Par. 4. Section 1.385-3 is added to read as follows:
Sec. 1.385-3 Certain distributions of debt instruments and similar
transactions.
(a) Scope. This section provides rules that treat as stock certain
interests in a corporation that are held by a member of the
corporation's expanded group and that otherwise would be treated as
indebtedness for federal tax purposes. Paragraph (b) of this section
sets forth situations in which a debt instrument is treated as stock
under this section. Paragraph (c) of this section provides three
exceptions to the application of paragraph (b) of this section.
Paragraph (d) of this section provides operating rules. Paragraph (e)
of this section limits the affirmative use of this section. Paragraph
(f) of this section provides definitions. Paragraph (g) of this section
provides examples illustrating the application of the rules of this
section. Paragraph (h) of this section provides dates of applicability.
For rules regarding the application of this section
[[Page 20935]]
to members of a consolidated group, see Sec. 1.385-4.
(b) Debt instrument treated as stock--(1) Effect of
characterization as stock. To the extent a debt instrument is treated
as stock under paragraphs (b)(2), (3), or (4) of this section, it is
treated as stock for all federal tax purposes. Any interest, or portion
thereof, that is not characterized as stock under this section is
treated as stock or indebtedness under applicable federal tax law,
without reference to this section.
(2) General rule. Except as provided in paragraphs (c) and (e) of
this section and in Sec. 1.385-4, a debt instrument is treated as
stock to the extent the debt instrument is issued by a corporation to a
member of the corporation's expanded group as described in one or more
of the following paragraphs:
(i) In a distribution;
(ii) In exchange for expanded group stock, other than in an exempt
exchange; or
(iii) In exchange for property in an asset reorganization, but only
to the extent that, pursuant to the plan of reorganization, a
shareholder that is a member of the issuer's expanded group immediately
before the reorganization receives the debt instrument with respect to
its stock in the transferor corporation.
(3) Funding rule--(i) In general. Except as provided in paragraphs
(c) and (e) of this section and in Sec. 1.385-4, a debt instrument is
treated as stock to the extent it is a principal purpose debt
instrument.
(ii) Principal purpose debt instrument. For purposes of this
paragraph (b)(3), a debt instrument is a principal purpose debt
instrument to the extent it is issued by a corporation (funded member)
to a member of the funded member's expanded group in exchange for
property with a principal purpose of funding a distribution or
acquisition described in one or more of the following paragraphs:
(A) A distribution of property by the funded member to a member of
the funded member's expanded group, other than a distribution of stock
pursuant to an asset reorganization that is permitted to be received
without the recognition of gain or income under section 354(a)(1) or
355(a)(1) or, when section 356 applies, that is not treated as ``other
property'' or money described in section 356;
(B) An acquisition of expanded group stock, other than in an exempt
exchange, by the funded member from a member of the funded member's
expanded group in exchange for property other than expanded group
stock; or
(C) An acquisition of property by the funded member in an asset
reorganization but only to the extent that, pursuant to the plan of
reorganization, a shareholder that is a member of the funded member's
expanded group immediately before the reorganization receives ``other
property'' or money within the meaning of section 356 with respect to
its stock in the transferor corporation.
(iii) Transactions described in more than one paragraph. Solely for
purposes of this section, to the extent all or a portion of a
distribution or acquisition by a funded member is described in more
than one of paragraphs (b)(3)(ii)(A) through (C) of this section, the
funded member is treated as engaging in only a single distribution or
acquisition described in paragraph (b)(3)(ii) of this section.
(iv) Principal purpose--(A) In general. Subject to paragraph
(b)(3)(iv)(B)(1) of this section, whether a debt instrument is issued
with a principal purpose of funding a distribution or acquisition
described in paragraph (b)(3)(ii) of this section is determined based
on all the facts and circumstances. A debt instrument may be treated as
issued with a principal purpose of funding a distribution or
acquisition described in paragraph (b)(3)(ii) of this section
regardless of whether it is issued before or after such distribution or
acquisition.
(B) Per se rule--(1) In general. Except as provided in paragraph
(b)(3)(iv)(B)(2) of this section, a debt instrument is treated as
issued with a principal purpose of funding a distribution or
acquisition described in paragraph (b)(3)(ii) of this section if it is
issued by the funded member during the period beginning 36 months
before the date of the distribution or acquisition, and ending 36
months after the date of the distribution or acquisition (72-month
period).
(2) Ordinary course exception. Paragraph (b)(3)(iv)(B)(1) of this
section does not apply to a debt instrument that arises in the ordinary
course of the issuer's trade or business in connection with the
purchase of property or the receipt of services to the extent that it
reflects an obligation to pay an amount that is currently deductible by
the issuer under section 162 or currently included in the issuer's cost
of goods sold or inventory, provided that the amount of the obligation
outstanding at no time exceeds the amount that would be ordinary and
necessary to carry on the trade or business of the issuer if it was
unrelated to the lender.
(3) Multiple interests. If, pursuant to paragraph (b)(3)(iv)(B) of
this section, two or more debt instruments may be treated as a
principal purpose debt instrument, the debt instruments are tested
under paragraph (b)(3)(iv)(B) of this section based on the order in
which they were issued, with the earliest issued debt instrument tested
first. See paragraph (g)(3) of this section, Example 6, for an
illustration of this rule.
(4) Multiple distributions or acquisitions. Except as provided in
paragraph (c)(3) of this section, if, pursuant to paragraph
(b)(3)(iv)(B) of this section, a debt instrument may be treated as
funding more than one distribution or acquisition described in
paragraph (b)(3)(ii) of this section, the debt instrument is treated as
funding one or more distributions or acquisitions based on the order in
which the distributions or acquisitions occurred, with the earliest
distribution or acquisition treated as the first distribution or
acquisition that was funded. See paragraph (g)(3) of this section,
Example 9, for an illustration of this rule.
(v) Predecessors and successors. For purposes of this paragraph
(b)(3), references to the funded member include references to any
predecessor or successor of such member. See paragraph (g)(3) of this
section, Examples 9, 10, and 12, for illustrations of this rule.
(vi) Treatment of funded transactions. When a debt instrument is
treated as stock pursuant to paragraph (b)(3) of this section, the
distribution or acquisition described in paragraph (b)(3)(ii) of this
section that is treated as funded by such debt instrument is not
recharacterized as a result of the treatment of the debt instrument as
stock.
(4) Anti-abuse rule. A debt instrument is treated as stock if it is
issued with a principal purpose of avoiding the application of this
section or Sec. 1.385-4. In addition, an interest that is not a debt
instrument for purposes of this section and Sec. 1.385-4 (for example,
a contract to which section 483 applies or a nonperiodic swap payment)
is treated as stock if issued with a principal purpose of avoiding the
application of this section or Sec. 1.385-4. This paragraph (b)(4) may
apply, for example, if a debt instrument is issued to, and later
acquired from, a person that is not a member of the issuer's expanded
group with a principal purpose of avoiding the application of this
section. Additional examples of when this paragraph (b)(4) could apply
include, without limitation, situations where, with a principal purpose
of avoiding the application of this section, a debt instrument is
issued to a person that is not a member of the issuer's expanded group,
and such
[[Page 20936]]
person later becomes a member of the issuer's expanded group; a debt
instrument is issued to an entity that is not taxable as a corporation
for federal tax purposes; or a member of the issuer's expanded group is
substituted as a new obligor or added as a co-obligor on an existing
debt instrument. This paragraph (b)(4) also may apply to a debt
instrument that is issued or transferred in connection with a
reorganization or similar transaction with a principal purpose of
avoiding the application of this section or Sec. 1.385-4. See
paragraph (g)(3) of this section, Example 18, for an illustration of
this rule.
(5) Coordination between general rule and funding rule. To the
extent a debt instrument is treated as stock under paragraph
(b)(2)(iii) of this section, the distribution of the debt instrument
(which is treated as a distribution of stock as a result of the
application of paragraph (b)(2)(iii) of this section) pursuant to the
same reorganization that caused paragraph (b)(2)(iii) of this section
to apply is not also treated as a distribution or acquisition described
in paragraph (b)(3)(ii) of this section. See paragraph (g)(3) of this
section, Example 8, for an illustration of this rule.
(c) Exceptions--(1) Exception for current year earnings and
profits. For purposes of applying paragraphs (b)(2) and (b)(3) of this
section to a member of an expanded group with respect to a taxable
year, the aggregate amount of any distributions or acquisitions that
are described in paragraphs (b)(2) or (b)(3)(ii) of this section are
reduced by an amount equal to the member's current year earnings and
profits described in section 316(a)(2). This reduction is applied to
the transactions described in paragraphs (b)(2) and (b)(3)(ii) of this
section based on the order in which the distribution or acquisition
occurs. See paragraph (g)(3) of this section, Example 17, for an
illustration of this rule.
(2) Threshold exception. A debt instrument is not treated as stock
under this section if, immediately after the debt instrument is issued,
the aggregate adjusted issue price of debt instruments held by members
of the expanded group that would be subject to paragraph (b) of this
section but for the application of this paragraph (c)(2) does not
exceed $50 million. Once this threshold is exceeded, this paragraph
(c)(2) will not apply to any debt instrument issued by members of the
expanded group for so long as any debt instrument that previously was
treated as indebtedness solely because of this paragraph (c)(2) remains
outstanding. For purposes of this rule, any debt instrument that is not
denominated in U.S. dollars is translated into U.S. dollars at the spot
rate (as defined in Sec. 1.988-1(d)) on the date that the debt
instrument is issued. See paragraph (g)(3) of this section, Example 17,
for an illustration of this rule. See paragraph (d)(1)(iii) of this
section for rules regarding the treatment of a debt instrument that
ceases to qualify for the exception provided in this paragraph (c)(2).
(3) Exception for funded acquisitions of subsidiary stock by
issuance. An acquisition of expanded group stock will not be treated as
described in paragraph (b)(3)(ii)(B) of this section if the acquisition
results from a transfer of property by a funded member (the transferor)
to an expanded group member (the issuer) in exchange for stock of the
issuer, provided that, for the 36-month period immediately following
the issuance, the transferor holds, directly or indirectly, more than
50 percent of the total combined voting power of all classes of stock
of the issuer entitled to vote and more than 50 percent of the total
value of the stock of the issuer. If the transferor ceases to meet this
ownership requirement at any time during that 36-month period, then on
the date that the ownership requirement ceases to be met (cessation
date), this paragraph (c)(3) ceases to apply and the acquisition is
treated as an acquisition described in paragraph (b)(3)(ii)(B) of this
section. In this case, for purposes of applying the per se rule, the
acquisition may be treated as having been funded by any debt instrument
issued during the 72-month period determined with respect to the date
of the acquisition (rather than with respect to the cessation date),
but, in the case of a debt instrument issued prior to the cessation
date, only to the extent that such debt instrument is treated as
indebtedness as of the cessation date (that is, a debt instrument not
already treated as stock). For purposes of this paragraph (c)(3), a
transferor's indirect stock ownership is determined by applying the
principles of section 958(a) without regard to whether an intermediate
entity is foreign or domestic. See paragraph (d)(1)(v) of this section
for rules regarding the treatment of a debt instrument that is treated
as funding an acquisition to which this exception ceases to apply.
(d) Operating rules--(1) Timing. This paragraph (d)(1) provides
rules for determining when a debt instrument is treated as stock under
paragraph (b) of this section. For special rules regarding the
treatment of a deemed exchange of a debt instrument that occurs
pursuant to paragraphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), or
(d)(1)(v), see Sec. 1.385-1(c).
(i) General timing rule. Except as otherwise provided in this
paragraph (d)(1), when paragraph (b) of this section applies to treat a
debt instrument as stock, the debt instrument is treated as stock when
the debt instrument is issued. When paragraph (b)(3) of this section
applies to treat a debt instrument as stock when the debt instrument is
issued, see also paragraph (b)(3)(vi) of this section.
(ii) Exception when a debt instrument is treated as funding a
distribution or acquisition that occurs in a subsequent taxable year.
When paragraph (b)(3)(iv)(B) of this section applies to treat a debt
instrument as funding a distribution or acquisition described in
paragraph (b)(3)(ii) of this section that occurs in a taxable year
subsequent to the taxable year in which the debt instrument is issued,
the debt instrument is deemed to be exchanged for stock when the
distribution or acquisition described in paragraph (b)(3)(ii) of this
section occurs. See paragraph (g)(3) of this section, Example 9, for an
illustration of this rule.
(iii) Exception when a debt instrument ceases to qualify for the
threshold exception. A debt instrument that previously was treated as
indebtedness pursuant to the threshold exception set forth in paragraph
(c)(2) of this section is deemed to be exchanged for stock when the
debt instrument ceases to qualify for the threshold exception.
Notwithstanding the preceding sentence, if the debt instrument was both
issued and ceases to qualify for the threshold exception during the
same taxable year, the general timing rule of paragraph (d)(1)(i) of
this section applies. See paragraph (g)(3) of this section, Example 17,
for an illustration of this rule.
(iv) Exception when a debt instrument is re-tested under paragraph
(d)(2) of this section. When paragraph (b)(3)(iv)(B) of this section
applies to treat a debt instrument as funding a distribution or
acquisition described in paragraph (b)(3)(ii) of this section as a
result of a re-testing described in paragraph (d)(2) of this section
that occurs in a taxable year subsequent to the taxable year in which
the debt instrument is issued, the debt instrument is deemed to be
exchanged for stock on the date of the re-testing. See paragraph (g)(3)
of this section, Example 7, for an illustration of this rule.
(v) Exception when a debt instrument ceases to qualify for the
exception for acquisitions of subsidiary stock by issuance. When
paragraph (b)(3)(iv)(B) and the modified ordering rule in paragraph
(c)(3) of this section apply to
[[Page 20937]]
treat a debt instrument as funding an acquisition of expanded group
stock that previously qualified for the exception set forth in
paragraph (c)(3) of this section, the debt instrument is deemed to be
exchanged for stock on the cessation date referred to in paragraph
(c)(3) of this section if the debt instrument was issued in a taxable
year preceding the taxable year that includes the cessation date. For
all other debt instruments that are treated as funding an acquisition
of expanded group stock that previously qualified for the exception set
forth in paragraph (c)(3) of this section, the general timing rule of
paragraph (d)(1)(i) of this section applies.
(2) Debt instrument treated as stock that leaves the expanded
group. Subject to paragraph (b)(4) of this section, when the holder and
issuer of a debt instrument that is treated as stock under this section
cease to be members of the same expanded group, either because the debt
instrument is transferred to a person that is not a member of the
expanded group that includes the issuer or because the holder or the
issuer cease to be members of the same expanded group, the debt
instrument ceases to be treated as stock under this section. For this
purpose, immediately before the transaction that causes the holder and
issuer of the debt instrument to cease to be members of the same
expanded group, the issuer is deemed to issue a new debt instrument to
the holder in exchange for the debt instrument that was treated as
stock in a transaction that is disregarded for purposes of paragraphs
(b)(2) and (b)(3) of this section. For purposes of paragraph
(b)(3)(iv)(B) of this section, when this paragraph (d)(2) causes a debt
instrument that previously was treated as stock pursuant to paragraph
(b)(3) of this section to cease to be treated as stock, all other debt
instruments of the issuer that are not currently treated as stock are
re-tested to determine whether those other debt instruments are treated
as funding the distribution or acquisition that previously was treated
as funded by the debt instrument that ceases to be treated as stock
pursuant to this paragraph (d)(2). See paragraph (g)(3) of this
section, Example 7, for an illustration of this rule.
(3) Inapplicability of section 385(c)(1). Section 385(c)(1) does
not apply with respect to a debt instrument to the extent that it is
treated as stock under this section.
(4) Taxable year. For purposes of this section, the term taxable
year refers to the taxable year of the issuer of the debt instrument.
(5) Treatment of partnerships--(i) Application of aggregate
treatment. For purposes of this section, a controlled partnership is
treated as an aggregate of its partners. Thus, for example, when a
corporation that is a member of an expanded group becomes a partner in
a partnership that is a controlled partnership with respect to that
expanded group, the corporation is treated as acquiring its
proportionate share of the controlled partnership's assets. In
addition, each expanded group partner in a controlled partnership is
treated as issuing its proportionate share of any debt instrument
issued by the controlled partnership. For this purpose, a partner's
proportionate share is determined in accordance with the partner's
share of partnership profits. See paragraph (g)(3) of this section,
Example 13, for an illustration of this rule.
(ii) Treatment of debt instruments issued by partnerships. To the
extent that the application of the aggregate approach in paragraph
(d)(5)(i) of this section causes a debt instrument issued by a
controlled partnership to be recharacterized under paragraph (b) of
this section, then the holder of the recharacterized debt instrument is
treated as holding stock in the expanded group partners. In addition,
the partnership and its partners must make appropriate conforming
adjustments to reflect this treatment. Any such adjustments must be
consistent with the purposes of this section and must be made in a
manner that avoids the creation of, or increase in, a disparity between
the controlled partnership's aggregate basis in its assets and the
aggregate bases of the partners' respective interests in the
partnership. See paragraph (g)(3) of this section, Examples 14 and 15,
for an illustration of this rule.
(6) Treatment of disregarded entities. If a debt instrument of a
disregarded entity is treated as stock under this section, such debt
instrument is treated as stock in the entity's owner rather than as an
equity interest in the entity.
(e) No affirmative use. The rules of this section and Sec. 1.385-4
do not apply to the extent a person enters into a transaction that
otherwise would be subject to these rules with a principal purpose of
reducing the federal tax liability of any member of the expanded group
that includes the issuer and the holder of the debt instrument by
disregarding the treatment of the debt instrument that would occur
without regard to this section.
(f) Definitions. The definitions in this paragraph (f) apply for
purposes of this section and for purposes of Sec. 1.385-4.
(1) Asset reorganization. The term asset reorganization means a
reorganization within the meaning of section 368(a)(1)(A), (C), (D),
(F), or (G).
(2) Controlled partnership. The term controlled partnership has the
meaning specified in Sec. 1.385-1(b)(1).
(3) Debt instrument. The term debt instrument means an interest
that would, but for the application of this section, be treated as a
debt instrument as defined in section 1275(a) and Sec. 1.1275-1(d).
(4) Distribution. The term distribution means any distribution made
by a corporation with respect to its stock.
(5) Exempt exchange. The term exempt exchange means an acquisition
of expanded group stock in which the transferor and transferee of the
stock are parties to an asset reorganization, and either--
(i) Section 361(a) or (b) applies to the transferor of the expanded
group stock and the stock is not transferred by issuance; or
(ii) Section 1032 or Sec. 1.1032-2 applies to the transferor of
the expanded group stock and the stock is distributed by the transferee
pursuant to the plan of reorganization.
(6) Expanded group. The term expanded group has the meaning
specified in Sec. 1.385-1(b)(3).
(7) Expanded group partner. The term expanded group partner means
any person that is a partner in a controlled partnership and that is a
member of the expanded group whose members own, directly or indirectly,
at least 80 percent of the interests in the controlled partnership's
capital or profits.
(8) Expanded group stock. The term expanded group stock means, with
respect to a member of an expanded group, stock of a member of the same
expanded group.
(9) Predecessor--(i) In general. The term predecessor includes,
with respect to a corporation, the distributor or transferor
corporation in a transaction described in section 381(a) in which the
corporation is the acquiring corporation. For purposes of the preceding
sentence, the transferor corporation in a reorganization within the
meaning of section 368(a)(1)(D) or (G) is treated as a transferor
corporation in a transaction described in section 381(a) without regard
to whether the reorganization meets the requirements of sections
354(b)(1)(A) and (B). The term predecessor does not include, with
respect to a controlled corporation, a distributing corporation that
distributed
[[Page 20938]]
the stock of the controlled corporation pursuant to section 355(c).
(ii) Special rules for funded acquisitions of subsidiary stock by
issuance. The term predecessor also includes, with respect to an issuer
that issues stock to a transferor in a transaction described in
paragraph (c)(3) of this section, the transferor, but, for purposes of
applying the per se rule in paragraph (b)(3)(iv)(B)(1) of this section,
only with respect to a debt instrument issued by the transferor during
the 72-month period determined with respect to the transaction
described in paragraph (c)(3) of this section, and only to the extent
of the value of the expanded group stock acquired from the issuer in
the transaction described in paragraph (c)(3) of this section.
(10) Property. The term property has the meaning specified in
section 317(a).
(11) Successor--(i) In general. The term successor includes, with
respect to a corporation, the acquiring corporation in a transaction
described in section 381(a) in which the corporation is the distributor
or transferor corporation. For purposes of the preceding sentence, the
acquiring corporation in a reorganization within the meaning of section
368(a)(1)(D) or (G) is treated as an acquiring corporation in a
transaction described in section 381(a) without regard to whether the
reorganization meets the requirements of sections 354(b)(1)(A) and (B).
The term successor does not include, with respect to a distributing
corporation, a controlled corporation the stock of which was
distributed by the distributing corporation pursuant to section 355(c).
(ii) Special rules for funded acquisitions of subsidiary stock by
issuance. The term successor also includes, with respect to a
transferor that transfers property to an issuer in exchange for stock
of the issuer in a transaction described in paragraph (c)(3) of this
section, the issuer, but, for purposes of applying the per se rule in
paragraph (b)(3)(iv)(B)(1) of this section, only with respect to a debt
instrument issued by the transferor during 72-month period determined
with respect to the transaction described in paragraph (c)(3) of this
section, and only to the extent of the value of the expanded group
stock acquired from the issuer in the transaction described in
paragraph (c)(3) of this section. A distribution by an issuer described
in paragraph (c)(3) of this section directly to the transferor is not
taken into account for purposes of applying paragraph (b)(3) of this
section to a debt instrument of the transferor.
(g) Examples--(1) Assumed facts. Except as otherwise stated, the
following facts are assumed for purposes of the examples in paragraph
(g)(3) of this section:
(i) FP is a foreign corporation that owns 100 percent of the stock
of USS1, a domestic corporation, 100 percent of the stock of USS2, a
domestic corporation, and 100 percent of the stock of FS, a foreign
corporation;
(ii) USS1 owns 100 percent of the stock of DS, a domestic
corporation, and CFC, which is a controlled foreign corporation within
the meaning of section 957;
(iii) At the beginning of Year 1, FP is the common parent of an
expanded group comprised solely of FP, USS1, USS2, FS, DS, and CFC (the
FP expanded group);
(iv) The FP expanded group has more than $50 million of debt
instruments described in paragraph (c)(2) of this section at all times;
(v) No issuer of a debt instrument has current year earnings and
profits described in section 316(a)(2);
(vi) All notes are debt instruments described in paragraph (f)(3)
of this section;
(vii) No notes are eligible for the ordinary course exception
described in paragraph (b)(3)(iv)(B)(2) of this section;
(viii) Each entity has as its taxable year the calendar year;
(ix) PRS is a partnership for federal income tax purposes;
(x) No corporation is a member of a consolidated group, as defined
in Sec. 1.1502-1(h);
(xi) No domestic corporation is a United States real property
holding corporation within the meaning of section 897(c)(2); and
(xii) Each note is issued with adequate stated interest (as defined
in section 1274(c)(2)).
(2) No inference. Except as provided in this section, it is assumed
for purposes of the examples that the form of each transaction is
respected for federal tax purposes. No inference is intended, however,
as to whether any particular note would be respected as indebtedness or
as to whether the form of any particular transaction described in
paragraph (g)(3) of this section would be respected for federal tax
purposes.
(3) Examples. The following examples illustrate the rules of this
section.
Example 1. Distribution of a debt instrument. (i) Facts. On Date
A in Year 1, FS lends $100x to USS1 in exchange for USS1 Note A. On
Date B in Year 2, USS1 issues USS1 Note B, which is has a value of
$100x, to FP in a distribution.
(ii) Analysis. USS1 Note B is a debt instrument that is issued
by USS1 to FP, a member of USS1's expanded group, in a distribution.
Accordingly, USS1 Note B is treated as stock under paragraph
(b)(2)(i) of this section. Under paragraph (d)(1)(i) of this
section, USS1 Note B is treated as stock when it is issued by USS1
to FP on Date B in Year 2. Accordingly, USS1 is treated as
distributing USS1 stock to its shareholder FP in a distribution that
is subject to section 305. Because USS1 Note B is treated as stock
for federal tax purposes when it is issued by USS1, USS1 Note B is
not treated as property for purposes of paragraph (b)(3)(ii)(A) of
this section because it is not property within the meaning specified
in section 317(a). Accordingly, USS1 Note A is not treated as
funding the distribution of USS1 Note B for purposes of paragraph
(b)(3)(ii)(A) of this section.
Example 2. Debt instrument issued for expanded group stock that
is exchanged for stock in a corporation that is not a member of the
same expanded group. (i) Facts. UST is a publicly traded domestic
corporation. On Date A in Year 1, USS1 issues USS1 Note to FP in
exchange for FP stock. On Date B of Year 1, USS1 transfers the FP
stock to UST's shareholders, which are not members of the FP
expanded group, in exchange for all of the stock of UST.
(ii) Analysis. (A) Because USS1 and FP are both members of the
FP expanded group, USS1 Note is treated as stock when it is issued
by USS1 to FP in exchange for FP stock on Date A in Year 1 under
paragraphs (b)(2)(ii) and (d)(1)(i) of this section. This result
applies even though, pursuant to the same plan, USS1 transfers the
FP stock to persons that are not members of the FP expanded group.
The exchange of USS1 Note for FP stock is not an exempt exchange
within the meaning of paragraph (f)(5) of this section.
(B) Because USS1 Note is treated as stock for federal tax
purposes when it is issued by USS1, pursuant to section Sec.
1.367(b)-10(a)(3)(ii) (defining property for purposes of Sec.
1.367(b)-10) there is no potential application of Sec. 1.367(b)-
10(a) to USS1's acquisition of the FP stock.
(C) Because paragraph (b)(2) of this section treats USS1 Note as
stock for federal tax purposes when it is issued by USS1, USS1 Note
is not treated as indebtedness for purposes of applying paragraph
(b)(3) of this section.
Example 3. Issuance of a note in exchange for expanded group
stock. (i) Facts. On Date A in Year 1, USS1 issues USS1 Note to FP
in exchange for 40 percent of the FS stock owned by FP.
(ii) Analysis. (A) Because USS1 and FP are both members of the
FP expanded group, USS1 Note is treated as stock when it is issued
by USS1 to FP in exchange for FS stock on Date A in Year 1 under
paragraphs (b)(2)(ii) and (d)(1)(i) of this section. The exchange of
USS1 Note for FS stock is not an exempt exchange within the meaning
of paragraph (f)(5) of this section because USS1 and FP are not
parties to a reorganization.
(B) Because USS1 Note is treated as stock for federal tax
purposes when it is issued by USS1, USS1 Note is not treated as
property for purposes of section 304(a) because it is not property
within the meaning specified in
[[Page 20939]]
section 317(a). Therefore, USS1's acquisition of FS stock from FP in
exchange for USS1 Note is not an acquisition described in section
304(a)(1).
(C) Because USS1 Note is treated as stock for federal tax
purposes when it is issued by USS1, USS1 Note is not treated as
indebtedness for purposes of applying paragraph (b)(3) of this
section.
Example 4. Funding occurs in same taxable year as distribution.
(i) Facts. On Date A in Year 1, FP lends $200x to CFC in exchange
for CFC Note A. On Date B in Year 1, CFC distributes $400x of cash
to USS1 in a distribution. CFC is not an expatriated foreign
subsidiary as defined in Sec. 1.7874-12T(a)(9).
(ii) Analysis. Under paragraph (b)(3)(iv)(B) of this section,
CFC Note A is treated as issued with a principal purpose of funding
the distribution by CFC to USS1 because CFC Note A is issued to a
member of the FP expanded group during the 72-month period
determined with respect to CFC's distribution to USS1. Accordingly,
under paragraphs (b)(3)(ii)(A) and (d)(1)(i) of this section, CFC
Note A is treated as stock when it is issued by CFC to FP on Date A
in Year 1.
Example 5. Additional funding. (i) Facts. The facts are the same
as in Example 4, except that, in addition, on Date C in Year 2, FP
lends an additional $300x to CFC in exchange for CFC Note B.
(ii) Analysis. The analysis is the same as in Example 4 with
respect to CFC Note A. CFC Note B is also issued to a member of the
FP expanded group during the 72-month period determined with respect
to CFC's distribution to USS1. Under paragraph (b)(3)(iv)(B) of this
section, CFC Note B is treated as issued with a principal purpose of
funding the remaining portion of CFC's distribution to USS1, which
is $200x. Accordingly, $200x of CFC Note B is a principal purpose
debt instrument that is treated as stock under paragraph
(b)(3)(ii)(A) of this section. Under paragraph (d)(1)(ii) of this
section, $200x of CFC Note B is deemed to be exchanged for stock on
Date C in Year 2. The remaining $100x of CFC Note B continues to be
treated as indebtedness.
Example 6. Funding involving multiple interests. (i) Facts. On
Date A in Year 1, FP lends $300x to USS1 in exchange for USS1 Note
A. On Date B in Year 2, USS1 distributes $300x of cash to FP. On
Date C in Year 3, FP lends another $300x to USS1 in exchange for
USS1 Note B.
(ii) Analysis. (A) Under paragraph (b)(3)(iv)(B)(3) of this
section, USS1 Note A is tested under paragraph (b)(3) of this
section before USS1 Note B is tested. USS1 Note A is issued during
the 72-month period determined with respect to USS1's $300x
distribution to FP and, therefore, is treated as issued with a
principal purpose of funding the distribution under paragraph
(b)(3)(iv)(B)(1) of this section. Beginning on Date B in Year 2,
USS1 Note A is a principal purpose debt instrument that is treated
as stock under paragraphs (b)(3)(ii)(A) and (d)(1)(ii) of this
section.
(B) Under paragraph (b)(3)(iv)(B)(3) of this section, USS1 Note
B is tested under paragraph (b)(3) of this section after USS1 Note A
is tested. Because USS1 Note A is treated as funding the entire
$300x distribution by USS1 to FP, USS1 Note B will continue to be
treated as indebtedness.
Example 7. Re-testing. (i) Facts. The facts are the same as in
Example 6, except that on Date D in Year 4, FP sells USS1 Note A to
Bank.
(ii) Analysis. (A) Under paragraph (d)(2) of this section, USS1
Note A ceases to be treated as stock when FP sells USS1 Note A to
Bank on Date D in Year 4. Immediately before FP sells USS1 Note A to
Bank, USS1 is deemed to issue a debt instrument to FP in exchange
for USS1 Note A in a transaction that is disregarded for purposes of
paragraphs (b)(2) and (b)(3) of this section.
(B) Under paragraph (d)(2) of this section, after USS1 Note A is
deemed exchanged, USS1's other debt instruments that are not treated
as stock as of Date D in Year 4 (USS1 Note B) are re-tested for
purposes of paragraph (b)(3)(iv)(B) of this section to determine
whether other USS1 debt instruments are treated as funding the $300x
distribution by USS1 to FP on Date B in Year 2. USS1 Note B was
issued by USS1 to FP within the 72-month period determined with
respect to the $300x distribution. Under paragraph (b)(3)(iv)(B)(1)
of this section, USS1 Note B is treated as issued with a principal
purpose of funding the $300x distribution. Accordingly, USS1 Note B
is a principal purpose debt instrument under paragraph (b)(3)(ii)(A)
of this section that is deemed to be exchanged for stock on Date D
in Year 4, the re-testing date, under paragraph (d)(1)(iv) of this
section. See Sec. 1.385-1(c) for rules regarding the treatment of
this deemed exchange.
Example 8. Distribution of expanded group stock and debt
instrument in a reorganization that qualifies under section 355. (i)
Facts. On Date A in Year 1, FP lends $200x to USS2 in exchange for
USS2 Note. In a transaction that is treated as independent from the
transaction on Date A in Year 1, on Date B in Year 2, USS2 transfers
a portion of its assets to DS2, a newly-formed domestic corporation,
in exchange for all of the stock of DS2 and DS2 Note. Immediately
afterwards, USS2 distributes all of the DS2 stock and the DS2 Note
to FP with respect to FP's USS2 stock in a transaction that
qualifies under section 355. USS2's transfer of a portion of its
assets qualifies as a reorganization within the meaning of section
368(a)(1)(D). The DS2 stock has a value of $150x and DS2 Note has a
value of $50x. The DS2 stock is not non-qualified preferred stock as
defined in section 351(g)(2). Absent the application of this
section, DS2 Note would be treated by FP as ``other property''
within the meaning of section 356.
(ii) Analysis. (A) The contribution and distribution transaction
is a reorganization within the meaning of section 368(a)(1)
involving a transfer of USS2's property described in section 361(a).
Thus, DS2 Note is a debt instrument that is issued by DS2 to USS2,
both members of the FP expanded group, pursuant to an asset
reorganization (as defined in paragraph (f)(1) of this section), and
received by FP, another FP expanded group member, with respect to
FP's USS2 stock. Accordingly, DS2 Note is treated as stock when it
is issued by DS2 to USS2 on Date B in Year 2 pursuant to paragraphs
(b)(2)(iii) and (d)(1)(i) of this section.
(B) Because DS2 Note is treated as stock when it is issued,
section 355(a)(1) rather than section 356 may apply to FP on FP's
receipt of DS2 Note. Alternatively, depending on the terms of DS2
Note and other factors, DS2 Note may be treated as non-qualified
preferred stock that is not treated as stock pursuant to section
355(a)(3)(D). If DS2 Note is treated as non-qualified preferred
stock, such stock would continue to be treated by FP as ``other
property'' for purposes of section 356 under section 356(e). In that
case, USS2's distribution of DS2 Note would be treated as ``other
property'' described in section 356, and thus the distribution of
DS2 note preliminarily would be described in paragraph (b)(3)(ii)(A)
of this section. However, under paragraph (b)(5) of this section,
because DS2 Note is treated as stock under paragraph (b)(2)(iii) of
this section, USS2's distribution of DS2 Note to FP pursuant to the
plan of reorganization is not also treated as a distribution or
acquisition described in paragraph (b)(3)(ii) of this section that
could cause USS2 Note to be a principal purpose debt instrument.
(C) USS2's distribution of $150x of actual DS2 stock is a
distribution of stock pursuant to an asset reorganization that is
permitted to be received by FP without recognition of gain under
section 355(a)(1). Accordingly, USS2's distribution of the actual
DS2 stock to FP is not a distribution of property by USS2 for
purposes of paragraph (b)(3)(ii)(A) of this section.
(D) USS2's transfer of assets to DS2 in exchange for DS2 stock
is not an acquisition described in paragraph (b)(3)(ii)(B) of this
section because USS2's acquisition of DS2 stock is an exempt
exchange. USS2's acquisition of DS2 stock is an exempt exchange
described in paragraph (f)(5)(ii) of this section because USS2 and
DS2 are both parties to a reorganization that is an asset
reorganization, section 1032 applies to DS2, the transferor of the
expanded group stock, and the DS2 stock is distributed by USS2, the
transferee, pursuant to the plan of reorganization. Because USS2 has
not made a distribution or acquisition that is treated as a
distribution or acquisition for purposes of paragraph (b)(3)(ii) of
this section, USS2 Note is not a principal purpose debt instrument.
Example 9. Funding a distribution by a successor to funded
member. (i) Facts. The facts are the same as in Example 8, except
that on Date C in Year 3, DS2 distributes $200x of cash to FP and,
subsequently, on Date D in Year 3, USS2 distributes $100x of cash to
FP.
(ii) Analysis. (A) DS2 is a successor with respect to USS2 under
paragraph (f)(11)(i) of this section because DS2 is the acquiring
corporation in a reorganization within the meaning of section
368(a)(1)(D). USS2 is a predecessor with respect to DS2 under
paragraph (f)(9)(i) of this section because USS2 is the transferor
corporation in a reorganization within the meaning of section
368(a)(1)(D). Accordingly, under paragraph (b)(3)(v) of this
section, a distribution by DS2 is treated as a distribution by USS2.
Under paragraph (b)(3)(iv)(B) of this section, USS2
[[Page 20940]]
Note is treated as issued with a principal purpose of funding the
distribution by DS2 to FP because USS2 Note was issued during the
72-month period determined with respect to DS2's $200x cash
distribution. Accordingly, USS2 Note is a principal purpose debt
instrument under paragraph (b)(3)(ii)(A) of this section that is
deemed to be exchanged for stock on Date C in Year 3 under paragraph
(d)(1)(ii) of this section. See Sec. 1.385-1(c) for rules regarding
the treatment of this deemed exchange.
(B) Because the entire amount of USS2 Note is treated as funding
DS2's $200x distribution to FP, under paragraph (b)(3)(iv)(B)(4) of
this section, USS2 Note is not treated as funding the subsequent
distribution by USS2 on Date D in Year 3.
Example 10. Asset reorganization; section 354 qualified
property. (i) Facts. On Date A in Year 1, FS lends $100x to USS2 in
exchange for USS2 Note. On Date B in Year 2, in a transaction that
qualifies as a reorganization within the meaning of section
368(a)(1)(D), USS2 transfers all of its assets to USS1 in exchange
for stock of USS1 and the assumption by USS1 of all of the
liabilities of USS2, and USS2 distributes to FP, with respect to
FP's USS2 stock, all of the USS1 stock that USS2 received. FP does
not recognize gain under section 354(a)(1).
(ii) Analysis. (A) USS1 is a successor with respect to USS2
under paragraph (f)(11)(i) of this section because USS1 is the
acquiring corporation in a reorganization within the meaning of
section 368(a)(1)(D). For purposes of paragraph (b)(3) of this
section, USS2 and its successor, USS1, are funded members with
respect to USS2 Note. Although USS2, a funded member, distributes
property (USS1 stock) to its shareholder, FP, pursuant to the
reorganization, the distribution of USS1 stock is not described in
paragraph (b)(3)(ii)(A) of this section because the property is
permitted to be received without the recognition of gain under
section 354(a)(1). The distribution of USS1 stock is also not
described in paragraph (b)(3)(ii)(C) of this section because FP does
not receive the USS1 stock as ``other property'' within the meaning
of section 356.
(B) USS2's exchange of assets for USS1 stock is not an
acquisition described in paragraph (b)(3)(ii)(B) of this section
because USS2's acquisition of USS1 stock is an exempt exchange.
USS2's acquisition of USS1 stock is an exempt exchange described in
paragraph (f)(5)(ii) of this section because USS1 and USS2 are both
parties to a reorganization, section 1032 applies to USS1, the
transferor of the expanded group stock, and the USS1 stock is
distributed by USS2, the transferee, pursuant to the plan of
reorganization.
(C) Because neither USS1 nor USS2 has made a distribution or
acquisition described in paragraph (b)(3)(ii) of this section, USS2
Note is not a principal purpose debt instrument.
Example 11. Triangular reorganization. (i) Facts. USS2 owns 100
percent of the stock of DS2, a domestic corporation. On Date B in
Year 1, FP issues FP stock and FP Note to USS1 as a contribution to
capital. USS1 does not formally issue additional USS1 stock to FP in
exchange for FP stock and FP Note, but is treated as issuing stock
to FP in an exchange to which section 351 applies. Immediately
afterwards, USS1 transfers the FP stock and FP Note to DS2 in
exchange for all of DS2's assets, and DS2 distributes the FP stock
and FP Note to USS2 with respect to USS2's DS2 stock in a
liquidating distribution.
(ii) Analysis. FP Note is issued by FP to USS1 in exchange for
stock of USS1 in an exchange that is not an exempt exchange
described in paragraph (f)(5) of this section. Under paragraph
(b)(2)(ii) of this section, FP Note is treated as stock beginning on
Date B in Year 1.
Example 12. Funded acquisition of subsidiary stock by issuance;
successor.
(i) Facts. On Date A in Year 1, FS lends $100x to USS1 in
exchange for USS1 Note. On Date B in Year 1, USS1 transfers property
that has a value of $20x to CFC in exchange for additional CFC stock
that has a value of $20x. On Date C in Year 2, CFC distributes $20
cash to USS1. On Date D in Year 3, CFC acquires stock of FS from FP
in exchange for $50x cash.
(ii) Analysis. (A) But for the exception in paragraph (c)(3) of
this section, USS1 Note would be treated under paragraph
(b)(3)(iv)(B) of this section as issued with a principal purpose of
funding an acquisition of expanded group stock described in
paragraph (b)(3)(ii)(B) of this section because USS1 Note is issued
to a member of the FP expanded group during the 72-month period
determined with respect to USS1's acquisition of CFC stock on Date B
in Year 1. However, because USS1's acquisition of CFC stock results
from a transfer of property from USS1 to CFC in exchange for CFC
stock and immediately after the transaction USS1 holds 100 percent
of the stock of CFC, the exception in paragraph (c)(3) of this
section applies. Accordingly, USS1's acquisition of CFC stock on
Date B in Year 1 is not treated as an acquisition of stock described
in paragraph (b)(3)(ii)(B) of this section, and USS1 Note is not
treated as stock.
(B) CFC is a successor with respect to USS1 under paragraph
(f)(11)(ii) of this section. For purposes of paragraph
(b)(3)(iv)(B)(1) of this section CFC is a successor only to the
extent of the value of the expanded group stock acquired from CFC in
the transaction described in paragraph (c)(3) of this section.
(C) Under paragraph (f)(11)(ii) of this section, CFC's $20x cash
distribution to USS1 on Date C in Year 2 is not taken into account
for purposes of applying paragraph (b)(3) of this section to USS1
Note.
(D) On Date D in Year 3, CFC continues to be a successor to USS1
for purposes of applying the per se rule in paragraph (b)(3)(iv)(B)
of this section. Accordingly, USS1 Note is a principal purpose debt
instrument under paragraph (b)(3)(ii)(A) of this section that is
deemed to be exchanged for stock on Date D in Year 3 under paragraph
(d)(1)(ii) of this section. See Sec. 1.385-1(c) for rules regarding
the treatment of this deemed exchange.
Example 13. Distribution of a debt instrument to partnership.
(i) Facts. CFC and FS are equal partners in PRS. PRS owns 100
percent of the stock of X Corp, a domestic corporation. On Date A in
Year 1, X Corp issues X Note to PRS in a distribution.
(ii) Analysis. (A) Under Sec. 1.385-1(b)(3), in determining
whether X Corp is a member of the expanded group that includes CFC
and FS, CFC and FS are each treated as holding 50 percent of the X
Corp stock held by PRS. Accordingly, 100 percent of X Corp's stock
is treated as owned by CFC and FS under Sec. 1.385-1(b)(3)(i)(B),
and X Corp is a member of the FP expanded group.
(B) Together CFC and FS own 100 percent of the interests in PRS
capital and profits, such that PRS is a controlled partnership
described in Sec. 1.385-1(b)(1). Under paragraph (d)(5)(i) of this
section, solely for purposes of this section, when X Corp issues X
Note to PRS, proportionate shares of X Note are treated as issued to
CFC and FS. Accordingly, for purposes of applying paragraph (b) of
this section, in Year 1, 50 percent of X Note is treated as issued
to CFC in a distribution and the other 50 percent of X Note is
treated as issued to FS in a distribution. Therefore, under
paragraphs (b)(2)(i) and (d)(1)(i) of this section, X Note is
treated as stock beginning on Date A in Year 1. Under paragraph
(d)(5)(i) of this section, CFC and FS are treated as holding X Note
solely for purposes of this section. For all other federal tax
purposes, X Note is treated as stock in X Corp that is held by PRS,
and X Corp is treated as distributing its stock to its shareholder
in a distribution that is subject to section 305.
Example 14. Loan to partnership; same-year distribution. (i)
Facts. The facts are the same as in Example 13, except that X Corp
does not distribute X Note to PRS; instead, on Date A in Year 1 FP
lends $200x to PRS in exchange for PRS Note. On Date B in Year 1,
CFC distributes $100x to USS1 and FS distributes $100x to FP. CFC is
not an expatriated foreign subsidiary as defined in Sec. 1.7874-
12T(a)(9).
(ii) Analysis. (A) Under paragraph (d)(5)(i) of this section,
solely for purposes of this section, CFC and FS are each treated as
issuing $100x of PRS Note on Date A in Year 1, which represents
their proportionate shares of PRS Note. CFC's and FS's shares of PRS
Note are each issued to FP, a member of the same expanded group,
during the 72-month periods determined with respect to the
distributions by CFC and FS. Under paragraph (b)(3)(iv)(B)(1) of
this section, PRS Note is treated as issued with a principal purpose
of funding the distributions by CFC and FS. Accordingly, under
paragraphs (b)(3)(ii)(A) and (d)(1)(i) of this section, PRS Note is
a principal purpose debt instrument that is treated as stock when it
is issued on Date A in Year 1.
(B) Under paragraph (d)(5)(ii) of this section, CFC and FS are
each treated as issuing $100x of stock to FP. Appropriate conforming
adjustments must be made to CFC's and FS's interests in PRS to
reflect the deemed treatment of PRS Note as stock issued by CFC and
FS, which must be done in a manner that avoids the creation of, or
increase in, a disparity between PRS's aggregate basis in its assets
and the aggregate bases of CFC's and FS's respective interests in
PRS. For example, reasonable and appropriate adjustments may occur
when the following steps are deemed to occur on Date A in Year 1:
[[Page 20941]]
(1) CFC issues stock to FP in exchange for $100x;
(2) FS issues stock to FP in exchange for $100x;
(3) CFC contributes $100x to PRS in exchange for a partnership
interest in PRS; and
(4) FS contributes $100x to PRS in exchange for a partnership
interest in PRS.
Example 15. Loan to partnership; distribution in later year. (i)
Facts. The facts are the same as in Example 14, except that CFC and
FS do not make distributions on Date B of Year 1; instead, CFC
distributes $100x to USS1 and FS distributes $100x to FP on Date C
of Year 2.
(ii) Analysis. (A) As in Example 14, CFC's and FS's shares of
PRS Note are each issued to FP, a member of the same expanded group,
during the 72-month periods determined with respect to the
distributions by CFC and FS. Under paragraph (b)(3)(iv)(B)(1) of
this section, PRS Note is treated as issued with a principal purpose
of funding the distributions by CFC and FS. Accordingly, PRS Note is
a principal purpose debt instrument that is treated as stock under
paragraph (b)(3)(i)(A) of this section. Under paragraph (d)(1)(ii)
of this section, PRS Note is treated as stock on Date C in Year 2.
(B) Under paragraph (d)(5)(ii) of this section, CFC and FS are
each treated as issuing $100x of stock to FP. Appropriate conforming
adjustments must be made to CFC's and FS's interests in PRS to
reflect the deemed treatment of PRS Note as stock issued by CFC and
FS, which must be done in a manner that avoids the creation of, or
increase in, a disparity between PRS's aggregate basis in its assets
and the aggregate bases of CFC's and FS's respective interests in
PRS. For example, reasonable and appropriate adjustments may occur
when the following steps are deemed to occur on Date C in Year 2:
(1) CFC assumes liability with respect to $100x of PRS Note;
(2) FS assumes liability with respect to $100x of PRS Note;
(3) CFC issues stock to FP in satisfaction of the $100x of PRS
Note assumed by CFC; and
(4) FS issues stock to FP in satisfaction of the $100x of PRS
Note assumed by FS.
Example 16. Distribution of another member's debt instrument.
(i) Facts. On Date A in Year 1, CFC lends $100x to FS in exchange
for FS Note. On Date B in Year 2, CFC distributes FS Note to USS1.
(ii) Analysis. Although CFC distributes FS Note, which is a debt
instrument, to USS1, another member of CFC's expanded group,
paragraph (b)(2)(i) of this section does not apply because CFC is
not the issuer of the FS Note.
Example 17. Threshold exception and current year earnings and
profits exception. (i) Facts. Before Date A in Year 1, the members
of FP's expanded group hold no outstanding debt instruments that
otherwise would be treated as stock under this section. On Date A in
Year 1, CFC issues CFC Note, which has an issue price of $40
million, to USS1 in a distribution. On Date B in Year 2, USS1 issues
USS1 Note, which has an issue price of $20 million, to FP in a
distribution. On Date C in Year 3, FS distributes $30 million in
cash to FP. On Date D in Year 3, DS lends $30 million to FS in
exchange for FS Note A. On Date E in Year 3, FS issues FS Note B,
which has an issue price of $19 million, to FP in a distribution. In
Year 3, FS has $35 million in earnings and profits described in
section 316(a)(2).
(ii) Analysis. (A) Because CFC does not have earnings and
profits described in section 316(a)(2) in Year 1, the exception in
paragraph (c)(1) of this section does not apply to CFC Note.
Immediately after CFC Note is issued to USS1 on Date A in Year 1,
the aggregate adjusted issue price of outstanding debt instruments
issued by members of FP's expanded group that would be subject to
paragraph (b) of this section but for the application paragraph
(c)(2) of this section does not exceed $50 million. Accordingly, the
threshold exception described in paragraph (c)(2) applies to the CFC
Note.
(B) Because USS1 does not have earnings and profits described in
section 316(a)(2) in Year 2, the exception in paragraph (c)(1) of
this section does not apply to USS1 Note. Immediately after USS1
Note is issued to FP on Date B in Year 2, the aggregate adjusted
issue price of outstanding debt instruments issued by members of the
FP expanded group that would be subject to paragraph (b) of this
section but for the application of paragraph (c)(2) of this section
exceeds $50 million. Under paragraph (d)(1)(iii) of this section,
CFC Note is deemed to be exchanged for stock on Date B in Year 2,
when debt instruments of the FP expanded group cease to qualify for
the threshold exception described in paragraph (c)(2) of this
section. In addition, the threshold exception described in paragraph
(c)(2) of this section does not apply to USS1 Note because,
immediately after USS1 Note is issued, the aggregate adjusted issue
price of outstanding debt instruments issued by members of the
expanded group that would be subject to paragraph (b) of this
section but for the application paragraph (c)(2) of this section
exceeds $50 million. Accordingly, USS1 Note is treated as stock when
it is issued on Date B in Year 2.
(C) Under paragraph (c)(1) of this section, for purposes of
applying paragraphs (b)(2) and (b)(3) of this section to a member of
an expanded group with respect to Year 3, the aggregate amount of
any distributions or acquisitions by FS that are described in
paragraphs (b)(2) or (b)(3)(ii) of this section are reduced by an
amount equal to FS's current year earnings and profits described in
section 316(a)(2) for Year 3, which is $35 million. Thus, $35
million of distributions or acquisitions by FS in Year 3 are not
taken into account for purposes of applying paragraphs (b)(2) and
(b)(3) of this section. The reduction is applied first against FS's
$30 million cash distribution on Date C in Year 3 and second against
FS's $19 million note distribution on Date E in Year 3. Accordingly,
under paragraph (c)(1) of this section, FS Note A is not treated as
stock under paragraph (b)(3) of this section. In addition, under
paragraph (c)(1) of this section a portion of FS Note B equal to $5
million is not treated as stock under paragraph (b)(2) of this
section.
(D) When FS Note B is issued in Year 3, CFC Note, which
previously was treated as indebtedness solely because of paragraph
(c)(2) of this section, remains outstanding. Accordingly, the
threshold exception described in paragraph (c)(2) of this section
does not apply to FS Note B. Accordingly, the remaining amount of FS
Note B equal to $14 million after applying the exception under
paragraph (c)(1) of this section is treated as stock under paragraph
(b)(2) of this section.
Example 18. Distribution of a debt instrument and issuance of a
debt instrument with a principal purpose of avoiding the purposes of
this section. (i) Facts. On Date A in Year 1, USS1 issues USS1 Note
A, which has a value of $100x, to FP in a distribution. On Date B in
Year 1, with a principal purpose of avoiding the application of this
section, FP sells USS1 Note A to Bank for $100x of cash and lends
$100x to USS1 in exchange for USS1 Note B.
(ii) Analysis. USS1 Note A is a debt instrument that is issued
by USS1 to FP, a member of USS1's expanded group, in a distribution.
Accordingly, under paragraphs (b)(2)(i) and (d)(1)(i) of this
section, USS1 Note A is treated as stock when it is issued by USS1
to FP on Date A in Year 1. Accordingly, USS1 is treated as
distributing USS1 stock to its shareholder FP. Because USS1 Note A
is treated as stock of USS1, USS1 Note A is not property as
specified in section 317(a) on Date A in Year 1. Under paragraph
(d)(2) of this section, USS1 Note A ceases to be treated as stock
when FP sells USS1 Note A to Bank on Date B in Year 1. Immediately
before FP sells USS1 Note A to Bank, USS1 is deemed to issue a debt
instrument to FP in exchange for USS1 Note A in a transaction that
is disregarded for purposes of paragraphs (b)(2) and (b)(3) of this
section. USS1 Note B is not treated as stock under paragraph
(b)(3)(ii)(A) of this section because the funded member, USS1, has
not made a distribution of property. However, because the
transactions occurring on Date B of Year 1 were undertaken with a
principal purpose of avoiding the purposes of this section, USS1
Note B is treated as stock on Date B of Year 1 under paragraph
(b)(4) of this section.
(h) Effective/applicability date and transition rules--(1) In
general. This section applies to any debt instrument issued on or after
April 4, 2016, and to any debt instrument treated as issued before
April 4, 2016 as a result of an entity classification election made
under Sec. 301.7701-3 of this chapter that is filed on or after April
4, 2016.
(2) Transition rule for distributions or acquisitions occurring
before April 4, 2016. For purposes of paragraph (b)(3)(iv) of this
section, a distribution or acquisition described in paragraph
(b)(3)(ii) of this section that occurs before April 4, 2016, other than
a distribution or acquisition that is treated as occurring before April
4, 2016 as a result of an entity classification election made under
Sec. 301.7701-3 of this chapter
[[Page 20942]]
that is filed on or after April 4, 2016, is not taken into account.
(3) Transition rule for debt instruments that would be treated as
stock prior to the date of publication in the Federal Register of the
Treasury decision adopting this rule as a final regulation. When
paragraphs (b) and (d)(1)(i) through (v) of this section otherwise
would treat a debt instrument as stock prior to the date of publication
in the Federal Register of the Treasury decision adopting this rule as
a final regulation, the debt instrument is treated as indebtedness
until the date that is 90 days after the date of publication in the
Federal Register of the Treasury decision adopting this rule as a final
regulation. To the extent that the debt instrument described in the
preceding sentence is held by a member of the issuer's expanded group
on the date that is 90 days after the date of publication in the
Federal Register of the Treasury decision adopting this rule as a final
regulation, the debt instrument is deemed to be exchanged for stock on
the date that is 90 days after the date of publication in the Federal
Register of the Treasury decision adopting this rule as a final
regulation.
0
Par. 5. Section 1.385-4 is added to read as follows:
Sec. 1.385-4 Treatment of consolidated groups.
(a) Scope. Section 1.385-1(e) provides that members of a
consolidated group are treated as one corporation for purposes of the
regulations under section 385. This section provides rules for applying
Sec. 1.385-3 to consolidated groups when an interest ceases to be a
consolidated group debt instrument or becomes a consolidated group debt
instrument. For definitions applicable to this section, see Sec.
1.385-3(f).
(b) Debt instrument ceases to be a consolidated group debt
instrument but continues to be an expanded group debt instrument--(1)
Member leaving the group. When a corporation ceases to be a member of
the consolidated group but continues to be a member of the expanded
group (such corporation, a departing member), a debt instrument that is
issued or held by the departing member is treated as indebtedness or
stock pursuant to paragraphs (b)(1)(i) or (b)(1)(ii) of this section.
(i) Exempt consolidated group debt instrument that ceases to be
consolidated group debt instrument. Any exempt consolidated group debt
instrument that is issued or held by the departing member is deemed to
be exchanged for stock immediately after the departing member leaves
the group. For these purposes, the term exempt consolidated group debt
instrument means any debt instrument that was not treated as stock
solely by reason of the departing member's treatment under Sec. 1.385-
1(e). See paragraph (d) of this section, Example 3, for an illustration
of this rule.
(ii) Non-exempt consolidated group debt instrument that ceases to
be consolidated group debt instrument--(A) In general. Any consolidated
group debt instrument issued or held by a departing member that is not
an exempt consolidated group debt instrument (non-exempt consolidated
group debt instrument) is treated as indebtedness unless and until the
non-exempt consolidated group debt instrument is treated as a principal
purpose debt instrument under Sec. 1.385-3(b)(3)(ii) and (d)(1) as a
result of a distribution or acquisition described in Sec. 1.385-
3(b)(3)(ii) that occurs after the departure.
(B) Coordination with funding rule. Solely for purposes of applying
the 72-month period under Sec. 1.385-3(b)(3)(iv)(B) (the per se rule),
a non-exempt consolidated group debt instrument is treated as having
been issued when it was first treated as a consolidated group debt
instrument. For all other purposes of applying Sec. 1.385-3, including
for purposes of applying Sec. 1.385-3(d), a non-exempt consolidated
group debt instrument is treated as issued by the issuer of the debt
instrument immediately after the departing member leaves the group.
(2) Consolidated group debt instrument that is transferred outside
of the consolidated group. Solely for purposes of Sec. 1.385-3, when a
member of a consolidated group that holds a consolidated group debt
instrument transfers the debt instrument to an expanded group member
that is not a member of the consolidated group, the debt instrument is
treated as issued by the issuer of the debt instrument (which is
treated as one corporation with the transferor of the debt instrument
pursuant to Sec. 1.385-1(e)) to the transferee expanded group member
on the date of the transfer. For purposes of Sec. 1.385-3, the
consequences of such transfer are determined in a manner that is
consistent with treating a consolidated group as one corporation. Thus,
for example, the sale of a consolidated group debt instrument to an
expanded group member that is not a member of the consolidated group
will be treated as an issuance of the debt instrument to the transferee
expanded group member in exchange for property. To the extent the debt
instrument is treated as stock upon being transferred, the debt
instrument is deemed to be exchanged for stock immediately after the
debt instrument is transferred outside of the consolidated group. For
examples illustrating this rule, see paragraph (d) of this section,
Examples 1 and 2.
(c) Debt instrument entering a consolidated group. When a debt
instrument that is treated as stock under Sec. 1.385-3 becomes a
consolidated group debt instrument, immediately before that debt
instrument becomes a consolidated group debt instrument, the issuer is
treated as issuing a new debt instrument to the holder in exchange for
the debt instrument that was treated as stock in a transaction that is
disregarded for purposes of Sec. 1.385-3(b).
(d) Examples--(1) Assumed facts. Except as otherwise stated, the
following facts are assumed for purposes of the examples in paragraph
(d)(3) of this section:
(i) FP is a foreign corporation that owns 100 percent of the stock
of USS1, a domestic corporation, and 100 percent of the stock of FS, a
foreign corporation;
(ii) USS1 owns 100 percent of the stock of DS1, a domestic
corporation;
(iii) DS1 owns 100 percent of the stock of DS2, a domestic
corporation;
(iv) At the beginning of Year 1, FP is the common parent of an
expanded group comprised solely of FP, USS1, FS, DS1, and DS2 (the FP
expanded group);
(v) USS1, DS1, and DS2 are members of a consolidated group of which
USS1 is the common parent (the USS1 consolidated group);
(vi) The FP expanded group has more than $50 million of debt
instruments described in Sec. 1.385-3(c)(2) at all times;
(vii) No issuer of a debt instrument has current year earnings and
profits described in section 316(a)(2);
(viii) All notes are debt instruments described in Sec. 1.385-
3(f)(3) and therefore have satisfied any requirements under Sec.
1.385-2, if applicable, and are respected as debt instruments under
general federal tax principles;
(ix) No notes are eligible for the ordinary course exception
described in Sec. 1.385-3(b)(3)(iv)(B)(2);
(x) Each entity has as its taxable year the calendar year;
(xi) No domestic corporation is a United States real property
holding corporation within the meaning of section 897(c)(2); and
(xii) Each note is issued with adequate stated interest (as defined
in section 1274(c)(2)).
(2) No inference. Except as provided in this section, it is assumed
for purposes of the examples that the form of each transaction is
respected for federal tax purposes. No inference is
[[Page 20943]]
intended, however, as to whether any particular note would be respected
as indebtedness or as to whether the form of any particular transaction
described in paragraph (d)(3) of this section would be respected for
federal tax purposes.
(3) Examples. The following examples illustrate the rules of this
section.
Example 1. Distribution of consolidated group debt instrument.
(i) Facts. On Date A in Year 1, DS1 issues DS1 Note to USS1 in a
distribution. On Date B in Year 2, USS1 distributes DS1 Note to FP.
(ii) Analysis. Under Sec. 1.385-1(e), the USS1 consolidated
group is treated as one corporation for purposes of Sec. 1.385-3.
Accordingly, when DS1 issues DS1 Note to USS1 in a distribution, DS1
is not treated as issuing a debt instrument to another member of
DS1's expanded group in a distribution for purposes of Sec. 1.385-
3, and DS1 Note is not treated as stock under Sec. 1.385-3. Under
paragraph (b)(2) of this section, when USS1 distributes DS1 Note to
FP, the USS1 consolidated group is treated as issuing a debt
instrument to FP in a distribution. Accordingly, DS1 Note is treated
as DS1 stock under Sec. 1.385-3(b)(2)(i). For this purpose, DS1
Note is deemed to be exchanged for stock immediately after DS1 Note
is transferred outside of the USS1 consolidated group.
Example 2. Sale of consolidated group debt instrument. (i)
Facts. On Date A in Year 1, DS1 lends $200x to USS1 in exchange for
USS1 Note. On Date B in Year 2, USS1 distributes $200x to FP. On
Date C in Year 2, DS1 sells USS1 Note to FS for $200x.
(ii) Analysis. Under Sec. 1.385-1(e), the USS1 consolidated
group is treated as one corporation for purposes of Sec. 1.385-3.
Accordingly, when USS1 issues USS1 Note to DS1 on Date A in Year 1,
USS1 is not treated as a funded member, and when USS1 distributes
$200x to FP on Date B in Year 2, Sec. 1.385-2(b)(3) does not apply.
Under paragraph (b)(2) of this section, when DS1 sells USS1 Note to
FS, the USS1 consolidated group is treated as issuing USS1 Note to
FS in exchange for $200x on Date C in Year 2. Because USS1 Note was
issued by the USS1 consolidated group to FS within 36 months of the
distribution by the USS1 consolidated group to FP, Sec. 1.385-
3(b)(3)(iv)(B)(1) treats USS1 Note as issued with a principal
purpose of funding that distribution. Accordingly, USS1 Note is a
principal purpose debt instrument that is treated as USS1 stock
under Sec. 1.385-3(b)(3)(ii)(A). Under paragraph (b)(2) of this
section, immediately after USS1 Note is transferred outside of the
USS1 consolidated group, USS1 Note is deemed to be exchanged for
stock.
Example 3. Treatment of exempt consolidated group debt
instrument when a consolidated group member leaves the consolidated
group. (i) Facts. On Date A in Year 1, DS1 issues DS1 Note A to USS1
in a distribution. On Date B in Year 2, USS1 lends $100x to DS1 in
exchange for DS1 Note B. On Date C in Year 4, FP purchases 25
percent of DS1's stock from USS1, resulting in DS1 ceasing to be a
member of the USS1 consolidated group.
(ii) Analysis. (A) Under Sec. 1.385-1(e), the USS1 consolidated
group is treated as one corporation for purposes of Sec. 1.385-3
until Date C in Year 4. Accordingly, when DS1 issues DS1 Note to
USS1 in a distribution on Date A in Year 1, DS1 is not treated as
issuing a debt instrument to a member of DS's expanded group in a
distribution for purposes of Sec. 1.385-3(b)(2), and DS1 Note A is
not treated as stock under Sec. 1.385-3 on Date A in Year 1. DS1
Note A is an exempt consolidated group debt instrument because DS1
Note A is not treated as stock on Date A in Year 1 solely by reason
of Sec. 1.385-1(e). Under paragraph (b)(1)(i) of this section,
immediately after DS1 leaves the USS1 consolidated group, DS1 Note A
is deemed to be exchanged for stock.
(B) DS1 Note B is a non-exempt consolidated group debt
instrument because DS1 Note B, which is issued in exchange for cash,
would not be treated as stock even absent the application of Sec.
1.385-1(e) because there have been no transactions described in
Sec. 1.385-3(b)(3)(ii) that would have been treated as funded by
DS1 Note B in the absence of the application of Sec. 1.385-1(e).
Accordingly, under paragraph (b)(1)(ii)(A) of this section, DS1 Note
B is not treated as stock when DS1 ceases to be a member of the USS1
consolidated group, provided there are no distributions or
acquisitions described in Sec. 1.385-3(b)(3)(ii) by DS1 that occur
later in Year 4 (after Date C).
Example 4. Distribution after a funded consolidated group member
leaves the consolidated group. (i) Facts. The facts are the same as
in Example 3, except that on Date D in Year 6, DS1 distributes $100x
pro rata to its shareholders ($75x to USS1 and $25x to FP).
(ii) Analysis. The per se rule in Sec. 1.385-3(b)(3)(iv)(B)(1)
does not apply to DS1 Note B and the distribution on Date D in Year
6 because under section (b)(1)(ii)(B) of this section, for purposes
of applying Sec. 1.385-3(b)(3)(iv)(B)(1), DS1 Note B is treated as
issued on Date B in Year 2, which is more than 36 months before Date
D in Year 6.
Example 5. Treatment of non-exempt consolidated group debt
instrument when a consolidated group member leaves the group. (i)
Facts. On Date A in Year 1, DS2 lends $100x to DS1 in exchange for
DS1 Note. On Date B in Year 1, DS1 distributes $100x of cash to
USS1. On Date C in Year 1, FP purchases 25 percent of DS2's stock
from DS1, resulting in DS2 ceasing to be a member of the USS1
consolidated group.
(ii) Analysis. After DS2 ceases to be a member of the USS1
consolidated group, DS1 and USS1 continue to be treated as one
corporation under Sec. 1.385-1(e), such that DS1's distribution of
cash to USS1 on Date B in Year 1 continues to be disregarded for
purposes of Sec. 1.385-3. Accordingly, DS1 Note is a non-exempt
consolidated group debt instrument because DS1 Note, which is issued
in exchange for cash, would not be treated as stock even absent the
application of Sec. 1.385-1(e) to DS2, because, taking into account
the continued application of Sec. 1.385-1(e) to USS1 and DS1, DS1
Note does not fund any transaction described in Sec. 1.385-
3(b)(3)(ii). Accordingly, under paragraph (b)(1)(ii)(A) of this
section, DS1 Note is not treated as stock when it ceases to be a
consolidated group debt instrument, provided there are no
distributions or acquisitions described in Sec. 1.385-3(b)(3)(ii)
by DS1 that occur later in Year 1 (after Date C).
(e) Effective/applicability date and transition rules--(1) In
general. This section applies to any debt instrument issued on or after
April 4, 2016, and to any debt instrument treated as issued before
April 4, 2016 as a result of an entity classification election made
under Sec. 301.7701-3 of this chapter that is filed on or after April
4, 2016.
(2) Transition rule for distributions or acquisitions occurring
before April 4, 2016. For purposes of this section, a distribution or
acquisition described in Sec. 1.385-3(b)(3)(ii) that occurs before
April 4, 2016, other than a distribution or acquisition that is treated
as occurring before April 4, 2016 as a result of an entity
classification election made under Sec. 301.7701-3 of this chapter
that is filed on or after April 4, 2016, is not taken into account.
(3) Transition rule for debt instruments that would be treated as
stock prior to the date of publication in the Federal Register of the
Treasury decision adopting this rule as a final regulation. When this
section otherwise would treat a debt instrument as stock prior to the
date of publication in the Federal Register of the Treasury decision
adopting this rule as a final regulation, the debt instrument is
treated as indebtedness until the date that is 90 days after the date
of publication in the Federal Register of the Treasury decision
adopting this rule as a final regulation. To the extent that the debt
instrument described in the preceding sentence is held by a member of
the issuer's expanded group on the date that is 90 days after the date
of publication in the Federal Register of the Treasury decision
adopting this rule as a final regulation, the debt instrument is deemed
to be exchanged for stock on the date that is 90 days after the date of
publication in the Federal Register of the Treasury decision adopting
this rule as a final regulation.
John Dalrymple.
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2016-07425 Filed 4-4-16; 5:00 pm]
BILLING CODE 4830-01-P